United States tax planning involving intangible assets has become increasingly common due to the growing amount of multinational companies and the steady increase in cross-border electronic commerce. Given the complexity of US tax law, there are a number of significant US tax implications involved in the use and exploitation of intellectual property. Tax planning for the intellectual property of US-based multinational companies involves determining which affiliate (or affiliates) in the multinational group should derive income from the intellectual property, as well as determining what is the desired character of the income. The US anti-deferral (or subpart F) rules and the source of income rules vary depending on the character of the underlying income. Other critical elements in maximizing the after-tax return from a US multinational group's intellectual property are the structure of inter-company transactions and the legal relationships between affiliates.
This article will address each of these issues and examine their effect on a multinational's effort to maximize after-tax return from its intellectual property.
TREATMENT OF ACQUISITION AND DEVELOPMENT COSTS
Acquisition costs
Intellectual property that is acquired as a part of the acquisition of a trade or business is a capital asset that may be amortized over 15 years from the date of acquisition, according to the provisions of the Internal Revenue Code. If the purchase is payable in contingent installments (similar to a royalty), each payment is capitalized and amortized over the remainder of the 15-year period from the date of acquisition.
The acquisition cost of a patent or copyright that is not acquired as a part of a trade or business is treated as a capital expenditure that may be amortized over the economic life of the property. Other forms of intellectual property that are not acquired as part of a trade or business must be capitalized and amortized over 15 years from the date of acquisition.
A royalty that is paid for the use of intellectual property is deductible when paid or accrued. The prepayment of future royalties must be capitalized and amortized over the term of the prepayment, even though the recipient must include the prepayment in income when received. As discussed below, the form of a payment for intellectual property (a single lump sum payment versus periodic payments) does not effect the character of the income.
Development costs
US tax law permits the expensing of research and development costs by the developer in the tax year those costs are incurred. At the taxpayer's election, these costs may be capitalized and amortized over not less than 60 months. However, once this election has been made it may only be revoked with the permission of the IRS. A more flexible, annual election is available to taxpayers. This election allows the research and development costs to be capitalized and amortized over a 10-year period. The election may be made for all or any portion of its research and development costs incurred during a tax year. The election is only binding for the identified costs incurred in the year of the election. The taxpayer may choose to expense all of its research and development costs incurred in the following year because the election is made annually.
TYPES OF INCOME GENERATED BY INTELLECTUAL PROPERTY
Service transactions
The first question to ask when characterizing income is whether the income results from a service transaction or a property transaction. The main distinguishing factor between these two is whether an interest in property is conveyed from one party to the other. If no interest in property is transferred, the income derived from the transaction is characterized as service income. Conversely, if an interest in property is conveyed, then income arising from the transaction is considered to arise from a property transaction.
A prerequisite to royalty or sale treatment is that the party earning the income possesses an interest in the underlying intellectual property that it purports to convey. While this point may seem obvious, it has been the subject of litigation between the IRS and surprised taxpayers. Furthermore, the labels assigned to a transaction by taxpayers are not given effect in determining the character of the resultant income.
If an agreement provides for services that are merely incidental, ancillary or subsidiary to the transfer of property, the transaction will be a property transaction and the income characterized as a sale or license accordingly. Ancillary services include those that are only necessary to effectuate the transfer of the intellectual property involved in the transaction, such as consulting services that are required to complete the transfer of the property. Examples of services that are generally considered to be more than ancillary or incidental include:
training people in certain skills that they do not otherwise possess; and
continuing technical advice after a start-up phase.
In no circumstance does the form of a payment, whether lump sum or periodic, affect the character or type of the income.
Property transactions
Patented intangible property: The US tax law addressing the proper character of income from the transfer of patents has been developed through years of statute, regulation and case law. The principles established to characterize the income arising from patent transfers have become the standard for the transfer of other intangible assets as well. Accordingly, the principles established for patents have been used by extension to other intangible assets that have less established bodies of law.
The determination of whether a transfer of a patent right is a sale or a license turns on whether "all substantial rights" to the patent have been transferred for the remaining economic life of the patent. The retention of a substantial right will preclude sales treatment, as does the transfer of all substantial rights for a limited period after which those rights revert to the transferor. All the relevant facts and circumstances of a transfer must be considered in making this determination.
