2012 - Issue 52—Several of our recent Tax Advisor Weekly articles have addressed the ways in which mature, global, multinational companies may manage their technology and intangible property (IP) in order to operate their businesses efficiently, while at the same time ensuring they have a manageable tax footprint and a comparable effective tax rate to others in their industry. While Rome was not built in a day, neither was the average multinational. In the early years, many of these high-tech and other startups derive much, if not all, of their initial value from and through the IP they develop.
Before Google, Microsoft and Apple, to name a few, became the huge multinationals they are today, many were startups with office space in garages, financed by part-time jobs and credit cards. There has been a great deal of press in recent months as jurisdictions like France, the U.K. and others have looked into the global IP footprints and transfer pricing strategies used by some of the largest high-tech companies in the world. While it is unclear where these inquiries may lead, one thing is clear: it is never too soon for a high-tech or other startup that has the potential to grow into a global business to assess and evaluate its current and future tax footprint and transfer pricing policies to ensure they are both creating tax efficiencies for the company and compliant with global tax and transfer pricing rules.
This article discusses the opportunity for startup companies that create IP in the U.S. to think about tax and IP planning at an early stage in their business's life. Migrating IP out of the U.S. is not for everyone, so this article also discusses some of the many considerations that a company must weigh before implementing a global IP strategy or making changes to its current strategy. Fina ly, this article describes some of the basic steps necessary for evaluating whether an IP transfer is right for a particular company, as we l the steps that need to be fo lowed to complete a successful IP migration.
Benefits Associated With Migrating IP Out of the U.S.
The U.S. has one of the highest corporate tax rates of any industrialized nation. Accordingly, migrating IP out of the U.S. to a jurisdiction with a low effective tax rate on intangible profits that is consistent with the operational objectives of the business can be a key decision and strategic opportunity, especia ly for a startup with an abundance of net operating losses (NOLs) or research and development tax credits. In addition to achieving a low effective rate of tax on intangible profits, an additional benefit to IP migrations is that royalty payments received from related parties that use the IP and are located in high-taxed jurisdictions may be deductible against these high rates of tax and further reduce a company's effective tax rate.
Tax Considerations in Determining Whether a Change to Your Global IP Strategy Makes Sense for Your Business
A U.S. company typica ly migrates IP out of the U.S. in one of two ways:
1. A U.S. company licenses or se ls a l or a portion of its IP to a related party located in a foreign jurisdiction with a lower effective tax rate on intangible profits in a fu ly taxable transaction governed under the principles of Internal Revenue Code Section 482; or
2. A U.S. company contributes its IP as a contribution of capital to a foreign subsidiary located in a foreign jurisdiction with a low effective tax rate on intangible profits in a transaction governed under IRC Section 367(d).
While this article focuses on some of the benefits and risks for a high-tech or other startup generating significant NOLs from inception to move IP out of the U.S. under IRC Section 482, the fundamentals of IP migration under both IRC Section 482 and IRC Section 367(d) are addressed briefly below.
A. Sale or License of IP to a Related Party
Under IRC Section 482, transactions between contro led parties (i.e., parent, subsidiary or entity owned by a common parent) must be conducted on an arm's-length basis. IRC Section 482 requires that a U.S. company charge an arm's-length price for IP that it se ls or licenses to a related party in a foreign jurisdiction. This ensures that any taxable gain inherent in the IP bears an appropriate amount of U.S. tax. It is important to notethat high-tech and other startups often incur significant net operating losses during the first several years of business. In a fu ly taxable transaction, these NOLs, to the extent not limited by the rules under IRC Section 382, may be used to offset taxable gain on a sale, or a stream of royalty payments from a license, of IP to a related party in a foreign jurisdiction.
B. Contribution of IP to a Related Party
Under IRC Section 367(d), if IP is transferred outside the U.S. to a foreign subsidiary as a contribution of capital, or pursuant to a plan of reorganization, the U.S. company contributing the IP wi l be treated as though it sold the IP in exchange for payments that are contingent on the productivity, use or disposition of the property. Under IRC Section 367(d), the U.S. company must recognize U.S. taxable income, annua ly, in the form of payments from the foreign company that holds the IP for the useful life of the property or upon disposition of the IP by the foreign company. This result can be costly. While an overa l reduction in the company's effective tax rate can be a significant benefit associated with the IP being moved out of the U.S. (achieved by choosing a jurisdiction with a favorable tax rate), IRC Section 367(d) results in the U.S. taxation of intangible profits associated with migrated IP and can negate some or a l of the benefit.
