GFOA Committee OKs Policy Criticizing Muni Market Patents

The Government Finance Officers Association’s committee on governmental debt management Friday approved a public policy supporting federal legislation that would prohibit the patenting of tax strategies, technologies, and business practices in the municipal market.

The policy, which still must be approved by the GFOA’s executive board at its next meeting this spring and by members at their annual meeting in June, warns that these types of patents could drive up issuance costs, expose bond issuers to litigation, and even prevent state and local governments from completing transactions.

“If patents become part of the public finance landscape, development of innovation and efficiencies created by evolving or developing financing techniques and technologies will be stifled,” the policy stated.

A draft of the policy had dealt only with patents on tax strategies and financing techniques, but was broadened to include “technologies” and “business practices” following some committee members’ requests for a more comprehensive position.

“The problem is not just tax strategies,” said J. Ben Watkins 3d, director of Florida’s bond finance division. “You should not to be able to hijack the application of technology to our business, which makes it more efficient and moves it forward for the collective good, for your own personal gain.”

The debt committee’s public policy comes as the Internal Revenue Service has proposed rules requiring transactions using patented tax strategies to be reported on tax forms and as legislation is pending in Congress that would prohibit tax strategies from being patented.

The IRS’ proposed rules appear to have slowed the applications for new patents, according to market participants.

“Right now, [the proposed regulations are] having an effect, I think, on the number of patents asked for,” said John Swendseid, a partner at Swendseid & Stern in Reno, Nev. “I have not seen any new applications in the tax-exempt bond area since the regulations were proposed.”

Swendseid said the slowdown in patent applications may be a sign that parties potentially interested in patenting a technique are waiting to see how the IRS’ proposed rules will be interpreted, whether they will be enacted, and whether lawmakers will pass legislation addressing tax patents.

“I think it has slowed it down, they want to think about it,” he said.

Currently 106 applications for so-called tax strategy patents are pending at the U.S. Patent and Trademark Office, but only seven new ones have been submitted since the IRS proposed the rules in September, according to Swendseid.

Of the 106 pending, only one involves a municipal bond-related tax strategy. The technique, called an 80-20 multiple owner structure, involves an ownership structure that received a favorable IRS private-letter ruling allowing the split ownership of a building that was treated as a single project under Section 142(d) of the tax code, which defines a residential rental project that can be financed with tax-exempt bonds.

Under patent regulations, there are four basic requirements needed to obtain a patent: the claimed invention must define eligible subject matter and have utility; it must be novel; it must not have been obvious to a “person having ordinary skill in the art” at the time the invention was made; and the inventor must have had possession of the claimed invention upon filing the patent application.

Since a U.S. Court of Appeals ruled in the State Street v. Signature Financial case, in 1998, that tax strategies could be patented as “business methods,” some 60 tax patents have been granted.

Some patented strategies involve the use of specific software or mathematical calculations, but others, such as the one granted to the 80-20 multiple owner structure in the muni market, are called “project” patents, cover a specific strategy requiring no special devices like software or calculations.

The IRS rules would require a party to a patented transaction to report its participation, under existing rules for “reportable” transactions, on Form 8886 and on its tax return. In addition, some advisers would need to disclose these transactions on a separate form on a quarterly basis.

The rules would define a patented transaction as one in which a taxpayer directly or indirectly pays a fee to a patent holder or its agent for the legal right to use a tax planning method that the taxpayer knows or has reason to know is the subject of the patent. The definition also would include transactions for which the patent holder has the right to receive such a payment.

Municipal market participants said the ramifications of the IRS’ proposed regs, and for tax patents in the muni market in general, are unclear.

“It’s troublesome because there are just too many unknowns here,” said Linda Schakel, a partner with Ballard Spahr Andrews & Ingersoll LLP. “I think for the muni bond industry, if you have to report that you’ve used a structure that is subject to a patent, all that is doing is giving the IRS information that I’m sure could be followed up by an audit, for example.”

Another concern is that the patent office lacks the expertise to determine if a tax strategy falls in line with IRS regulations. The Treasury has expressed concern in the past that a patent could mislead individuals into believing a specific tax shelter practice is legitimate and has been approved by the federal government.

“Basically, the IRS doesn’t want to be seen as having approved the structure just because another branch of the federal government has awarded a patent,” Schakel said. “I’m not sure that the patent office necessarily has tax experts.” She added, however, that the patent office would likely defer to the IRS if the legitimacy of a patented strategy came into question.

It also is possible that an issuer could unknowingly use a patented strategy, and not be aware of the patent until it is too late.

“The basic problem is that you often don’t know that something has been awarded a patent in the tax area,” Schakel said. “This is still relatively new, and it’s hard for us to know whether something is under a patent unless someone asserts it.”

Swenseid said it is unclear how the issue of tax patents ultimately will affect municipal issuers of tax-exempt bonds.

In its announcement of the proposed rules, the IRS said “taxpayers” would be required to report the use of patents. Technically state and local governments who issue bonds do not pay taxes.

“They drafted the rules thinking of the applications to people like you or me who want to use tax strategies to lower their federal income taxes. They didn’t draft it for situations where the person who pays the royalties on the patent is not the person who files a tax return,” Swendseid said. “Whether they’ll fix it or not, I don’t know.”

But Schakel said that she expects state and local governments probably would report the use of patented strategies to the IRS and would also notify bondholders.

“The taxpayer here is the bondholder, so if the state and local governments were not reporting it, the bondholder would have to be reporting it,” she said. “I imagine state and local governments, for audit purposes and a lot of the regulatory rules, would still report it. They would have to let the bondholder know that this was a reportable transaction.”

Anita Soucy, an attorney-adviser at the Treasury, told the GFOA’s debt committee late Thursday that the proposed IRS rules intend for municipal issuers to report the use of patented strategies. The patent holder or agent performing on behalf of the patent holder, as well as the parties using the patent, would be required to report the transaction to the IRS, she said.

The failure to report these transactions could result in a $10,000 fine for individuals and $50,000 for organizations, she added.

Soucy said the IRS is providing its expertise to the patent office, as well as to lawmakers working on patent legislation. She noted that the bill introduced in November by Senate Finance Committee chairman Max Baucus, D-Mont., and ranking minority member Charles Grassley, R-Iowa, is the first proposed ban on specific patents since 1952, when Congress decided to prohibit patents on atomic energy.

“They [lawmakers] see this as very, very significant,” Soucy said.

The House has already approved a comprehensive patent bill that would ban tax patents. Swendseid said if the lawmakers approve a law banning tax patents, the IRS would probably drop its proposed regulations.

Soucy conceded that Congress has created a “chicken-and-egg situation” for the IRS.

But she added that even if lawmakers prohibit the issuance of new tax patents, the IRS will still need to come up with a solution to deal with transactions using tax strategies that have already been patented.

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