PRIVILEGED AND CONFIDENTIAL — ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP 599 Lexington Avenue, 36th Floor New York, NY 10022
INTERNAL RESEARCH MEMORANDUM
Date: March 18, 2024 Matter Number: 1037-00007
To: Sylvia Hartwell, Partner (Tax)
From: Leila Nazari, Senior Associate (Tax), and Robert Jansen, Associate (Tax)
Re: IRC § 367(d) and § 482 Analysis — Outbound IP Transfer from Solstice Medical Technologies Inc. to Solstice IP Holdings DAC
Reviewed by: Sylvia Hartwell
CONFIDENTIALITY NOTICE: This memorandum is prepared in connection with the rendering of legal advice and is protected by attorney-client privilege and work product doctrine. It should not be disclosed to any person outside Calderwood & Harkness LLP without the prior written consent of the responsible partner. This memorandum is intended solely for internal use by the attorneys and staff of Calderwood & Harkness LLP working on the above-referenced matter. Any unauthorized disclosure, copying, or distribution of this memorandum is strictly prohibited.
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I. Executive Summary
This memorandum analyzes the United States federal income tax consequences under Internal Revenue Code ("IRC" or "Code") §§ 367(d) and 482 of the proposed outbound transfer of certain intellectual property assets (the "IP Portfolio") from Solstice Medical Technologies Inc. ("SMT Inc."), a Delaware C-corporation (EIN 84-3291507; Delaware File No. 7482916), to Solstice IP Holdings Designated Activity Company ("SIP Holdings" or "SIPH"), an Irish designated activity company (CRO No. 714538), a related foreign corporation wholly owned by Solstice Biomedical Devices Ltd. ("SBD"), the Irish parent entity (CRO No. 587241).
The IP Portfolio to be transferred encompasses forty-seven (47) granted United States utility patents, twelve (12) pending United States patent applications, and associated trade secrets, technical know-how, engineering drawings, manufacturing process documentation, and proprietary software algorithms. The transferred IP relates principally to SMT Inc.'s "NaviPulse" catheter guidance platform and "ClearVue" intra-operative cardiac imaging system, which together constitute the core technology underlying the Solstice group's product portfolio.
The key financial parameters underlying this analysis are as follows:
• Fair Market Value of IP Portfolio: $214.5 million, as determined by Whitmore Valuation Advisors LLC ("WVA") in its draft valuation report (report number WVA-2023-1187), dated January 29, 2024, employing an income-approach discounted cash flow ("DCF") methodology with a weighted average cost of capital ("WACC") of 13.5%.
• Adjusted US Tax Basis: $11.3 million on the books of SMT Inc., the IP having been substantially fully amortized or expensed.
• Built-in Gain: $203.2 million ($214.5 million fair market value less $11.3 million adjusted basis).
• Arm's-Length Royalty Rate: 8.0% of net sales, as benchmarked by WVA through comparable uncontrolled transaction ("CUT") analysis.
• Projected Year 1 Royalty Stream: $15.136 million, calculated as $189.2 million in projected Year 1 net sales multiplied by the 8.0% royalty rate.
• Remaining Weighted-Average Useful Life: 12.8 years, as determined by WVA.
The proposed transaction is structured as follows: SIP Holdings will acquire the entire IP Portfolio from SMT Inc. for a purchase price of $214.5 million. The purchase price will be funded through a combination of an intercompany loan from SBD to SIP Holdings in the amount of €180.0 million (approximately $196.2 million at a spot exchange rate of €1 = $1.09) and an equity or capital contribution from SBD to SIP Holdings of approximately €16.7 million. Following the acquisition, SIP Holdings will license the IP back to SMT Inc. pursuant to an exclusive License-Back Agreement for North American exploitation at an arm's-length royalty rate of 8.0% of net sales, and will enter into separate license agreements with SBD and other group entities for rest-of-world exploitation at royalty rates ranging from 4.0% to 6.5% of net sales, varying by territory and functional scope. SMT Inc. will continue to perform contract research and development services for SIP Holdings under a Cost-Plus R&D Services Agreement at cost plus an 8.0% mark-up.
Based upon the analysis set forth in detail in this memorandum, and subject to the assumptions, qualifications, and recommendations discussed herein, we conclude at a should level of confidence (i.e., a greater than 50% likelihood of being sustained if challenged by the Internal Revenue Service) that the proposed structure should be respected under IRC §§ 367(d) and 482. The $214.5 million purchase price and the 8.0% arm's-length royalty rate should satisfy the arm's-length standard and the commensurate-with-income requirement of § 482. The § 367(d) deemed royalty inclusions to SMT Inc. should be offset, in whole or in substantial part, by the actual royalty payments received by SMT Inc. under the License-Back Agreement, such that the deemed inclusion regime should not create material incremental US tax cost beyond the tax attributable to the actual royalty stream.
This memorandum addresses only the § 367(d) and § 482 issues. Companion memoranda addressing the GILTI, Subpart F, and BEAT implications (anticipated delivery date: March 22, 2024) and the Irish tax and treaty issues (anticipated delivery date: March 25, 2024) are being prepared separately.
II. Statement of Facts
The following factual summary is based upon our review of the documents and information identified in Section II.D below, including the Factual Assumptions and Representations Letter from SBD dated March 8, 2024, signed by Fiona Gallagher (CFO) and Dr. Cathal Morrissey (CEO). We have assumed the accuracy and completeness of all factual information provided to us without independent verification. Any material change in the facts described below could alter our analysis and conclusions.
A. The Parties
1. Solstice Biomedical Devices Ltd. (SBD)
Solstice Biomedical Devices Ltd. ("SBD") is an Irish private company limited by shares, registered with the Companies Registration Office under CRO No. 587241. SBD's registered office is located at Unit 14, Corrib Technology Park, Headford Road, Galway, H91 XR72, Ireland. SBD serves as the ultimate parent company of the Solstice corporate group and is engaged in the design, manufacture, and worldwide distribution of minimally invasive cardiac catheter navigation systems and intra-operative imaging devices.
