Each edition of Tax Matters consists of free-flowing responses by three tax practitioners to a question regarding a current issue in tax law and policy. Tax Matters commentaries provide insightful perspectives on a broad range of topics, making important contributions to the dialogue within the tax bar about cutting-edge issues. Although the commentaries are certainly of interest to the academic community, they are primarily directed toward tax professionals and their clients.
Paul L. Caron, Charles Hartsock Professor of Law, University of Cincinnati College of Law
The Leahy-Smith America Invents Act of 2011 (“2011 Act”), like its predecessor, the Patent Act of 1952, requires patented inventions to be useful, novel, and non-obvious. Thus, the invention must not be anticipated by “prior art,” such as publications and other patents. The 2011 Act specifies that any tax strategy patent, with some limited exceptions, “shall be deemed insufficient to differentiate a claimed invention from the prior art.” That is, the 2011 Act denies patentability to tax strategy patents by creating a per se rule that they cannot satisfy the requirements of novelty and non-obviousness. This approach, however, was adopted only after other approaches proved unsuccessful. Comparing the choice ultimately made to two other possibilities clarifies the purpose of the provision as enacted.
The first approach, which several professional groups endorsed in 2007, would have limited liability for infringing or inducing infringement of tax patents. Such limitation on liability would have paralleled a provision of the patent law enacted in 1996, the Physicians’ Immunity Statute, which bars patent holders from obtaining damages or injunctions against medical practitioners for infringing patents on medical procedures. Those supporting the Physicians’ Immunity Statute argued: 1) that it would be unethical for physicians to seek patents on medical procedures; 2) that the medical profession had long relied on the open exchange of information and that patents on medical procedures would affect relationships with patients; 3) that these patents would increase the cost of serving clients; and 4) that they would complicate patient confidentiality. Tax groups making similar arguments called for a similar solution.
Experience with the Physicians’ Immunity Statute, however, has shown the limitations of its approach. First, the provision has a narrow reach; it fails to protect processes if they also involve patented drugs, device or products. Second, whether the immunity provision applies is a question of fact. It cannot be resolved on summary judgment and does not protect practitioners from the cost of preparing a full defense. As a result, it failed to provide the kind of protection crucial to a practitioner. In short, immunity for liability implicates a number of practical difficulties.
The approach of the Physicians’ Immunity Statute also raises significant questions regarding compliance with TRIPs, the Agreement on Trade Related Aspects of Intellectual Property. TRIPs provides that “patents shall be available for any inventions, whether products or processes, in all fields of technology, provided that they are new, involve an inventive step and are capable of industrial application.” Moreover, it requires that patent rights are to be enjoyable without discrimination, and limiting liability for a particular category of patents discriminates among patent rights. While TRIPs contains an exception for compliance with its requirements for inventions related to human life and health that may cover the Physicians’ Immunity Act, this exception would not be available for tax strategy patents.
“The Patent Reform Act of 2007, which passed the House of Representative, but not the Senate, took the second approach. Largely because of concerns about TRIPs, it excluded tax strategy patents from the very definition of a patentable invention. The House Judiciary Committee Report accompanying the 2007 legislation argued that defining patents to exclude tax strategy patents fared well under TRIPs. It took the position that this approach did not violate the anti-discrimination provision of TRIPs because many members of the World Trade Organization did not consider business methods, of which tax strategy patents are a subclass, as a “field of technology” for which TRIPs requires patent rights.
Amending the provision of the patent law defining a patentable invention failed to gain sufficient traction because the patent bar views a broad definition of patentable invention as sacrosanct. Patent practitioners, deeply committed to the U.S. patent system as promoting innovation crucial to our country’s economic success, objected to limiting this definition in any way. In other words, defining patentability to exclude tax patents faced a conceptual difficulty.
