PricewaterhouseCoopers, Boston
The paramount importance of IP as a value driver in the economy is widely acknowledged by the business, academic, market, and practitioner communities. Following this awareness came an appreciation of the fact that for tax purposes IP is a strategic asset that generates value; that profitability in the various parts of a multinational group should reflect this; and that income should be taxed accordingly. Thus far, the prevailing view is almost unanimous.
However, recent challenges to corporate behaviour and the IRS's attacks on tax shelter transactions combined with what the authors believe is a limited understanding of the issues and complexities by the general investing public have encouraged growing media hype over 'creative' tax-planning strategies. For example, in one of several recent articles in the Wall Street Journal the author accuses US-based multinational companies of 'stashing' IP abroad to 'shelter' income. Specific companies have been cited as examples of this. Given the profile this issue now has in the US, this article focuses on the US issues. However, similar concerns apply elsewhere.
The purpose of this chapter is to consider whether the fuss is justified and to consider the case from both sides.
Response of the informed
The basic response to the main accusation is that the typical strategy of transferring IP is intended to align foreign revenues and operating income with the use of that IP in overseas markets. The intention is to limit cross border tax exposures such as transfer pricing to as few jurisdictions as possible. This kind of planning involves real economic consequences including risk of operating losses and the loss of deductions in the country of IP development once these costs are borne elsewhere.
By moving legal or economic ownership of IP to a different jurisdiction, a company also moves the responsibility for funding present and future development. Those IP development costs, which originally could be used to reduce taxable income in, say, the US, may no longer be claimed as deductions against US income, thus increasing US tax liabilities. The quid pro quo for the rights to use IP where the development costs have already been deducted is that the US taxes the fair value of that IP upon transfer (or exit) from the US
Continuing with the US for the purposes on illustration, if it was possible simply to remove IP from the US and book untaxed income offshore, the current accusations would be justified. The point, however, is that the US rules make it practically impossible to remove IP from the US and book untaxed income offshore without recognising a gain on asset disposal or charging a royalty for the income earned by the asset thereafter. Both the disposal and the royalties would have to be at market value. Furthermore, if the assets in question are merely transferred to an entity owned by a US corporation (or a US person), the income and increase of value are still subject to future US taxation. That is because the US tax system provides no exemption for income earned outside the US, but only a temporary deferral of taxation.
Despite these restrictive rules, many companies still undertake the taxable transfers of IP outside the US, for several reasons:
- Some companies choose to pay the tax because there is a commercial purpose behind the move or because it reduces tax exposures elsewhere.
- Some companies can offset all or part of the current tax impact with losses.
- For some companies the value at the time of the transfer is not as great as the future value created in other geographies.
- IP migration typically results in only a temporary deferral of tax.
- A successful IP planning strategy has to be based in business reality and should aim to help companies deal with numerous international business issues including legal restrictions, the way they run their businesses and their exposures to foreign country taxation.
- Tax authorities have an armoury of tools to tax any migration, to challenge the deferral; and to test the business reality.
Business reality
Tax directors of multinational companies are not usually in a position to drive a substantial business change. However, they are responsible for managing the tax rate, tax costs and the changes thereto. This usually means aligning income with costs and always means minimising risks, penalties and tax audit problems. Directors that do not (or cannot) make recommendations for structuring ownership of IP in line with its use in the international business find it increasingly difficult to better manage those issues.
The fact that IP transfers are not necessarily driven by motives of tax minimisation is also supported by the fact that many companies transfer their IP to high-tax jurisdictions. A US multinational automobile manufacturer, for example, uses the cost-sharing arrangements to manage economic ownership of its IP among its North American business units. Managing the economic ownership of IP allows the company to efficiently transfer technology from the locations in which it is developed to sites where it is used.
Some companies have resorted to structures that are disconnected from commercial reality. Broadly speaking, cases of synthetic tax planning (whether they involve IP or not) are becoming increasingly risky and are more likely to run afoul of regulations and applicable case law. Structures that involve the use of tax-haven affiliates attempting to earn passive income are not per se objectionable, provided they are viewed only as a temporary measure toward more permanent business substance. The tools possessed by tax authorities to challenge tax schemes that are not connected to business reality are many and varied, although they are also highly country specific. The point, however, is that the rules necessary to attack such abuses already exist.
