This Article advocates for a new approach to incentivizing innovation through the design of ex post tax incentives for research and development (R&D) investment. In contrast to many nations, the United States relies largely on ex ante tax incentives, namely a tax deduction and tax credit for qualified R&D spending. Fundamental design flaws exist with these ex ante incentives; moreover, innovation occurs continuously and yields results at the back end of the innovation cycle. An appropriate framework should take into consideration the key players in the innovation landscape. These players are often treated differently under the tax laws such that incentives for each may be justified. This Article fills a void in the literature, which focuses mostly on ex ante R&D tax incentives, and proposes several new ex post tax incentive options for both corporations and individual inventors. Moreover, this Article redirects the renewed attention focusing on the proper role of government in supporting risky R&D in response to pandemics and the race for future vaccines.
In Attacking Innovation, we forewarned of an innovation crisis in the United States caused, in recent years, by a decline in direct government funding of basic research and a weakening of both the patent system and tax policy tools used to encourage research and development (R&D). Shortly after we called for changes in order to instill confidence in the R&D landscape, the United States was hit with the coronavirus pandemic, the country’s greatest public health crisis in 100 years.
The government’s initial response to the pandemic was to provide direct economic assistance to various sectors of the economy impacted by the pandemic. In addition to delivering cash payments to Americans to prevent a decline in spending, the government offered financial assistance to millions of businesses which would have closed otherwise. The government also provided relief from taxation for these various forms of government assistance.
While many sectors of the health community were also provided resources to contain and combat the virus, the biotechnology and pharmaceutical companies developing a COVID-19 vaccine candidate were largely ignored. While the government provided necessary liquidity for a struggling economy, it did not directly fund vaccine development on a wide scale as was seen in other countries. Indeed, Pfizer announced that it developed its COVID-19 vaccine with its own resources, not U.S. government financial support.
The government relied heavily on private investment in fighting the pandemic. Most notably, the government relied on the strong financial position of big pharmaceutical companies themselves to fund critical R&D. It has been suggested that the “deep pockets” of big pharma were a key to rapid vaccine development. “On average, pharmaceutical companies spend about one-quarter of revenues on R&D.” In addition, the government relied on charitable dollars from private donors to play a role. Philanthropic organizations, such as the Gates Foundation, and individual donors, such as Alibaba founder Jack Ma and country music star Dolly Parton, all contributed to the cause.
To say the government relied solely on private investment to fund vaccine development would be misleading. Historically, the government has funded some basic scientific research, conducted in government and university labs, which may be relied upon by pharmaceutical companies in developing innovative drugs. Indeed, the United States “has invested in basic scientific research” over the years “for a number of reasons[,] including defense, technology development, and health.” And these investments are crucial for generating “hypotheses for understanding the fundamental causes of disease or to developing new technologies.” Thus, while Pfizer argues that it received no financial support for the development of its vaccine, we cannot ignore the fact that the U.S. government has invested in mRNA vaccine technology (via the National Institutes of Health and the Defense Advanced Research Projects Agency) that ultimately allowed companies like Pfizer and Moderna to develop the vaccine as quickly as they did.
In addition, the government occasionally subsidizes drug acquisitions, which provides a market for drug makers. Indeed, in the recent COVID-19 pandemic, the United States purchased millions of doses of vaccines from drug makers in “advance purchase” agreements. So, while private industry bore the costs to produce a vaccine that is cheap, highly effective, and available to everyone in the shortest time possible, the government contributed funds, through Operation Warp Speed, to enable companies to build the capacity to produce millions of doses of their vaccines.
It is hard, however, to measure the impact of these forms of government spending. The role that government-funded basic research actually plays in technology development and health is unclear, as we have seen a dramatic decline in government funding of basic research for quite some time. In the 1960s and 1970s, the government shouldered 70% of the funding for basic research. This amount was cut back to 61% as of 2004, and then again to below 50% in 2013. In 2015, the government provided only 44% of the total amount spent on basic research, or $38 billion. Again in 2017, the number dropped to $34.9 billion. There are some hopeful signs, however, that this decline in investment in pure forms of research may soon end.
In addition, the role that “advance purchase” agreements play in the development of drugs or vaccines is questionable. Indeed, the purchase agreement with Pfizer occurred only after Pfizer had already invested significantly in R&D, and it was one of many supply deals with a number of countries, including the United Kingdom, Canada, Japan, and the European Union. Furthermore, that financial incentive was itself contingent on the success of Pfizer’s research (i.e., receiving Emergency Use Authorization or licensure from the U.S. Food and Drug Administration).
Aside from indirect spending measures, the government has in place two long-standing public policy tools designed to incentivize private investment in R&D. As an ex ante policy tool, the government provides firms an up-front tax incentive—either a tax deduction or tax credit—for qualified R&D spending. In theory, these tax benefits lower the cost of R&D (and increase the expected after-tax return on successful R&D), and firms respond by spending more. Indeed, there is some data and economic research on the tax credit’s effectiveness in increasing research spending by private businesses. As an ex post policy tool, the government provides patent protection for innovative drugs. The government does not provide patent protection for basic scientific research, which explains why private industry does not focus on fundamental discoveries. But the government does grant a 20-year monopoly to the drug companies that develop an innovative drug that relies on that basic research.
These current policy tools (ex ante tax incentive to encourage new R&D followed by ex post patent protection to reward successful R&D) are the bedrock for innovation in the United States. And they are becoming increasingly significant in the wake of declining direct and indirect funding of R&D by the government. Their role has become highlighted in the wake of the recent coronavirus pandemic and in the debate about how to prepare for the next health care crisis. What happens if, during the next epidemic or pandemic, relevant basic scientific research is nonexistent due to both a decline in government funding of such research and a shift in corporate funding from fundamental research to applied research? What happens next time if a few big firms lack the multi-billion-dollar balance sheets and the deep pockets to fund and protect their own research? Or, even if they do have deep pockets, what if they choose not to fund research because the potential rewards fail to justify the spending?
An enhanced patent system is not a likely government response in preparing for the next health crisis. The trend in recent years has been in the opposite direction—to weaken the patent system and “close the door on patent inclusion.” Moreover, some commentators suggest that patent monopolies might not even be justified in times of humanitarian crises and have called for the sharing or pooling of know-how and other intellectual property in such times.
Enhanced tax policy tools to incentivize new R&D, however, should be seriously considered. As history has shown, the government modifies tax laws often as they are important tools for shaping economic behavior. Whenever Congress wants to stimulate the economy, encourage private investment in distressed communities, or reward charitable giving, as just a few examples, it enacts special tax incentives designed to achieve the desired economic outcome. Recent examples of economic or social engineering can be seen in Congress’s immediate response to the coronavirus pandemic. In March 2020, shortly after the pandemic hit the United States, Congress quickly passed several tax law changes to inject liquidity into the economy. Most notably, the economic impact payments that many Americans received were actually in the form of refundable tax credits. Other tax law changes, seemingly enacted overnight, eliminated tax penalties for coronavirus-related distributions and loans from retirement plans, modified tax rules governing discharged loans used for payroll costs, suspended limitations on certain business deductions, and enacted refundable payroll tax credits for employers who retained employees. Congress even changed the charitable tax deduction rules to encourage gifts to charity during the health crisis.
Tax policy tools have several advantages. First, tax incentives for R&D can be designed to be easily accessible by taxpayers. In many cases, a firm merely needs to claim a particular tax benefit on the firm’s annual tax return, and in some cases submit a separate form. There are few hurdles in claiming many tax breaks, which is not the case in receiving other forms of government support. Government grants, for instance, often involve convoluted grant applications, bureaucracy, and long timelines for grant review and award. And patents are expensive, costing thousands of dollars and taking years to receive.
Second, because tax returns are not publicly available, R&D tax incentives are largely invisible rewards for important research. This might be important to some pharmaceutical companies that do not want to be seen as profiting too much from drugs or vaccines, especially in the midst of a health crisis. Even if a drug company sold its vaccine at a price that just covered its costs, an R&D tax incentive, such as a tax credit, would still provide some financial reward to the company unbeknownst to the public.
