Type of acquisition vehicle – taxable vs. non taxable entity
The type of entity to hold the IP will be a relevant consideration regardless of whether the IP itself is acquired or shares in an IP holding company (or other interests in an IP holding entity) are acquired. This entity will be subject to:
- profits tax in that entity;
- withholding taxes on payments by that entity; and
- withholding taxes on royalty payments to that entity.
Therefore, tax planning will involve considering which entity would be effective in reducing profits tax and withholding tax, thereby assisting to lower the effective rate.
This entity could either be:
- an entity subject to tax (taxable entity) such as a company incorporated in the UK; or
- an entity not subject to tax (non taxable entity) such as a company incorporated in a tax haven.
If a taxable entity is required it may be possible to make it resident in a territory with a preferential regime for holding IP (e.g. Luxembourg, Belgium, The Netherlands, Cyprus or Ireland) (IP holding regime).
The flow chart below could assist in determining whether to use a taxable or a non taxable entity:
Asking whether a tax advantage exists in holding the IP in a taxable entity (second question) might seem like an unusual question. However, as tax havens do not tend to have decent tax treaty networks, withholding taxes may dictate having a taxable entity in the structure (and therefore access to a tax treaty network). The availability of certain tax advantages could nevertheless result in a competitive effective tax rate. Such advantages include:
- low corporate tax rate on royalty income;
- availability of reliefs – the “taxable” jurisdiction may offer attractive reliefs for holding IP or undertaking research and development activities. For example, in Belgium and Luxembourg a partial exemption of royalty income, in the UK amortisation of purchased IP and, in the UK and France, the availability of research and development tax credits;
- benefits to investing shareholders - there may be tax (or commercial) advantages arising to an investor in that jurisdiction;
- availability of a double tax treaty or an EU Directive - withholding taxes in the country of source of the IP may arise which could be eliminated through suitable double tax treaties. Double tax treaties are only likely to be available in a taxable territory. The EU’s Interest and Royalty Directive (applicable to payments between EU Member States) would also reduce withholding taxes on royalties to nil; and
- commercial practicalities - the relevant people developing the IP are based in a taxable jurisdiction making the IP profits subject to tax there in any event. However, it may be possible to hold IP in one jurisdiction while the company’s research and development centre is located in another, and still benefit from the tax rules from the first jurisdiction.
Minimising taxes – IP held in taxable entity
If IP is held in a taxable structure, tax planning will concentrate around minimising the tax rate (e.g. using special tax regimes applicable in that jurisdiction) and maximising reliefs (e.g. amortisation of acquisition cost, research and development reliefs and finance costs).
If any debt financing is required to fund the acquisition, a local SPV (acting as the borrower) may be required. The trick would be to form a consolidated local tax group with the taxable entity or to merge the SPV and the IP company in order to offset interest charges against IP income. The structure may then be as follows:
Withholding tax potentially arises on royalties to the IP company (and through any royalty conduit vehicle), dividends up the chain to SPV/ shareholders/investors and on debt finance.
Ideally, the licencees would be residents of jurisdictions which do not apply withholding tax on the relevant payments or which have suitable double tax treaties which reduce or eliminate any withholding tax.
Additionally, taxes in all the taxable entities must be mitigated to the extent possible. Taking each company in turn:
- IP company – in this scenario, the IP company would be subject to tax on the royalty income. The key is to reduce the tax liability to the extent possible by making deductible interest payments to the SPV in respect of the debt funding, amortising (for tax purposes) the IP and obtaining any other tax benefits (e.g. on research and development costs). This requires an analysis of the local rules restricting interest deductions, particularly in respect of any shareholder debt (e.g. “thin capitalisation” or transfer pricing rules). It may be possible to further enhance the tax efficiency of debt by using structures which provide a “double dip” (two tax deductions for one interest payment) or a one sided deduction (i.e. an interest deduction in the SPV treated as a distribution for the noteholder).
- SPV – this should only have dividend income from The IP company which is in the same jurisdiction. In most jurisdictions one would hope that the dividends are not taxable (e.g. under a “participation exemption” or because the two companies form a consolidated tax group or are merged such that dividends are not taxable in the SPV). If the SPV is located in a different jurisdiction to The IP company, and does not benefit from a participation exemption, then there may be tax on The IP company dividends. There may also be “controlled foreign company” (CFC) or similar rules which could impute income of The IP company to the SPV or to the ultimate shareholders. These would need to be considered in detail in light of the relevant jurisdiction.