The tax strategy provision of the 2011 Act sidesteps both of these problems by respecting not only TRIPs, but also the definition of a patentable invention. Moreover, this approach recognizes the difficulty that United States Patent and Trade Office examiners face in finding prior art to determine whether tax strategy patents are in fact novel and non-obvious. As the legislative history states, “any future tax strategy will be considered indistinguishable from all other publicly available information that is relevant to a patent’s claim of originality.” The legislative history also acknowledges the important policy reasons for thwarting tax strategy patents – ensuring that the ability to interpret and implement the tax law “remain[s] in the public domain, available to all taxpayers and their advisors.” Patents give their holders a 20-year right to exclude others from making, selling, or using the patented invention. When inventions would bar American citizens from adopting methods by which they can fulfill their obligation to supply the government with revenue, the values of the patent system give way to the needs of the tax system.
Congress recently enacted legislation intended, with limited exceptions, to prohibit patents on tax strategies. The events leading to adoption of this statute and the potential aftermath present important issues relating to the differing objectives of the tax and patent systems.
The possibility that tax strategies could be patented can be traced to the Federal Circuit’s 1998 decision in State Street Bank & Trust Co. v. Signature Financial Group, 149 F.3d 1368. Although State Street is known as the seminal case on the patentability of business methods, the patent claims at issue included tax reduction strategies. State Street may therefore be the first tax patent case. Tax patents received modest attention after State Street until the filing in January 2006 of a patent infringement action involving a tax and estate planning method for transferring compensatory stock options (the “SOGRAT” strategy). The SOGRAT lawsuit dramatically raised public awareness of tax patents not only because it implicated a tax planning strategy but also because many estate planners considered that strategy to be an obvious and well-known technique. The case provoked widespread concern regarding the potential for patenting tax strategies and the attendant implications for the tax system.
Tax patents have inspired disparate reactions in the tax and patent communities. Patent experts perceived the issue as a small part of the much larger question of whether business methods, including tax strategies, could be patented at all, a subject that the Supreme Court recently sidestepped in Bilski v. Kappos, 130 S. Ct. 3218 (2010). For patent lawyers, there was no important policy reason to distinguish tax strategy business methods from other business methods. Patent law, they argued, should be applied neutrally across technologies, whether by judicial analysis or statute, and regardless of the concerns expressed by tax practitioners. They noted that although problems had often arisen as the patent law was applied to new technologies, exceptions had not been created as a result. In one sense, the problems with tax patents, even if valid, were simply a cost of maintaining the integrity of the patent system.
The reaction to tax patents among tax professionals was profoundly different. Knowledge of tax strategies is generally available through discussion, publication, and otherwise; this minimizes the significance of one policy justification – dissemination of new ideas – for granting patents. Encouraging innovation, another important policy justification for patents, struck many as singularly inappropriate for tax patents. As Professor Ellen P. Aprill testified at a July 2006 Congressional hearing “… it would be hard to identify a subject less in need of further innovation than tax planning. Existing economic incentives already provide ample inducement for the development, promotion, and implementation of tax planning strategies.” Moreover, the source and focus of tax strategies – laws enacted by governments – seemed ill-suited to the right to exclude others from using the invention protected by a patent. In addition, the existence of tax strategy patents posed challenging questions as to ownership of the invention, which party could be held responsible for infringement, and ethical and other professional responsibility concerns. Finally, the initial experience with the patent system did not inspire confidence that administrators could apply basic patent requirements such as novelty and non-obviousness on a consistent basis to identify tax strategies that should be recognized as patentable inventions.
The congressional response to tax patents was consistently negative, starting with hearings held in July 2004 and July 2006, and followed by numerous legislative proposals introduced in early 2007 and afterward. The principal obstacle to enacting a legislative response was jurisdictional. As a practical matter, a legislative remedy could be fashioned only in the judiciary committees, not the tax writing committees. This dilemma was finally resolved by incorporating a tax patent statute within the broader context of a patent reform bill, which was eventually enacted.