Accordingly, this article addresses the sale or license of IP from a U.S. company to a foreign related party.
Timing Is Everything
In the U.S., transfer pricing rules are set forth in IRC Section 482. The transfer pricing rules are intended to place related parties in tax parity with unrelated parties by determining the true taxable income of the related parties. This is achieved by comparing related-party transactions with similar transactions entered into by unrelated parties dealing at arm's length. Accordingly, under IRC Section 482, the IRS has the authority to increase
the price charged for IP (for tax purposes) in a sale or license between related parties if the price charged is too low. IP is often valued according to the future revenue it is projected to produce. High-tech startups typica ly own a l the rights to IP. This IP wi l increase in value quickly (when a company begins producing revenue). These companies typica ly incur various costs that create NOLs in the U.S. (i.e., R&D, overhead, facilities, etc.) before the IP becomes profitable. These companies should consider migrating IP. Often, these startup companies can use their NOLs and/or research and development tax credits to significantly reduce or eliminate tax paid in the U.S. on the sale or license of the IP in what is otherwise a fu ly taxable transaction.
What Is IP Migration?
1. Identify and Value the IP
To transfer U.S.-based IP to a related party in a foreign jurisdiction, an arm's-length price must be determined. It is typica ly recommended that a company's IP be identified and valued by an independent third party, although an in-house team may perform this function if they are qualified to do so. To identify and define a company's IP, a series of interviews with the company's management and employees wi l be necessary to identify how the company earns revenue as we l as what assets (tangible as we l as intangible) are used to derive the revenue. From these conversations, a determination wi l be made as to what, if any, IP is owned by the company that is currently producing revenue or has the potential to do so in the foreseeable future.
Once the IP to be migrated has been identified, if the company plans to transfer the IP in a license or an outright sale to a related party, the Treas. Reg. 1.482-4 transfer pricing rules provide several methodologies to determine the proper transfer price (arm's-length pricing). IP assets are typica ly valued individua ly. But for companies in early operations, an alternative approach is often used to estimate the fair market value of the IP. In this situation, IP may be valued using an income approach that estimates the overa l value of the company using a discounted cash-flow method. The net book value of company's tangible assets is then deducted from the overa l value of the business to derive the fair market value of the intangible assets. Note that there are numerous ways to value IP — this is simply an example of one approach that is specific to early-stage companies.
2. Determine the Foreign Jurisdiction in Which to Migrate the IP
Once a company's IP has been identified and valued, the foreign jurisdiction where the IP wi l be migrated to must be determined. Various considerations must be taken into account, and tax professionals should always remember that a tax planning strategy must take into account the business realities of the company they work for. Below are several tax benefits that IP migration can provide:
Local country may provide a lower statutory rate. Local country may a provide tax holiday. Local country may provide tax reduction strategies.
3. Taxable Transfer of the IP
For U.S. tax purposes, a transfer of IP can be considered either (1) a license of the IP or (2) a sale or exchange of the IP. In the case described above, careful attention should be paid to the drafting of the intercompany agreements in order to assure that the transaction is characterized for U.S. federal income tax purposes as intended. The characterization of an IP migration as a license can have unintended and severe consequences for a company. For example, payments received by a U.S. company pursuant to a license agreement are characterized as ordinary income and are typica ly based on the "income produced by the IP." Because U.S. persons are taxed on their worldwide income, a license wi l result in ordinary income to the U.S. se ler of the IP and not taxed at capital gains rates (e.g., where the se ler is an individual or a partnership with individual partners) or eligible for an offset of any basis that was inherent in the IP prior to the transaction.
To achieve "sale" treatment, the tax law requires a transfer of "a l substantial rights" in the underlying IP. For example, to assure that the sale of a customer list is treated as a sale (as opposed to a license) for U.S. federal income tax purposes, an intercompany agreement for the sale should make clear that the company transferring the customer list is transferring any and a l rights in the customer list in perpetuity for a valuable consideration.
4. Analysis of the Tax Consequences of the Sale of IP
The tax consequences of the sale of IP from a U.S.-based company to a foreign related party wi l vary depending on the facts and circumstances of each case. Some of the major considerations include:
A. Determination of and Taxability of the Gain in the U.S.
The U.S. taxes the worldwide income of corporations incorporated in the U.S. Accordingly, a l gain from the sale of the IP from a U.S.-based company to a related party in a foreign jurisdiction wi l be taxable in the U.S. When IP is sold or exchanged in a taxable transaction, the amount of gain that is realized is equal to the difference between the amount realized from the sale or exchange of the property and the taxpayer's adjusted basis for the property. For example, if Company A se ls valuable IP with an adjusted basis of $1 mi lion to a related party, Company B, for $3 mi lion, then Company A recognizes $2 mi lion of taxable gain in the U.S.