The definition of the term "all substantial rights" is "all rights (whether or not then held by the grantor) that are of value at the time the rights to the patent (or an undivided interest therein) are transferred. Whether all substantial rights in a patent have been transferred is measured by reference to the rights the transferor retains and not the rights the transferee receives from the transferor. Courts have held that the sale of a patent will arise whenever the owner of a patent conveys (whether by sale or license) the exclusive right to make, use, offer for sale, and sell an invention for the remaining life of the patent.
It is significant to note that legal title or ownership of the patent is not among the rights considered substantial. In fact, the income tax regulation that contains this list specifically states that the possession of legal title will not be considered a substantial right if the title is held for the purpose of guaranteeing payment under the transfer agreement. Furthermore, the retention of a "vendor lien" or reservation in the nature of a condition subsequent to permit reversion of rights upon the transferee's non-performance of its contractual obligations are generally not considered substantial rights that would preclude sale treatment.
The ability to separate legal ownership of patents from US tax ownership is a significant consideration in tax planning. Multinationals are able to transfer the tax ownership of a patent to a non-US affiliate without losing the benefits of US legal ownership and protection under US law. Furthermore, an arbitrage of the differing tax treatments is possible between the US and non-US jurisdictions that give greater or decision weight to legal ownership when determining the tax owner of a patent under their tax rules. In a properly structured arrangement, two different group members could be treated as the owner of the patent in different tax jurisdictions.
Trademarks: The rules that govern the characterization of the transfer of franchises, trademarks, and tradenames (all intellectual property under US law) are similar to those for patents. Under these rules, a transfer is not a sale if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark or trade name. The rights considered substantial rights for trademarks are similar to those for patents.
As in distinguishing between service and property transactions, the determination of whether a transaction is a sale or license is a fact-intensive analysis. The parties to contracts involving transfers of intellectual property should pay close attention to detail to assure that the desired character of income from the transaction is achieved.
SOURCE OF INCOME
The source rules for income are important because they provide limits on the income that the US may tax. The foreign source income of a non-US person will be subject to US tax only under limited circumstances, while the same person's US source income is generally subject to US tax. Furthermore, the non-US income of a US person may be sheltered from US taxation if foreign tax credits are available. The source-of-income rules differ by character of income, making the character determination all the more important.
Income from the sale of intellectual property generally has the same source as the residence of the seller, whereas the source of royalty income is the place where the property is used. The place in which services are performed will determine its source. The source of income from the sale of inventory property is generally the place that ownership of the goods changes hands. A significant exception to this is source of manufactured goods. Generally, the income from manufactured goods is bifurcated into a manufacturing component and a sales component. The manufacturing income has the source of the property used to manufacture the goods, while the source of the sales portion of the income is determined by the place where the goods change ownership.
Unlike the rules for characterizing income, the form of consideration is relevant in applying the US source-of-income rules. As stated above, the general source rule for the sale of intellectual property is that it has the same source as the residence of the seller. However, if the payments are contingent upon the use or productivity of the subject intangible asset, the royalty source rules will apply, as laid out in section 865(d). For example, if a transferor transfers all substantial rights in intellectual property, such that the transfer is a sale, but a portion of the consideration is based on productivity of the intellectual property (eg 5% of revenue), the consideration will be a royalty for sourcing-rule purposes; thus, while a transferor may expect income to be sourced to the residence of the seller, it will instead be sourced based on where the intellectual property is used. Thus, a multinational may alter the source of income from the sale of intellectual property by altering the terms of payment. This source rule allows multinationals welcome flexibility in tax planning for intellectual property transfers between group members.
CFC RULES
US tax law contains a complex regime of anti-deferral or CFC rules, the most significant of which are the subpart F rules. These rules identify certain tainted forms of income that are excluded from the general rule that defers US taxation of the profits of non-US subsidiaries (controlled foreign corporations) until those profits are distributed to a US person. These rules also differ according to the character of the tainted income. The CFC rules most relevant to intellectual property income are the sales, service and royalty income rules.