For the fiscal year ended December 31, 2023 ("FY2023"), SBD reported consolidated revenue of €347.6 million and consolidated EBITDA of €78.4 million, representing an EBITDA margin of approximately 22.5%. The Solstice group employs approximately 1,640 persons worldwide across its Irish, US, and other international operations.
SBD is privately held. The ownership structure is as follows:
• Pinnacle Growth Equity Partners Fund III, L.P. ("Pinnacle GEP III"): 62.3% of issued share capital. Pinnacle GEP III is a Delaware limited partnership with its general partner being Pinnacle Growth Equity Advisors III LLC. Pinnacle GEP III is a $2.1 billion fund with a 2019 vintage year. The Managing Partner of Pinnacle GEP III is Jonathan Whitfield, who serves on the board of directors of SBD.
• Dr. Cathal Morrissey (Founder & CEO): 18.4% of issued share capital, held through Morrissey Family Holdings Unlimited Company (CRO No. 492103).
• Fiona Gallagher (CFO): 2.1% of issued share capital.
• Remaining management and other shareholders: 17.2% of issued share capital.
Under the terms of the SBD shareholders' agreement, Pinnacle GEP III holds approval rights over material intercompany transactions exceeding €10 million in value. The proposed IP transfer, with a purchase price of $214.5 million (approximately €196.8 million), substantially exceeds this threshold and accordingly requires Pinnacle GEP III board-level approval.
2. Solstice Medical Technologies Inc. (SMT Inc.)
Solstice Medical Technologies Inc. ("SMT Inc.") is a Delaware C-corporation, incorporated under Delaware File No. 7482916, with EIN 84-3291507. SMT Inc.'s principal office is located at 2200 Biopharma Drive, Suite 300, Waltham, Massachusetts 02451. SMT Inc. is a wholly owned subsidiary of SBD.
SMT Inc. is the current holder of the IP Portfolio that is the subject of this memorandum. In addition to holding the IP, SMT Inc. is responsible for research and development activities, US regulatory submissions (including FDA submissions for the NaviPulse and ClearVue product lines), and North American commercial operations, including sales, marketing, and customer support.
For FY2023, SMT Inc. reported revenue of $189.2 million, which represents approximately 50.1% of SBD's consolidated revenues when translated at an average exchange rate of €1 = $1.09. SMT Inc. employs approximately 580 persons. For FY2023, SMT Inc.'s total deductions were $174.8 million, as reported by Lattimore & Stern CPAs LLP, SMT Inc.'s US tax return preparer.
3. Solstice IP Holdings DAC (SIP Holdings)
Solstice IP Holdings Designated Activity Company ("SIP Holdings" or "SIPH") is an Irish designated activity company, registered with the Companies Registration Office under CRO No. 714538. SIP Holdings' registered office is co-located with SBD at Unit 14, Corrib Technology Park, Headford Road, Galway, H91 XR72, Ireland.
SIP Holdings was newly incorporated on January 18, 2024. It has an authorized and issued share capital of €1,000 in ordinary shares, 100% of which are held by SBD. SIP Holdings has no operating history or employees at the time of this memorandum, though it is intended that SIP Holdings will retain a managing director and relevant personnel (or shared services from SBD) to exercise management and control over the IP Portfolio from Ireland.
The intended business purpose of SIP Holdings is to acquire the IP Portfolio from SMT Inc. and thereafter to license it back to SMT Inc. for North American exploitation and to SBD and other group entities for rest-of-world exploitation. SIP Holdings is also intended to qualify for capital allowances under Section 291A of the Taxes Consolidation Act 1997 ("TCA 1997") on the Irish side, an analysis that is the subject of the forthcoming companion Irish tax memorandum.
B. The IP Portfolio
The intellectual property to be transferred from SMT Inc. to SIP Holdings (the "IP Portfolio") comprises the following categories of assets:
• Patents: Forty-seven (47) granted United States utility patents covering various aspects of the NaviPulse catheter guidance platform and the ClearVue intra-operative cardiac imaging system, including patents relating to catheter tip positioning algorithms, electromagnetic field generation and sensing technologies, real-time imaging processing software, biocompatible materials for catheter construction, and related methods of medical treatment.
• Pending Patent Applications: Twelve (12) pending United States patent applications relating to next-generation enhancements to the NaviPulse and ClearVue platforms, including improved imaging resolution capabilities, expanded multi-catheter coordination features, and novel software-driven diagnostic analytics.
• Trade Secrets and Know-How: A comprehensive body of trade secrets and technical know-how associated with the design, development, manufacturing, testing, calibration, and quality control of the NaviPulse and ClearVue systems, including proprietary manufacturing process documentation, engineering drawings, design specifications, and testing protocols.
• Proprietary Software Algorithms: Software algorithms embedded in the NaviPulse and ClearVue systems, including real-time signal processing algorithms, catheter navigation mapping algorithms, and image rendering and display optimization routines.
The IP Portfolio was valued as of a valuation date of December 31, 2023. WVA determined the fair market value ("FMV") of the IP Portfolio to be $214.5 million in its draft valuation report (WVA-2023-1187), issued January 29, 2024. WVA employed an income approach / DCF methodology utilizing a WACC of 13.5%, which reflects the cost of equity for comparable medical technology companies, appropriate leverage assumptions, and an IP-specific risk premium. The remaining weighted-average useful life of the IP Portfolio was determined by WVA to be 12.8 years.
On the books of SMT Inc., the IP Portfolio has an adjusted US tax basis of $11.3 million, the assets having been substantially fully amortized and/or expensed in prior taxable years. The resulting built-in gain is $203.2 million ($214.5 million FMV less $11.3 million adjusted basis).
