ORDER RE: TAIWANESE WITHHOLDING TAX OBLIGATIONS ARISING FROM SETTLEMENT AGREEMENT

PAUL S. GREWAL, Magistrate Judge.

On the eve of Valentine's Day, on February 13-14, 2014, the parties in this breach of contract case met with the undersigned in a lengthy and ultimately successful settlement conference. Unfortunately, mere days later, the parties confronted significant differences in their views of the tax withholding responsibilities created as a result of the agreement. This dispute is no mere technicality; the effect of a resolution one way or another could be worth as much as $49 million. Despite multiple letter briefs and further conferences, these issues have not yet been resolved. And so the undersigned was left with no choice but to resolve the dispute by shifting roles from facilitator to decision-maker. After submitting further briefing, the parties appeared for a hearing on the matter.

A district court has ancillary jurisdiction to resolve settlement agreement disputes when it explicitly retains jurisdiction,1 as the parties here provided in the term sheet.2 Having considered the parties' arguments, the court finds that PTI acted largely in accordance with the parties' agreement when it withheld Taiwanese tax from the settlement payments. With respect to the $31.4 million settling claims for unpaid royalties, however, PTI shall "gross-up" this payment, if necessary, to ensure Tessera receives a net payment of $31.4 million. With respect to the portion of payments settling all other claims, PTI may continue to withhold the appropriate taxes, as required by Taiwanese law.

I. BACKGROUND

PTI is a Taiwan-based manufacturer of semiconductors. PTI filed the underlying case against Tessera in December 2011, alleging claims breach of contract and fraud arising out of a license agreement signed by the parties in 2003.3 Despite the hammer-and-tong litigation that followed, the parties nevertheless engaged in parallel and ongoing settlement negotiations beginning in December 2012. At one point during those discussions, in May 2013, Tessera produced a draft settlement agreement.4 But any real progress was hard to come by. In late 2013, however, Chief Judge Wilken's rulings on several summary judgment motions significantly changed the landscape.5 This case was then referred to this court for the purpose of facilitating a final settlement agreement.6

On January 27, 2014, the parties joined the undersigned here in San Jose for a settlement conference. No settlement was reached. On February 13, 2014, after a series of follow-up calls, the parties again joined the undersigned for a settlement conference. In addition to their attorneys, the parties' representatives at both conferences included Tessera Chief Executive Officer Tom Lacey and PTI Chairman and Chief Executive Officer D.K. Tsai. After about 14 hours of negotiations, at around 12:30 a.m. on February 14, 2014, the parties reached a deal resolving Tessera's claims that was memorialized in a signed term sheet.7 There was no equivocation as to the finality of the agreement; the parties explicitly agreed that this was a binding, enforceable agreement.8 The term sheet provided that PTI would pay Tessera a "total of $196 million in payments," to be made over the next five years.9 The term sheet also terminated the License Agreement between the parties, as of December 2012, that would have otherwise extended until 2027.10 The term sheet did not, however, explicitly provide for the tax treatment of the payments; specifically, which party would be responsible for paying any tax obligations owed as a result of the agreement to the Taiwanese tax authority.

Consistent with the term sheet, and as the parties worked to transform the term sheet into a more fulsome document, PTI made its first payment on February 27, 2014.11 As required by Taiwanese law, PTI withheld 20 percent of that payment.12 PTI provided to Tessera a receipt of both the wire transfer and income tax withheld.13 This dispute arose because Tessera complained that it should receive the total payment agreed to in the term sheet, net of taxes, and any withholding requirement should be borne by PTI.14 Tessera thus views the payment as a breach of the settlement agreement.15 PTI maintains the payment was not to be made net of taxes and it therefore must withhold the required taxes from the agreed-upon amount. The issue before this court is whether PTI should withhold the mandatory 20 percent from the total amount specified in the agreement, or whether it should withhold from a "grossed-up" amount so that Tessera receives the full amount net of taxes.