Sales income
This type of income is derived by a non-US subsidiary from the purchase or sale of goods in a transaction involving a related party. In certain circumstances, a branch office of a non-US subsidiary may be treated as a related person (the Branch Rule). The related party may be the purchaser of the goods, the seller of the goods or the person on whose behalf the goods are purchased or sold. There are two main exceptions to the subpart F sales rules. The first exception excludes income from goods that are either manufactured in or sold for use in the non-US subsidiary's country of incorporation. This exception applies whether or not the non-US subsidiary is a tax resident of that country. The strict "country of incorporation" exception allows for significant tax planning opportunities because of arbitrage potential between tax residence and country of incorporation.
The second exception excludes income from goods that are manufactured by the non-US subsidiary. A non-US subsidiary may meet this exception if the goods it sells are "substantially transformed" while it owns the goods. There is a lively debate between the Internal Revenue Service (IRS) and multinationals over when a company may be considered to have manufactured goods. Many multinationals assert that the activities of a contract manufacturer, whether a related person or an unrelated person, may be attributed to the non-US subsidiary for this purpose.
Services income
Services that are performed (1) for (or on behalf) of a related person and (2) outside the non-US subsidiary's country of incorporation give rise to subpart F service income. Given this definition, a non-US subsidiary may avoid these rules by addressing one of the two tests. As noted above, the strict country of incorporation rule allows multinationals to use a dual resident company to ensure the services are performed "in the country of incorporation". Also, services performed for or on behalf of a branch are excluded from these rules because, unlike the sales income rules, there is no branch rule for service income.
Royalty income
Royalty income is part of a broader class of passive income of a non-US subsidiary that is subject to the CFC rules. There are two main exceptions to the subpart F treatment of royalties. The first exception is for royalties received from related person for intellectual property used in the non-US subsidiary's country of incorporation. Interestingly, this exception is not available for royalties received from unrelated persons. Royalties that are received from unrelated persons may be exempt from the CFC rules if those royalties are earned in an active trade or business. A non-US subsidiary earns active royalties if it either develops the intellectual property or actively markets the intellectual property with its own employees located outside the US.
TAX PLANNING FOR INTELLECTUAL PROPERTY BY US MULTINATIONALS
Transfers of intellectual property
US multinationals attempting to maximize the after-tax return on their intellectual property must navigate a myriad of US tax rules designed to prevent them from doing so. The first set of such rules address the transfer of existing intellectual property from a US person to a non-US affiliate. If the transfer of intellectual property to the non-US affiliate otherwise qualifies as a tax-free contribution or corporate reorganization, US tax law treats the transfer of intellectual property as a taxable sale. The deemed sale rules require the US transferor to include in income an amount equal to the arm's length royalty for the transferred intellectual property. This income inclusion is required for each year of the intellectual property's economic life limited to 20 years. The purpose of this rule is to ensure that intellectual property that was developed within the US is not transferred outside the US taxing jurisdiction tax-free. The problem with these rules is that the jurisdiction of the non-US transferee does not see a license agreement and will likely not allow a local tax deduction for the deemed sale proceeds – resulting in double taxation.
Given the harshness of the deemed sale rules, most US multinationals ensure the transfer of existing intellectual property occurs on arm's length terms. US tax regulations provide for the joint ownership of newly developed intellectual property among group members. These cost-sharing rules and the arm's length pricing issues will be discussed in the Transfer pricing article in this publication.
Exploitation of the intellectual property
The simplest mode to exploit intellectual property after its transfer to a non-US subsidiary is to license the property to group members in exchange for a royalty. While simple, the US CFC rules applicable to royalty income will trigger current US income tax on the licensor's royalty income unless the recipient is incorporated in the same country as the royalty is used. This lack of flexibility limits the usefulness of this "same country exception" in tax planning.
Another possibility for using a royalty model to exploit the intellectual property is to effectively eliminate the royalty through US check-the-box planning. Without spending too much time, US tax law allows a US multinational to elect whether its foreign subsidiaries will be treated as corporations or will be disregarded from their shareholders and taxed as a branch (a disregarded entity). This check-the-box approach is clearly simple, but it is simplicity at the price of effective foreign tax credit planning. Good foreign tax credit planning requires the separation of non-US earnings into pools of high-taxed and low-taxed earnings, so that the high-taxed income may be repatriated while the low-taxed income is kept offshore and the US tax on it deferred. US multinationals that convert all their subsidiaries into disregarded entities under a "super holding company" blend together the high- and low-taxed earnings of their non-US subsidiaries destroying their ability to do effective foreign tax credit planning. In this case, deferral of US tax on the royalty income is purchased at far too high a price.