Third, tax incentives for R&D also provide the added benefit of certainty for firms; a firm should know at the outset whether its R&D spending will qualify for the benefit. Indeed, firms can take available tax incentives into account when setting their annual research budgets and deciding on the research projects to undertake. In contrast, nothing is certain about grants or patent applications.
A final benefit of R&D tax incentives is that they can be designed to benefit both small and large firms alike. In times of health crises, attention usually focuses on the large R&D firms with deep pockets—the giants in the field such as GlaxoSmithKline, Pfizer, Moderna, and Johnson & Johnson (J&J). As noted above, the U.S. government relied heavily on the deep pockets of big pharmaceutical companies to fund Covid-19 vaccine development. But this ignores the important role small biotechnology companies can play in developing the underlying technology, and thus the important role of partnerships between such companies and larger pharmaceutical companies. Indeed, one lesson learned from the coronavirus pandemic is that the government must rely less on large drug manufacturers and look more to smaller biotechnology companies to help develop vaccines. Appropriately designed tax incentives can encourage more small and mid-size firms to work in this space—an environment in which government funding is unreliable and private investors cannot anticipate a return on investment.
One might make the argument that R&D tax incentives are inappropriate—specifically, that they reward spending that would have occurred even without the tax break. This might be true for some R&D spending, for example, R&D directed at producing huge profit-making medications that require daily doses for common ailments and that are wanted by wealthy nations. But this is not true with respect to all R&D spending, especially R&D spending on vaccine development, which can be a long, complex, and costly process. Vaccine development differs from other drug development; with vaccine development, we cannot assume that the market will work. The truth is that vaccine development, especially in the midst of a humanitarian crisis, “hasn’t proved very profitable in the past.” Profitability depends on a number of factors (e.g., production speed, how long immunity lasts, and how many other vaccines are brought to the market). For Pfizer, the first to file for approval of a COVID-19 vaccine, the profits were predicted to be short-lived. While sales potential existed for the first two years, long-term profits were never expected to be dramatic. Indeed in early 2021, just months after its vaccine was approved, the value of Pfizer’s shares fell amid questions about the durability of the market for the vaccine.
The global community has recognized that “market incentives alone are insufficient to produce an adequate supply of R&D, making it crucial for governments to stimulate private R&D spending.” So, too, has the United States. According to the Treasury Department, the current R&D tax credit was designed to address the underinvestment in R&D and to increase the total amount of research activity undertaken in the United States. Why are markets insufficient and why do firms underinvest in R&D? Through the lens of economic theory, firms underinvest in R&D because they cannot capture all the benefits of their private investment due to the spillover effects of research (i.e., the social returns to private spending greatly exceed the average private returns). This excess (the spillover effects or external benefits) takes on the appearance of market failure; specifically, too few resources are being spent on R&D. To remedy this market failure, the government must step in to support R&D. In short, public policy must supplement private investment in R&D.
The question still remains, however, as to the appropriate design of R&D tax incentives. A one-size-fits-all R&D tax break may not be warranted across the innovation spectrum. And that is fine, as tax rules are malleable and can be specifically crafted to target different taxpayers and specific spending. R&D tax incentives can fall on the development side of innovation (ex ante incentives), on the back end of the innovation cycle (ex post incentives), or both. A combination of the two can be a powerful incentive to R&D. Unfortunately, in the United States, individual and corporate inventors have historically benefited from front-end tax incentives only—a tax deduction or tax credit for qualified R&D spending. Back-end tax incentives, in contrast, are used less as a tax policy tool to incentivize or reward R&D. Indeed, corporations do not receive any ex post tax break (e.g., a reduced rate) on income from successful R&D. Individual inventors can qualify for an ex post tax break, but qualification is often difficult due to flaws in the benefit’s design.
In the Tax Cuts and Jobs Act of 2017 (TCJA), Congress eliminated the 100% tax deduction for R&D for research expenditures after 2021 without explanation. The change makes the United States an outlier internationally and reduces its international competitiveness in R&D. Moreover, the TCJA failed to enhance the research tax credit, which some had predicted and argued was necessary to enhance its effectiveness. Indeed, many companies, including pharmaceutical companies, fail to take advantage of the credit either because they do not sufficiently understand its requirements or do not have the necessary documentation to support credit claims. In the wake of the COVID-19 crisis, some have argued that Congress should enhance the research tax credit. Professors Eyal-Cohen and Rutschman, for example, propose purposeful ex ante tax subsidies for vaccine research that can complement ex post intellectual property incentives for vaccine innovation. They suggest, more specifically, combining tax and grant-like mechanisms in the form of tax incentives for a predetermined list of qualified underfunded diseases (i.e., tax credits refundable on a tiered basis for specifically designated underfunded diseases).
In contrast to proposals for enhanced ex ante R&D tax incentives, we explore in this Article the possibility of ex post tax subsidies for R&D to complement other ex post intellectual property and non-intellectual property incentives. Enhanced ex ante R&D tax incentives proposed by commentators would be most effective if paired with a more competitive business tax system, which includes ex post R&D tax incentives. Currently, the government does not provide ex post R&D tax incentives to corporate innovators and provides a very limited ex post R&D tax incentive to individual inventors. We explore here a change to these schemes and recommend several alternative approaches.
To begin with, this Article accepts several premises. No attempt is made here to debate the following, which have previously been vetted in the literature. First, R&D is important to economic growth and building national wealth. Second, government support of R&D is important. Third, government support for R&D can be provided not only directly (e.g., legal protections for intellectual property, grants, direct loans, and loan guarantees), but also indirectly through tax incentives. Fourth, tax incentives for R&D can fall within one of two categories—ex ante incentives and ex post incentives. Finally, because of design flaws in current ex ante R&D tax incentives, ex post R&D tax incentives should play an important role in R&D tax policy.
In exploring options for ex post R&D tax incentives, however, consideration must be given to the key players in the R&D landscape. On the one hand, enterprises play a vital role in facilitating innovations in the workplace, innovations that lead to the procurement of patents and the development and distribution of products in the marketplace. On the other hand, individual inventors play a valuable role in generating ideas, experimenting, and perfecting the ideas that lead to patentable inventions and the development of patented products. Both enterprises and individual inventors are the two inseparable sides of the innovation space. These important, dual roles were evident in the recent COVID-19 vaccination R&D efforts. The researchers at BioNTech and Pfizer perfected their efforts in developing the mRNA vaccines while the corporate enterprises utilized their resources and expertise to conduct testing and obtain necessary regulatory approval in order to finally deliver the vaccines into the arms of the people. Part II of this Article examines these distinct roles, as the tax laws often treat individuals and entities differently.
Part III focuses on corporate players in the R&D landscape. Because no ex post R&D tax incentives are currently available to corporations, Part III explores several options. One possibility is a complete exemption from taxation of intellectual property income. Another is a low effective tax rate applicable to intellectual property income. A third option is postponement, or deferral, of taxation of intellectual property income. While the first two options would face substantial hurdles, the third—deferral of taxation of profits from successful R&D if such profits are reinvested in specifically defined categories of underfunded research—is worthy of serious consideration. Part IV of the Article shifts focus to individual inventors, who play more of a silent role in the R&D landscape. This Part explores the limited ex post tax reward for R&D currently available to certain individual inventors and recommends several changes to enhance the tax benefit. Specifically, Part IV recommends expanding the group of taxpayers eligible for the benefit and adding three additional patent transfers to the list of eligible transactions that qualify.
In the United States, corporations cannot be inventors under patent law. The Supreme Court in Stanford v. Roche Molecular Systems, Inc. emphasized that patents can only be issued to individual inventors. Generally, the named inventors on patents are presumed to be the true and only inventors. Nevertheless, enterprise entities exist as the creators of inventions because they recruit and hire researchers, scientists, and other talent to invent. In turn, their inventor-employees are obliged to assign patents and other intellectual property to the enterprises in accordance with their employment agreements. Routinely, individual inventors’ employers file the patent application and spend resources to prosecute the application. At the end of the prosecution period, if the USPTO grants the patents, the USPTO lists the employer enterprises, not the inventor-employees, as the assignees. Annually, the list of companies with the most patents obtained generates the bragging rights and prestige of being leaders in innovation. Patents are often viewed as the reward for devoting significant investment dollars in R&D by companies. The number of patents granted also represents the fact that these enterprises have cultivated a corporate culture and provided conditions conducive for innovation and the creation of intellectual property.