II. DISCUSSION

A. Settlement Payments May Be Taxed in both Taiwan and in the United States

The Taiwan Income Tax Act requires a local company making payments to a foreign company, without a permanent establishment or business agent in Taiwan, to withhold from such payments the income tax imposed upon such payments and payable by the foreign company.16 The applicable income tax rate is 20 percent.17

Under a 2004 program, the Taiwanese National Taxation Bureau may grant an exemption from this requirement, determined on a case-by-case basis, for the purpose of encouraging the importation of new technologies into Taiwan.18 This exemption is available for royalty payments for foreign technology, but does not apply to settlement payments unrelated to the acquisition of technology.19 PTI thus is required by Taiwanese law to withhold 20 percent from each payment to Tessera unless an exemption is granted by the Taiwanese tax authorities.20

There is no double taxation treaty between the United States and Taiwan.21 The U.S. does, however, provide some relief to businesses paying tax on foreign source income both in a foreign jurisdiction and in the U.S. In order to avoid double taxation, the U.S. provides a Foreign Tax Credit ("FTC"), allowing businesses to receive a credit towards their U.S. tax liability for any income taxes paid to a foreign jurisdiction on income derived from a non-U.S. source.22 The business has ten years to claim the full value of this credit.23

Under this scheme, Tessera may claim a FTC for any amount PTI withholds and pays to the Taiwanese government, which can then be used to offset U.S. taxes otherwise owed on foreign source taxable income.24 If Tessera does not have sufficient foreign source taxable income in a particular income year, it cannot use the FTC and will have to carry it over to the next year.25 Tessera argues FTCs involve risks not associated with cash payments because they might expire before they can be used, meaning they may have little to no value for Tessera.26 However, it is also possible that Tessera will be able to use the FTCs to offset its U.S. taxes, in which case they will have tremendous value. There is simply no certainty at this point.

The parties agreed to $196 million in settlement payments, which is either (1) the total amount received by Tessera or (2) the total amount paid out by PTI. Because of the mandatory 20 percent withholding requirement in Taiwan, it cannot be both. The parties agree on this much. The parties disagree, however, on which scenario they agreed to under the terms of the settlement.

B. The Tax Burden of the Settlement Agreement Should Be Born By Both Parties

The construction and enforcement of settlement agreements are governed by principles of local law that apply to the interpretation of contracts, even if the underlying cause of action is federal.27 In California, a contract must be "interpreted as to give effect to the mutual intention of the parties as it existed at the time of contracting," looking to the whole contract taken together and the circumstances under which it was made.28

PTI initially requests the court to simply incorporate into the final agreement the language of Section 3.2(c) from the proposal drafted by Tessera in May 2013 ("May 2013 Draft").29 Under that section, Tessera would bear all tax responsibilities and PTI would withhold as required.30 However, "for the terms of another document to be incorporated into the document executed by the parties the reference must be clear and unequivocal" and "the reference must be called to the attention of the other party and he must consent thereto."31 Here, the term sheet did not clearly and unequivocally incorporate the May 2013 Draft or any of its terms. That much is clear. The language of Section 3.2(c) therefore may not simply be incorporated. To resolve this dispute, the court must turn elsewhere.

Tessera argues the amount it was to receive under the agreement would be net of any withholding tax by focusing on the language of the term sheet.32 For example, the term sheet provides "PTI and MTI will pay $50 million (`the up front payment') to Tessera" and it later provides "conditioned upon receipt by Tessera of the initial $50 million payment."33 Tessera urges that because this language is framed as amounts Tessera would receive, it shows the parties intended the settlement payments to be net cash payments.34 PTI, however, also argues the language of the term sheet substantiates its interpretation. For example, the term sheet acknowledges there will be a "total of $196 million in payments," not a total of $196 million plus amounts necessary to pay applicable withholding taxes.35 PTI also points to the provision in Tessera's proposed final agreement that acknowledges PTI's legal obligation is subject to the Taiwanese government tax laws.36 Because the language of the term sheet is unclear and susceptible to more than one reasonable interpretation, the court must look to the circumstances surrounding the preparation of the term sheet.37

The May 2013 proposal would appear to be evidence of the intent of the parties because it was the starting point of the settlement conference and Tessera even used that draft to compile the proposed final agreement.38 Furthermore, before the settlement conference, the undersigned suggested the parties use the May 2013 Draft to compile a list of issues to discuss. However, Tessera explicitly withdrew its proposal before attending the conference in February. It would be unreasonable to bind either party to any of those terms of May 2013 proposal to which it did not specifically agree. Furthermore, the draft was produced before the parties received rulings on several summary judgment motions, which substantially changed the parties' assessments of the case's value.39 The court is not persuaded the parties intended the undiscussed terms of the May 2013 Draft to be binding on this new round of settlement negotiations.

