by James H. Barrett and Steven Hadjilogiou
It is quite common that a single business operates through the use of multiple entities such as partnerships, corporations, and, in the international context, through foreign corporations or partnerships. For tax purposes, the intercompany transactions by and among commonly controlled entities may be scrutinized by the IRS and the income, deductions, credits, and other allowances among two or more organizations, trades, or businesses may be reallocated under Internal Revenue Code §482. The transfer of foreign intellectual property to foreign operating companies by a U.S. multinational business is an area that has been the subject of much discussion. The structure can often result in a foreign corporate subsidiary reducing its effective foreign tax rate to below 15 percent. Thus, a U.S.-based company that generates income and operates outside the United States, whether publicly traded or closely held, can be greatly benefitted by such a structure.
In 2000, the world’s gross domestic product (GDP) was $32 trillion.1 At that time, U.S. GDP accounted for about $10 trillion (or about one-third) of the world’s GDP.2 Ten years later in 2010, U.S. GDP had climbed to $14 trillion, and the world GDP had climbed to $63 trillion.3 As such, in 10 years, the U.S. share of world GDP went down from one-third of the world’s GDP to one-quarter. Similarly, the number of cell phones in the world has increased from 15.5 per hundred in 2001 to 86.7 per hundred (i.e., 4.6 billion) in 2010.4 Computers and telephones permit much easier access to individuals around the world. Thomas L. Friedman and Michael Mandelbaum illustrate how a multinational, closely held business can be readily formed in their recently published book That Used To Be Us.5 In their example, they discuss a company named EndoStim. The example discusses how six people from three continents readily formed a cutting edge company in the medical devices field to develop a sophisticated device based on a heart pacemaker. Through the Internet, they were able to obtain financing, develop a prototype, and supervise the manufacture of the device.
Over the last 30 years, U.S. companies have significantly increased their international operations. These companies now have more significant marketing, research and development, and sales operations outside the United States. Inevitably, this has led to a greater number of employees working outside the United States. It also has led to a greater amount of intellectual property being developed and exploited offshore. Moreover, companies headquartered outside the United States account for a greater share of the world’s sales.
The tax world has followed this trend. The increasing international presence of U.S. multinationals has resulted in a significant amount of public scrutiny. Feature articles on these ownership structures have been the subject of extensive articles in the New York Times,6 The Wall Street Journal,7 and 60 Minutes.8 Also, with regard to the legislative discussions concerning the future of U.S. income taxation of U.S. corporations, the taxation of internationally held intellectual property has constituted a significant portion of the tax debates in the U.S. Congress. This article describes how U.S. multinational corporations have held their intellectual property, the U.S. and foreign tax consequences to this ownership, and how the tax benefits of this ownership can be utilized by closely held businesses.
Description of Basic IP Ownership and Tax Benefits
The ownership structure is designed to mirror the increased international nature of the U.S. company. Thus, a company that, initially, may have managed all of its IP in the United States is now managing its foreign IP outside the United States. The structure reflects that managerial reality. The U.S. parent contributes, sells, or licenses its current IP for a note and/or cash. Under current law, the contribution of foreign goodwill, and going concern value should be exempt from U.S. federal income tax. The balance of the transfer is subject to U.S. federal income tax.
Future foreign IP that is developed is developed by the foreign subsidiary. As such, the new IP is not taxed in the United States. The foreign subsidiary typically is in a low-tax jurisdiction paying tax at a top marginal rate of 12.5 percent or less (e.g., Ireland, Switzerland, or Singapore). With the IP offshore, the foreign subsidiaries in higher tax jurisdictions are required to license the IP from the IP holding company.
The royalty deduction in the high-tax jurisdiction offsets a portion of the income tax in the high-tax jurisdictions. Tax is paid in the home country of the IP holding company at a low-tax rate. Thus, the overall effective tax rate for the group outside the United States is reduced.