In startups, founders and employees work tirelessly to reach milestones in order to obtain necessary funding to scale to the next stage. Startups burn cash because they compete at a breakneck pace of innovation to develop their products or services to capture the market. The intellectual property creation and ownership distinguish each startup from the others. In more than 30 innovation centers across the United States, vibrant startups collaborate and compete against one another, shaping, challenging, and realizing impossible dreams. Startup failures and successes produce ideas and knowledge fueling the next layer of collective knowledge enjoyed by all.
Established companies either acquire startups for their new technologies or enter into technology licensing deals with startups. From Microsoft to Facebook, from Google to Apple, from Amazon to eBay (among others), acquisitions of startups are among key corporate transactions that allow big companies to survive and thrive in the marketplace. Simply put, legacy companies often prove too big and too ingrained in their own rhythm in order to continue the dynamic innovations that constantly demand new ideas and present threats to a self-imposed sense of comfort. Fear of oblivion keeps enterprises innovative and surviving, often through technologies obtained from others for subsequent incorporation into their own R&D in the hope of closing the gap between the legacy enterprises and their rivals.
In the biotech industry, companies participate in licensing deals with others for their technologies and products with the desire to augment their R&D and to expand product lines. In many instances, established companies rely on startups for the missing, early-stage innovations. For example, large pharma companies obtain the drug candidates and associated technologies from small biotech companies after Phase II of the drug development cycle. That means the small biotech companies focus on preclinical and Phases I and II discovery before big biotech companies devote their resources to the subsequent clinical studies and regulatory approval process. Small biotech companies, lacking size in commercialization and expertise to navigate through complex regulatory processes, may team up with partners in contract development and manufacturing organizations for opportunities to bring products to market. Other small biotech companies with venture capital backing might take a different and bolder step; the small biotech companies develop their treatments and products through commercialization in a particular niche.
In the biopharma ecosystem, contrary to the perception of innovation at large enterprises, studies demonstrate that big pharma companies actually do not engage all in-house drug development innovation. For instance, only 23% of Pfizer products are in-house and 11% of J&J products are developed by their own scientists. The majority of Pfizer products are originated or developed by other companies. Pfizer’s highest selling product, Prevnar 13 vaccine for pneumococcal disease, is the direct result of Pfizer’s purchase of Wyeth in 2009. Similarly, Pfizer acquired from Warner-Lambert and Onyx Pharmaceuticals the drug palbociclib (Ibrance). Likewise, J&J’s top product, infliximab (Remicade) comes from the monoclonal antibody synthesized by Centocor.
Moreover, with respect to the COVID-19 vaccine development, the collaboration between Pfizer and BioNTech illustrates the current biopharma ecosystem. BioNTech is a young biotech company founded in 2008, having a narrow focus on developing mRNA vaccines. As a new and small enterprise, BioNTech holds no track record of success in its efforts to develop vaccines. BioNTech, nevertheless, possesses expertise in mRNA vaccine development. Additionally, in August 2018, the company entered into a multi-year R&D agreement with Pfizer to develop mRNA-based flu vaccines. When the COVID-19 virus hit Wuhan, China, and spread to other countries, BioNTech raced into action under “Project Lightspeed” in January 2020. Two months later, BioNTech and Pfizer capitalized on their collaboration and devoted their efforts to mRNA vaccine development for COVID-19, as announced to the world in March 2020. BioNTech and Pfizer complemented each other to accelerate the development of the vaccine for the benefit of all.
In summary, big pharma conducts in-house drug development and testing and acquires drugs in preclinical studies from other enterprises. The same approach is also common in big tech. Moreover, innovation occurs at all stages of the R&D process. An understanding of the process of innovation at small and large enterprises in the tech, pharma, and other sectors is necessary if tax policy is to be used effectively as a tool to incentivize innovation.
Individual innovators are the brain ushering companies into competition space, sustaining the gruesome pace, and capturing the unimaginable. Simply put, without the talented individuals in tech, pharma, and other sectors, there will be little to no economic growth and innovation in a particular city, nation, or continent.
Talented employees at companies collaborate and innovate. As companies cultivate a culture that truly fosters creative thinking and values innovation, they must attract and retain talented individuals. Illustratively, among the top 50 companies recognized as “best workplaces for innovators,” the freebies of great snacks and a generous leave policy prove not to be the key determinants. Instead, “offering people time to pursue bold projects (both within and outside their main jobs),” “configuring work spaces” for greater collaboration across teams, placing “premiums on inclusivity,” and “giving people room to fail” are among the main drivers that propel innovations in the workplace. The list of best workplaces includes some familiar and not very familiar names, including 3M, Activision Blizzard, Amazon, AMD, Ansys, Chobani, Compass, Kronos, Procter & Gamble, Reverb, Sephora, Sonatype, Workday, Thorn, and Xinova.
Through collaboration and experimentation, innovators become inventors when their employers file for and subsequently obtain patents. Whether the inventors work at the “Top 50 Best Workplaces for Innovators” or other companies in the United States, the inventors generally do not receive a share in the profit generated from the patents. The rationale for the lack of profit-sharing from patents is that the employer already has provided its employees with the facilities and work environments, in addition to salary and benefits, conducive to innovation. The U.S. approach with respect to the absence of profit-sharing between employers and inventor-employees is similar to that in other Western countries. Consequently, lawsuits demanding a share of the profits from patents brought by employee-inventors against their employers are extraordinarily rare. Likewise, few companies implement special programs rewarding their employee-inventors.
Contrary to U.S. practice, China, a nation with more international patent filings than the United States in recent years, embraces a different approach to employee-inventors and special compensation. Under Chinese law, when employees invent under the scope of employment or use mainly the materials and facilities of the employer, the employer must provide the employee-inventor with reasonable remuneration in accordance with the economic results achieved in association with the invention. The remuneration should not be less than two percent of the annual operating profit generated through the exploitation of the invention or ten percent of the royalties from the licensing of the issued patents.
In U.S. research universities, the university is often the owner of patents based on the efforts of employees engaged in research since the passage of the Bayh-Dole Act in 1980. Universities have adopted policies that require that researchers disclose their inventions, thereby allowing university tech offices to determine whether the university should seek patent protection. Large research universities such as the University of California system, MIT, Stanford, the University of Texas, Johns Hopkins, and Purdue are among the top 100 universities with the most patents in 2020. Inventors at these top universities often receive rewards if their patents are exploited by their universities through licensing deals. For instance, at Stanford University, the inventors receive one-third of the net equity which is the total equity minus 15% of such equity to cover the university’s administrative expenses.
In summary, individual innovators are the true creators of patented inventions. Depending on the workplaces, employees are encouraged to innovate through various incentives. For the innovators who invent, however, they rarely receive a share of profits from their patented inventions under U.S. law and practice.
Corporations (unlike individuals) are taxed at the same rate on all of their income—regardless of the classification of that income. Thus, royalties received from the licensing of a patent are taxed at the same rate as gains realized from the sale of the patent. And both of these are taxed at the same rate as any other category of corporate income received. For example, royalties from the licensing of a patent are taxed the same as rent received from the leasing of a building. And gains realized from the sale of a patent are taxed the same as gains realized from the sale of land.
Historically, the U.S. government has eschewed offering ex post tax rewards to corporations for successful R&D efforts, such as a lower tax rate for patent royalties or patent gains. Instead, the government relies on its ex ante rules—tax deduction or tax credit—to incentivize corporate R&D investment. These ex ante tools, however, have fundamental design flaws that have been highlighted in the literature. For example, the current, immediate tax deduction for R&D spending is slated to expire in 2022; at that point R&D costs will only be deductible ratably over a five-year period. Furthermore, the current tax credit for R&D, while now permanent, is less robust than the R&D tax credit in many other countries. The U.S. tax credit is 20% of qualified R&D spending above a company’s normal level of R&D investment; in contrast, many other countries offer a tax credit greater than 20% (e.g., 25% in Spain and Ireland; 30% in France). In addition, the U.S. credit is incremental (applicable only if the company increases its R&D over time); many other countries, on the other hand, offer a volume-based credit (applicable simply on the volume or amount of qualified R&D spending).