C. Transaction Structure
The proposed transaction consists of the following integrated steps, with a target effective date of March 1, 2024:
Step 1 — IP Acquisition. SIP Holdings will acquire the entire IP Portfolio from SMT Inc. pursuant to an IP Assignment Agreement (currently in draft form, reviewed by this firm and by Dalton Byrne & Partners on the Irish corporate/IP side). The purchase price is $214.5 million, equal to the fair market value determined by WVA.
The purchase price will be funded as follows:
(a) Intercompany Loan: SBD will extend an intercompany loan to SIP Holdings in the principal amount of €180.0 million (approximately $196.2 million at a spot exchange rate of €1 = $1.09). The loan terms, as set forth in the intercompany loan term sheet reviewed by this firm, include a ten-year term with maturity on March 1, 2034; a fixed interest rate of 3.75% per annum (benchmarked by WVA's intercompany debt pricing analysis as an arm's-length rate); interest-only payments during years one through three; and equal annual principal installments of approximately €25.71 million (€180.0 million divided by seven) plus accrued interest, commencing in year four and continuing through maturity. Annual interest on the full principal balance is €6.75 million.
(b) Equity / Capital Contribution: In addition to SIP Holdings' existing share capital of €1,000 in ordinary shares, SBD will make a shareholder capital contribution of €16.7 million to SIP Holdings. Together with the intercompany loan proceeds, these funds will be sufficient to fund the $214.5 million purchase price.
Step 2 — License-Back to SMT Inc. Following the IP acquisition, SIP Holdings and SMT Inc. will enter into an exclusive License-Back Agreement (currently in draft form), pursuant to which SIP Holdings will grant SMT Inc. exclusive rights to exploit the IP Portfolio in North America (the United States, Canada, and Mexico). The license will carry an arm's-length royalty rate of 8.0% of net sales attributable to products and services incorporating or derived from the licensed IP. Based on projected Year 1 net sales of $189.2 million (consistent with SMT Inc.'s FY2023 revenue), the projected Year 1 royalty payment from SMT Inc. to SIP Holdings is $15.136 million.
Step 3 — Rest-of-World License Agreements. SIP Holdings will enter into separate license agreements with SBD and other group entities for the exploitation of the IP Portfolio outside of North America. The royalty rates for these rest-of-world licenses will range from 4.0% to 6.5% of net sales, varying by territory and functional scope of the licensee. These rates have been benchmarked by WVA as falling within the arm's-length range for comparable arrangements.
Step 4 — Cost-Plus R&D Services Agreement. SMT Inc. will continue to perform research and development activities related to the NaviPulse and ClearVue platforms. However, following the transfer, these activities will be performed on behalf of SIP Holdings (as the IP owner) pursuant to a Cost-Plus R&D Services Agreement (currently in draft form). SMT Inc. will be compensated at cost plus an 8.0% mark-up for its contract R&D services. This arrangement is designed to ensure that the economic risks and rewards of IP ownership reside with SIP Holdings, while SMT Inc. is compensated on a routine basis for the functions it performs, the assets it employs, and the risks it assumes in its capacity as a contract R&D services provider.
For purposes of the Irish tax analysis (which will be addressed in the forthcoming companion memorandum), the IP value in euros is approximately €196.8 million ($214.5 million ÷ $1.09). Under Section 291A TCA 1997, SIP Holdings is expected to claim annual capital allowances of approximately €13.12 million (€196.8 million divided by the fifteen-year statutory capital allowance period).
D. Advisors and Key Documents Relied Upon
In preparing this memorandum, we have reviewed and relied upon the following documents and information sources:
1. WVA Draft IP Valuation Report (Report No. WVA-2023-1187, dated January 29, 2024; lead professional: Marcus Whitmore, ASA, Managing Director, Whitmore Valuation Advisors LLC). This report sets forth the fair market value determination of $214.5 million, the WACC derivation, the comparable transaction analysis supporting the 8.0% royalty rate, and the 12.8-year remaining weighted-average useful life determination.
2. Factual Assumptions and Representations Letter from SBD, dated March 8, 2024, signed by Fiona Gallagher (CFO) and Dr. Cathal Morrissey (CEO), setting forth the factual background, corporate structure, transaction rationale, and representations upon which this memorandum relies.
3. Harrington & Cahill (Irish tax advisors; lead: Niamh O'Sullivan, Tax Partner), who are advising on Irish tax compliance and transfer pricing documentation under the Finance Act 2019 amendments to TCA 1997.
4. Lattimore & Stern CPAs LLP (US tax return preparer for SMT Inc.; lead: David Lattimore, CPA), who provided SMT Inc. tax return data, the adjusted basis information for the IP Portfolio ($11.3 million), and the FY2023 total deductions figure of $174.8 million.
5. Dalton Byrne & Partners, Solicitors (Irish corporate and IP solicitors; lead: Séamus Dalton), who are handling the IP assignment documentation, the incorporation and corporate governance of SIP Holdings, and related Irish corporate law matters.
6. Pemberton Hale LLP (statutory auditors; lead: Aisling Brennan), who prepared the audited SBD consolidated financial statements for FY2023, which we have reviewed for purposes of confirming the financial parameters referenced in this memorandum.
7. Draft IP Assignment Agreement between SMT Inc. (assignor) and SIP Holdings (assignee).
8. Draft License-Back Agreement between SIP Holdings (licensor) and SMT Inc. (licensee).
9. Draft Cost-Plus R&D Services Agreement between SMT Inc. (service provider) and SIP Holdings (service recipient).
10. Intercompany Loan Term Sheet between SBD (lender) and SIP Holdings (borrower).
We have assumed the accuracy and completeness of all information provided to us, including all factual representations in the March 8, 2024 Representations Letter. We have not independently verified any financial data, projections, or valuation conclusions prepared by WVA or any other advisor.
