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Tax Planning for Inbound Licenses of IP: What Is Left After Tax Reform?

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Intellectual property (IP) rights broadly include, among other items, patents, copyrights, trademarks, know-how, proprietary data, and trade secrets. Although the creator of IP typically retains these rights throughout the life of the IP, in many cases, an owner of IP may want to transfer some or all of its IP rights to a third party in a transaction other than an outright sale. If the desired revenue goal is an ongoing stream of income, then licensing such IP in exchange for royalties is often the most appropriate choice, as this typically maximizes profits from the property’s commercial use or exploitation. Historically, foreign owners of IP could enter into inbound U.S. licensing arrangements with minimal U.S. tax costs, and U.S. licensees could fully deduct the outgoing royalty payments on the IP. Recently, however, structuring such licensing arrangements in a tax-efficient manner in the U.S. inbound context has become increasingly difficult, thanks to several recent changes in applicable law.

Critical U.S. Tax Issues

For a non-U.S. taxpayer licensing IP for use in the United States, a number of key issues arise: 1) whether the royalty will be subject to U.S. withholding tax; 2) whether the payment or accrual of the royalty will be deductible for U.S. federal income tax purposes; and 3) how to minimize the non-U.S. income tax consequences that result from the receipt of the royalty (either through structuring or the use of various patent box regimes, the most common of which are listed at the conclusion of the article). Recent U.S. federal income tax developments have an impact on the resolution of these issues.

U.S. Withholding Tax Issues

Non-U.S. taxpayers are subject to U.S. federal income taxation on a limited basis. Unlike U.S. taxpayers — who are subject to U.S. federal income tax on their worldwide income — non-U.S. taxpayers generally are subject to U.S. taxation on two categories of income: 1) certain passive types of U.S.-source income, e.g., interest, dividends, rents, annuities, and other types of fixed or determinable annual or periodical income (FDAP);[1] and 2) income that is effectively connected to a U.S. trade or business (ECI).[2] FDAP income is subject to a 30% withholding tax that is imposed on a non-U.S. taxpayer’s gross income (subject to reduction or elimination by an applicable income tax treaty).[3] ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. taxpayers.

Although U.S.-source royalties typically are subject to a statutory 30% U.S. withholding tax, many bilateral U.S. income tax treaties completely eliminate this withholding tax. For example, the U.S. income tax treaties with the following countries provide an exemption from withholding tax on certain types of U.S.-source royalties: 1) Austria; 2) Belgium; 3) Canada; 4) Cyprus; 5) the Czech Republic; 6) Denmark; 7) Finland; 8) France; 9) Germany; 10) Greece; 11) Hungary; 12) Iceland; 13) Ireland; 14) Italy; 15) Japan; 16) Luxembourg; 17) the Netherlands; 18) Norway; 19) Pakistan; 20) Russia; 21) Slovak Republic; 22) South Africa; 23) Spain; 24) Sweden; 25) Switzerland; and 26) the United Kingdom.[4]

Provisions that May Deny Treaty Benefits

To qualify for treaty benefits, a non-U.S. taxpayer must be a resident of a particular treaty jurisdiction, as well as satisfy the treaty’s limitation of benefits (LOB) provision, if any. Even if a non-U.S. taxpayer qualifies for treaty benefits, however, there are two statutory provisions that may prevent the non-U.S. taxpayer from claiming treaty benefits: §894(c) and §7701(l).

Section 894(c) would deny treaty benefits when a non-U.S. taxpayer licenses IP (or otherwise invests in the U.S.) through an entity that is “fiscally transparent” under the laws of the U.S. and/or any other jurisdiction. The regulations under §894(c) deny treaty benefits on payments of U.S.-source royalties to the extent such income is not “derived by” a treaty resident.[5] For example, U.S.-source royalties paid to a disregarded Cayman Islands entity that is wholly owned by a U.K. parent will not be eligible for benefits under the U.S.-U.K. income tax treaty, even though the U.S. treats the royalties as being paid directly to the U.K. parent.[6] Conversely, U.S.-source royalties paid to a disregarded U.K. entity wholly owned by a Cayman Islands parent may be eligible for U.S.-U.K. treaty benefits, despite the fact that the U.S. treats the royalties as being paid directly to the Cayman parent.[7] The reason for the disparate treatment is that, in the first situation, the U.K. entity is not treated as “deriving” the royalties, whereas in the second situation, the U.K. entity is treated as “deriving” such income.[8]

