Category: International; Corporations
Subject: Personal Holding Company
Title: Royalties Defined/PHC Ramifications of Domestic Corporation with Foreign Shareholders
IRC Sections: 543(a), 542(c)(7), 552(a)(2)
Filename: 1161.html
Date Produced: 7/96

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Facts
A group of no more than five foreign individuals owns a U.S. corporation the only activity of which will be licensing a trademark in the fashion industry.

Issues
1. Are the license fees derived from this activity personal holding company (PHC) income? Could these fees alternatively be considered copyright royalties?

2. If the corporation is a PHC, how do the PHC rules work given the presence of nonresident shareholders?

3. Assume the same scenario as set forth above except the corporation is a foreign corporation licensing to companies in the U.S. Do the PHC rules apply? What about the foreign personal holding company rules?

Answers
1. I believe the license fees are clearly PHC income. With respect to the copyright question, it seems clear to me that the fees involved could not be treated under the copyright rules for PHC purposes; however, to be absolutely certain, we must answer a legal question I am not qualified to address.

2. I can discern very few special PHC rules specifically applicable to domestic corporations with nonresident shareholders.

3. A foreign corporation with nonresident shareholders is not subject to the PHC tax provided the income of the corporation is not from personal services contracts. The foreign personal holding company rules are inapplicable to this set of circumstances.

Discussion: Issue 1
Section 543(a)(1) provides that general rule that royalties are PHC income. Other portions of Section 543 provide various exceptions and modifications with respect to computer software royalties, copyright royalties, and mineral royalties. The copyright exception is set forth at Section 543(a)(4).

In general, Regulation Section 1.543-1(b)(3) says the term royalties means amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property. It seems to me this rule squarely hits license fees for use of a name in the fashion industry.

There are a number of cases dealing with receipt of money in exchange for the use of a trade name. These cases hold that such amounts are royalties within the general meaning of the term as set forth in the statute. See Puritan Mills, 43 BTA 191, Dec. 11,602; Hugh Smith, Inc., CA-6, 49-1 USTC ¶9196, 173 F2d 224. Cert. den., 337 U.S. 918; Dairy Queen of Oklahoma, Inc., CA-10, 58-1 USTC ¶9155, 250 F. 2d 503;

As to the copyright issue, Section 543(a)(4) says copyright royalties means compensation for the right to use works protected by Title 17 of the U.S. Code or similar protection afforded by foreign countries under the laws of any other country by virtue of any international treaty. Regulation Section 543-1(b)(12)(c)(iv) provides as follows.

Copyright royalties defined. For purposes of section 543(a)(9) and this subparagraph, the term "copyright royalties" means compensation, however designated, for the use of, or the right to use, copyrights in works protected by copyright issued under Title 17 of the United States Code (other than by reason of section 2 or 6 thereof), and to which copyright protection is also extended by the laws of any foreign country as a result of any international treaty, convention, or agreement to which the United States is a signatory. Thus, "copyright royalties" includes not only royalties from sources within the United States under protection of United States laws relating to statutory copyrights but also royalties from sources within a foreign country with respect to United States statutory copyrights protected in such foreign country by any international treaty, convention, or agreement to which the United States is a signatory. The term "copyright royalties" includes compensation for the use of, or right to use, an interest in any such copyrighted works as well as payments from any person for performing rights in any such copyrighted works.

Note that Section 543(a)(4) of the current Internal Revenue Code was designated as Section 543(a)(9) at the time this regulation was written.

I would assume that the type of rights in question here are not protected by Title 17 and are thus not considered copyrights, but this is really a question for an attorney. CCH Standard Federal Tax Service commentary, generally reliable but obviously not authoritative, says Code Sec. 543(a)(4) applies only to federally secured copyrights. It does not apply to royalties for the use of trademarks, franchises, or common law copyrights. It seems to me that the rights in question here would be protected by trademark law. As I understand it, trademark law is covered by Title 15 of the U.S. Code. If all this is correct, it is fairly clear to me that the license fees in question are not subject to the special rule for copyrights. Again, in order to be absolutely certain, I suggest checking with an attorney to make sure that the rights in question here are not somehow covered under Title 17 of the U.S. Code.

Discussion: Issue 2
There is nothing in the law or the regulations to exempt an otherwise qualifying corporation from the personal holding company rules by virtue of the fact that the shareholders are nonresidents of the United States, provided that the corporation in question is a domestic corporation. Rev. Rul. 85-140, 1985-2 CB 172, speaks directly to this issue holding that a domestic corporation owned entirely by a nonresident alien individual is subject to the personal holding company tax.

Beyond the ruling discussed above, there seems to be little in the way of special rules specifically applicable to domestic corporations with nonresident shareholders. There are a few rulings which answer some of the more obvious question that arise in this special situation.

With respect to the PHC dividends paid deduction, what happens if the dividends are not subject to U.S. withholding tax by virtue of a tax treaty between the U.S. and the shareholder's home country? I.T. 4099, 1952-2 C.B. 117; and Rev. Rul. 60-34, 1960-1 C.B. 203 provide that the PHC dividends paid deduction is available even if there is no U.S. withholding tax on the dividends giving rise to the dividends paid deduction.

Where a dividend is paid to a nonresident alien who is subject to withholding tax, the dividend is considered paid for purposes of the dividends paid deduction when such withholding occurs. Regs. Section 1.561-2(a)(7).

Discussion: Issue 3
Section 542(c)(7) says a foreign corporation is not a PHC if all its shareholders are nonresidents unless the corporation has income to which Section 543(a)(7) applies (income from personal service contracts). Since the corporation does not have income to which Section 543(a)(7) applies, it seems clear that if the trademark rights are owned by a foreign corporation with only foreign shareholders, the PHC rules will be totally inapplicable.

The foreign personal holding company (FPHC) rules do not apply either. An FPHC exists when more than 50% of the stock of a foreign corporation is owned by 5 or fewer U.S. persons and more than 60% of the income of the corporation is foreign personal holding company income. Section 552(a)(2). Again, since the shareholders in this case are all foreign individuals, the FPHC rules can have no application in this case.