Parties Bear Their Own Tax Consequences Unless Settlement Agreement Provides Otherwise

Authored by D. Brian Kacedon, Christopher L. McDavid, and John C. Paul

Abstract

A Michigan court recently ruled on the proper terms of a settlement agreement where the defendants sought to add provisions relating to tax consequences and the definition of "affiliates" to the agreement that were arguably consistent with the parties' intent as expressed in a settlement conference. The court found that the parties never raised the tax consequences of the settlement during the settlement conference, and if the receiving party wanted to ensure that they would receive the full settlement payment without regard to any withholding tax consequences, they should have negotiated that result into the agreement. The court also rejected a proposal to later define the term "affiliates" in the cross-license to include both present and future affiliates of the parties because that proposal would necessarily require including a "change of control" provision that was never contemplated by the parties.

Even when plaintiffs and defendants in patent-infringement litigation reach a settlement agreement to resolve all claims in the suit, disputes as to certain details may arise when the parties seek to memorialize the settlement to a written agreement. While courts encourage the parties to resolve such differences without further judicial intervention, the parties sometimes reach an impasse. This scenario recently played out in I.E.E. International Electronics & Engineering, S.A. v. TK Holdings, Inc.,¹ where the parties reached an agreement during a settlement conference but in reducing the settlement to writing reached an impasse as to two points.

First, although the parties did not discuss the tax consequences of the agreement during the settlement conference, the defendants proposed to add a provision allowing them to withhold a portion of their $1.1 million settlement payment to comply with German tax law. Second, the defendants sought to define the term "affiliates," encompassed by the cross-licensing terms of the settlement, to include both present and future affiliates of the parties. As to the first issue, the court agreed with the defendants, reasoning that if the plaintiffs wished to ensure that they would receive the full $1.1 million settlement payment without regard to any tax consequence, they should have negotiated that result into the agreement. On the second issue, the court rejected the defendants' definition of "affiliates," finding their proposal would necessarily require including a "change of control" provision, a term that was never mentioned or contemplated by the parties at the settlement conference.

Background

The plaintiffs, I.E.E. International Electronics & Engineering and IEE Sensing, Inc., and defendants, TK Holdings, Inc. and Takata A.G ., reached an agreement during a settlement conference to resolve their patent infringement dispute. At the conference, the parties agreed to grant one another a worldwide, nonexclusive, paid-up license to certain patents with no right to sublicense "except to affiliates." The defendants agreed to pay I.E.E. $1.1 million with no indication that any taxes would be withheld from this payment. The defendants later learned that such payment was subject to tax withholding under German tax law. When reducing the parties' settlement agreement to writing, the defendants sought to include a provision, over the plaintiffs' objection, that would permit them to withhold a portion of their $1.1 million settlement payment to comply with German tax law.

In addition, the parties did not explicitly define the term "affiliates" during the settlement conference, and the defendants sought to define the term in the written agreement to include both present and future affiliates. The plaintiffs further objected to this proposal. Reaching an impasse on these two points, the plaintiffs filed a motion asking the court to enforce the settlement agreement without the provisions offered by the defendants. Each side argued that its interpretation was consistent with the intent of the parties as expressed in the settlement conference. The court ruled for the defendants as to the tax provision and for plaintiffs as to the definition of affiliates.

The Court's Decision

The court began its analysis by clarifying the issue at hand. That is, the parties did not dispute that they had reached an enforceable agreement during the settlement conference. Rather, the parties differed only as to how certain terms of the settlement should be memorialized in a written agreement.

The court then agreed with the defendants that the settlement agreement allowed them to withhold a portion of their $1.1 million settlement payment to comply with German tax law. In failing to address the issue, the court reasoned, the parties were subject to a presumption that each side must bear the tax consequences associated with their obligations under the settlement agreement. According to the court, if the defendants were required to pay the full $1.1 million and also satisfy the payment required under German tax law, they would ultimately pay in excess of the $1.1 million figure agreed to in the settlement, to the benefit of the plaintiffs. The court viewed this outcome as an improper "reapportionment of the parties' benefits and burdens under their agreement." The plaintiffs, the court stated, should have negotiated a term into the agreement if they wished to ensure that they would receive a full $1.1 million payment without regard to any tax consequences.

As to the second issue, the court rejected the defendants' proposal to define "affiliates" to include both present and future affiliates. Although the defendants argued that the parties could have expressly specified that the settlement license agreement was limited to "existing" affiliates if that was their true intention, the court found no reason to adopt the defendants' expansive approach. Rather, according to the court, if the term included future affiliates, it would have been necessary to include a "change of control" provision into the agreement to prevent a current competitor of one or both of the parties from securing rights under the agreement by becoming affiliated with one of the parties at a later time. That the parties never contemplated a "change of control" provision during the settlement conference was a "strong indicator," according to the court, that the defendants' interpretation was incorrect.

Strategy and Conclusion

This decision shows that parties who do not raise and settle important terms while negotiating an enforceable oral agreement may possibly forgo the ability to include those terms when reducing that agreement to writing. It also shows the value of investigating and understanding, in advance, complex issues, such as tax consequences.

Endnotes

¹ The court's opinion can be found at http://www.finnegan.com/files/upload/LES_Insights_Column/2015/IEE_v_TKHoldings.pdf.