In addition to §894(c), the conduit financing regulations promulgated under §7701(l) also may prevent a non-U.S. taxpayer from claiming treaty benefits with respect to royalty payments. In general, regulation §1.881-3(a)(1) allows the IRS to disregard the participation of one or more “intermediate entities” in a “financing arrangement” where such entities are acting as conduit entities. For this purpose, a financing arrangement is defined as a series of financing transactions by which one person (the financing entity) advances money or other property, or grants rights to use property, and another person (the financed entity) receives money or other property, or rights to use property, if the advance and receipt are effected through one or more other persons (intermediate entities).[9] If the IRS were to disregard the participation of the conduit entity, the financing arrangement is recharacterized as a transaction directly between the financed and the financing entities for purposes of §§871, 881, 1441, and 1442.[10]

For example, assume a Bermuda corporation owns certain IP that it intends to license for use in the United States. Given that the U.S. does not have a comprehensive income tax treaty with Bermuda,[11] any U.S.-source royalties paid to the Bermuda corporation pursuant to such a license would be subject to a 30% U.S. withholding tax. If, on the other hand, the Bermuda corporation licenses the IP to a Dutch corporation, which in turn sublicenses the IP for use in the United States, then any U.S.-source royalties paid to the Dutch corporation may be exempt from U.S. withholding tax under the U.S.-Netherlands income tax treaty.[12] Under the conduit financing regulations, however, the IRS may disregard the conduit entity (i.e., the Dutch corporation) and treat the royalties as being paid directly to the Bermuda corporation, in which case the royalties would be subject to a 30% U.S. withholding tax.

A “financing transaction” includes: 1) debt, 2) any lease or license, or 3) any other transaction pursuant to which a person makes an advance of money or other property or grants rights to use property to a transferee who is obligated to repay or return a substantial portion of the money or other property advanced, or the equivalent in value.[13] Notably, stock in a corporation (or a similar interest in a partnership or trust) will constitute a financing transaction only if one of the following conditions is satisfied:

1) The issuer is required to redeem the stock or similar interest at a specified time or the holder has the right to require the issuer to redeem the stock or similar interest or to make any other payment with respect to the stock or similar interest;

2) The issuer has the right to redeem the stock or similar interest, but only if, based on all of the facts and circumstances as of the issue date, redemption pursuant to that right is more likely than not to occur; or

3) The owner of the stock or similar interest has the right to require a person related to the issuer (or any other person who is acting pursuant to a plan or arrangement with the issuer) to acquire the stock or similar interest or make a payment with respect to the stock or similar interest.[14]

Given that stock typically does not constitute a financing transaction, it was common under prior law for non-U.S. taxpayers to utilize a hybrid instrument (e.g., an instrument treated as debt for foreign tax purposes but as equity for U.S. tax purposes) to capitalize an IP holding company (i.e., foreign licensor), which would in turn license IP to the U.S. In this situation, the payment of royalties from the U.S. to the foreign licensor, followed by a payment that was treated as interest for foreign tax purposes, was typically not subject to the conduit financing regulations because the U.S. treated the subsequent payment by the IP holding company as a dividend.

Recent changes to the conduit financing regulations, however, will prevent a non-U.S. taxpayer from claiming U.S. treaty benefits in situations similar to the one described above, where a non-U.S. taxpayer capitalizes a foreign licensor with a hybrid instrument to reduce resulting foreign income tax. In the preamble to the 2008 proposed conduit financing regulations, the IRS indicated that it was studying transactions in which a financing entity advances cash or other property to an intermediate entity in exchange for a hybrid instrument and stated that the IRS may issue separate guidance in future regulations.[15] Under final regulations recently released in August 2020,[16] the IRS and Treasury indicated that the conduit regulations should apply in these cases where a hybrid instrument is present. The final regulations cause the conduit financing regulations to apply in these situations by expanding on the types of equity interests that are treated as financing transactions.