It remains to be seen whether the new patent law provides a satisfactory solution from the perspective of tax professionals. Some believe that creative drafting of patent claims may be used to avoid the intended objectives of the new law. Others have noted that exceptions in the statute for tax preparation programs and for financial management may provide room to work around the new limitations. Moreover, it may take years of administrative experience, litigation, and judicial decisions before the scope of the new statute becomes clear. Finally, the courts must still grapple with the general issue of whether and under what circumstances business methods, including tax strategies, may be patented, a process that also may take some time to yield useful guidance. In the interim, tax practitioners may take comfort from the recent sympathetic intervention by Congress, which may influence future administrative and judicial responses.
Grandfathered Tax Strategy Patents
The notion that tax strategies could be patented came as quite a shock to tax lawyers. The nearly universal reaction was, “That can’t be true!” Patent lawyers essentially responded by saying, “Get over it. Tax is just another area that will have to get used to the existence of business method patents.” While much of the reaction in the tax bar may have been based on resistance to such a “new reality,” the patent bar seemed to miss the larger public policy issues raised by tax strategy patents, issues that are not generally present with respect to business method patents. These policies prevailed with the enactment of section 14 of the Leahy-Smith America Invents Act (the “Act”), which essentially precludes tax strategy patents by deeming “any strategy for reducing, avoiding or deferring tax liability” to be “insufficient to differentiate a claimed invention from prior art.”
Unfortunately, the legislation is limited to patent applications pending on the date of enactment (September 16, 2011) and any patent issued after that date. That leaves a substantial number of existing tax strategy patents to deal with. The exact number of such patents is not easy to determine. Several years ago, the Patent and Trademark Office established a subclass of business method patents (36T) for tax patents that contains well over 100 patents, but other tax patents may have been granted and placed in other categories.
The legislation and associated legislative history are less than helpful in setting the stage for dealing with existing tax patents. One would have expected that the worst case would be language indicating that no inference should be drawn from the legislation that any tax strategy patents already issued were valid or that tax strategies were even patentable subject matter. Not only do the statutory language and legislative history omit such a statement, but the legislation itself can be read as implying the contrary. Section 14(d) of the Act states, “Nothing in this section shall be construed to imply that other business methods are patentable or that other business method patents are valid” (emphasis added). By banning tax strategy patents on a prospective basis and simultaneously saying that no inference is intended as to the validity of other business method patents, without addressing existing tax patents, did Congress create an inference that it thought tax strategies were patentable under prior law? That would seem to be a stretch, but it would have been nice if the “no inference” language had also encompassed existing tax patents.
In any event, the validity of existing tax patents remains uncertain. It is unclear when or whether this uncertainty will be resolved. My impression is that in the case of a number of the more sophisticated strategies that have been patented, the patent was obtained for defensive purposes. In other words, the developer of the strategy was concerned that someone else might obtain a patent for it and seek to prevent the developer from using the strategy or marketing the strategy to others. These patent holders are unlikely to raise infringement claims.
An example of a defensive patent is the patent on contingent convertible debt instruments (Patent No. 7,219,079), which was filed in 2001 and granted in 2007. A version of the transaction covered by the patent is described in Revenue Ruling 2002-31, 2002-1 C.B. 1023, which concludes that when properly structured, these debt instruments result in higher interest deductions to their issuers than traditional convertible debt. Many corporations issued contingent convertible debt instruments in the 2000’s, and did so in offerings registered with the SEC. Information as to these offerings was thus publicly available, yet as best I am aware, the patent holders have never asserted any infringement claims.
As to holders of existing tax patents who may be inclined to assert infringement claims, there remain significant obstacles to discovering potential infringement in light of the confidentiality between tax advisors and their clients and the confidentiality of tax return information. In the absence of promoters marketing a potentially infringing tax strategy or public documents disclosing the use of the strategy (as in the case of contingent convertible debt instruments), patent holders will typically have difficulty identifying potential infringers. Even if they can identify a potential infringer and assert a claim of infringement, there is a significant likelihood the claim will be settled. Patent litigation is notoriously expensive. Thus, any judicial resolution of the legitimacy of tax patents grandfathered under the Act may never occur. Given the frequent changes in the tax law, and the impact of those changes on the consequences of any tax strategy, the likelihood of any judicial resolution of this question seems likely to diminish rapidly over time.