To prevent taxation in the United States, profits generally are not immediately repatriated to the U.S. parent. Care must be taken not to generate income that is effectively connected with the conduct of a U.S. trade or business or business profits that are attributable to a U.S. permanent establishment, as the case may be. The structure generally is accomplished through the use of one holding company in a typical holding company jurisdiction (e.g., The Netherlands or Luxembourg) owning an IP company and also owning other foreign subsidiaries. The use of the holding company typically facilitates the payment of interest and dividends among the companies by reducing the foreign withholding tax that can apply. The IP company and the operational subsidiaries typically make check-the-box elections to be treated as disregarded entities. Thus, from a U.S. income tax perspective, they are considered to be one foreign corporation. This allows the foreign group to avoid the application of the U.S. subpart F rules that could otherwise cause the royalty income to become immediately taxable in the United States. The income from the operation that is earned by the IP company typically is royalty income paid by foreign subsidiaries to the IP holding company. The other foreign operational subsidiaries are typically performing services or selling goods that utilize the IP.
The IP ownership structure basically balances a tax cost in the U.S. from the sale or license of the foreign IP (excluding nontaxable foreign goodwill and going concern value) with a future benefit of a lower foreign tax rate. Because of the importance of the value of the upfront sale or license by the U.S. company, the value of the IP is often a critical element to affecting these structures. As such, appraisals of the IP are typically obtained. The reorganization of the company typically involves a broad range of the foreign rights to intellectual property. For example, the reorganization may involve the foreign rights to patents, trademarks, trade secrets, and trademarks. The value of a company’s trademarks is often an important part of an IP migration.
The IP migration structure should not be considered unless the taxpayer is substantially certain (e.g., an 80 percent level of certainty), that it will have profits offshore that will offset the upfront tax cost. If not, the offshore IP ownership should not be utilized. Offshore IP ownership that results in losses offshore is not tax efficient. Losses that could be used in the United States or in a high-tax foreign jurisdiction are, instead, moved to a low-tax foreign jurisdiction where they have much less value.
An important element of foreign IP ownership is how the IP will be developed and exploited. A staff is required in the IP company that controls the foreign IP. The staff often is important to avoid subpart F income on royalty income that is paid by third parties.
Qualifying for the benefits of the foreign tax regime is often an important element of the structure. Some countries (e.g., Singapore and Switzerland) require that the taxpayer obtain a ruling. The applicable holding company also may require a ruling.
The structure can often result in a foreign corporation reducing its effective tax rate to below 15 percent. When compared with the combined federal and state income tax rate of over 40 percent that applies to income that is taxable in the United States, the deferral can defer taxes of a typical company representing a tax savings of more than 25 percent. It should be noted that U.S. taxes are paid when the income is deferred and the profits are not distributed as a dividend by the foreign holding company (i.e., the Dutch BV) to the U.S. parent corporation. If a distribution is made, the income will be taxed at a 35 percent U.S. federal income tax rate, but will receive a U.S. foreign tax credit for the lower tax rate that was paid abroad (e.g., 15 percent). However, it should be noted that in 2005, a repatriation provision was enacted which taxed the repatriated earnings at a rate of 5.25 percent.9 A similar provision currently is being considered by the U.S. Congress.
Ability of Smaller Companies to Utilize IP Migrations
Historically, the foregoing proposed structure has been utilized primarily by Fortune 1000 companies. However, the structure is equally available to closely held businesses that have significant offshore operations. The two most significant questions are whether the company is substantially certain that its offshore operations will be sufficiently profitable to merit the transfer of the IP and whether the company can house a sufficient staff of foreign executives in the low-tax jurisdiction who will have the authority to manage the foreign company’s IP.