III. Issues Presented
This memorandum addresses the following five issues:
1. Section 367(d) Applicability. Whether the outbound transfer of the IP Portfolio from SMT Inc. (a US transferor corporation) to SIP Holdings (a related foreign corporation) constitutes a transfer of intangible property subject to IRC § 367(d), and, if so, the nature and duration of the resulting deemed royalty income inclusions to SMT Inc.
2. Useful Life Election. Whether the "useful life" election under Treasury Regulation ("Treas. Reg.") § 1.367(d)-1T(c)(3)(ii) is available and advisable for SMT Inc. in light of the 12.8-year remaining weighted-average useful life of the IP Portfolio, as an alternative to the default twenty-year deemed inclusion period prescribed by Treas. Reg. § 1.367(d)-1T(c)(3)(i).
3. Arm's-Length Standard and Commensurate-with-Income Requirement. Whether the $214.5 million purchase price and the 8.0% royalty rate under the License-Back Agreement satisfy the arm's-length standard under IRC § 482 and the "commensurate with income" requirement of § 482, as applied to controlled transfers and licenses of intangible property.
4. Interaction of § 367(d) Deemed Inclusions with Actual Royalties. How the § 367(d) deemed royalty inclusions interact with the actual royalty payments to be received by SMT Inc. under the License-Back Agreement, and whether the actual royalties can be treated as satisfying the deemed royalty obligation so as to avoid double-counting of income.
5. Overall Structure Sustainability. Whether the overall structure — encompassing the IP transfer, the license-back arrangement, the cost-plus R&D services agreement, and the intercompany financing — should be respected as a bona fide arm's-length transaction at a should level of confidence.
IV. Short Answers
Issue 1 — Section 367(d) Applicability. The transfer of the IP Portfolio from SMT Inc. to SIP Holdings constitutes a transfer of intangible property within the meaning of IRC § 367(d). SMT Inc. will be treated as receiving deemed annual royalty payments from SIP Holdings over the useful life of each intangible asset transferred, in amounts commensurate with the income attributable to the transferred IP. The built-in gain of $203.2 million defines the economic significance of the deemed inclusion stream and establishes the magnitude of value that will be subject to US taxation through the annual inclusion mechanism.
Issue 2 — Useful Life Election. The useful life election under Treas. Reg. § 1.367(d)-1T(c)(3)(ii) should be available to SMT Inc. and is likely advisable. By electing to calculate deemed royalty payments over the 12.8-year remaining weighted-average useful life rather than the default twenty-year period, SMT Inc. can align the deemed inclusions with the actual economic life of the IP Portfolio. While this election results in higher annual deemed inclusions during the 12.8-year period, it avoids deemed inclusions in years when the IP may have negligible residual economic value. The election should be supported by the WVA valuation report documenting the useful life determination.
Issue 3 — Arm's-Length Standard and Commensurate-with-Income. The $214.5 million purchase price and the 8.0% royalty rate should satisfy the arm's-length standard under IRC § 482. The WVA valuation employed an income-approach DCF methodology with a 13.5% WACC and comprehensive comparable transaction benchmarking analysis. The 8.0% royalty rate is supported by the CUT analysis and falls within the interquartile range of comparable uncontrolled license agreements in the medical devices sector. The commensurate-with-income standard is also met based on current projections, but will require periodic review to ensure ongoing compliance as actual income from the IP materializes.
Issue 4 — Interaction of Deemed Inclusions with Actual Royalties. The § 367(d) deemed royalty inclusions and the actual royalty payments under the License-Back Agreement should be coordinated under Treas. Reg. § 1.367(d)-1T(c)(2) to avoid double inclusion of income to SMT Inc. Actual royalty payments received by SMT Inc. from SIP Holdings under the License-Back Agreement should be treated as satisfying, in whole or in part, SMT Inc.'s deemed royalty obligation under § 367(d). To the extent that actual royalties in any given year equal or exceed the deemed inclusion amount for that year, no additional phantom income should arise.
Issue 5 — Overall Structure. At a should level of confidence (i.e., greater than 50% but less than "will" level likelihood of being sustained if challenged by the IRS), the overall structure — including the IP transfer, the license-back arrangement, the cost-plus R&D services agreement, and the intercompany financing — should be respected as a bona fide arm's-length transaction for purposes of IRC §§ 367(d) and 482. This conclusion is subject to the assumptions, qualifications, and recommendations set forth in this memorandum.
V. Analysis — IRC § 367(d)
A. Statutory Framework
1. Overview of IRC § 367(d)
IRC § 367(d) was enacted as part of the Deficit Reduction Act of 1984 ("DEFRA"), Pub. L. No. 98-369, § 131(a), 98 Stat. 494, 659–64 (1984). The provision was designed to address a perceived loophole in the international tax rules under which a US person could transfer appreciated intangible property to a related foreign corporation in a tax-free exchange (e.g., under §§ 332, 351, 354, 356, or 361), thereby removing the intangible and its future income stream from the US tax base without any current recognition of the built-in gain.
Congress recognized that intangible property transfers present unique challenges because the value of intangibles is often difficult to determine at the time of transfer and because the income attributable to intangibles may grow significantly over time. Rather than requiring a one-time gain recognition event (which would require precise valuation and could be subject to manipulation), Congress adopted a deemed royalty approach under which the US transferor is treated as receiving annual payments contingent on the productivity, use, or disposition of the transferred intangible over the useful life of the property.
Section 367(d) applies when a "United States person" transfers "intangible property" (as defined in § 936(h)(3)(B)) to a "foreign corporation" in an exchange described in §§ 332, 351, 354, 356, or 361. When these conditions are met, the transferor is required to include in its gross income, on an annual basis, amounts determined under the deemed royalty framework described in § 367(d)(2)(A).
