Wednesday, April 10, 2019

IRS described itself as Qualcomm's 'silent partner' in imposing patent tax on mobile device industry

Standard-essential patent (SEP) holders with ambitious monetization goals and aggressive tactics notoriously refuse to extend licenses to chipset makers. There's more than one reason for this, but besides the real reasons--the primary one of which is money--there are some cheap pretexts and excuses that they'll present when challenged. It's the next best thing to hypocrisy.

I do appreciate it, however, when those companies come clean and tell it like it is. Ericsson, thankfully and boastfully, created an entire slide deck that explains it's just about (more) money plus a reduced risk of retaliation. That was just disarmingly honest.

Toward the end of the FTC v. Qualcomm antitrust trial in January, a transcript of a 2012 interview conducted by the Internal Revenue Service (IRS) with some Qualcomm employees made it into the record over Qualcomm's lawyer's objections. Given how incriminating that document is from an antitrust point of view, and imagining how Judge Lucy H. Koh in the Northern District of California might view it especially in the strategically critical context of chipset-level licensing, it's easy to see why Qualcomm wouldn't want that transcript to be considered by any judge or jury in any dispute.

But it's great stuff and proves that Qualcomm, too, can be disarmingly honest in the right context. In a long interview with the IRS (the actual transcript spans 120 pages), they were just as forthcoming as Ericsson in the aforementioned slide deck. So here's the transcript, and I'll quote some passages and share some observations below:

19-01-28 Qualcomm IRS Inter... by on Scribd

After reading the transcript as a whole I've concluded that the IRS apparently conducted some sort of preliminary investigation of whether Qualcomm's corporate structure results in an underpayment of U.S. taxes due to (and this is not clear to me) either a violation of the arm's-length principle for inter-company charges between QTL and QCT (because of QTL, the licensing business, not charging a patent royalty to QCT, the chipset division) or because of the possibility of some revenues being taxed in foreign jurisdictions like China--or some combination. In any event, what matters here s what was said more so than why the interview took place, but I tried my best to figure out the context.

The IRS wasn't being hostile in that interview. They were just trying to understand Qualcomm's business and were appreciative of the information they got. The Qualcomm licensing executives they interviewed were just trying their best to explain that their decisions make economic sense and that, between the lines, there was no tax avoidance or tax-shifting scheme there.

In Judge Koh's courtroom in January, Qualcomm's attorneys also presented legitimate, if not even pro-competitive, business justifications for everything, even for the refusal to license rival chipset makers. But the story there was completely different from what they told the IRS. It was far-fetched stuff such as arguing that there'd be fewer licensees if you extend licenses only to device makers (and contract manufacturers)--but there's only a very few chipset makers in this space versus literally hundreds of device makers.

What they told the IRS, however, is the true story. It's also pretty consistent with Ericsson's slide deck. And, especially, common sense.

The revenue maximization part of that interview was already mentioned in January: "obviously the handset is humongously more ucrative for a bunch of -- a bunch of reasons."

In the vicinity of that statement (page 72 of the PDF document), Qualcomm explains that royalties on handsets accounted, at the time (and probably still), for 95% of their patent licensing revenue stream. Elsewhere they explain that the chipset opportunity was just in the 1% range. The remainder would then be attributable to base stations.

On page 74, Qualcomm's Mr. Blecker explains:

"Yeah, but if I would average royalty on all the handsets that we collect royalties on -- I don't remember what it is anymore, I used to know the number -- but if -- if it were ten dollars, for example, you couldn't charge a ten-dollar royalty on a chipset that cost five dollars, or six dollars, or seven dollars."

His colleague Fabian Gonell then noted that "[t]heorectically you could, but as a practical matter you can't. As a practical matter it's hard." Mr. Blecker then added that "it would be hard to convince a court that that was a fair royalty also."

Then, at the very bottom of that page of the transcript, the IRS's Mr. Howell essentially assures Qualcomm that they should just maximize their income because it's in the agency's interest:

"Right. No, we're your silent partner. We want for you to make a lot of money, for that to happen."

And then Qualcomm's Mr. Blecker stressed again that it's on the handset where the money is."

There are some other interesting statements in there. In particular, starting on page 25, Qualcomm explained to the IRS the doctrine of patent exhaustion, how it evolved, and how that evolution required Qualcomm to change its licensing terms so as to avoid exhaustion. They also explain how patent exhaustion is always something that adversaries in legal disputes might hold against them, so they have to be very careful to navigate around it.

Ideally they don't want to do business with other chipset makers at all, but sometimes it can't be avoided, such as because the other party may have patents that Qualcomm wants to license (and typically exhaustively so it can tell its customers that they're covered). Early on it would have been possible to make a covenant not to sue a chipset maker, but then the Federal Circuit held that a covenant not to sue was tantamount to a license for exhaustion purposes, so as to avoid double-dipping.

In response to that case law, Qualcomm then switched to a structure called a "covenant to sue last" (as I reported during the trial) or, more formally, a covenant to exhaust remedies, meaning that Qualcomm wouldn't sue a chipset maker unless it would have a problem to obtain and collect damages from the device makers who buy those chipsets. In other words, they'd have to sue a device maker first, and then the device maker would have to go bankrupt so they'd have a basis for suing the chipset maker--theoretically possible, but practically rather unlikely.

As I wrote further above, the question is what Judge Koh will think of everything that's in that transcript. Her ruling could come down any moment now. And I think she already sees through all those smokescreens. Sure, there are patents that are not implemented in a baseband chipset, such as user interface or antenna patents. And there are patents that are't embodied in a baseband chipset alone. But cellular standard-essential patents are, and that's what she's held in an unrelated case (GPNE Corp. v. Apple) and in her partial summary judgment in FTC v. Qualcomm, which both Judge Gonzalo P. Curiel in the Southern District of California (at a recent hearing) and Judge James L. Robart of the Western District of Washington (at a Munich conference last Friday) appear to like as well. That IRS interview transcript just validates Judge Koh's and her colleagues' thinking. It's just clear that it's just about Qualcomm not wanting to go to court or conduct arbitration and argue over the reasonable royalty on a chipset when the end product--a smartphone or tablet--can serve as a far higher royalty base to start from.

What's almost funny in that transcript is how those Qualcomm licensing executives--all of whom are lawyers--remind each other of not making definitive concessions regarding the law. For instance, each time one of says some kind of contract may be exhaustive, someone else says "may be," even when they're all convinced it's simply certain to be the case.

Finally, from a competition policy perspective it's also interesting to read what they say about a contract term under which they require rival chipset makers to disclose their customers and the number of units they ship to them. They concede in the interview that it's very helpful for them to obtain such information on a competitor's business, and they try to impose that term whenever and wherever they can, but sometimes they don't have enough leverage to get all that they want and may then focus on other contract terms.

Another problematic term that was also mentioned already in the FTC trial is that they get other chipset makers to promise not to sell chips to device makers that don't have a patent license from Qualcomm. Such a contract clause enables Qualcomm at least to threaten with the pursuit of an injunction against shipments by a chipset maker to an unlicensed device aker.

With their covenant-to-exhaust-remedies approach to rival chipset makers, they're basically trying to achieve anticompetitive goals with respect to those competitors--and to make the end products more expensive. For Qualcomm's self-declared "silent partner," the IRS, that's just fine: whatever makes them the most money. But in an antitrust and FRAND context, a different kind of analysis is performed...

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