Proactive IP planning is especially critical in cases where a substantial portion of a company's business is anticipated to come from sources outside its home country. Absent proper planning, the routine sharing of knowledge and use of IP within a multinational could yield unexpected tax costs, such as toll-charges, gain recognition, transfer pricing adjustments and withholding taxes. Conversely, a company's most valuable assets may not be properly protected and may be under-utilised.
Many critics unfamiliar with the matter seem to focus on legal ownership of registered IP (patents, trademarks). This ignores the principle of 'economic ownership' which many countries will apply to a greater or lesser degree when assessing taxes (this is considered in more detail in a subsequent chapter) and the fact that other valuable IP, such as marketing rights and contracts, can also have significant value in international commerce. Due to a variety of legal protection considerations, as well as maintaining efficient internal control, companies frequently do not transfer the legal title to IP offshore.
Even economic ownership of IP rights must be transferred for full value. In addition, such transfers must be in alignment with business functions, risks, and transactions across geographic borders.
Financial statement issues - SFAS 142
Thanks to the new merger accounting rules promulgated by the Financial Accounting Standards Board in the US (FASB), investors and other corporate stakeholders (including the government) can gain unprecedented visibility into the way companies manage their intangible assets. Before the rule changes companies involved in acquisitions, joint ventures, or similar transactions were typically combining IP with other considerations and recording it as goodwill. There has certainly been a lot of uncertainty regarding goodwill, including what assets companies put into that category and what they don't, as well as how the assets are valued and depreciated. Historically, companies have been able to spread the results of their decisions - good or bad - over long periods of time, sometimes as much as 40 years, without having to disclose much detail. Under the new rules, companies must recognise certain intangible assets separate from goodwill. These assets must be accounted for and, in some cases, amortised over specific and more compacted periods of time. Acquiring companies must not only account for them at the time of the transaction but in some cases, continuously over future periods. The remaining goodwill must be written down if annual tests find it to be impaired.
As a result, M&A advisers will be increasingly called on to consider the impact of intangible assets as the principal sources of value and the primary means for increasing value. The FASB's new rules are the most recent recognition of this new reality, foreshadowing increased pressures for accounting transparency, particularly in the area of intangible assets. It has become imperative for companies involved in M&A to sharpen their focus on the IP they are buying and subsequently managing.
The mechanics of IP transfers
Perhaps the most misunderstood notion of IP structuring is that there may be no particular income tax benefit to be derived from either owning a foreign corporation, or from that company owning rights to IP. Any potential benefit would be a direct result of the functions, risks and assets employed by the entity, and would be subject to numerous anti-deferral rules in the US and in many other jurisdictions.
The most widely used approach to managing global IP is the sharing of the costs of development expenses between business units (aka 'cost-sharing'). If a multinational organisation expects significant economic benefits from its IP, the sharing of development costs can ensure that all business units that are parties to the sharing arrangement may benefit from and have rights to the resulting IP.
The value for IP transfer purposes (typically represented as a 'buy-in' payment) is a very fact-specific determination, which is usually made only after careful economic and functional analysis of the company. Authors believe that it is imprudent to use IP transfers with low buy-in values as tools in reducing taxes. In fact, such transfers should be viewed as conveying a right to use IP, and the buy-in payment should be viewed as the up-front cost to participate in cost sharing with respect to future IP development.
In the US, a company will pay US tax on the value of transferred IP, either on the date of transfer or over the economic life of the IP. Periodic adjustments and 'look-back' rules (in the US under Treasury Regulations Sec. 1.482-4) prevent companies from understating the buy-in value.
It is overly aggressive for companies to view the determination of the buy-in price as an opportunity for reducing taxes. Rather, the general approach should be to value the initial intangible rights such that the result is equitable, both to the taxpayer and to the IRS, and supportable by sound economic analysis. Regarding the buy-in payments for the pre-existing IP, Treasury regulations require that these payments must be made in accordance with the arm's-length standard and be commensurate with income attributable to the intangible.
Prudent IP planning helps companies develop business-specific strategies that not only reduce the potential tax exposures, but can be used to extract the most value from the international use of their IP assets. IP strategies should be designed to proactively ensure that they adhere to the applicable rules and regulations in all cases involving related party transactions.
