Historically taxpayers have faced difficulty overcoming a presumption against a change in domicile to a foreign jurisdiction.
Intellectual property generally will be the most valuable asset held by technology companies and, in fact, many other business entities across all sectors of the economy. A recent analysis of S&P 500 companies showed that IP accounted for an average of over 80% of company value a considerable increase from only 17% 40 years ago. Whether the IP consists of manufacturing patents, marketing trademarks, corporate know-how, analytic formulas, or web source code, there are a number of significate issues to consider on an ongoing basis. Some of these include:
- IP investment and development how can it be accomplished most efficiently in order to better insure the business future success as well as protect the founders’ interests from dilution as the result of third party capital investment; and
- Leveraging IP globally how does a company best utilize its IP for international growth?
While each company has its own unique IP issues, there are certain strategies that should be put in place in order to better achieve the development and improvement of IP most efficiently.
Regardless of its form, IP is a strategic asset and potentially extremely profitable for a company. Keeping IP in the United States may in some circumstances be optimal for tax and management purposes. However, it business extends beyond the US borders, non-tax business reasons as well as lower effective tax rates may make the ownership and development of IP in multiple jurisdictions a better strategy. The resulting tax savings can be significant and can help to create additional capital while reducing the need to seek third party capital. Google, Apple, Microsoft, and many other well-known companies have taken advantage of this strategy-doing so promotes management and tax efficiencies, the consequences of which can provide a distinct competitive advantage.
International IP Structures in Operation
Given the complexity of the IP international tax rules as well as the operational complications potentially inherent in the deployment of IP throughout an international corporate structure, there are two general choices with respect to the ultimate ownership of IP rights within a multinational corporate group.
If US and foreign IP rights can feasibly be “split” and separated from an IP perspective, a cost-sharing arrangement may be an attractive option. In this type of structure, a non-US IPCo and its US affiliate/parent enter into a cost-sharing arrangement whereby the companies share the costs of future development of IP in proportion to each company’s anticipated share of economic benefit. Thus both US affiliate/parent (as to the US IP rights) and non-US IPCo (as to the foreign IP rights) are treated as “owners” of the IP, and no royalties are imputed to US affiliate/parent with respect to the use of the IP outside of the United States. The result should allow for growth of non-US IP rights with minimal US tax exposure and, provided a favorable jurisdiction is selected for non-US IPCo, a low overall effective tax rate.
However, some types of IP cannot or should not be “split” among US and non-US IP rights. In that situation, the tax preference likely will be to own all of the IP in a non-US IPCo (although as mentioned below, generally, this raises US tax complications) and, to the extent research and development is done in the United States, to have a services contract in place by which the non- US IPCo contracts for such R&D. Thus, the US company would directly, or through a US subsidiary research and development company (“US R&D Co”) carry out the global R&D functions of the multinational group. Non-US IPCo will then contract with US R&D Co, under an arm’s-length services agreement at fair market compensation, to perform non-US research and development services on behalf of non-US IPCo. As IP is developed under the services agreement, non-US IPCo will have full title as confirmed by the terms of the R&D services contract. In addition to the ownership rights of US and foreign IP, there is also the question of jurisdiction for Foreign IPCo. While the variables are complex, some of the common considerations of selecting an appropriate location usually include: a jurisdiction with a skilled labor force, stable economy, low corporate tax rates, R&D incentives, and an extensive tax treaty network.
Issues Surrounding Cross-Border IP Transfers: The Tax Perspective
One of the most common hurdles to creating a tax efficient offshore IP structure is the effective transfer of the IP from the United States abroad. Many US companies have developed their IP domestically and hold IP in a domestic subsidiary or even the parent corporation. Generally, if IP will be utilized only in the United States, it is likely more tax efficient for such rights to remain in the US rather than offshore.2 However, if it is anticipated that IP will be utilized internationally, there are alternative ways to transfer foreign IP rights offshore to more favorable tax jurisdictions.
Assuming global IP rights are held in the US, one option is for the US company (“US Parent”) to simply sell all foreign IP rights to a foreign corporate subsidiary (“Foreign IPCo”). This option is ideal for new start-ups with IP that currently has a low (or no) value attributable to foreign rights but is expected to appreciate significantly in future years. A sale of this IP today should result in minimal current US income tax to US Parent because of the IP’s low value and will allow for appreciation of the IP free of US tax. Any resulting gain should be capital gain for US tax purposes (taxed at 20% for individuals). This option may not be efficient for companies with IP that has successfully been deployed or utilized and therefore would have a higher valuation. In that case, an outright sale could result in significant US tax, since the basis in the IP is likely low.
An alternative to this structure is for US Parent to contribute all foreign IP rights to Foreign IPCo in exchange for shares of stock in Foreign IPCo. Generally, contributions of IP to domestic corporations in exchange for stock are tax-free transactions; however, when the transferee corporation is foreign, US tax law imputes a royalty to the contributing taxpayer. The amount of this imputed royalty reasonably reflects the licensing income that would have been paid to US Parent annually over the IP’s useful life, but not for a period of more than 20 years. These imputed royalties are ordinary income for US tax purposes (taxable at 39.6% for individuals or 35% for corporations).
It is crucial for any company considering an offshore IP transfer to carefully consider these alternatives in determining which method presents the optimal after-tax result.
Each of these structures present excellent tax planning opportunities, but also some potential landmines that need to be carefully monitored by a qualified tax advisor. A recommendation, however, is to address daunting tax and commercial issues relating to an IP holding structure sooner than later. It’s rarely easy, but the financial and emotional costs are considerably less when IP planning is a part of the earlier developmental stages, especially for technology companies with potential for significant global growth.