Recent media coverage has highlighted the use of non-US entities by US-based multinational companies to conduct intellectual property operations and to own intangible property related to their businesses. The widespread use of this strategy and the growing significance of intellectual property for business in the 21st century underscore the need for companies that have not yet examined the merits of the strategy to do so. There are several jurisdictions, such as Switzerland, the Netherlands, Luxembourg, Ireland and Singapore, where it has become common for US companies to establish an entity to hold intangible property given the laws of such jurisdictions that are beneficial to the protection and management of intangible property. In addition to the business reasons for consolidating intangible property and operations related to that intangible property in such jurisdictions, establishing an entity to hold intangible property in such a jurisdiction can give rise to significant tax advantages if properly structured.
One benefit to a US company of holding intangible property through a non-US affiliate is the potential to lower the rate of taxation on income earned with respect to such intangible property. For example, royalty payments made by a US company to its non-US affiliate for the use of intangible property held by the non-US affiliate may be subject to a lower rate of tax if the jurisdiction in which the non-US affiliate is organized is a low-tax jurisdiction. The US company, meanwhile, may be able to deduct the royalty expenses required to be paid to the non-US affiliate for the US company’s use of the intangible property. This intangible property ownership structure can be particularly advantageous if the non-US affiliate is located in a jurisdiction with which the United States has entered into a tax treaty, thereby reducing or eliminating the US withholding tax that would otherwise be applicable to the royalty payments to the non-US affiliate. In that case, only the non-US jurisdiction’s income tax would apply to the royalty payments. The ability to achieve these tax benefits is dependent on the facts specific to the organization and the presence of significant business operations outside the United States.
The manner of transferring intangible property to a non-US affiliate can have a substantial impact on the tax consequences of the transaction. If the intangible property is transferred pursuant to a transaction that is treated as a sale or exchange for US federal income tax purposes, the US company would recognize gain or loss on such transaction. If the US company has sufficient tax attributes (such as losses or credits) to shield any tax arising on the transfer of the intangible property to the non-US affiliate, this type of transaction may be appealing. For some companies, however, it may be possible to structure the transfer of intangible property to a non-US affiliate as a tax-free transaction if the non-US affiliate is treated as a partnership for US federal income tax purposes.
Methods of Transferring Intangible Property to a Non-US Affiliate
The business reasons driving a transfer of intangible property to a non-US affiliate may require that the non-US affiliate be the legal owner of the intangible property, rather than merely the substantive economic owner. Transferring the ownership of intangible property to the non-US affiliate often is also desirable from a US federal income tax perspective in order to receive the tax benefits described above.
In order to achieve an ownership transfer for US federal income tax purposes, all substantial rights with respect to the intangible property must be transferred to the non-US affiliate. One way to achieve such a transfer is an outright assignment of the intangible property rights.
Patents, patent applications and trademarks are types of intangible property that usually can be transferred pursuant to an outright assignment, because they can be specifically identified and typically relate to a specific jurisdiction. Certain other types of “soft” intellectual property, such as know-how, copyrighted material and confidential information are more difficult to divide on a jurisdictional basis. In those cases, it may be appropriate to transfer rights through a perpetual, exclusive, royalty-free license. For US federal income tax purposes, such a license, if properly drafted, is treated as a sale or exchange of the licensed intellectual property.
For intangible assets that have not yet been developed, a US company may wish to enter into a cost-sharing arrangement with its non-US affiliate. Pursuant to the cost-sharing arrangement, the US company and its non-US affiliate would share the costs of developing certain intangible property and would receive certain rights to the benefits arising with respect to any intangible property developed pursuant to the cost-sharing arrangement.
Entering into a cost-sharing arrangement, however, may diminish the potential US federal income tax benefits available to the US company as the US company and its non-US affiliate would be required to share future research and development costs and expenses relating to the intangible property being developed. This can result in the loss of US federal income tax deductions and tax credits previously available as a result of research and development expenses borne by the US company.