Source-of-income rules
The source rules for income are important because they provide limits on the income that the US may tax. The foreign source income of a non-US person will be subject to US tax only under limited circumstances, while the same person's US source income is generally subject to US tax. Furthermore, the non-US income of a US person may not result in current US taxes if foreign tax credits are available. The source-of-income rules differ by character of income, making the character determination all the more important.
Income from the sale of intellectual property generally has the same source as the residence of the seller, whereas the source of royalty income is the place where the property is used. The place in which services are performed will determine its source. The source of income from the sale of inventory property is generally the place that ownership of the goods changes hands. A significant exception to this is source of manufactured goods. Generally, the income from manufactured goods is bifurcated into a manufacturing component and a sales component. The manufacturing income has the source of the property used to manufacture the goods, while the source of the sales portion of the income is determined by the place where the goods change ownership.
Unlike the rules for characterising income, the form of consideration is relevant in applying the US source-of-income rules. As stated above, the general source rule for the sale of intellectual property is that it has the same source as the residence of the seller. However, if the payments are contingent upon the use or productivity of the subject intangible asset, the royalty source rules will apply, as laid out in IRC Section 865(d). For example, if a transferor transfers all substantial rights in intellectual property, such that the transfer is a sale, but a portion of the consideration is based on productivity of the intellectual property (eg, 5% of revenue), the consideration will be a royalty for sourcing-rule purposes; thus, while a transferor may expect income to be sourced to the residence of the seller, it will instead be sourced based on where the intellectual property is used. Thus, a multinational may alter the source of income from the sale of intellectual property by altering the terms of payment. This source rule allows multinationals welcome flexibility in tax planning for intellectual property transfers between group members.
Tax deferral
The US is an atypical case in that it has what may be the most draconian anti-deferral rules in the world. However, most other countries have their own equivalents. While deferral of a portion of US income taxes on non-US earnings is possible, there is little hope for most US-based companies of escaping taxation of worldwide income in the long run. It is worth noting that the exportation of ideas and brands is what drives a large portion of the US economy.
Ultimately, then, foreign profits are subject to home country taxes when the corresponding cash is brought back (repatriated) to fund distributions or other home country needs. As such, it may not be possible to report any or all of the potential tax benefit in the financial statements. In the meantime, the deferral and the cash flow benefits can help keep companies globally competitive, as well as freeing more funds for reinvestment.
To believe that IP planning necessarily is about tax avoidance is a gross over-simplification of the realities of cross-border business. It is also very misleading from a tax policy standpoint. Furthermore, companies in most major markets for the perfectly legitimate reasons given above should consider reorganisation of their IP. However, it is our experience that few companies (certainly less than 20%) actually implement such strategy.
That exportation is far from a tax-avoidance technique - it is how major US multinationals have grown revenues and profits.
| Tax authority powers to combat abuse | |
All major countries deploy specific anti-abuse doctrines to allow tax authorities to challenge and, in some cases, unwind what they perceive to be abuse. These range from specific legal provisions (eg, the 'General Anti-Avoidance Rule' in both Australia and Canada), to legal doctrine (eg, the Dutch principle of 'Fraus Legis') or even judicial approaches. Case law in the US is rich in variations on this theme and set out below is a brief summary of the different considerations, which apply.
Recent testimony by the US Treasury Department regarding the review of US tax provisions with respect to 'disguised transfers' of IP and changes in various enforcement mechanisms will bring even more focus to these issues in the US. A body of US law has evolved in response to transactions that may comply with the literal language of a specific tax provision yet yield tax results that are unwarranted, unintended or inconsistent with the underlying policy of the specific tax code provision governing the transaction. This body of law takes the form of five doctrines:
Courts use business purpose as part of a two-prong test for determining whether a transaction should be disregarded for tax purposes:
The business purpose test is a subjective inquiry into the motives of the taxpayer. Where appropriate, the court may bifurcate a transaction in which independent activities with non-tax objectives have been combined with an unrelated transaction having only tax avoidance objectives in order to establish a business purpose for the overall transaction. Thus, a taxpayer cannot utilise an unrelated business objective to hide the lack of business purpose with respect to the particular tax-motivated activities. Economic substance doctrine The courts generally will deny claimed tax benefits if the transaction that gives rise to those benefits lacks economic substance independent of tax considerations, notwithstanding that the purported activity did actually occur. In a recent case involving |
a plan designed to create losses where offsetting gains would escape US taxation, the courts held that the economic consequences of certain transactions and the subjective analysis of their intended purposes revealed an insufficient economic substance to allow the transactions to be respected. The courts also observed that the economic substance doctrine could apply even if the purported activity in the transaction actually occurs, ie, the transaction may be disregarded when (apart from tax consequences) the transaction results in no net change in the taxpayer's economic position.