2. Definition of "Intangible Property"
For purposes of § 367(d), "intangible property" is defined by reference to IRC § 936(h)(3)(B), which provides an expansive enumeration of intangible property types. The definition encompasses, among other things:
(i) patents, inventions, formulae, processes, designs, patterns, and know-how;
(ii) copyrights and literary, musical, or artistic compositions;
(iii) trademarks, trade names, and brand names;
(iv) franchises, licenses, and contracts;
(v) methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, and technical data; and
(vi) any similar item, the value or potential value of which is not attributable to tangible property or the services of any individual.
We note that the Tax Cuts and Jobs Act of 2017 ("TCJA") broadened the definition of intangible property for purposes of § 367(d) by cross-referencing § 197(d)(1)(C)(iii), which includes "any goodwill, going concern value, or workforce in place." However, for purposes of the present transaction, the IP Portfolio does not include goodwill, going concern value, or workforce in place, so this expanded definition does not materially alter our analysis. The IP Portfolio does, however, squarely fall within the enumerated categories of § 936(h)(3)(B) as patents, inventions, processes, know-how, and technical data.
3. Application to the Present Transaction
The proposed transfer satisfies each of the threshold conditions for the application of § 367(d):
(a) US Person. SMT Inc. is a Delaware C-corporation and therefore a "United States person" within the meaning of IRC § 7701(a)(30).
(b) Intangible Property. The IP Portfolio consists of patents, pending patent applications, trade secrets, technical know-how, engineering drawings, manufacturing process documentation, and proprietary software algorithms — all of which fall within the definition of "intangible property" under § 936(h)(3)(B).
(c) Transfer to a Foreign Corporation. SIP Holdings is an Irish designated activity company and therefore a "foreign corporation" within the meaning of IRC § 7701(a)(5). The IP Portfolio is being transferred (via assignment) from SMT Inc. to SIP Holdings.
(d) Exchange Described in §§ 332, 351, 354, 356, or 361. While the transaction is structured as a sale for a stated purchase price of $214.5 million (rather than as a contribution to capital under § 351), we note that § 367(d)(1) has been interpreted broadly to cover outbound transfers of intangibles to related foreign corporations, including sales. Moreover, even if the transaction were recharacterized as a § 351 exchange (because SIP Holdings is transferring cash consideration funded by intercompany borrowings from a common parent), the result would be the same — § 367(d) would apply. The IRS has consistently taken the position that § 367(d) applies to outbound transfers of intangibles regardless of the form of the transaction. See Treas. Reg. § 1.367(d)-1T(b); see also Notice 2012-39, 2012-31 I.R.B. 95 (discussing the broad scope of § 367(d)).
Conclusion. The transfer of the IP Portfolio from SMT Inc. to SIP Holdings squarely falls within the scope of IRC § 367(d). SMT Inc. will be treated as a US transferor of intangible property to a related foreign corporation, triggering the deemed royalty inclusion regime.
B. Deemed Royalty Inclusion Mechanism
1. The Deemed Royalty Framework
Under IRC § 367(d)(2)(A), when § 367(d) applies to a transfer of intangible property, the US transferor is treated as having sold the intangible in exchange for payments that are contingent upon the productivity, use, or disposition of the property. These deemed payments are treated as ordinary income to the US transferor and must be recognized on an annual basis over the useful life of the intangible property.
The critical feature of the deemed royalty mechanism is that it is inherently forward-looking and income-tracking. The amount of deemed income in each year must be "commensurate with the income attributable to the intangible," incorporating the same standard that governs controlled transactions under IRC § 482. This linkage between § 367(d) and the § 482 commensurate-with-income standard ensures that the annual deemed inclusions reflect the actual economic contribution of the transferred intangible to the income of the transferee (and its licensees) in each period.
2. Quantification of the Deemed Inclusion
The built-in gain of $203.2 million ($214.5 million FMV less $11.3 million adjusted basis) represents the economic value that would be subject to US taxation through the deemed inclusion mechanism. However, § 367(d) does not impose a one-time gain recognition event on this built-in gain. Instead, the deemed royalty stream is calculated each year based on the income attributable to the transferred intangible, effectively spreading the US tax cost over the useful life of the IP and tying it to the actual economic performance of the intangible.
In practical terms, the annual deemed royalty inclusion is determined by reference to the arm's-length compensation that would have been paid for the use of the intangible property in an uncontrolled transaction. For the NaviPulse and ClearVue IP Portfolio, WVA has determined this arm's-length compensation to be 8.0% of net sales. Accordingly, in Year 1, the deemed royalty inclusion to SMT Inc. should be approximately $15.136 million ($189.2 million projected net sales × 8.0%), assuming that the projected net sales materialize as expected.
3. Characterization of Deemed Income
The deemed royalty payments are treated as ordinary income to SMT Inc. They are not treated as capital gains, even though the underlying transfer involves appreciated intangible property with a substantial built-in gain. This ordinary income characterization is consistent with the treatment of royalty income generally and reflects Congress's intent that the annual deemed inclusions be taxed at ordinary income rates.
Furthermore, the deemed royalty payments are treated as received from a foreign source for purposes of the foreign tax credit rules, which may have implications for SMT Inc.'s foreign tax credit computation. This issue will be addressed in greater detail in the forthcoming companion memorandum on GILTI and Subpart F.
C. Useful Life Election — Treas. Reg. § 1.367(d)-1T(c)(3)
1. Default Rule: Twenty-Year Period
Under the default rule set forth in Treas. Reg. § 1.367(d)-1T(c)(3)(i), deemed royalty inclusions are calculated over a twenty-year period commencing on the date of the transfer. This default period was selected by the Treasury Department as a conservative measure intended to capture the full economic value of the transferred intangible, even where the actual useful life of the intangible may be shorter.
Application of the default twenty-year period to the present transaction would require SMT Inc. to include deemed royalty income with respect to the IP Portfolio for each of the twenty years following the March 1, 2024 transfer date — i.e., through approximately February 28, 2044. Given that WVA has determined the remaining weighted-average useful life of the IP Portfolio to be only 12.8 years, the default twenty-year period would extend approximately 7.2 years beyond the estimated economic life of the IP, potentially resulting in deemed inclusions in years when the IP has negligible or no residual economic value.