As a backstop to inadequately designed deduction and credit rules, the U.S. government could consider back-end tax incentives for successful R&D. Back-end, or ex post, tax incentives could take one of three forms: (1) complete exemption from taxation of income from intellectual property; (2) imposition of a lower effective tax rate on income from intellectual property; or (3) current deferral (i.e., postponement) of taxation of income from intellectual property. In the current political climate, the first two options may be unrealistic. The third approach for R&D is a novel, but perhaps more realistic, approach.
Corporations first became subject to an entity tax in 1895. The Revenue Act of 1894 imposed a two percent income tax on individuals and corporate income. The 1894 Act was declared unconstitutional a year after its enactment. In 1909, however, corporate taxation arose again. The 1909 Revenue Act imposed a one percent tax on the net income of corporations. The corporate income tax has been in existence ever since, with rate fluctuations over time. Different theories have been used to justify an entity tax on corporations. Under the “natural entity theory,” the corporation is viewed as an entity separate and distinct from its owners, with many of the qualities of natural persons. As the corporation is like a natural person, it should pay tax like a person. The United States is not alone in taxing corporations. Most industrialized countries—indeed all advanced countries that comprise the Organization for Economic Cooperation and Development (OECD)—levy a tax on corporate profits.
The ultimate tax incentive for R&D activity would be total exemption from taxation of income derived from intellectual property—royalties from licensing of successful intellectual property or gains from dispositions of such property. As a general rule, a corporation is taxed on all of its “income,” broadly defined as “undeniable accessions to wealth, clearly realized, and over which the taxpayer has complete dominion.” Although realized income is a broad concept, there are limitations on its meaning. Indeed, Congress has decided, for various policy reasons, to exclude certain types of receipts or benefits from the income tax base. Each statutory exclusion addresses some particular congressional concern or achieves some particular goal.
Many of these statutory exclusions are available to individuals and not corporations. For example, damages received in certain tort actions are excluded from taxation, perhaps reflecting congressional compassion for those who suffer personal physical injury or sickness. Gain from the sale of an individual’s principal residence is excluded, promoting the goal of eliminating tax considerations from the decision to move from one home to another. And certain fringe benefits received by an employee are excluded, in part reflecting congressional concern about administrative convenience.
While many statutory exclusions benefit individual taxpayers, some do benefit corporate taxpayers. Examples include interest on state and local bonds, income from discharge of indebtedness, improvements by lessees on corporate property, and contributions to the capital of corporations, to name a few.
Statutory income exemptions are often designed to encourage certain economic behavior. While an ideal tax system would be neutral in order to avoid unnecessarily shaping economic behavior, this neutrality principle has lost ground over the past half century to what might be termed “social engineering.” Indeed, many tax rules have been enacted to encourage various behaviors; they deliberately attempt to drive economic decision making. A prime example is section 1202 of the Code. It provides taxpayers other than corporations a 100% exclusion for gains recognized with respect to the stock of qualified small business corporations. This exemption was enacted as an incentive for taxpayers to start and invest in certain small businesses. Of course, various requirements must be met to benefit from the 100% exclusion. The stock must be in a company that satisfies an active business requirement, and the stock must be held for more than five years.
A more recent example of social engineering is a new rule relating to investments in qualified opportunity zones, created by the TCJA. The new rule provides tax benefits to taxpayers who realize capital gains and invest them in certain so-called qualified opportunity funds (QOFs) that invest in businesses and real estate located in economically distressed communities. More specifically, if a taxpayer has a capital gain, the taxpayer can defer paying tax on that capital gain by making an investment in a qualified opportunity zone—that is, by making an investment in a QOF within 180 days. The original deferred gain must be recognized in 2026 (or in the year of sale if the QOF investment is sold earlier), providing a healthy amount of deferral. In addition to providing for deferral of the original gain, the rule provides for the exclusion of gain in some cases. Most notably, the appreciation in the QOF investment in excess of the original deferred gain is completely exempt from tax if the taxpayer holds its QOF investment for at least ten years.
The United States could consider enacting something along these lines (the rules for qualified small business investments and QOF investments) for taxpayers with certain R&D investments. A 100% income exclusion for intellectual property income could be designed narrowly to achieve targeted goals and minimize revenue loss for the government. Taxpayers eligible for the exclusion could be limited to companies that engage in original research (and not available to companies that outsource R&D or purchase R&D); the benefit could be geared toward small or large companies. R&D activity eligible for the exclusion could be specified. A list of R&D projects, such as vaccine development, could be targeted for the benefit; alternatively, the exemption could be designed to apply only to registered R&D activities. And the type of intellectual property income exempt from taxation could be specified (e.g., royalties from licensing of intellectual property, gains from the sale of intellectual property, gains from the sales of products whose value lies predominantly in the underlying intellectual property, etc.).
The statutory income exclusion would no doubt be costly for the government, as are most of the statutory exclusions in the Code. Exclusions create what are known as “tax expenditures,” which occur when a special rule causes the government to collect less revenue than it would collect if all net accessions to wealth were taxed. Already federal income tax revenues are reduced by hundreds of billions of dollars annually because of existing tax expenditures. In fact, the ex ante tax incentives (deduction and credit) for R&D represent some of the largest business tax expenditures for the U.S. government. Expensing of R&D expenditures was expected to cost the government $119 billion over the ten-year, 2018–2027 period. The tax credit for R&D was expected to cost the government $163 billion in tax revenues over the same ten-year period. The additional revenue loss from a new intellectual property income exclusion may not be viewed as outweighing its benefit, especially since the government already has two costly tax expenditures to encourage new R&D (i.e., the tax deduction and tax credit referenced earlier). The costs of total exemption may explain why most countries have not adopted such approach.
As an alternative to exempting intellectual property income from taxation, the U.S. government could consider adopting a reduced tax rate on R&D investment returns. The concept is not a new one. Indeed, many countries in recent years have adopted such an approach. In these countries, so-called “patent boxes” or “innovation boxes” basically provide a reduced effective tax rate on income associated with eligible intellectual property. Some of these regimes exempt a certain percentage of income (royalty income, and, in some cases gains from disposition) from qualifying intellectual property, which has the effect of reducing the effective corporate tax rate on that intellectual property. In contrast, some regimes allow certain income from qualifying intellectual property to be taxed at reduced rates.
The United States has yet to follow the global trend and adopt a low tax rate specifically for intellectual property income, although there have been congressional proposals for such a regime. There are several plausible reasons why. First, the government seems stuck on accepting ex ante tax incentives (R&D deduction and credit provisions) as doing a better job of encouraging new R&D; ex post tax incentives (patent box regimes) can be viewed as less effective because they provide benefits for intellectual property already in existence. Second, patent box regimes require new rules and compliance checks which would only further complicate our tax system. Third, patent boxes can result in a “race to the bottom” wherein countries compete to have the lowest rate on intellectual property income. Finally, patent boxes are costly. If the United States adopted a patent box, the regime, considering the large size of the U.S. market, could result in a significant loss of revenue.
In lieu of targeting intellectual property specifically for a special low tax rate, the government could consider adopting, more generally, a reduced tax rate applicable to corporate capital gains. From 1913 (the year of the enactment of the modern income tax) to 1921, the tax laws did not distinguish between gains from the disposition of capital assets and other types of income. Since 1921, however, gains from sales or exchanges of capital assets have been subject to preferential tax rates for individual taxpayers only and not corporate taxpayers. Corporate taxpayers generally have not been allowed preferential tax treatment on capital gains.
Preferential treatment for corporate capital gains would lower the rate of tax on gains recognized on sales of corporate patents but not on royalty income received with respect to corporate patents. That is because, under general characterization principles, the capital gain preference is given only to “sales or exchanges” of “capital assets.” Unless considered inventory, corporate patents would qualify as capital assets and, hence, give rise to capital asset treatment. This lower rate would incentivize risky R&D investment. Indeed, one argument in favor of preferential treatment for capital gains is that the preference reduces a disincentive to risk taking. A company’s patent portfolio, which would be subject to capital asset treatment, reflects risk capital. Taxation of patent gains at the regular corporate income tax rate undermines, rather than incentivizes, risk taking.