Specifically, the final regulations now include as a financing transaction an instrument that is stock or a similar interest (including an interest in a partnership) for U.S. tax purposes, but is treated as debt under the tax law of the country of which the issuer is tax resident.[17] In addition, the final regulations provide that if the issuer is not a tax resident of any country, such as an entity treated as a partnership under foreign tax law, the instrument is a financing transaction if the instrument is debt under the tax law of the country where the issuer is created, organized, or otherwise established.[18] Accordingly, a non-U.S. taxpayer will no longer be able to claim U.S. income tax treaty benefits on the receipt of a U.S.-source royalty payment if it capitalizes the foreign licensor with a hybrid instrument in order to reduce the foreign income tax of such licensor.

Query whether a leveraged purchase of IP by a foreign licensor followed by a license of such IP to the United States would be subject to the conduit financing regulations. In other words, would the U.S.-source royalty be ineligible for treaty benefits if the foreign licensor makes an interest payment on the related loan. As noted above, a loan followed by a license typically would be treated as a conduit financing arrangement.[19] This is because both transactions are treated as financing transactions.

Where the character of the payment made by the financed entity is different from the character of the payment made to the financing entity, the regulations provide that the character of the payment made by the financed entity is characterized by reference to the character of the payment made to the financing entity.[20] In other words, where a royalty payment is followed by an interest payment, the royalty is recharacterized as interest. The question is whether these transactions should be carved out from the conduit financing regulations if the interest payment would have been eligible for an exemption from U.S. withholding tax (e.g., as portfolio interest) to begin with (i.e., in the absence of the related license).

The preamble to the 1995 final conduit financing regulations appears to support such an exclusion. In the preamble, the IRS noted that some commentators suggested that leveraged leases be excluded from the definition of a financing transaction because, “in substance, the financing arrangement would be the equivalent of a loan from a financing entity entitled to a zero rate of withholding on interest.”[21] The IRS agreed with this comment and noted in the preamble that, under the final regulations, a “leveraged lease generally will not be recharacterized as a conduit arrangement if the ultimate lender would be entitled to an exemption from withholding tax on interest received from the financed entity, even if rental payments made by the financed entity to the financing entity would have been subject to withholding tax.”[22] This language would seem to support the position that a leveraged acquisition of IP by a foreign licensor followed by a license of such IP for use in the U.S. should be exempt from the conduit financing regulations, if the ultimate non-U.S. lender would be eligible for an exemption from U.S. withholding tax on the receipt of interest from the financed entity.

There are some limitations to this rule, however. The regulations indicate that the characterization of the payment as interest will not extend to qualification of a payment for any exemption from withholding tax under the code or a provision of any applicable tax treaty if such qualification depends on the terms of, or other similar facts or circumstances relating to, the financing transaction to which the financing entity is a party that do not apply to the financing transaction to which the financed entity is a party.[23] The regulations provide an example where payments made by a financed entity that is not a bank cannot qualify for the bank deposit exemption from U.S. withholding tax provided by §881(i) even if the loan between the financing entity and the conduit entity is a bank deposit.[24] Therefore, it would seem that so long as the financing entity would be entitled to an exemption from withholding under the portfolio debt rules (or an income tax treaty) if a loan were made to the financed entity, the conduit financing regulations should not apply to a leveraged acquisition of IP.[25]

Denial of Deductions for Royalties Paid

As part of the Tax Cuts and Jobs Act of 2017 (TCJA), Congress enacted §267A to prevent erosion of the U.S. tax base through the use of hybrid instruments and entities. Section 267A generally disallows a deduction for any “disqualified related party amount” paid or accrued
“pursuant to a hybrid transaction or by, or to, a hybrid entity.”[26] The disqualified-
related party amount is any interest or royalty paid or accrued to a related party, and
that related party does not include the payment in income under foreign tax law, or is allowed a corresponding deduction with respect to such amount.[27] The term, “hybrid
entity” includes an entity that is fiscally transparent for U.S. federal income tax
purposes, but is regarded for foreign tax law purposes.[28] In the statute, Congress
provided Treasury with a broad mandate to issue regulations or other guidance to
carry out the purposes of §267A.[29]