2. Elective Alternative: Useful Life Period
Treas. Reg. § 1.367(d)-1T(c)(3)(ii) provides an elective alternative under which the US transferor may determine deemed payments over the "useful life" of the intangible property rather than the default twenty-year period. This election permits the taxpayer to align the deemed inclusion period with the actual economic life of the transferred intangible, provided that the useful life is established through competent evidence.
WVA has determined the remaining weighted-average useful life of the IP Portfolio at 12.8 years, measured from the December 31, 2023 valuation date. This determination reflects a probability-weighted analysis of the remaining patent terms for each of the forty-seven granted patents, the expected grant and remaining terms of the twelve pending patent applications, and the estimated useful life of the associated trade secrets, know-how, and software algorithms (which may extend beyond the patent terms but are subject to technological obsolescence and competitive erosion).
3. Analysis of Whether the Election Is Advisable
The decision whether to make the useful life election involves a balancing of competing considerations:
Arguments in Favor of the Election:
Alignment with Economic Reality. The 12.8-year useful life more accurately reflects the period over which the IP Portfolio is expected to generate economic value. Deemed inclusions beyond 12.8 years (i.e., in years 13 through 20 under the default rule) would represent phantom income attributable to intangible property that may have negligible or no remaining value, creating an unwarranted tax burden on SMT Inc.
Matching of Income and Tax. Accelerating the deemed inclusions into the 12.8-year period when the IP is actively generating income ensures that the tax cost is borne during the same years in which the actual royalty stream is expected to flow. This matching principle is consistent with sound tax policy and should be favorable from a cash flow management perspective.
Avoidance of Tail-Period Deemed Inclusions. Under the default twenty-year rule, SMT Inc. would be required to include deemed royalty income in years 13 through 20 even if the IP has been fully exploited, has expired, or has become technologically obsolete. The useful life election avoids this outcome.
Arguments Against the Election:
Higher Annual Deemed Inclusions. Compressing the deemed inclusion period from 20 years to 12.8 years results in higher annual deemed inclusions during the 12.8-year period, increasing SMT Inc.'s current US tax liability in the near term. However, this increase should be offset by the actual royalty payments under the License-Back Agreement (as discussed in Section V.D below).
Documentation Burden. The election requires robust documentation supporting the 12.8-year useful life determination. If the IRS challenges the useful life as being too short, it could assert a longer deemed inclusion period, potentially resulting in both a longer inclusion period and higher annual inclusions. However, the WVA valuation report provides substantial support for the 12.8-year determination.
Blended Nature of the Useful Life. The 12.8-year figure is a weighted average across multiple intangible assets with varying individual useful lives. Certain patents may have shorter remaining terms (as little as three to five years), while others may have longer terms (up to approximately seventeen years for recently granted patents). The IRS could potentially challenge the appropriateness of using a weighted-average useful life rather than determining the useful life of each individual intangible separately. However, the weighted-average approach is commonly used in transfer pricing and valuation practice, and we believe it should be defensible.
4. Recommendation. On balance, we recommend that SMT Inc. make the useful life election under Treas. Reg. § 1.367(d)-1T(c)(3)(ii), electing to use the 12.8-year remaining weighted-average useful life. The election should be supported by the WVA valuation report (WVA-2023-1187), which provides detailed documentation of the useful life determination, including the individual useful life estimates for each category of intangible and the basis for the probability-weighted average. We recommend that Lattimore & Stern CPAs LLP be instructed to make the election on SMT Inc.'s timely filed federal income tax return for the taxable year that includes the March 1, 2024 transfer date.
D. Interaction Between § 367(d) Deemed Inclusions and Actual Royalties
1. The Offset Mechanism
A critical practical question in any § 367(d) transaction is how the deemed royalty inclusions interact with actual payments received by the US transferor with respect to the transferred intangible. Treas. Reg. § 1.367(d)-1T(c)(2) addresses this question by providing that amounts actually received by the US transferor (or a related person) with respect to the transferred intangible are treated as satisfying (i.e., offsetting) the deemed royalty obligation under § 367(d).
This offset mechanism is essential to avoiding double taxation. Absent the offset, SMT Inc. would be required to include both the deemed royalty under § 367(d) and the actual royalty received under the License-Back Agreement, effectively being taxed twice on the same economic income.
2. Application to the Present Transaction
In the proposed structure, SMT Inc. will receive actual royalty payments from SIP Holdings under the License-Back Agreement at a rate of 8.0% of net sales. These royalty payments directly relate to the exploitation of the same IP Portfolio that is being transferred from SMT Inc. to SIP Holdings. The projected Year 1 royalty payment is $15.136 million ($189.2 million × 8.0%).
Under Treas. Reg. § 1.367(d)-1T(c)(2), these actual royalty payments should be treated as satisfying the § 367(d) deemed royalty obligation, at least to the extent of the actual amounts received in each year. The operative question is whether the actual royalties "qualify" as amounts received "with respect to" the transferred intangible within the meaning of the regulation.
3. Qualification of Actual Royalties as Offsetting Amounts
We believe that the actual royalty payments under the License-Back Agreement should qualify as offsetting amounts under Treas. Reg. § 1.367(d)-1T(c)(2) for the following reasons:
(a) Direct Relationship to Transferred IP. The License-Back Agreement directly relates to the exploitation of the same NaviPulse and ClearVue IP that is being transferred from SMT Inc. to SIP Holdings. The royalties are denominated as a percentage of net sales attributable to products and services incorporating or derived from the licensed IP. There is a direct and explicit nexus between the royalty payments and the transferred intangible property.