A tax rate preference for corporate capital gains generally would amount to an indirect ex post incentive for successful R&D. However, a reduced tax rate on capital gains generally would face the same hurdles as a more targeted rate reduction on intellectual property specifically. The incentive may be viewed as unnecessary, or less effective than ex ante rules, in encouraging new R&D activity. The general rate preference for a corporation’s capital gains over other types of income would only increase the stakes on which intellectual property income qualifies (e.g., what types of intellectual property should qualify and what types of dispositions should qualify), adding additional complexity to the Code and transaction costs for corporate taxpayers. Unless targeted at risky R&D projects, the approach would be extremely costly as a number of non-intellectual property assets and transactions would also qualify for the special treatment.
As a final note, the appropriate tax rate to impose on corporate income has been the subject of fierce debate. Until recently, the United States maintained the same high corporate tax rate for 30 years. During that period, many OECD countries lowered their corporate tax rates in an effort to attract investment. In fact, the average top marginal corporate income tax rate in the OECD dropped from approximately 48% to approximately 25%. Recently, in response, the United States lowered its corporate tax rate from 35% to 21%. Historically, however, the United States has been an outlier when it comes to rate reduction policies. Lowering the rate on intellectual property income, or extending a capital gain rate preference to corporations, seems highly unlikely in the present political climate. Indeed, the Biden Administration has recently proposed to move in the opposite direction—raising the corporate income tax rate as well as the capital gains tax rate applicable to individuals.
In lieu of exempting intellectual property income from taxation or reducing the effective tax rate on such income, the U.S. government could consider a third option—taxation deferral. The income tax is imposed on an annual basis, the tax year. Taxpayers will nearly always be economically advantaged by the deferral of taxable income to a later year. The advantage is a reduction of the taxpayer’s current tax liability, which leaves the taxpayer with the use of its money for a while longer.
Deferral of income reporting is at the heart of tax planning. Indeed, taxpayers often attempt to structure transactions to delay income taxation to a later year. An example is the so-called “installment sale.” If a taxpayer sells a patent for $1,000,000 cash in Year 1, the taxpayer will have to report and pay tax on $1,000,000 of gain in Year 1. However, if a taxpayer sells a patent for $1,000,000 in an installment sale whereby the taxpayer receives $100,000 each year for the next ten years, the taxpayer will report and pay tax on only $100,000 of gain in Year 1, $100,000 in Year 2, and so on. The installment method of reporting, which is sanctioned by the Code, is favorable to taxpayers because it defers tax liability until actual payment (as distinguished from the installment note) is received. It is justified primarily on the basis of taxpayer liquidity.
There are numerous provisions in the Code that sanction deferral of income reporting. Settling on a unified justification for these pro-taxpayer rules is difficult. Some of these deferral rules, also known in tax jargon as “nonrecognition” provisions, are premised on the fact that a taxpayer’s economic position has not substantially changed as a result of the transaction. Consider the formation of a corporation. From a tax perspective, formation of a corporation is essentially a sale or exchange between a corporation and its founding shareholders. The shareholders transfer property (e.g., a highly appreciated patent) to the corporation in return for stock in the corporation; the corporation issues its valuable stock for the property received from the shareholders. In the absence of overriding rules, each party would have to report gain or loss on the exchange. However, Congress has chosen to treat corporate formations as nonrecognition events under certain circumstances. A justification for the approach is that current gain recognition may be inappropriate because the shareholder may have simply changed the form but not the substance of her investment (the shareholder once owned the patent directly but now owns it indirectly through a controlling interest in the corporation).
The tax rules with respect to corporate formations bear a strong similarity to the so-called “like-kind” exchange rules. The Code grants nonrecognition of gain or loss on the exchange of business or investment real property for like-kind business or investment real property. The basic rationale for the rule, as for most nonrecognition provisions, is that the taxpayer has not substantially changed her overall economic position. The investment vehicle may have changed but the substance of the investment remains. Put another way, one might say that the taxpayer has not “cashed in her chips.”
Nonrecognition provisions are generally considered taxpayer friendly. However, there is a catch. Nonrecognition usually means deferral, not exemption, from gain recognition. In the case of a corporate formation, any gain lurking in property transferred to a corporation will be taxed when the taxpayer sells the stock received in exchange. In the case of a like-kind exchange, any gain lurking in property transferred in the exchange will be taxed when the taxpayer sells the property received in the exchange. In short, nonrecognition provisions merely postpone the reporting of gain to a later year when the property received in the transaction is sold or disposed of in a taxable transaction.
In some cases, nonrecognition rules are justified as incentivizing desirable behavior. In the case of corporate formations, discussed above, nonrecognition fosters capital formation, that is, the pooling of money and other productive assets. In a capitalist society, capital formation is a good thing since it generates economic activity leading to profits for investors and jobs for employees.
A recent example of a nonrecognition rule designed to incentivize certain activities is the provision governing investments in qualified opportunity zones, discussed earlier. Basically, investors can defer tax on capital gain by making an investment in a qualified opportunity zone—that is, by making an equity investment in a QOF. The original gain deferred is not recognized until 2026 (or in the year of sale if the QOF investment is sold earlier). The tax benefit—several years of tax deferral—was designed to encourage taxpayers to invest in businesses and real estate located in economically distressed communities.
In addition to providing incentives aimed at encouraging investment in distressed communities, the government has a history of providing incentives aimed at encouraging investment in small businesses. For example, section 1045 of the Code allows the tax-deferred rollover of gain from the sale of stock of one qualified small business into stock of another.
These examples of tax incentives aimed at encouraging investment in distressed communities and in small businesses are more broadly aimed at encouraging economic growth. Most people would agree that R&D investment is equally important to economic growth in this country. R&D activity, with its own positive spillover effects, can lead to technological advances, which can lead to economic growth. Indeed, few would dispute that R&D spending to find a COVID-19 vaccine did more for the economy than many other forms of investment spending. Contextualizing the R&D spending for the COVID-19 vaccine and its impact requires an acknowledgment that without the successful vaccine, people cannot return to work safely in many sectors of the economy. The healthcare cost associated with infection and hospitalization, if there was no COVID-19 vaccine, would continue to escalate. With the success of the COVID-19 vaccine, evidence now demonstrates that vaccinated people receive immediate and measurable health benefits and are more likely to plan for their futures. Overall, the R&D spending for developing the COVID-19 vaccines rescued both life and the economy.
Moreover, as discussed in an earlier section on the collaboration between BioNTech and Pfizer for purpose of illustration, R&D investments by BioNTech occur in the early stage of developing mRNA-based vaccines. As recalled, the subsequent and substantial R&D investments came from Pfizer and were key factors to accelerate the pace of R&D at BioNTech on mRNA for a flu vaccine in 2018. The R&D investments made by Pfizer for the mRNA vaccine for COVID-19, as well as the subsequent clinical phases and regulatory submissions, were both enormous and risky. Overall, the R&D spending and risks associated with developing a new mRNA vaccine in response to a rapidly ravaging pandemic beg the question on the adequacy of incentivizing innovations.
For these reasons, this Article proposes a new incentive regime—specifically, deferral of taxation of profits from successful R&D if such profits are reinvested in further R&D. Profits eligible for deferral could include either royalties from the licensing of self-developed patents or gains from the sale of self-developed patents, or both. The types of patents eligible for tax deferral could be limited to vaccine development and related disease diagnosis and treatments. In light of the rapid mutations of the coronavirus, the new normal now includes living with new variants of coronavirus. The new normal will require the development of vaccines against these new variants and treatments of associated diseases for the foreseeable future. This recognition provides the rationale for limiting the types of patents eligible for tax deferral.
The incentive regime should reward and encourage similar collaborations as seen in the partnership between BioNTech and Pfizer. The incentives should benefit both small biotech companies where innovations occur and large pharma companies who direct resources to small biotech companies for specialized R&D. Without the resources from large companies directed to small biotech companies under contractual agreements, innovation stagnation will result, and drug candidates will fail to reach late stages of clinical development.
Likewise, if large companies obtain technologies and know-how whether through purchases or licenses, the acquirers should still receive some benefits under the incentive regime, as long as the acquirers continue and further their R&D efforts. The burden is on the acquirers to demonstrate that they are actually spending on additional R&D to bring the products to market. As we have seen, there are high risks in racing to conduct the late phases of clinical trials and obtain regulatory approval for COVID-19 vaccines. The incentive regime must recognize and encourage such risks.