The Treasury Regulations relating to cost-sharing arrangements are extremely complicated and require the non-US affiliate to compensate the US company for the platform value of the property contributed by the US company to the cost-sharing arrangement and further require that value be adjusted to the extent future facts show that the US company did not receive sufficient compensation. As a result, tax advantages with respect to intangible property developed pursuant to a cost-sharing arrangement can be limited if substantial development of such intangible property took place in the United States prior to entering into the cost-sharing arrangement.
Transfers of intangible property from US entities to a non-US affiliate are often highly complex transactions from a US federal income tax perspective. Certain of the key US federal income tax considerations in an intangible property migration are discussed below:
- Section 367(d)
Certain provisions set forth in the Internal Revenue Code of 1986, as amended (the “Code”), limit the ability of a US transferor to receive the tax benefits described above. If, for example, a US entity transfers intellectual property to a non-US corporation pursuant to certain transactions that do not trigger immediate taxation from a US federal income tax perspective, then Section 367(d) of the Code treats the transfer of the intangible property as a sale from the US entity to its non-US affiliate for payments which are contingent upon the productivity, use or disposition of the intangible property. The US entity is treated as receiving payments annually over the useful life of the intangible property (or until the non-US affiliate disposes of the intangible property) and the amount of those payments must be commensurate with the income attributable to the intangible property.
If Section 367(d) of the Code applies to a transaction, the non-US affiliate’s upside with respect to the intangible property is limited. With a limited upside in the intangible property, the potential tax benefits to the US company are also limited because higher royalty payments from the US company to the non-US affiliate attributable to the increase in value of the intangible property would be offset by the payments the US company is treated as receiving from the non-US affiliate under Section 367(d) of the Code.
In certain circumstances, the impact of Section 367(d) of the Code on a transfer of intangible property may be avoided by structuring a transaction as a transfer to a non-US affiliate treated as a partnership for US federal income tax purposes, although the benefit of such a transaction depends on a company’s factual situation.
- Section 482
Similar to the rules set forth in Section 367(d) of the Code, Section 482 of the Code sets forth certain requirements on transfers of intangible property between affiliated entities. In general, Section 482 of the Code allows the US Secretary of the Treasury to make adjustments to transactions between certain affiliated entities in order to prevent the evasion of taxes or to clearly reflect the income of the entities.
Section 482 of the Code can have implications in a variety of the aspects of a migration of intangible property to a non-US affiliate. It requires, among other things, that any consideration paid by the non-US affiliate to the US company for the transfer or license of the intangible property be for an arm’s-length amount that is commensurate with the income attributable to the intangible property. Section 482 of the Code also would require that any license of the intangible property owned by the non-US affiliate to the US company must be for an arm’s-length royalty.
- Economic Substance
The potential US federal income tax benefits arising from the transfer of intangible property from a US company to a non-US affiliate may invite scrutiny of the transaction by the US Internal Revenue Service (the “IRS”). The economic substance doctrine is one means by which the IRS can attack a transaction. Generally, the economic substance doctrine looks at whether the economic substance of a transaction is different than the form of the transaction.
The common law economic substance doctrine, which was somewhat inconsistently applied, was recently codified in Section 7701(o) of the Code. In codified form, the economic substance doctrine applies an objective test that requires that the relevant transaction change in a meaningful way the taxpayer’s economic position, other than with respect to any US federal income tax benefits. This prong of the inquiry can be difficult to satisfy when the potential tax benefits of the transaction are hundreds of millions of dollars and the non-tax business objectives are more difficult to quantify. The codified economic substance doctrine also applies a subjective test which requires that a taxpayer have a “substantial” purpose for the transaction apart from US federal income tax effects.
Provided that substantial business objectives (other than tax benefits) are achieved from the intangible property migration, careful tax planning generally can withstand a challenge on economic substance grounds and can result in significant tax benefits.
In addition to being highly complex transactions from a US federal income tax perspective, such intangible property migrations often involve complicated business, legal, accounting and intellectual property issues, including standing and damage recovery theories in the event of a dispute. Consequently, such transactions usually require significant internal planning and coordinated efforts with advisors. When a company is undertaking a migration of intangible property outside the United States, it is important to seek experienced US federal income tax counsel to ensure that the transaction is undertaken in the appropriate manner.