(b) Same Parties. The deemed royalty under § 367(d) is treated as paid by SIP Holdings (the transferee) to SMT Inc. (the US transferor). The actual royalty under the License-Back Agreement is paid by SMT Inc. to SIP Holdings. At first glance, the direction of the actual royalty payment appears to be the reverse of the deemed royalty — SIP Holdings is the licensor receiving royalties, while SMT Inc. is the licensee paying royalties. However, the regulation contemplates that amounts received "with respect to" the transferred intangible should offset the deemed inclusion. The license-back royalty is a payment made "with respect to" the same IP, and the economic substance of the arrangement is that SIP Holdings is compensating SMT Inc. for the value of the IP by licensing it back on terms that generate a royalty stream flowing from the exploitation of that IP.
(c) Economic Equivalence. The actual royalty stream (8.0% of net sales) and the deemed royalty inclusion (commensurate with income attributable to the IP) are calculated on the same basis — the income generated by the exploitation of the transferred IP. To the extent these amounts are equivalent, the offset should be complete.
4. Practical Implications of the Offset
The interaction between the deemed inclusions and actual royalties produces the following practical outcomes:
Scenario A — Actual Royalties Equal or Exceed Deemed Inclusions. If the actual royalty stream received by SMT Inc. under the License-Back Agreement in any given year equals or exceeds the § 367(d) deemed inclusion amount for that year, SMT Inc. should not be required to include any additional phantom income. The actual royalty income (which is taxable to SMT Inc. as ordinary income in any event) fully satisfies the deemed inclusion obligation. In this scenario, § 367(d) does not impose any incremental tax burden beyond what would arise from the actual royalty stream.
Scenario B — Actual Royalties Fall Below Deemed Inclusions. If the actual royalty stream in any given year falls below the § 367(d) deemed inclusion amount (e.g., because the deemed inclusion is calculated at a higher rate or because net sales are lower than projected), the difference must be included as additional deemed income by SMT Inc. This "top-up" amount represents phantom income — income that SMT Inc. must recognize for US tax purposes even though it has not received a corresponding cash payment. This scenario could arise if the IRS determines that the arm's-length royalty rate should be higher than 8.0%, or if the deemed inclusion is calculated using a methodology that produces a higher annual amount than the actual royalty.
5. Structuring Recommendation
To maximize the likelihood that the actual royalties fully offset the deemed inclusions, we recommend that the License-Back Agreement be carefully structured to ensure that:
(a) the royalty payments are explicitly linked to the same IP Portfolio that is being transferred;
(b) the royalty rate is set at a level that is at least equal to the arm's-length rate determined under § 482 (and therefore at least equal to the commensurate-with-income rate under § 367(d));
(c) the royalty base (net sales) is defined consistently with the income base used to calculate the § 367(d) deemed inclusions; and
(d) the agreement includes a periodic adjustment mechanism (discussed further in Section VI.C below) to ensure that the royalty rate remains arm's-length over time.
E. Gain Recognition Agreement Alternative
1. Availability of Gain Recognition
Treas. Reg. § 1.367(d)-1T(g) provides an alternative to the annual deemed royalty inclusion regime. Under this provision, a US transferor may elect to recognize gain on the outbound transfer of intangible property immediately, rather than being subject to annual deemed royalty inclusions over the useful life (or default twenty-year period) of the intangible.
If this election were made in the present case, SMT Inc. would be required to recognize the entire built-in gain of $203.2 million ($214.5 million FMV less $11.3 million adjusted basis) in the taxable year of the transfer. At the current corporate tax rate of 21%, this would produce an immediate federal income tax liability of approximately $42.67 million (before considering any state tax implications or potential application of foreign tax credits).
2. Analysis. The immediate gain recognition alternative is significantly less favorable to SMT Inc. than the annual deemed royalty approach with actual royalty offset, for several reasons:
(a) Immediate Cash Tax Cost. Recognition of $203.2 million of gain in a single taxable year would produce an immediate tax liability of approximately $42.67 million, creating a substantial and potentially burdensome cash outflow. By contrast, the annual deemed royalty approach spreads the tax cost over 12.8 years (under the useful life election) and, to the extent that actual royalties offset the deemed inclusions, does not generate any incremental tax cost beyond the tax on the actual royalty stream.
(b) Time Value of Money. Even if the total tax cost over the 12.8-year useful life were identical under both approaches (which it would not be, given the offset mechanism), the deferral of tax payments under the annual approach provides a significant time-value-of-money benefit.
(c) Actual Royalty Offset Not Available. If gain recognition is elected, SMT Inc. recognizes the full built-in gain immediately and is not subject to annual deemed royalty inclusions. However, SMT Inc. would still receive actual royalty payments under the License-Back Agreement, which would be separately taxable as ordinary income. There would be no offset mechanism, and the total tax burden (gain recognition plus ongoing royalties) would likely exceed the tax burden under the deemed royalty approach (where actual royalties offset the deemed inclusions).
3. Recommendation. We recommend that SMT Inc. not elect gain recognition under Treas. Reg. § 1.367(d)-1T(g). The annual deemed royalty approach, combined with the actual royalty offset under Treas. Reg. § 1.367(d)-1T(c)(2), is clearly more advantageous from both a cash flow and total tax cost perspective.
F. Conclusion on § 367(d)
Based upon the analysis set forth above, we reach the following conclusions with respect to the application of IRC § 367(d) to the proposed transaction:
1. The transfer of the IP Portfolio from SMT Inc. to SIP Holdings will trigger the § 367(d) deemed royalty inclusion regime. SMT Inc. will be treated as receiving annual deemed royalty payments from SIP Holdings, in amounts commensurate with the income attributable to the transferred IP, over the useful life of the intangible property.
2. The useful life election under Treas. Reg. § 1.367(d)-1T(c)(3)(ii) should be made, resulting in a 12.8-year deemed inclusion period rather than the default twenty-year period.
3. The actual license-back royalties at 8.0% of net sales should offset the § 367(d) deemed royalty obligations in whole or substantial part under Treas. Reg. § 1.367(d)-1T(c)(2), provided that the License-Back Agreement is properly structured as recommended above.