Eligible intellectual property income or gains would be tax-deferred only if rolled over or reinvested within so many days (say 180 days) in qualified R&D investment activities or funds. Of course, qualified R&D reinvestment activities or funds would have to be specified, but such reinvestment could include not only direct investment in the taxpayer’s own R&D but also investments in qualified R&D funds set up by universities and foundations that engage in important basic research. The option to roll over the income and gains from intellectual property into basic research efforts is vital as U.S. government support for basic research has dwindled in recent years; yet, as we just learned with the COVID-19 vaccines, basic research is an essential part of the overall R&D landscape.
A tax deferral regime for R&D income may be less costly for the government than the other two options discussed above (the complete tax exemption of income from intellectual property or a lower effective tax rate on such income). The period of deferral should be specified and could be limited as is the case with the deferral regime governing qualified opportunity zones; recall from above that taxation of capital gains invested in a QOF is deferred for a set number of years (until 2026). Deferral would not necessarily have to be limited, however. In other words, taxation of qualified intellectual property income could be deferred until the taxpayer sells its investment in the R&D activity or fund, in other words, cashes in its chips.
In contrast to the other options, a tax deferral regime would also ensure continued investment in R&D activity. A rule completely excluding R&D income from taxation, or a rule lowering the effective tax rate on R&D income, provides no guarantee that a beneficiary taxpayer will continue to engage in valuable R&D activity or reinvest R&D gains in other R&D efforts. One can speculate that an income exemption or a lower effective tax rate on R&D gains would encourage firms to respond by investing more in R&D. But only a deferral tax regime would mandate that result in order for the regime’s benefits to accrue to a taxpayer.
As noted earlier, corporate taxpayers do not receive preferential tax treatment for their capital gains; individual taxpayers, in contrast, generally do. But individuals must satisfy the requirements of either (1) the general characterization provisions in the Code or (2) some special characterization provision in the Code, which trumps the general characterization provisions.
By the mid-twentieth century, amateur inventors (but not professional inventors) had both tools at their disposal. Sales of their patents qualified as “sales or exchanges” of “capital assets” and, thus, qualified for preferential capital asset treatment under general characterization principles. Moreover, a special characterization provision enacted in 1954, section 1235, guaranteed capital asset treatment to individual inventors (both amateur and professional inventors) who did not meet the requirements under the general characterization provisions, provided such individuals satisfied certain statutory and administrative requirements.
In 2018, in a remarkable shift in tax policy, Congress made individual inventors ineligible for capital asset treatment under long-standing general characterization rules in the Code. Specifically, the TCJA amended the “capital asset” definition to exclude self-created patents and similar property. Under the act, a patent, invention, model or design (patented or not), or secret formula or process is not a capital asset in the hands of the taxpayer whose personal efforts created the property. Thus, gains from the sale of self-created patents and similar property are no longer eligible for preferential capital asset treatment under general characterization principles.
Interestingly, when Congress removed self-created patents and inventions from capital asset characterization, it failed to repeal section 1235. As noted above, section 1235 is a special characterization provision that acts like a safe harbor for certain patent dispositions by individuals. When it applies, it provides statutory assurance to certain inventors that the sale of their inventions will qualify for reduced capital gains rates, as opposed to ordinary income tax rates, even if the sale would otherwise fail to qualify under general characterization principles (e.g., the transferor is a professional inventor or the invention has been held for less than one year).
If section 1235 had been repealed in 2018, then individual inventors would have absolutely no chance of receiving capital asset treatment on their gains. But Congress kept it. And, thus, as the only ex post tax incentive for R&D, the special characterization rule has taken on a more significant role in R&D tax policy.
By allowing individuals to qualify for capital asset treatment on the sale of their inventions, Congress intended to encourage R&D that potentially leads to patentable inventions. Indeed, a stated policy goal underlying section 1235’s enactment was “to provide an incentive to inventors to contribute to the welfare of the Nation.” Unfortunately, section 1235’s design limits its effectiveness. For instance, the rule applies only to transfers of “all substantial rights” to a patent, which, for example, does not include grants that are limited geographically or grants that are limited to fields of use within particular trades or industries. Further, the rule’s favorable capital asset treatment applies only if the transferor is a “holder” of the patent, defined narrowly as any individual whose personal efforts created the property and who would qualify as the “original and first” inventor under the patent laws. In many cases, these and other hurdles to capital asset treatment can be insurmountable.
In light of section 1235’s design flaws, yet increased significance as an R&D tax policy tool after the TCJA, Congress should consider design enhancements. Recommended below are several suggestions to expand the scope of section 1235 to cover more taxpayers and more patent transactions in the hopes of achieving the provision’s original goals of incentivizing R&D activity and harmonizing ex ante and ex post R&D tax incentives.
Section 1235’s favorable capital asset treatment applies only if the taxpayer-transferor is a statutorily defined “holder” of the patent. The holder of a patent is defined narrowly as (1) any individual whose personal efforts created the patent property and who would qualify as the “original and first” inventor, or joint inventor, under the patent laws or (2) any other individual who acquired his or her interest in the patent property from the original inventor in exchange for money or money’s worth prior to the actual reduction to practice of the invention covered by the patent (e.g., a “financial backer”). There are several problems with this narrow construct of who can benefit from the special rule.
As an initial observation, only individuals can qualify for section 1235’s safe harbor treatment. Startup companies and small research entities whose employees conduct their research do not qualify. This is ironic since such companies are critical to economic growth in the United States; indeed they constitute 51% of firms engaged in innovation. Technology-based startups are particularly important, as they account for more than 70% of business R&D investment and nearly 60% of R&D jobs in the United States. Recently Congress expanded the R&D tax credit for startups and small businesses. Expanding section 1235’s scope to cover such entities would better align front-end and back-end R&D tax incentives. Of course, guaranteeing capital asset treatment for corporate startups under section 1235 would be irrelevant for tax rate purposes, as all corporate income (both ordinary income and capital gain income) is currently taxed at the same rate. Nevertheless, capital asset treatment is often sought by companies since their capital losses are deductible in any given year only to the extent of their capital gains. In other words, to the extent company income is characterized as capital gain, any capital losses the company might possess will offset that income.
A significant anomaly with section 1235 as currently designed is that an inventor’s employer, even if an individual, does not qualify for the provision’s special capital asset treatment. As noted earlier, an individual qualifies if his personal efforts created the patent property and he would qualify as the “original and first” inventor under the patent laws. Under this approach, an inventor’s employer would not qualify “even though he may be the equitable owner of the patent by virtue of an employment relationship with the inventor.” Also as noted, a financial backer can qualify. However, the statute makes clear that a financial backer cannot be the employer of the inventor nor be related to him or her.
Excluding employers from section 1235’s benefit seems incongruous with present ex ante R&D tax incentives for such employers. Indeed, both the R&D tax deduction and tax credit become available to employers whose employees invent. Qualified research expenses eligible for the tax credit, for instance, include in-house research expenses, which include wages paid to an employee for qualified services performed by such an employee. Expanding section 1235 to apply to an inventor’s employer would provide harmony between ex ante and ex post R&D tax incentives.
More importantly, excluding employers from section 1235’s safe harbor treatment ignores the fundamental patent law relating to inventorship and the relationship between inventor-employees and their employers. As explained by the Supreme Court in Stanford v. Roche Molecular Systems, Inc., inventors under patent law are individuals; therefore, the USPTO can only grant patents to individuals, not entities. Individual inventors today are typically employed at small and large companies, and they are hired to invent. Under employment agreements or handbooks, individual inventors assign their patents and all other types of intellectual property to their employers because the employers have already compensated the employees for their efforts. Through collaboration in the workplace and the use of the employer’s facilities, the employees disclose their inventions to the employer. Thereafter, the employers spend financial resources to prosecute and procure the patent applications upon the employee’s disclosure and cooperation. The patents are subsequently issued by the USPTO with the employees listed as inventors and the employers as assignees. Unquestionably, the employers arise as the equitable owners of the patents and should be qualified for section 1235 treatment.