Prior to the TCJA, whether an item was deductible for U.S. federal income tax purposes generally was determined under U.S. tax principles, without consideration of the treatment of that item under foreign tax law.[30] Largely as a result of the OECD’s Base Erosion and Profit Shifting (BEPS) initiatives, Congress enacted §267A as part of the TCJA. Section 267A primarily targets situations in which a U.S. taxpayer makes a deductible payment of interest or royalties to a foreign taxpayer and no income inclusion results for foreign tax purposes. An example of this result may occur when a U.S. corporate subsidiary makes an interest payment to its foreign corporate parent on an instrument that is treated as debt for U.S. tax purposes and equity in the foreign corporate parent’s local country. Assuming the foreign corporate parent’s local country has a participation exemption for dividends, this transaction would result in a deduction in the U.S. and no income inclusion in the foreign country.[31]

Impact on Inbound Structuring

With respect to the license of IP for use in the United States, a number of common tax planning structures have been impacted as a result of the enactment of §267A. For example, pre-TCJA it was common for an Irish company to capitalize a foreign licensor (typically in Luxembourg or the Netherlands) with an interest-free loan, with the foreign licensor in turn licensing IP to the United States. The goal of this structure was to obtain a deduction in the U.S. on the payment of the royalty to the Luxembourg or Dutch company while also obtaining an exemption from U.S. withholding tax under the respective U.S. income tax treaty, and then to claim a deduction in the local jurisdiction of the foreign licensor on the interest that would accrue pursuant to the interest-free loan. Ireland did not require the inclusion of interest income with respect to such interest-free loans, based on applicable Irish transfer pricing principles. The net result was a deduction in the U.S., and no corresponding inclusion in any foreign country. The §267A regulations no longer allow this result.[32]

Another common approach was to capitalize a foreign licensor with a hybrid instrument (debt under the laws of the issuer of the instrument but equity under the laws of the holder of the instrument), and then to cause the foreign licensor to license IP for use in the U.S. The result was a royalty deduction in the U.S., and an inclusion in the hands of the licensor that was offset by an interest payment or accrual that would be treated as an exempt dividend in the hands of the holder of the hybrid instrument.

The so-called “disqualified imported mismatch rules” contained in the §267A regulations shut these structures down.[33] The regulations achieve this by denying the deduction in the U.S. for the royalty paid to the foreign-related party. It is important to note that §267A would deny the royalty deduction in the U.S. even if the payment were subject to a 30% U.S. withholding tax pursuant to the conduit financing regulations.[34] As explained earlier, the conduit financing regulations targeted this exact structure, albeit by a different method (i.e., imposition of withholding tax, rather than denial of deduction). Under current law, such payments suffer a form of double taxation (once as a result of the withholding tax and a second time as a result of the denial of the deduction).[35]

Conclusion — What Structures Remain?

With the recent promulgation of regulations under 1.881-3 (the conduit financing regulations) and the enactment of §267A, many structures commonly used before passage of the TCJA to minimize U.S. and foreign tax on licenses of IP for use in the U.S. have been rendered unattractive. The question is whether any structures still exist that may permit inbound licensors to achieve tax-efficient results.

One structure that should be considered by non-U.S. owners of IP is to license the IP into the U.S. through a Hungarian entity. The U.S. income tax treaty with Hungary contains a complete exemption from withholding tax on royalties,[36] and Hungary has a 9% corporate tax rate on such royalty income. Therefore, even if the IP does not qualify for a reduced rate of tax under Hungary’s patent box regime (either because the IP was not developed in Hungary or because the type of IP is not covered by the regime), Hungary’s overall effective tax rate is manageable. As noted earlier, it may even be possible to further reduce the effective tax rate in Hungary through the use of a leveraged acquisition of IP, as the conduit financing regulations may not be applicable, and the §267A regulations should not apply to a straight debt instrument.

 

[1] Sections 871(a) and 881(a). All references to section refer to those of the Internal Revenue Code of 1986, as amended (the code), and the Treasury Regulations promulgated under the code.

[2] I.R.C. §§871(b) and 882.

[3] For purposes of this article, it is assumed that the royalties paid from a U.S. taxpayer will be treated as U.S.-source income. Unlike income derived from tangible property, which typically is sourced where the property is physically located, the source of income from intangible property generally is sourced to be the jurisdiction that provides legal protection for the use of the intangible assets. See I.R.C. §861(a)(4). Unfortunately, this determination is not always clear. See, e.g., Molnar v. Commissioner, 156 F.2d 924 (2d Cir. 1946); Rohmer v. Commissioner, 5 T.C. 183 (1945), cert. denied, 328 U.S. 862 (1946).

