The US Court of Appeals for the Ninth Circuit held that patent royalties were not capital gains for tax purposes when the patentee retained effective control over the corporate recipient of the patents, since the patentee could retrieve the patent rights and had therefore not transferred “all substantial rights” to the patents. Cooper v. Commissioner of Internal Revenue, Case No. 15-70863 (9th Cir., Dec. 15, 2017) (Graber, J) (Kleinfeld, J, dissenting in part).

James Cooper is an inventor of more than 75 US patents related to the transmission of audio and visual signals. His patents generated significant royalties, and Cooper sought favorable tax treatment on those royalties by transferring all formal rights in the patents to Technology Licensing Corporation (TLC).

Under 26 USC § 1235(a), if a patent holder transfers “all substantial rights” to a patent, then the resulting royalty payments qualify as capital gains. However, a patent holder that retains control over the recipient of the patents has not transferred “all substantial rights,” and the resulting royalties are taxed as ordinary income, not as capital gains.

Cooper structured ownership of TLC in a way that eliminated his formal control over the patents. Cooper owned only 24 percent of TLC. In contrast, his sister-in-law, Lois Walters, and a long-time friend, Janet Coulter, together owned 76 percent of TLC. Neither had prior experience in patent licensing or patent commercialization. Each retained full-time jobs unrelated to TLC. Cooper then transferred to TLC all rights to certain patents in exchange for royalty payments. Cooper claimed that the royalty payments qualified as capital gains. The Internal Revenue Service Commissioner and the Tax Court (after litigation) disagreed. Cooper appealed.

The Ninth Circuit found that the patent royalties did not qualify as capital gains because Cooper retained effective control over TLC and therefore had not transferred “all substantial rights” to the patents. The Court agreed that Cooper did not have formal control over TLC but explained that a “bedrock principle of tax law” is that “substance controls over form.” The real issue was whether there was an actual transfer of the patent rights.

Here, the Ninth Circuit determined there was no actual transfer. At TLC, Walters and Coulter followed Cooper’s directions and did not exercise independent judgment. Cooper made all of the decisions regarding patent licensing, infringement and transfers. Cooper therefore retained effective—albeit informal—control over TLC.

A key factor in the Court’s analysis was that Cooper retained the right to terminate the transfer at will. Cooper exercised this right for some of the transferred patents. TLC had returned certain patents to Cooper for no consideration, even though the patents had commercial value. The Court therefore affirmed the Tax Court’s determination that the patent royalties were not entitled to capital gains treatment.