Sham transaction doctrine Sham transactions are those in which the economic activity that is purported to give rise to the desired tax benefits does not actually occur. The transactions have been referred to as 'facades' or mere 'fictions' and, in their most egregious form, one may question whether the transactions might be characterised as fraudulent. Courts may either take the approach that the transactions never actually occurred, or occurred, but lacked the substance that their form represents. Substance over form doctrine When the substance over form doctrine is applied, courts determine the tax results of a transaction based on the underlying substance rather than an evaluation of the mere formal steps by which the transaction was undertaken. The aim of this doctrine is to achieve the same tax result for transactions that are substantively similar, although achieved through different legal steps. As a general rule, the IRS or the courts may employ this doctrine because taxpayers are ordinarily bound by the facts they create. However, there is some authority that allows taxpayers to assert the doctrine themselves under certain limited circumstances. Step transaction doctrine An extension of the substance over form doctrine is the step transaction doctrine. The step transaction doctrine treats a series of formally separate 'steps' as a single transaction if such steps are in substance integrated, interdependent, and focused toward a particular result. Whether the doctrine will be applied depends on the intent of the taxpayer and the temporal proximity of the steps. If a taxpayer can provide evidence that at the time the first of a series of steps was undertaken, there was no plan or intention to effectuate the other steps, then the transactions should not be stepped together. A taxpayer's lack of intent is found where subsequent steps are prompted by external, unexpected events that are beyond the taxpayer's control. If there is no legally binding commitment to engage in subsequent steps after undertaking the initial transaction, the span of time between the events is an important measure - although not dispositive - in determining whether the transactions should be stepped together. |
US Treasury authority on the issue
In addition to the tools illustrated separately, there are usually detailed rules on transfer pricing and cost sharing to ensure that exit taxes are based on market value. In the cases when related parties may have artificially reduced valuation of IP, a 'commensurate with income' standard should be applied to look forward to future revenues, instead of hoping to settle with the tax authorities down the road.
In the 1986 Tax Reform Act, Congress legislated that IP being transferred out of the US was subject to a 'toll charge' equal to its fair market value. In 1994, Treasury issued regulations describing methods to determine taxable income in connection with a transfer of IP. In 1996, the US Treasury promulgated cost-sharing regulations to address the business reality that development does not always take place in the country in which IP is used. These regulations provided clarity to taxpayers while offering safeguards for IRS that IP transfers are not unfairly eroding the US tax base. By offering this level of certainty to all involved parties, the regulations effectively reduce disputes between taxpayers and the IRS, thus preventing the expenditures of resources, both public and private, which would be required to resolve disputes.
Other countries use different tools to achieve the same effect. In the UK there are detailed rules for situations where a company used to be the beneficial owner of IP and becomes a licensee.
US 'tax shelter' considerations
Although firms operating outside of the US may not have the same limitations, the IRS generally prohibits the promotion of 'tax-shelters'.
In general, reasonable, prudent, and well-documented IP structuring projects do not constitute tax shelters. In particular, most IP strategies are highly fact specific and no assurance can be given in any particular case that the arrangements are totally free from potential challenge. In fact it is conceivable that in some cases a successful implementation, under adverse factual developments, could lead to a detrimental tax result, rather than being advantageous. That risk underscores the individual nature of the analysis and distinguishes IP transfers from the kind of transactions that generate readily identifiable tax benefits, and which are generally thought of as tax shelters. Reputable advisory firms do not guarantee a specific reduction in tax rates.