[4] It should be noted that some treaties included in this list do impose withholding tax on royalties received from the license of certain types of IP. For a non-U.S. taxpayer to be eligible for reduced withholding tax rates on U.S.-source FDAP income under a U.S. income tax treaty, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any limitation on benefits (LOB) provision in the treaty.

[5] Treas. Reg. §1.894-1(d).

[6] This assumes that the U.K. entity would be able to satisfy the treaty’s LOB provision.

[7] This assumes that the U.K. entity satisfies the treaty’s LOB provision.

[8] These examples ignore any implications of the U.K.-controlled foreign corporation rules.

[9] Treas. Reg. §1.881-3(a)(2)(i)(A).

[10] Id.

[11] The U.S. tax treaty with Bermuda is limited to insurance enterprises and specifically exempts insurance business profits from U.S. federal income tax.

[12] This assumes that the Dutch corporation is eligible for treaty benefits and satisfies the treaty’s LOB provision. It should be noted that in such a structure, the IRS may argue that the royalties paid from the Dutch corporation to the Bermuda corporation are treated as U.S.-source income and, therefore, subject to U.S. withholding by the Dutch corporation. See Rev. Rul. 80-362, 1980-2 C.B. 208. See also Regulation §1.881-3(e), example 10.

[13] Treas. Reg. §1.881-3(a)(2)(ii)(A).

[14] Treas. Reg. §1.881-3(a)(2)(ii)(B)(1).

[15] REG-113462-08.

[16] T.D. 9922.

[17] Treas. Reg. §1.881-3(a)(2)(ii)(B)(1)(iv).

[18] Id.

[19] The regulations do provide certain exceptions where significant financing activities are performed by the conduit entity. Treas. Reg. §1.881-3(b)(3)(i).

[20] Treas. Reg. §1.881-3(a)(3)(ii)(B).

[21] T.D. 8611.

[22] Id.

[23] Treas. Reg. §1.881-3(a)(3)(ii)(B).

[24] Id.

[25] For example, the financing entity cannot be a 10% shareholder of the financed entity. See, e.g., 26 U.S.C. §881(c)(3)(B).

[26] I.R.C. §267A(a).

[27] I.R.C. §267A(b).

[28] I.R.C. §267A(d).

[29] See I.R.C. §267A(e).

[30] An exception to that general principle is the dual consolidated loss (DCL) rules, which disallow the use of the same loss to offset the income of both a domestic affiliate and a foreign affiliate. See §1503(d).

[31] It should be noted that the §267A regulations do not deny a deduction in the U.S. in situations in which the payment is a royalty for U.S. tax purposes, but for purposes of the tax law of the recipient, it is treated as consideration received in exchange for property. Treas. Reg. §1.267A-2(a)(2)(ii)(B).

[32] Treas. Reg. §1.267A-4(b)(2)(i)(A)(2). The §267A regulations also target structures that utilize notional interest deductions (which is common in Belgium and Brazil) to offset the foreign related party’s income inclusion. Treas. Reg. §1.267A-4(b)(1)(ii).

[33] Treas. Reg. §1.267A-4.

[34] Treas. Reg. §1.267A-3(b).

[35] Although beyond the scope of this article, the Base Erosion and Anti-Abuse Tax (BEAT) imposed by §59A also may apply in certain circumstances.

[36] This is true of both the existing treaty with Hungary (which has no LOB provision) and the new treaty with Hungary, which has yet to be ratified.

 

Jeffrey L. RubingerJeffrey L. Rubinger is a tax partner at Baker McKenzie in Miami. He received his J.D. from the University of Florida Levin College of Law and an LL.M. in taxation from New York University School of Law. He is admitted to the Florida and New York bars.

 

 

Summer Ayers LePreeSummer Ayers LePree is a tax partner at Baker McKenzie in Miami. She received her J.D. and her LL.M. in taxation from the University of Florida Levin College of Law. She is a member of The Florida Bar.

This column is submitted on behalf of the Tax Section, Dennis Michael O’Leary, chair, and Taso Milonas, Charlotte A. Erdmann, and Jeanette E. Moffa, editors.

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