While significant international operations are necessary, the requisite amount of foreign operations can often be achieved by closely held businesses. The foregoing foreign substance is becoming easier to meet as countries become more international in nature. Frequently, closely held U.S. multinational businesses will choose to conduct their international operations through entities that are taxed as flow-through entities from a U.S. federal income tax perspective (i.e., partnerships or disregarded entities). Thus, all items of income, gain, loss, deduction, and credit of the international business are reported by the U.S. shareholders on their U.S. federal income tax return. This form can be preferable because it permits one level of tax to the U.S. tax resident shareholders. An important feature of the one level of tax is that foreign income taxes that are paid by the business can offset foreign source income as foreign tax credits. Also, the subpart F rules are avoided by a flow-through structure. In contrast, a corporate structure involves a second level of tax on dividends from the U.S. parent to the U.S. shareholder that will be taxed at rates between 15 percent and 35 percent. Thus, the reduction in the overall effective tax rate from the corporate structure must offset the second-level tax (taking into account the applicable tax rate and the timing of the dividends). It should be noted that when successful, IP migration can lower a foreign corporation’s effective tax rate outside the U.S. By lowering the effective tax rate, a closely held company may opt for a corporate model as opposed to a partnership model.
Intangible Planning: Background and Planning for Outbounding U.S.-Owned IP
• Business Issues — The migration of IP abroad must be driven by business considerations. Frequently, the goal of the IP restructuring is to match the ownership of IP with the location of its exploitation. Thus, the ownership of the right to use a trademark in Europe is transferred to a European IP company. Due to the U.S. parent’s increased international presence, it has developed international employees who have had increasing amounts of authority. The IP migration is merely a reflection of what is happening from an operational perspective. In the closely held setting, companies that do not have significant numbers of offshore employees and who do not plan on expanding the employee base abroad, typically are not good candidates for IP restructurings.
Frequently, the foreign IP holding company will enter into further contractual arrangements with other foreign affiliates. These arrangements typically are structured as full-fledged distributor, limited-risk distributor, or commissionaire structures.
• Contribution — An IP migration involves a taxable contribution, sale, or license of historic IP in exchange for lower tax rates of foreign taxable income. A typical IP migration does not generate deductions in the United States. Rather, it generates sales and royalty income to the U.S. For mature international companies, the sale may represent an opportunity to repatriate cash as part of the sale and royalty payments back to the United States.
Contributions of intangible property other than foreign goodwill and going concern value generally are taxable for this purpose. Intangible property included patents, inventions, formulae, designs, patterns, knowhow, copyrights, artistic and literary compositions, trademarks, trade names, franchises, licenses, contracts, methods, programs, systems, customer lists, and similar items.10 A contribution of intangible property will require the U.S. contributor to receive an arm’s length royalty for the use of the IP over its useful life.11 The useful life of the IP may not exceed 20 years.12 On the other hand, the contribution of foreign goodwill and going concern value is generally considered by the taxpayer to be tax-free. Exempt foreign goodwill and going concern value do not include the goodwill directly associated with a trademark.13
The foreign goodwill and going concern value must be contributed to the foreign affiliate in a transaction that must satisfy the requirements for a tax-free contribution under Code §§351 and 367. Other tangible assets associated with the foreign contribution can be included in a tax-free contribution. Among other things, the contribution must satisfy the foreign active trade or business exception under Code §367.14
As an alternative to a contribution in a Code §351 transaction, the transfer of the IP can be structured as either a sale or a license for tax purposes. The taxable element can be in the form of a license payment, a promissory note (e.g., an installment note), or cash. Other intangibles that form a part of the foreign business typically are transferred offshore in conjunction with the transfer of the IP. These intangibles frequently include executory operational contracts that relate to the foreign business (e.g., contracts with suppliers and customers). Although often taxable under Code §367, these contracts frequently have little inherent value because they are executory. As discussed below, the contribution of foreign goodwill should occur in a manner that does not disturb the goodwill that is associated with the trademark.
The tax benefits of the IP migration are illustrated by the following example (see chart): U.S. parent has taxable income of $100 outside the U.S. and $100 inside the U.S. U.S. parent transfers its IP to a newly formed Swiss subsidiary of its Dutch holding company for $500 in license payments that are made over the next 20 years (i.e., $25 a year). The Swiss company will receive royalties equal to $80 from the U.S. corporation’s operational subsidiaries. Assume that the effective tax rate in Switzerland is 10 percent, the effective tax rate in other foreign countries is 35 percent and the effective tax rate in the U.S. is 35 percent. Thus, each year, the U.S. parent will recognize $25 in license payments from the Swiss subsidiary that results in an additional $8.75 in U.S. tax. It will save $100 to the U.S. parent’s taxable income resulting in a tax savings of $35/year. Abroad, the Swiss company will pay tax of $8 on the $80 of income and the operational subsidiaries will pay local country income tax of $7 on $20 of income. Netting the increases and decreases, the U.S. will recognize a net tax savings of $11.25/year from the IP migration. This represents an overall tax savings of over 5 percent to the company’s effective tax rate and over 10 percent to the company’s foreign operations.
