This article looks at recent tax changes and the impact these may have on ownership of IP through offshore vehicles. In particular, we look at the new foreign profit rules and how these will be a benefit to offshore ownership of IP and the latest position on CFCs following the Vodafone 2 case.
Migrating assets offshore
UK companies are increasingly looking at the location from which R&D activities and ownership of intangible assets is based and there is increasing tax competition between jurisdictions to attract R&D and IP ownership through favourable tax regimes.
In general, the time to look at location of IP is when purchasing IP from a third party, or developing IP from scratch as it will be easier to ensure such IP is located in the necessary jurisdiction without crystallising a tax charge which would not otherwise have accrued. Nevertheless, it is possible to migrate pre-existing IP offshore without crystallising tax charges, e.g. through incorporation of a foreign branch, although any such planning would have to be carefully considered to ensure that no unexpected traps arise and also to ensure that it is implemented correctly. Attempting to migrate pre-existing valuable IP to a location outside the UK will inevitably be attacked by the Revenue who will also carefully scrutinise any offshore holding vehicles to establish that they are not managed and controlled in the UK.
For UK headquartered groups, once IP is held in an offshore entity, it is likely to be subject to the UK CFC rules under which the profits of the subsidiary are attributed to its UK parent for tax purposes. Exemption is, broadly speaking, available under these rules where the CFC:
- is subject to at least 75% of the tax which would have been paid by a UK company;
- follows an acceptable distribution policy (ADP) (although with the introduction of the new dividend exemption – see below - an ADP will no longer provide exemption);
- is engaged in exempt activities (broadly speaking bona fide trading activities and certain holding companies);
- has chargeable profits which are de minimis (i.e. do not exceed £50k);
- falls within the Excluded Countries regulations; or
- meets the motive test.
Historically, straightforward IP licensing companies in low tax jurisdictions were subject to attack under the UK CFC rules. Specifically, the exempt activities exemption does not apply to investment business which specifically means the holding of intellectual property.
Following the Cadbury Schweppes decision by the ECJ (Case C-196/04), the Government introduced a new provision in the legislation under which a CFC apportionment on an EU/EEA business establishment may be reduced to the extent that chargeable profits represent “net economic value” which is created directly by work done by individuals working for the CFC in the EU or in other EEA States with which the UK has International Tax Enforcement Arrangements. This would not help typical IP licensing companies where the chargeable profits would be derived in part by individuals managing brands offshore but may mainly be derived from the capital employed in the business.
However, we now have the Vodafone 2 case1 under which the Court of Appeal held that the UK CFC rules are compliant with EU law following a conforming interpretation which requires adding in another exclusion from the rules, for companies established in another EU Member State, or in certain other States in the EEA, carrying on genuine economic activities there.
Crucially the court did not define what is meant by “genuine economic activities”. However, it must be arguable that actively managing an IP portfolio, including deriving value from capital employed in the business, would be a genuine economic activity. So the Vodafone decision, whilst on one level advantageous to HMRC, may nevertheless open up further planning opportunities for those looking to establish offshore IP holding companies within the EU.
Further consultation on the UK’s CFC rules is proposed and it is certain that the law in this area is going to change. However, unless any legislation is equally applicable to UK companies (which appears unlikely), HMRC will be stuck with limitations on the applicability of any CFC rules to EU/EEA subsidiaries which are carrying out genuine economic activities.
Following the foreign profits consultation, this year’s Finance Act will finally introduce an exemption for dividends received by a UK company from overseas companies. However, there are exclusions from the exemption which will need to be scrutinised in detail.
For small companies (i.e. a small or macro company as defined by the Annex to the Commission Recommendation 2003/361/EC of 6 May 2003), the distribution will not be exempt if the overseas company is not resident in a territory with a tax treaty with the UK that has a non discrimination clause or the distribution is made “as part of a tax advantage scheme”. So small companies with offshore IP holding vehicles may find it difficult to obtain the tax exemption on distributions from that company.
For medium and large companies (as defined in the above Commission recommendation), subject to certain targeted anti-avoidance rules, dividends received from a controlled company should be exempt from corporation tax provided that they are not deductible in the payer. This is generally good news if seeking to establish an offshore IP holding vehicle as it provides the opportunity for an absolute saving of UK tax rather than a deferral only.
Whilst not IP specific, the recent DSG case2 highlights the need to ensure that robust transfer pricing advice is taken in respect of any intra-group transactions, including royalty payments. It also highlights the difficulties in relying upon comparable uncontrolled prices, which may be attacked by the Revenue if not on all fours with the relevant transaction – a virtual impossibility where looking at intra-group royalties for IP.
As well as the proposed consultation on CFCs, it was announced as part of the 2009 Budget that the Government proposes to review the taxation of “innovative activity”, including intellectual property. The Government proposes to set out its proposed approach before the 2009 Pre Budget Report. Therefore, any company looking to change the manner in which it currently carries out R&D activities and holds its IP, may well consider deferring implementation of any planning until after the proposals are finalised.