Licensee Not Required to Share Benefits From Foreign Tax Credit
 
September 30, 2004
 

Negotiating and documenting commercial arrangements presents the parties and their counsel with a variety of challenges. The ultimate goal is to have an agreement that reflects the parties’ business deal. Doing so involves striking a balance between competing objectives. One is arriving at an agreement that will be clear, concise and easy to administer and interpret. A second, equally important objective is to cover all the necessary issues in a manner that establishes clearly the “rules of the road,” limits the possibility of a later dispute as to the meaning of the agreement and minimizes each side’s exposure to surprise. This is as true in the licensing context as in any other area of commercial contracting.

License agreements usually provide that the licensee will pay the licensor a royalty based on revenue derived from the licensee’s use or exploitation of the licensed rights. It is common for the parties to agree on certain deductions from gross revenue, in an effort to arrive at a fair royalty base which takes into account the licensee’s net revenue.

In the case of Evans v. Famous Music Corp., 1 N. Y. 2d 452, 775 N.Y.S. 2d 757 (2004), the New York Court of Appeals, the state’s highest court, interpreted a series of music licensing agreements that used a net profit-based royalty structure. The royalties were to be based on “net sums actually received by the [licensor] … less all expenses and charges in connection with administering said rights or collecting such sums… and less all deductions for taxes.”

The specific point at issue was whether this clause required the licensee to share with the licensors the benefit of U.S. foreign tax credits for foreign taxes paid on non-U.S. licensing revenue. The contract did not expressly address foreign tax credits. The Court held that the licensee was not required to share this benefit with the licensors. In so doing, it upheld the decision of the appellate court, which reversed the trial court’s decision. The trial court had held that the licensors were entitled to share in the benefit of the tax credits. Taking what appears to be a common-sense approach, it reasoned that because the licensee had used the credit, it did not suffer a loss from the payment of the foreign taxes.

The Court of Appeals reversed. In reaching its conclusion that the licensee did not need to share the benefit of the tax credits, the Court of Appeals applied basic principles of contract interpretation. First, it analyzed the clause in question and found it ambiguous. Judge Smith noted: “While it is clear that Famous obligated itself to deduct taxes, it is not equally clear that it obligated itself to make payments to the songwriters in the event that the foreign tax credit proved beneficial.” Evans, 1 N. Y. 2d at 459. Having found the provision ambiguous, it looked to extrinsic evidence, or evidence outside of the contract language. The Court noted that the agreements had been in effect for decades without the licensors demanding a share of the foreign tax credit benefit. It also relied on testimony concerning industry custom and practice. According to the testimony, when music publishers have shared foreign tax credits with licensors, they have done so pursuant to an explicit contractual provision.

Judge Read, dissenting from the decision, took a different approach, finding the parties’ behavior and industry practice irrelevant. The dissent found that the contractual scheme was clear and unambiguous, calling for the parties to “split the profits evenly.” Evans, 1 N. Y. 2d at 461. Focusing on what he perceived as the intent of the parties, he interpreted the phrase “less all deductions for taxes” as covering taxes for which Famous, the licensee, was out of pocket. Since the foreign taxes were reimbursed through the use of the tax credit, he concluded, Famous was not out of pocket, and therefore the credited taxes should not reduce the royalty base.

The decision is instructive in several ways: it illustrates a specific drafting pitfall that can arise in a variety of licensing contexts; it underscores the importance of carefully considering all elements of possible revenue or cash flow in structuring a royalty arrangement; and it demonstrates the extent to which an ambiguity can influence the determination of a dispute. Finally, the different conclusions reached by the judges who reviewed the case serves as a useful reminder that a degree of uncertainty is inherent in litigation.

For more information, e-mail Michael Student at michael.student@hklaw.com or call toll free, 1-888-688-8500.