It should be noted that the benefits are largely driven by the license payments from the local operating companies to the Swiss subsidiary and are reduced by the U.S. tax cost of the royalty payments from Swiss company to the U.S. parent. After the initial IP transfer, the structure will become more tax beneficial as additional IP is created by the foreign subsidiary. The foregoing example assumes that profits are not repatriated to the U.S.
• Tax Issue: Key Questions — The IP migration should only be utilized where the taxpayer has significant personnel outside the United States, and it is substantially likely to be generating a profit from its international operations. Since business operations can never be predicted with certainty, the determination of the foreign operations’ prospects is an important part of the process. The structure will cause R&D expenses to be incurred in a low-tax jurisdiction. As such, the losses will be expensed at a lower tax rate. In general, if the foreign venture is unsuccessful, the investment in the foreign company may only be deductible when the foreign company is liquidated as a worthless company. As such, the loss may never be taken in the United States. Alternatively, it may only be taken many years in the future when the foreign company has become worthless.15
• Reasons to Consider in a Down Economy — Due to the recent economic downturn, the value of foreign IP may have gone down for a given company. The U.S. parent typically has expensed all of the amounts associated with developing the IP in the United States. Thus, it usually has a zero basis in the intangibles being transferred offshore. However, intangibles often have a value that is based upon earnings potential. In a down economy, projected earnings potential is often reduced. As such, the value of intangibles transferred offshore may be reduced. The sale or license of the taxable IP can be beneficial in that it brings cash back to the U.S. As such, the U.S. tax on the sale or license can be offset by the benefit of the repatriation of the cash. Selling for a promissory note or licensing the intangibles to the foreign subsidiary can serve as the basis for tax-favorable repatriations in the future. U.S. companies with growing foreign operations will want to time the contribution of the IP so that it occurs when the foreign IP has a sufficiently small value that the U.S. tax cost from the sale or license is not prohibitive. However, it should occur at a time when the company is substantially likely to achieve a foreign profit. Only the rights to the foreign IP owned by the U.S. parent are subject to U.S. federal income tax on the outbound license or sale.16 Intangibles that are subsequently created by foreign IP company subsidiary should not result in a tax liability of the U.S. parent. Thus, the foreign rights to a scientific patent that is developed by the foreign subsidiary after the contribution of the IP generally should not be taxed to the U.S. parent.
Foreign Requirements Substance: Potential Ruling Requirement
Adequate foreign substance is a requirement for a successfully implemented foreign IP holding company. Typical jurisdictions for an IP holding company are Ireland, Switzerland, and Singapore. It is common for Ireland and Switzerland to be utilized for European operations and for Singapore to be used for Asia/Pac operations.