Illustratively, IBM has led among all companies in the number of patents issued by the USPTO for several decades. IBM’s researchers are the inventors, and IBM is the assignee on all the patents. IBM, as the employer, owns the patents under patent law, not the inventors. Moreover, according to normative transactions, third parties negotiate for purchases or licenses to use the patents with IBM, not IBM’s inventors, because IBM stands as the rightful owner of the patents. Whenever an infringement action occurs, IBM and not the inventors decide whether to bring an infringement action and whether to settle any lawsuit. Similarly, in a university setting, the researchers receive a salary and use university facilities to conduct extensive experiments that may lead to patents. University technology offices often prosecute the patent applications, which list the researchers as inventors and the universities as assignees. The universities then negotiate license deals and share some of the profits generated from the licensed patents with the inventors. Clearly, universities should not be excluded from section 1235 treatment; but because most universities are tax-exempt entities, any issue related to capital asset treatment is irrelevant. Nevertheless, the norms of understanding with respect to the original owners of patents in the employment context are well established: the employers are the original and equitable owners. Accordingly, the employers should be included within the scope of section 1235 treatment.
Equally problematic to the fact that employers currently do not qualify for section 1235 treatment is the fact that many of their employees who invent also fail to qualify. As a general rule, section 1235 does not apply to a transfer by an employee to an employer of the rights to any invention by such employee if the transfer was in exchange for compensation pursuant to an employment contract. The reason for this exception is that an employee who is hired by an employer to invent cannot make a transfer of inventions in which he or she has no rights. An employee paid by an employer to invent receives compensation for services rendered (taxable as ordinary income), and not consideration for the assignment of inventions constituting capital assets (taxable as capital gains under section 1235).
This presents an interesting double-whammy in hired-to-invent situations. An employee hired to invent cannot benefit from the section 1235 tax incentive, and as discussed above, the inventor’s employer cannot benefit from section 1235 either. The contractual arrangement is quite common in the current innovation landscape, but the tax system’s only ex post R&D tax incentive fails to apply to either player.
The rule for employees also creates added complexities to the tax regime and raises potential factual disputes between taxpayers and the government. Whether payment received by an inventor-employee from his or her employer is treated as compensation for service rendered by the employee or as proceeds derived from the transfer of patent rights is, of course, a question of fact. Consideration is given to not only all of the facts and circumstances of the employment relationship but also whether the amount of such payments depends upon the production, sale, or use by, or the value to, the employer of the patent rights transferred by the employee. If an employee shares in the proceeds from the sale or licensing of the patent and receives a percentage of royalties in addition to wages, courts are likely to treat the payments as consideration for the transfer of patent rights, thereby entitling the employee to capital asset treatment under section 1235. If, however, an employee is to receive a fixed salary or a percentage of the employer’s earnings regardless of whether the patented invention is licensed or sold, courts are likely to treat the amounts received as compensation for services taxable as ordinary income.
In determining whether an inventor-employee was “hired to invent,” courts look closely at whether payments to the employee are a function of his or her services. If the contract contains no provision for services to be rendered or provides that the employee is required to render only advisory services incidental to the transfer (perhaps because the patented invention is technical or intricate), courts are likely to determine that payments received are attributable to the sale of patent rights rather than compensation for services. On the other hand, if the employment agreement requires the employee to assign patented inventions to the employer and does not obligate the employer to pay for the patented inventions, later payments may be viewed as an award or compensation for the employee’s continuing contributions to the employer as part of his or her employment. If the employment agreement provides that no further consideration is due to the employee for inventions developed during employment, then payment received is not based on the value of the invention to the employer. Nevertheless, in some cases, courts find that payments received are both partially attributable to the sale of patent rights (capital gain) and partially represent compensation for services rendered (ordinary income).
There are many “ifs” in the analysis just described, which creates uncertainty for employees engaged in valuable R&D. As illustrated, numerous courts have had to address section 1235’s application to employees, even in recent years. Additionally, the government must provide administrative guidance. Consequently, the rule can produce unexpected tax consequences. For example, section 1235 may apply to university employees who transfer patent rights to their employer-universities in exchange for a percentage of the employer’s future licensing revenue (that is, a royalty sharing agreement or RSA). But when payments from an RSA are made to the employee’s “research account,” unexpected tax results may occur. Current advice to tax planners is that university agreements with faculty members should be reviewed to determine whether they meet the requirements under section 1235 for capital asset treatment.
In sum, a solution to the concerns raised here would be to expand section 1235’s application beyond the current, limited category of beneficiaries. Consideration could be given to extending its application to non-individual creators, including employers who have “equitable” ownership of patents. Consideration could also be given to extending its application to employees who are hired to invent. In extending section 1235’s capital asset treatment to both employers and employees with respect to revenue generated from patents, the regime would recognize that the individuals who invent and the entities that enable patented inventions should be rewarded. Additionally, in light of China’s patent law favoring employee-inventors with statutory remuneration to promote innovations in China, our proposed solution of expanding section 1235 to cover both employer and employee-inventors would situate the United States in a more competitive position in the current global tech war.
Section 1235 applies only to a transfer of all substantial rights to a patent or an undivided interest therein. The term “all substantial rights” is limited and refers to all rights (whether or not then held by the grantor) that are of value at the time the rights to the patent (or an undivided interest in it) are transferred. There are some transfers that logically should not fit the definition, and, thus, should not be eligible for capital asset treatment. For example, the grant of a patent that is limited in duration by the terms of the agreement to a period less than the remaining life of the patent does not, and should not, qualify. Likewise, the grant of less than all the claims or inventions covered by the patent that exists and possesses value at the time of the grant does not, and should not, qualify. And, no one would disagree that a transfer in which the grantor retained the right to terminate or revoke the transfer at will should not qualify.
Nevertheless, there are several patent transfers that presently do not qualify for section 1235 treatment, but that, in our opinion, should qualify. These include (1) the grant of a patent in which nonexclusive rights are outstanding; (2) the grant of a patent that is limited geographically within the country of issuance; and (3) the grant of a patent that is limited to fields of use within particular trades or industries. Each is considered below.
It is well settled that section 1235 does not apply to the transfer of all patent rights held by the transferor if there are nonexclusive rights in the patent that are outstanding. The reason is because the Treasury regulations clearly provide that “all substantial rights to a patent” means “all rights (whether or not then held by the grantor) that are of value at the time the rights to the patent are transferred.”
Courts that have directly considered the issue have concluded that a prior license (whether exclusive or nonexclusive) constituted a substantial right such that the licensor could not be said to have transferred all substantial rights in a subsequent conveyance subject to the earlier license. In Blake v. Commissioner, the Sixth Circuit held that section 1235 did not apply to a transfer of rights in remaining fields of use after a prior transfer (exclusive license subject to a field-of-use restriction) to the same transferee. The Sixth Circuit ruled that under section 1235, “all substantial rights” means all rights then in existence, whether or not held by the transferor. In First National Trust & Savings Bank of San Diego v. United States, the district court similarly concluded that section 1235 did not apply to a second transfer of bifurcated patent rights. According to the court:
The conveyance of a nonexclusive license . . . is not a transfer of a capital asset; nor, in our opinion, is a subsequent transfer of a so-called exclusive license of the same rights, but subject to the first license. That the end result of such latter conveyance may accomplish a divestiture of all substantial rights which the transferor had in the patent at the time, is not the proper criterion.
The Tax Court once questioned the validity of the Regulation and this approach. The Service, however, has made clear that the Regulation is controlling for purposes of section 1235, and caselaw, as discussed above, has sanctioned that approach. Under present law, for section 1235 to apply there must be a transfer of all substantial rights to the patent, not only those rights held by the transferor immediately prior to the conveyance.
The scope of section 1235 should be expanded to cover complete transfers of patents even if subject to a nonexclusive license. It is not uncommon for an outstanding license to already exist at the time a transferor wishes to convey all remaining rights to another party (subject to the previous agreement). Moreover, in recent years, the practice of patent transfers subject to outstanding nonexclusive licenses has become the tech industry norm. Illustratively, there are more than 1,400 tech companies that have joined the License on Transfer (LOT) Network. Google, Canon, SAP, Newegg, Dropbox, and Asana are examples of companies that have joined the LOT Network and listed 300,000 patents into the LOT portfolio. As members of LOT, whenever another member sells or transfers a patent to a third party, the transaction is subject to a license of the transferred patent to all the members. The reason for such a patent-transfer-subject-to-license scheme is that LOT members want to avoid lawsuits brought by third parties who are patent assertion entities (PAEs). PAEs are known to demand payments through asserting patent infringement suits against tech companies causing companies to incur large litigation costs. The Federal Trade Commission’s PAE Study reveals that “nuisance infringement litigation [brought by some PAEs] can tax judicial resources and divert attention away from productive business behavior.” Accordingly, to act collectively against PAEs who acquire patents through purchases and transfers from a member of the LOT Network, the other members of LOT enjoy automatic immunity against the acquirer’s lawsuits involving the transferred patent for the life of that patent.