IP migrations and transfer pricing
Transfer pricing rules impose a test to determine whether or not a transfer of IP between related taxpayers meets the arm's length standard. This standard provides that if IP is transferred under an arrangement that involves more than one year, then the consideration charged in each taxable year must be adjusted to ensure that the standard is satisfied. The amount of such adjustment is based on facts and circumstances of each case and as such, is often ambiguous.
In addition, multinationals involved in transfers of IP face the challenge of balancing one country's rules with (often conflicting) rules and regulations of other taxing jurisdictions. To address these uncertainties, multinational companies can and do take advantage of advance pricing agreement (APA) programs. An APA is an agreement between taxpayers and tax authorities (usually more than one), which establishes that a particular transfer pricing methodology produces an arm's length result when employed in particular intercompany transactions. The flexibility of the APA process can also provide certainty over difficult valuation issues. The fact that tax authorities are prepared to agree these matters underscores the point that IP planning can be both reasonable and above-board.
Best-in-class planning approach
A global IP strategy can help a US multinational company to attain these non-tax advantages:
- Identify value-creating functions and likely sources of IP.
- Establish a flexible structure for future acquisitions or development of IP.
- Develop a methodology for dealing with international growth issues, such as subsidiary formation, branch offices, and foreign licensing.
- Focus on legal protection of the IP in international markets.
- Make foreign partnerships, such as joint ventures and licensing agreements, more flexible and lucrative.
| IP structuring v 'inversion transactions' | |
| One specific form of corporate restructuring has attracted a lot of press in the US recently and this is the so-called 'inversion'. There are several variations on a corporate inversion but it is typically a series of transactions through which a multinational group restructures itself so that the group's ultimate parent corporation becomes one resident in a friendlier tax jurisdiction. These are not specifically US transactions, but it is in the US where the most debate has recently occurred.
While inversions have been associated recently with IP migration issues, IP migration is only one of a number of relevant issues. In principle, the US tax benefits from an inversion are three-fold. First, because the ultimate parent of the worldwide group ceases to be a US corporation, the non-US part of the group ceases to be subject to certain US anti-deferral rules, for example the Subpart F regime. Second, the future earnings of non-US subsidiaries will not be subject to additional US income taxes prior to distribution to shareholders. And finally, payments of interest, and/or royalties from the US group could reduce the US taxable base (so-called 'earnings-stripping'). Politics continues to play a major role in affecting tax planning opportunities for multinational companies. Some congressional leaders point to US companies moving overseas as lacking in patriotism and are promoting legislation to curb this practice. Others, on the other hand, argue that companies want to invert because of onerous US tax rules, not because they lack patriotism. In testimony before the House Ways and Means |
Committee, Pam Olson, the Acting Assistant Treasury Secretary for Tax Policy, presented the Department's proposals to revise the US taxation of non-US multinationals operating in the United States.
These proposals elaborated on a Treasury Department report on Inversions released in May and concludes that US multinationals were reincorporating outside the US due to certain favourable rules with regard to US taxation of multinationals, including:
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Companies can begin the planning process by determining which intangible value drivers, or operational resources, account for the success of a particular product or service. One way to accomplish this is to perform a 'functional analysis' of the company, which usually requires interviewing company employees (for example, R&D engineers, supply chain managers, marketing and distribution personnel) to understand the value-creating activities that generate assets.
Resolving questions about IP ownership within a group of related entities can be complex particularly where little attention has been paid to this in the past. In terms of 'best practice' this is important housekeeping.
One approach that multinational companies often consider is to establish a 'shared service' centre to achieve economies of scope and scale. These centres (often in the form of corporations) can perform treasury, cash management and distribution or procurement functions. This allows the company to benefit from reduced transactions costs and respond to financial and operational challenges with increased speed and efficiency. Financial managers can use shared service centres to design transaction flows with customers and between business units that will support the global IP strategy. For example, if the shared service company retains the economic rights to developing IP it can become a profit centre when IP rights result in future income. But if the IP ownership lies elsewhere, the shared service company can be operated as a cost-centre and reduce redundant costs through pooling resources and standardising processes.
What is always true is that whatever the approach taken, IP planning can be a valuable exercise in and of itself. It is rarely the monster depicted in the press. Properly done it can save tax without abusive or underhand methods.
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