As an initial matter, the foreign substance can be a requirement to obtain a favorable tax ruling. A tax ruling may be a requirement for the favorable tax consequences in a jurisdiction, such as Singapore or Switzerland. The ruling often requires that the foreign IP company have an operation that is maintaining and exploiting the intangibles within the country. The required size of the operation depends upon the nature and complexity of the intangibles involved. Maintenance and exploitation of the intangibles can include both the development and the marketing of the intangible. The customers utilizing the IP can be related affiliates, joint ventures involving the taxpayer or unrelated foreign users. In addition to requiring substance for a favorable ruling, the additional substance can help address other relevant U.S. and foreign income tax issues including qualification for beneficial withholding tax rates and qualifying for exceptions from subpart F.17
Minimizing Withholding Tax and Qualifying for Relevant Treaty Networks on Royalties, Interest, and Dividends
The IP holding company typically is organized in a jurisdiction that has a favorable tax treaty network so that royalty payments to the IP holding company are subject to a reduced amount of withholding tax. Here, the relevant inquiry is whether the royalty payment from, say, Spain to Ireland is subject to a reduced withholding tax rate. As such, the limitation of benefits issues that frequently apply to U.S. income tax treaties are not a significant tax issue because countries outside the U.S. typically have a materially more liberal limitation of benefits provisions. However, the requirements for obtaining such benefits need to be understood as part of the process of obtaining an IP holding company. Also, any required substance needs to be factored in as part of the process of determining whether to form an IP holding company. In general, the foreign company’s offshore operations in the country where IP is being utilized (e.g., Spain) will involve the company having personnel in that jurisdiction who are soliciting sales and conducting other activities for the benefit of customers (and potential customers). Similarly, the IP company will have employees who are maintaining, improving, and exploiting the IP. The foregoing workforce typically is sufficient to satisfy the requirements for treaty residence that permit reduced withholding tax rates on royalties.
The foreign holding company that owns the IP company typically will be organized in a country (e.g., The Netherlands) that has an extensive income tax treaty network to minimize the withholding tax on dividends, interest, and royalties.
Subpart F — Avoiding FBCSI, Contract Manufacturing Issues
Subpart F provides that certain types of income that is earned by a controlled foreign corporation is subject to tax immediately to its U.S. shareholders.18 A “controlled foreign corporation” is a corporation that is controlled by U.S. taxpayers who each own (after application of the appropriate direct and indirect ownership rules) at least 10 percent of the company.19 By immediately taxing income of the controlled foreign operations, subpart F effectively negates the deferral obtained by an IP migration. As such, it is important to avoid recognizing subpart F income in an IP deferral structure.
The types of subpart F income that can be generated include income on royalties, sale of goods, and sale of services. With regard to royalties, intercompany payments typically are disregarded. There is no “branch rule” for royalty income. As such, the intercompany royalties should not generate subpart F income. With regard to royalties from third parties, the license generally must qualify for the active royalty exception to avoid an income inclusion under subpart F.20 In order to qualify for the exception, the CFC (or the disregarded entity under the CFC) can take advantage of a number of exceptions.21 For example, a royalty will be deemed to qualify for the active royalty exception where the taxpayer developed, added substantial value to, or acquired the IP and the company regularly engages in the development or acquisition of IP.22 Similarly, royalty income will qualify for the active marketing exception where the license is the result of marketing activities that are substantial in relation to the royalty income and the taxpayer, through its own personnel, regularly engages in such marketing activities in such country.23 In determining whether marketing activities are substantial, there is a safe harbor that applies when the “active licensing expenses” equal or exceed 25 percent of the total “adjusted licensing profit.”24 It should be noted that marketing activities do not qualify as adding substantial value.
With regard to the sales of goods, subpart F can apply when there are related party sales.25 These related party sales can arise when related CFCs jointly effect a sale. Even where only one CFC is involved, foreign branches can be treated as separate corporations, thus, potentially creating subpart F income.26 Services income can also be taxable as subpart F income.27 As with royalty income, there is no “branch rule”; however, services performed by employees of foreign parents or U.S. shareholders can generate subpart F income. Of particular value in avoiding the subpart F rules on services is the “substantial assistance” safe harbor that permits less than 80 percent of the services to be performed in the U.S. (or by U.S. affiliates) without generating U.S. federal income tax.
U.S. Issues — Issues of Substance, Countering ECI Arguments
A foreign company with income effectively connected with the conduct of a U.S. trade or business is taxable in the United States.28 Thus, the benefits of an IP holding company would be negated by most of its income being taxed in the United States by ECI. The foregoing risk is mitigated where the IP holding company is from a treaty jurisdiction. In such a case, the IP holding company would need to have income that is attributable to a U.S. PE to be taxable in the United States. The PE standard is higher than the ECI standard. It generally permits certain activities that could create an ECI risk not to create a PE risk. For example, it is common for a PE not to be created by the maintenance of inventory in a country even though the maintenance of inventory might result in ECI. In the context of an IP company, the most important concern will relate to the research concerning the IP and the decisions regarding the licensing of the IP. The ECI risks and the PE risks are generally addressed by creating substance in the foreign jurisdictions. As such, the same substance that is required for a favorable foreign tax ruling can be helpful in addressing the U.S. ECI/PE risks and the subpart F risks that are discussed above. The ECI and PE risks need to be regularly monitored on an ongoing basis after the structure is in place.