B. Character of Income
Generally, the sale of IP between related parties is considered ordinary income subject to certain limited exceptions. For corporations, the distinction between capital and ordinary income is largely irrelevant because capital gains and ordinary income are both taxed at 35%.
As stated above, NOLs may be used to offset U.S. taxable gain on the sale of the IP. Thus, the company needs to understand and have documentation to back up its NOL position.
5. Determining Any Intercompany Transfer Pricing Necessary Following the Transfer of IP
Once IP is migrated from the U.S. to a foreign jurisdiction, the U.S. company wi l likely sti l have operations in the U.S. Furthermore, the U.S. company may need to use the IP it has transferred overseas in order to operate the business. As stated above, transfer pricing rules are set forth in IRC Section 482 and apply to sales of IP between related parties. Additiona ly, IRC Section 482 also applies to the license of IP between related parties. Thus, if a U.S. company se ls worldwide rights to its IP to a related party and then continues to use any portion of the IP, the foreign entity that now owns the IP must charge the U.S. company an arm's-length rate (royalty) for its use. Intercompany agreements documenting the IP used, as we l as the amounts paid for its use, are needed to support the company's transfer pricing position. Alternatively, many companies only transfer non-U.S. rights to foreign related parties in these types of structures.
As an alternative to an outright sale of IP, many multinational companies are entering into cost-sharing arrangements. Such arrangements are particularly useful where existing IP must be further developed to attain or maintain its potential future value. These arrangements involve a transfer of a l or a portion of the existing IP platform as an initial step, and then obligate the parties to bear their proportional shares of costs relating to the development of intangible property based on their anticipated share of the revenue to be derived from that property in the future. By matching development costs and risks to relative anticipated benefits from the development effort, the future developed IP is treated for tax purposes as coming into existence in the hands of the cost-sharing parties, obviating the need for any future taxable transfers of the IP created by successful research and development. A cost-sharing agreement, however, does not eliminate the need for determining a value for pre-existing intangible property that is contributed to the arrangement. The transfer pricing rules for determining the "buy-in," or value of pre-existing intangible property, are complex but, in general, are based on projections of expected future value derived from the use of the pre-existing IP.
When cost-sharing agreements are accepted by tax authorities, the need to develop an arm's-length price transfer price (as described above) for inter-group royalty payments for the use of IP between related parties may be eliminated. While there is inherent risk in entering a cost-sharing agreement (because they are often cha lenged by local taxing authorities), they have four potential benefits for companies:
- Simplification of intercompany transactions: Uncertainty over the potential tax treatment of intercompany royalty payments may be minimized in jurisdictions that respect the agreement. However, care must be taken so that the burden of the costs borne by the parties correlates with their anticipated relative benefits. Moreover, the offshore cost-sharing participant must have sufficient substance to bear and manage the risks of the development process.
- Matching of business objectives: A cost-sharing agreement often reflects the intended economics of intangible development by a multinational group. The various companies in a multinational group may agree to the resources that should be expended by each member in the development of IP, as we l as the estimated return from that investment.
- Reduced risks of double taxation: When a l taxing jurisdictions in which a multinational operates accept a cost-sharing agreement, the risk that transfer pricing adjustments wi l lead to double taxation is greatly reduced.
- Managing the group's worldwide tax exposure: A cost-sharing agreement may be used to manage a multinational group's worldwide tax exposure. Some examples of this benefit are the elimination of withholding tax on inter-group royalties and the separation of the up-front costs of IP development.
Alvarez & Marsal Taxand Says:
Recent events indicate that IP planning must be thoughtfu ly carried out in a manner that makes sense from a business perspective and wi l withstand scrutiny by not just U.S. but also other taxing authorities throughout the world. The basic principles and considerations in this article are just the starting point for discussing and understanding what types of IP planning opportunities may exist for your company. For a typical startup to identify whether this type IP planning is a possibility, it needs to consider the fo lowing steps from an international tax planning, transfer pricing and valuation perspective:
- Identify the IP;
- Value the IP;
- Determine relevant foreign jurisdiction/s for migration;
- Ensure the proper intercompany agreements are in place;
- Analyze the tax consequences of an IP sale or license; and
- Put in place any intercompany transfer pricing documentation necessary fo lowing the transfer of IP.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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