12 December 2019 - Article
By Mitchell R. Kops, Nancy Yamaguchi, and Steven J. Moore
Intellectual property (“IP”) generally is the most valuable asset held by technology companies and, in fact, in many business entities across all sectors of the economy. IP accounts for an average of over 80% of company value. Whether the IP consists of manufacturing patents, marketing trademarks, corporate know-how, analytic formulas, or source code, there are a number of significant issues to consider. Some of these include:
• Investment and Development: The most efficient methods for carrying out IP investment and development to better ensure the future success of the business, as well as protect the founders' interests from dilution as the result of third party capital investment.
• Global Leverage: The most effective use of IP for international growth and competitive advantage.
Keeping IP in the US may be optimal for revenue generation (including IP monetization). However, if a company's business extends beyond US borders, non-tax business reasons as well as lower effective tax rates may make the ownership and development of IP in foreign jurisdictions a better strategy. The resulting tax savings can be significant and can help to create additional capital while reducing the need to seek third party investment. Google, Apple, Microsoft, and many other well-known technology companies have taken advantage of this strategy.
INTERNATIONAL IP STRUCTURES IN OPERATION
Given the complexity of international tax rules and potential operational complications in the deployment of IP throughout an international corporate structure, there are two general choices with respect to the ownership of IP rights within a multinational corporate group.
A cost-sharing arrangement may be an attractive option if US and foreign IP rights can feasibly be “split” from an IP perspective. In this type of structure, a foreign IP holding company (“IPCo”) and its US affiliate/parent enter into a cost-sharing arrangement whereby the companies share the costs of future IP development in proportion to each company's anticipated share of associated economic benefit. Thus, both US affiliate/parent (as to US IP rights) and foreign IPCo (as to foreign IP rights) are treated as “joint owners,” and no royalties are imputed to the US affiliate/parent with respect to the use of the IP outside of the US. This structure should allow for growth of foreign IP rights with minimal US tax exposure and a low overall effective tax rate.
Some types of IP cannot or should not be “split” up. In that situation, the tax preference likely will be to own all of the IP in a foreign IPCo and, to the extent research and development (“R&D”) is done in the US, to have a services contract in place whereby the foreign IPCo contracts for such R&D. Thus, the US company would directly, or through a US subsidiary R&D company (“US R&D Co”), carry out the global R&D functions of the multinational group. The foreign IPCo will then contract with US R&D Co, under an arm's-length services agreement at fair market compensation, to perform foreign-based R&D services on behalf of the foreign IPCo. As new IP is developed under the services agreement, the foreign IPCo acquires full title.
In addition to the ownership rights of US and foreign IP, there is also the question of an appropriate jurisdiction for the foreign IPCo. While the variables are complex, some of the common considerations include (1) a jurisdiction with a skilled labor force and engineering talent, (2) a stable economy, (3) low corporate tax rates, (4) R&D incentives, and (4) an extensive tax treaty network.
ISSUES SURROUNDING CROSS-BORDER IP TRANSFERS: THE TAX PERSPECTIVE
One of the most common hurdles to creating a tax efficient offshore IP structure is the effective transfer of the IP from the US abroad. Many US companies have developed and continue to own their IP domestically. Generally, if IP will be utilized only in the US, it is likely more tax efficient for such rights to remain in the US rather than offshore. However, if it is anticipated that IP will be utilized and commercialized internationally, there are several ways to transfer foreign IP rights offshore.
Assuming global IP rights are held in the US, one option is for the US company (“US Parent”) to simply sell all foreign IP rights to a foreign corporate subsidiary (“Foreign IPCo”). This option is ideal for new startups with IP that currently has a low (or zero) value attributable to foreign rights but is expected to appreciate significantly in future years. A sale of this IP today should result in minimal current US income tax to US Parent because of the IP's low value and will allow for appreciation of the IP free of US tax. Any resulting gain should be capital gain for US tax purposes (taxed at 20% for individuals). This option may not be efficient for companies with IP that has successfully been deployed or utilized and therefore would have a higher valuation. In that case, an outright sale could result in significant US tax, especially since the basis in the IP would likely be low.
An alternative to this structure is for US Parent to contribute all foreign IP rights to Foreign IPCo in exchange for shares of stock in Foreign IPCo. Generally, contributions of IP to domestic corporations in exchange for stock are tax-free transactions; however, when the transferee corporation is foreign, US tax law imputes a royalty to the contributing taxpayer.
It is crucial for any company considering an offshore IP transfer to carefully consider these alternatives in determining which method presents the optimal after-tax result, and there is no sensible “one-size fits all” approach.
Each of these structures present excellent tax planning opportunities, but also some potential landmines that need to be carefully monitored by a qualified tax advisor. A recommendation, however, is to address daunting tax and commercial issues relating to an IP holding structure sooner rather than later. It is rarely easy, but the financial and emotional costs are considerably less when IP planning is a part of the earlier developmental stages, especially for technology startups and other IP-intensive companies with potential for significant global growth.
This article originally published on Inside Counsel on September 2, 2015
Reprinted with permission from “InsideCounsel”© 2015 ALM Media Properties, LLC. All rights reserved.