In addition to the PE and ECI risks, it is also possible that the IP holding company could be wholly disregarded. Such a risk is reduced by favorable cases respecting IP ownership.29 However, it nevertheless exists, particularly where corporate formalities are not adhered to.
The successful implementation of a foreign IP company also involves intellectual property law and valuation issues. It should be noted that there are various U.S. tax legislative proposals that currently are being considered by Congress. However, given the accelerated pace that companies are becoming truly international, it is likely that economic realities will require the taxation of foreign IP companies to continue to evolve.
1 World Bank, World Development Indicators, Google Public Data Explorers.
4 International Telecommunications Union, United Nations, ICT Data and Statistics.
5 Thomas L. Friedman & Michael Mandelbaum, That Used To Be Us at 67-68 (Farrar, Straus, and Giroux 2011).
6 U.S. Has High Business Tax Rates, Technically, N.Y. Times, May 3, 2011.
7 Titans Vow Overseas Tax Fight — Obama Administration Plan Would Hit Biggest Companies Hardest, Wall Street J., April 22, 2009.
8 A Look at the World’s New Corporate Tax Havens (CBS 60 Minutes broadcast March 25, 2011).
9 I.R.C. §965.
10 Treas. Reg. §1.482-4(b); Treas. Reg. §§1.367(d)-1T(b) and 1.367(a)-1T(d)(5); I.R.C. §936(h)(3)(B).
11 Treas. Reg. §1.367(d)-1T(c).
12 Treas. Reg. §1.367(d)-1T(c)
13 Nestle Holdings v. Commissioner, 152 F. 3d 83 (CA4 1998).
14 See I.R.C. §865.
15 See I.R.C. §865.
16 See Veritas Software Corp. & Subsidiaries, et al. v. Comm., 133 T.C. 297 (2009).
17 See Treas. Reg. §1.954-2(d).
18 I.R.C. §§951-965.
19 I.R.C. §957 and 951.
20 See I.R.C. §954(c)(2)(A).
21 See Treas. Reg. §1.954-2(d).
22 Treas. Reg. §1.954-2(d)(1)(i).
23 Treas. Reg. §1.954-2(d)(1)(ii).
24 Treas. Reg. §1.954-2(d)(2)(ii).
25 See I.R.C. §954(d).
26 See Treas. Reg. §§1.954-3 and 1.954-3T.
27 I.R.C. §954(e).
28 I.R.C. §882(a)(1).
29 See Moline Properties, 319 U.S. 436 (1943).
Steven Hadjilogiou is an attorney at Baker & McKenzie law firm in Miami, where he concentrates in the area of domestic and multinational businesses and individuals with respect to international tax planning. His practice includes worldwide tax minimization, state and local tax planning, subpart F planning, treaty issues, general and international tax planning, and partnership taxation. He was a primary drafter of the amicus curiae brief filed on behalf of the Florida Bar Tax Section in Knight v. Commissioner before the U.S. Supreme Court (2008).
James Barrett is a partner at Baker & McKenzie LLP, in Miami, where he serves as the chair of the tax department. He is a member of The Florida Bar Tax Section, Long Range Planning Committee and practices in the area of U.S. federal income tax, focusing on outbound and inbound international tax planning.
Based upon James H. Barrett, Steven Hadjilogiou, and Robert Heller (PriceWaterhouse Coopers), Florida Bar Tax Section FICPA, International Tax Conference Presentation, January 19-20, 2012.
This column is submitted on behalf of the Tax Section, Domenick R. Lioce, chair, and Michael D. Miller and Benjamin Jablow, editors.