It may be possible to enhance the structure using a royalty company where The IP company does not have a good treaty of tax networks.
Minimising taxes – IP held non taxable entity
If IP is acquired through a non taxable company and then licensed, the licensee may be required to withhold tax on the royalty income (the amount of which would probably not be reduced as tax havens do not generally benefit from double tax treaties).
One way to reduce withholding taxes is by using another entity (royalty company) through which the royalties would flow. The structure could be as follows:
There should be no withholding tax on any interest paid by the non taxable entity in respect of debt finance or in respect of the payment of dividends to the shareholders.
By flowing the royalties through a royalty company which:
- has a suitable tax treaty with the licensee’s jurisdiction (which eliminates or reduces withholding taxes on royalties); and
- is incorporated in a country that does not levy withholding tax on royalty payments, withholding taxes on the royalties could be mitigated (subject to anti-avoidance rules).
Additionally, the taxes in all the entities should be mitigated to the extent possible. This will either be through:
- making the entity non taxable (e.g. located in a tax haven); or
- ensuring that income is matched by expenditure for tax purposes.
In the case of the royalty company, in order to benefit from appropriate double tax treaties, one would envisage the royalty company to be taxable. The key is to match royalty income to royalty payments such that there is no taxable income (or a very limited turn). Care is needed here as various tax treaty provisions prevent “treaty shopping”. Additionally, anti avoidance rules may apply to deny treaty benefits or the tax authorities may not view the royalty company as being entitled to the royalties for treaty purposes (see Indofood International Finance Ltd v JP Morgan Chase Bank NA London Branch  STC 1195).
Minimising taxes on entry
In many jurisdictions, a taxable gain will be crystallised when the selling owner disposes of the IP asset. Such a gain could potentially be reduced or avoided with careful planning. Assume the IP is owned by, say, a company. A disposal of this IP could be structured by selling the IP or alternatively, the shares in that company could be sold.
Is there a participation exemption on share disposals?
Many jurisdictions are exempt from tax disposals of shares, but not assets. Therefore in such jurisdictions a share disposal is more attractive.
Where does the seller have “tax basis”?
The “tax basis” (i.e. the amount to be deducted from any taxable gain) in the IP may be different to the base cost in the shares. Therefore, a seller may obtain a better tax outcome by selling shares rather than assets.
The down side to a share deal (besides fixing the location as mentioned above) is that the purchaser will usually inherit the seller’s historic tax base cost position in the IP asset giving rise to an increased liability to tax in the event of a future sale and, generally speaking, no ability to amortise the acquisition cost for tax purposes. This “deferred” tax liability will usually be factored into the price that the purchaser is willing to pay for the shares.
Does the seller/holding entity have tax assets which it can utilise against a gain?
For example, the seller/holding entity may have losses which it can use against a gain to mitigate the tax.
Can the seller license the IP rather than sell it?
A licence of IP may not give rise to a disposal of the asset. Instead the seller may be taxed over a number of years on the income or have income losses to offset against the taxable income.
Whether or not the licence amounts to a disposal depends on its terms. An exclusive licence for a long period is likely to constitute a disposal whereas a non-exclusive licence for a short period is not. However this will vary between jurisdictions.
Similarly, in some jurisdictions one may distinguish between a sale of the IP and a right of “usufruct” (i.e. right to use/benefit from the IP).
Rather than sell IP or a company, the seller might issue shares to the purchaser – effectively creating a joint venture between the seller and the purchaser. The purchaser’s economic rights in the IP would be reflected in the share rights.
From a tax perspective, value shifting rules might make this transaction a deemed disposal of the shares of the seller. Also, care needs to be taken to ensure that this will not trigger a “de-grouping charge” in the IP holding company or the forfeiture of losses carried forward in the IP holding company as a consequence of “change of control” rules.
Minimising taxes on exit
It can be expected that some tax on exiting the structure could arise. However, one should ensure that cash taxes are not payable in advance of the time at which cash returns from the investment are received.
Where an IP holding entity is used, the preferred exit will be the disposal of that entity – particularly if the vendor is a company which benefits from a participation exemption on disposal of shares.
In some jurisdictions, non residents are taxed on gains. Whilst this is often mitigated through an appropriate double tax treaty, if this is not possible an additional holding company is often inserted into the structure to allow a disposal at a level which will not give rise to such tax.