4. The gain recognition alternative under Treas. Reg. § 1.367(d)-1T(g) should not be elected.
5. At a should level of confidence, the deemed inclusion regime should be manageable and should not create material incremental US tax cost beyond the tax that would arise from the actual royalty stream under the License-Back Agreement.
VI. Analysis — IRC § 482
A. Statutory Framework and Arm's-Length Standard
1. Overview of IRC § 482
IRC § 482 authorizes the Secretary of the Treasury (and, by delegation, the Internal Revenue Service) to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among two or more organizations, trades, or businesses that are owned or controlled directly or indirectly by the same interests, if the Secretary determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or to clearly reflect the income of any of such organizations, trades, or businesses.
Section 482 provides the statutory foundation for the US transfer pricing regime. Its purpose is to ensure that transactions between commonly controlled entities produce results that are consistent with the results that would have been realized in comparable transactions between unrelated parties dealing at arm's length.
2. The Arm's-Length Standard
The overarching standard for evaluating controlled transactions under § 482 is the arm's-length standard, codified in Treas. Reg. § 1.482-1(b)(1). Under this standard, a controlled transaction meets the arm's-length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances. The arm's-length standard is applied by comparing the results of the controlled transaction with the results of comparable uncontrolled transactions, using the methods specified in the regulations.
The regulations provide detailed guidance on comparability factors, including the functions performed, risks assumed, and assets employed by each party; the contractual terms of the transaction; economic conditions; and the property or services transferred. See Treas. Reg. § 1.482-1(d).
3. Application to the Present Transaction
Both the sale of the IP Portfolio from SMT Inc. to SIP Holdings (at a purchase price of $214.5 million) and the license-back of the IP from SIP Holdings to SMT Inc. (at a royalty rate of 8.0% of net sales) are controlled transactions within the meaning of § 482, because SMT Inc. and SIP Holdings are commonly controlled by SBD. Accordingly, both transactions must satisfy the arm's-length standard.
B. Transfer Pricing Methods Applicable to the IP Transfer
The Treasury Regulations under § 482 prescribe specific methods for determining arm's-length prices in controlled transactions involving intangible property. The following methods are potentially applicable to the present transaction:
1. Comparable Uncontrolled Transaction (CUT) Method
The CUT method, set forth in Treas. Reg. § 1.482-4(c), determines an arm's-length royalty rate by reference to comparable uncontrolled license agreements involving similar intangible property under similar circumstances. The CUT method is generally considered the most reliable method when sufficiently comparable uncontrolled transactions can be identified, because it provides a direct market-based benchmark.
WVA's benchmarking analysis identified a set of comparable uncontrolled license agreements in the medical devices sector involving patents, know-how, and related intangible property. The royalty rates observed in these comparable transactions ranged from approximately 5.5% to 10.0% of net sales, with an interquartile range that encompasses the 8.0% royalty rate selected for the License-Back Agreement. The comparables were identified through searches of licensing agreement databases (including the Sundial Health IT and Vireo Health IT databases, as described in the WVA report) and were adjusted for differences in the scope of the licensed IP, the exclusivity of the license, the geographic territory, and other relevant comparability factors.
WVA applied the CUT method as its primary method for determining the arm's-length royalty rate. We consider this application to be appropriate given the availability of reasonably comparable uncontrolled transactions in the medical devices sector.
2. Comparable Profits Method (CPM)
The CPM, set forth in Treas. Reg. § 1.482-5, evaluates whether the amount charged in a controlled transaction is arm's length by comparing the profitability of the tested party (here, SMT Inc. in its capacity as a licensee and contract R&D provider) to the profitability of comparable companies performing similar functions, assuming similar risks, and employing similar assets.
While WVA did not apply the CPM as its primary method, the CPM is available as a corroborative method. Under a CPM analysis, the operating profit margin of SMT Inc. (after payment of the 8.0% royalty) would be compared to the operating profit margins of comparable medical device companies that license their core technology from a related or unrelated party. If SMT Inc.'s residual profitability (after the royalty payment and the cost-plus R&D services compensation) is consistent with the profitability of comparable companies performing similar functions and bearing similar risks, this would provide additional confirmation that the 8.0% royalty rate is arm's length.
3. Profit Split Method
The profit split method, set forth in Treas. Reg. § 1.482-6, may be appropriate where both parties to the controlled transaction contribute unique and valuable intangibles. In the present case, SIP Holdings will own the IP Portfolio, while SMT Inc. will contribute its specialized R&D capabilities, regulatory expertise, established commercial infrastructure, and workforce in North America. A residual profit split analysis could be used to allocate the combined profits of the controlled group between the routine returns attributable to each party's functions, risks, and assets and the residual profit attributable to the IP.
WVA did not apply the profit split method as its primary method, but the profit split method could serve as an additional cross-check on the 8.0% royalty rate. We understand that WVA intends to include a profit split analysis as a supplementary check in its final report.
4. Assessment of WVA's Analysis
WVA applied the income approach / DCF methodology to value the IP Portfolio at $214.5 million and benchmarked the 8.0% royalty rate using the CUT method with comparable uncontrolled transactions in the medical devices sector. WVA also confirmed the arm's-length pricing of the intercompany loan from SBD to SIP Holdings at a fixed interest rate of 3.75%.
We have reviewed the WVA draft valuation report (WVA-2023-1187) and consider the analysis to be robust, methodologically sound, and consistent with IRS guidance and established transfer pricing principles. The income approach is a widely accepted methodology for IP valuation, and the 13.5% WACC reflects appropriate risk considerations for a medical technology IP portfolio, taking into account the cost of equity for comparable medtech companies, the debt/equity structure of the intercompany financing, and an IP-specific risk premium. The CUT analysis supporting the 8.0% royalty rate is based on a reasonable set of comparable transactions with appropriate comparability adjustments.