In short, section 1235 should apply if a taxpayer is transferring all the rights it holds at the time of conveyance. The fact that the taxpayer previously granted nonexclusive rights to someone else should not matter. The same approach should apply if the taxpayer acquired the patent already subject to a nonexclusive license and the taxpayer otherwise satisfies the requirements of section 1235.
Support for our recommendation can be found in the legislative history to section 1235. According to the legislative history, the “all substantial rights” test of section 1235 “recognizes the basic criteria of a ‘sale or exchange’ under existing law” (i.e., general characterization provisions). Interestingly, under the general characterization provisions of the Code, transfers of patents already subject to a nonexclusive license do qualify for “sale or exchange” treatment. In MacDonald v. Commissioner, the Tax Court held that the transfer of all the rights a taxpayer ever held in a patent, but did not include all then existing rights in the patent because the patent was already subject to a nonexclusive license, may qualify for capital asset treatment under the general characterization provisions of the Code. In Revenue Ruling 78-328, the Service addressed a situation similar to that in MacDonald and held that a transfer could qualify for capital asset treatment under general characterization provisions. The Service noted that the transferor acquired the patent already subject to a license, transferred no interest in the patent prior to its sale, and thus transferred all the rights it had ever held in the patent.
If a preexisting nonexclusive license is not fatal in satisfying the “sale or exchange” requirement under general characterization principles, it should not be fatal in obtaining capital asset treatment under section 1235. This is especially true as the legislative history suggests that the transfer of “all substantial rights” should equate to a “sale or exchange” under general characterization principles.
Under current Treasury regulations, patent transfers that are limited geographically within the country of issuance do not qualify for capital asset treatment under section 1235. The Tax Court in Keuneman v. Commissioner reversed its earlier decision in Rodgers v. Commissioner, which had held that the regulation involving geographical limitations was invalid. Thus, a transfer subject to a geographical limitation will not qualify for section 1235 treatment.
This approach, however, fails to recognize realities in the patent marketplace. Grants with geographical restrictions reflect the understanding of both the grantor and the grantee that the grantee’s capability to use and commercialize the patent may be limited to a particular geographical territory. The grantor may want to transfer the technology to multiple grantees, each of whom can maximize the value of the patent in a particular territory. Similarly, a grantee does not want to acquire all of the rights under the patent if the grantee does not have the capacity and feasibility to exploit the patent outside a particular territory.
Moreover, the Federal Circuit in Rite-Hite Corp. v. Kelley Co., Inc. recognized that “a conveyance of legal title” by the patent owner “can be made only of the entire patent, an undivided part or share of the entire patent, or all rights under the patent in a specified geographical region of the United States.” All three types of transfers would entitle the assignees to sue others for patent infringement. In reaching its decision, the Federal Circuit relied on the Supreme Court’s famous opinion in Waterman v. Mackenzie decided in 1891. The Waterman court recognized the transfer of a patent subject to geographical restrictions as an assignment of legal title in the patent and further recognized that the transferee could bring an infringement suit without joining the transferor. In light of the patent marketplace and patent law, transfers subject to a geographical limitations should be within the scope of section 1235 treatment.
Regulatory restrictions on geographical limitations is also inconsistent with the approach taken under the general characterization provisions of the Code. Prior to the enactment of section 1235 in 1954, courts concluded that transfers with geographical limitations could qualify for “sale or exchange” treatment so long as the entire bundle of rights regarding such geographical designation were transferred. In Watson v. United States, for instance, the Tenth Circuit noted that “[i]t is a firmly accepted principle of law that if the patentee conveys by an instrument in writing the exclusive right to make, use, and vend the invention . . . within a specified area within the United States, the conveyance constitutes an assignment of the patent” eligible for capital asset treatment.
If a geographical limitation does not preclude capital asset treatment under general characterization principles, we see no reason it should preclude capital asset treatment under section 1235. This is especially true now after the TCJA, which left section 1235 as the only ex post tax incentive for individual inventors.
It is not uncommon for a patent transfer to include a field-of-use limitation (i.e., a restriction that the patent granted can only be used by the transferee in a certain industry). Section 1235 generally does not apply to such transfers.
Field-of-use limitations have generated considerable, and conflicting, litigation. For example, in Rouverol v. Commissioner, a 1964 decision, the Tax Court held that a transfer of the exclusive rights in one field of use qualified for section 1235 treatment (i.e., constituted a transfer of all substantial rights in that field). Five years later, in Fawick v. Commissioner, the Tax Court followed its earlier decision in Rouverol. The Sixth Circuit, however, soon reversed the Tax Court’s Fawick decision. A few years later, the Ninth Circuit agreed with the Sixth Circuit in Mros v. Commissioner. In a more recent case, Spiereas v. Commissioner, the Third Circuit affirmed a Tax Court decision holding that a transfer that dealt with only the pharmaceutical field of use (and not other fields of use) did not qualify for capital asset treatment under section 1235.
In our opinion, field-of-use limitations can be compared to geographical limitations, discussed above. Neither should be fatal in obtaining section 1235 capital asset treatment so long as the transferor has transferred the right to make, use, and sell within that field of use. Moreover, transfers with field-of-use limitations are beneficial to both the grantor and grantee because both recognize that the field-of-use restrictions are useful for technology that may contain multiple and distinct usages. The grantor transfers its rights in a particular field of use, enabling the grantee to acquire exactly what is needed for a distinct area of technology or research. In other words, transfers with field-of-use restrictions reduce waste. Further, other scholars have noted that a field-of-use limitation might incentivize investment in a particular niche technology by small enterprises that do not possess the necessary resources to “risk their startup costs if an established firm were already in the field.” Such transfers should be encouraged, not penalized, under section 1235.
Interestingly, under the general characterization provisions of the Code, a patent transfer with a field-of-use restriction may qualify as a “sale or exchange.” Indeed, prior to section 1235’s enactment, courts held that transfers of patents broken into different fields of use could enjoy capital asset treatment under general characterization principles (provided the transferors conveyed the right to make, use, and sell).
Unfortunately, and as noted previously, general characterization provisions of the Code no longer allow capital asset treatment for individual inventors. The reason is because self-created patents and inventions are not considered capital assets in their hands, a prerequisite for capital asset treatment under the general characterization rules. Section 1235 is their only path to capital asset treatment and should, thus, be expanded to cover transfers of patents that have been divided into different fields of use.
In contrast to most industrialized nations, the United States has never fully embraced the use of ex post tax incentives for R&D efforts. Instead, the chosen tax policy tool to incentivize risky R&D investments in the United States exemplifies an ex ante incentive—the current tax credit for incremental increases in qualified R&D spending. In light of fundamental design flaws with ex ante incentives, consideration should be given to rewarding risky R&D investment on the back end of the innovation cycle. An appropriate framework should take into consideration the key players in the R&D landscape—not only the giant corporate entities, such as those receiving credit for the COVID-19 vaccine, but also individual inventors who often work quietly behind the scene on research. Because these players are often treated differently under the tax laws, different R&D tax incentives may be justified for each. Moreover, with the new R&D tax incentives, the United States would provide additional encouragements to innovations by individuals that may position the country on a better footing in the current global tech war with China, whose patent law bestows statutory remuneration to individuals based on the employer’s exploitation of an employee’s patents.
Professor Nguyen expresses her appreciation and joy of working with Professor Maine on their numerous Taxation of IP & Innovation projects. She wishes to thank Michelle Swinney for her superb editing assistance.
Professor Maine gives special thanks to Professor Nguyen for the wonderful journey into intellectual property taxation. He wishes to thank Colin Casey for his valuable research assistance.