The most significant surrounding circumstance and best evidence of the parties' intentions is the 2003 License Agreement. That agreement was the factual predicate for Tessera's unpaid royalty claims in this litigation and nothing in the settlement agreement changed the prior method of tax allocation.40 Under the 2003 License Agreement, Tessera was to receive royalty payments net of any Taiwanese taxes withheld.41 Although Tessera did not pay income tax on these royalty fees, neither did PTI. This was because Tessera had received an exemption from the Taiwanese National Taxation Bureau, which relieved PTI of its corresponding withholding requirements.42 Absent this exemption, however, PTI would have needed to gross-up payments and withhold taxes in order to pay Tessera the net payment amount. Because the parties previously agreed on this tax allocation structure with respect to royalty payments, and in the absence of bad faith,43 the court concludes it should continue to control. Because the agreement settled more than just claims for unpaid royalties, however, applying this framework to the whole agreement is not appropriate.44

The portion of the payments attributable to unpaid royalties should be treated separately from the rest of the payments.

With respect to the portion of the payments settling claims for unpaid royalties, PTI should bear the responsibility for paying any taxes owed to the Taiwanese government arising out of these payments. The tax exemption previously granted was of limited scope and does not necessarily extend to payments made under the settlement agreement, even if paid to compensate for unpaid royalties.45 The parties will thus need to apply again for the exemption.46 Apparently, PTI has already initiated this process, but requires an invoice from Tessera to show the portion of the settlement payments attributable to back royalties.47 Tessera shall cooperate and make all reasonable efforts to assist PTI in this process. But PTI is ultimately responsible for grossing up payments compensating for unpaid royalties, if necessary, so that Tessera receives the net amount.

With respect to the portion of the payments settling all other claims, the language of the agreement is not clear, and there is no course of dealing between the parties from which to glean their intentions, so the general principals of law underlying settlement payments apply. Looking to the more common, purely domestic, settlement context, it is well-established that settlement payments do not escape the purview of mandatory tax laws. For example, settlement payments in the United States constitute gross income and are subject to income tax unless expressly excluded by another provision in the Tax Code.48 It also is well-established that employers are to withhold tax from those portions of the agreed upon settlement amounts paid to compensate for lost wages.49 The case law thus establishes that when there is a withholding requirement imposed on one party by a government authority, that party must comply with the requirement as it applies to settlement payments. Where the parties do not establish otherwise, the presumption is that taxes are levied on the total settlement amount agreed upon.50 Even if royalties to a company are not the same as wages to an employee, the court finds no reason why the same principals should not apply. Withholding taxes from the settlement amount is proper, whether required by the United States government or a foreign government, especially under an agreement between equally and quite sophisticated parties.

Tessera finally argues the FTCs do not have comparable value to it as cash, and so any structure allocating tax responsibilities other than one that results in Tessera receiving the full settlement amount net of taxes would deprive it of the full value of the agreement. However, it is undisputed that the FTCs do have some value, and possibly even comparable value as cash. Therefore, an allocation structure "grossing up" the settlement payment would result in a windfall for Tessera, and at PTI's expense.51 Tessera would receive the full amount of the settlement net of taxes, as well as FTCs for the 20 percent withheld.

In sum, the court finds that the $196 million settlement amount should be classified as $31.4 million for unpaid royalties and $164.6 million for all other claims. The parties shall cooperate to apply for an exemption from the Taiwanese government from paying tax on the portion settling claims for unpaid royalties. Because PTI bears the tax burden on this unpaid royalty portion, PTI shall pay Tessera $31.4 million net of taxes, regardless of the success of the exemption. With respect to the remaining $164.6 million settling all other claims, the court finds that PTI need not "gross up" this amount. Instead, PTI shall pay out a total of $164.6 million, with $131.68 million to Tessera and $32.92 million withheld as required by the government of Taiwan.

IT IS SO ORDERED.