Group restructuring of inter-company transactions
Most US multinationals undertake some degree of restructuring of their inter-company transactions or legal structure or both to achieve the tax benefits that flow from effective intellectual property tax planning. As noted above, the character of income is very important in determining which US anti-deferral rule is applicable. Thus, if the character of the intellectual property income can be changed from royalties to the sales of goods or the provision of services, CFC rules that are more flexible will apply.
In the environment of a multinational manufacturing operation, the US multinational should consider converting the intellectual property-owning subsidiary into a principal that sells finished goods to the end customer or a sales affiliate. In this structure, the returns on intellectual property are recognized in the form of higher sales profits, rather than royalties. The CFC rules for sales income as discussed above must be addressed to ensure deferral of the US tax on these profits.
Single manufacturing site or market
If the multinational has its manufacturing concentrated in one or two locations, it may be possible to incorporate the intellectual property owner in the same jurisdiction as the manufacturing facility. The intellectual property owner may use the residence tiebreaker in an income tax treaty to establish it is a tax resident in a favourable jurisdiction. For example, many US multinationals have manufacturing in Singapore, which generally follows the place of effective management principle in determining tax residence. Thus, the multinational could form a Singapore company and establish its tax residence in a more favourable jurisdiction. In this structure, the dual resident is selling goods made in its country of incorporation and is therefore exempt from US CFC rules on this income. This dual resident structure may also be used if there is one primary market in which the multinational's goods are sold, but this is rarely the case.
Multiple manufacturing sites and markets
A multinational with several manufacturing facilities and several markets must undertake a more significant restructuring of its operations and inter-company transactions to achieve both local country tax savings and deferral of US tax. In this case, the intellectual property owner must avoid the purchase or sale of goods with a related party unless it can demonstrate that it manufactured those goods.
The first stage of the restructuring is to put the procurement function for raw materials in the intellectual property owner. This will avoid a purchase of raw materials from a related party, but also will require some amount of substance. The personnel responsible for raw material procurement will either be employed by the intellectual property owner or will work on its behalf. The raw materials procured by this company will remain the property of the intellectual property owner throughout the production cycle.
In this structure, the intellectual property owner acts as a general contractor and will employ its manufacturing affiliates to process the raw materials into finished goods on its behalf. This transaction is a provision of service versus a property transaction, so there should be no CFC problem for the intellectual property owner. The manufacturing affiliate is providing a service to a related party, but its income should be protected from the US CFC rules if it performs its services in its country of incorporation. The intellectual property owner may also hire the manufacturing affiliate or another affiliate to provide warehouse and storage services for its raw materials and finished goods.
Most OECD and US model-based income tax treaties treat the manufacturing services and the presence of goods as auxiliary activities that do not create a permanent establishment and current taxation. Thus, the only income subject to tax in the country in which the manufacturing and warehousing takes place is the fee paid to the affiliate providing the service.
The sales process may be restructured under two alternative forms. The first alternative is for the intellectual property owner to hire the marketing affiliates as sales agents that earn a commission for selling goods on its behalf. If properly structured the sales agency should not create a permanent establishment for the intellectual property owner in the country of sale. Under this structure, there is no sale to a related person and no possibility of the sales income being subject to the CFC rules. An alternative would be a direct sale of the finished goods to the marketing affiliate for resale in the local country. This structure puts pressure on the issue of whether the intellectual property owner is the manufacturer, but may be simpler to operate. In either case, the income of the sales affiliate should be protected from the CFC rules if the sales affiliate is incorporated in the country that the sales take place.
Under this scenario, the US group has successfully restructured its operations to achieve significant US and local country tax savings on the income produced by its intellectual property.
CONCLUSION
The tax planning for intellectual property for a US-based multinational requires a careful assessment of the numerous tax rules designed to reduce or eliminate the attractiveness of this planning. Oftentimes, proper tax planning in this area requires some degree of operational restructuring. This involves altering inter-company transactions, legal relationships or both to achieve the goal of maximizing the after-tax return on the US multinational's intellectual property.
James M Gannon
Arthur Andersen LLP
1666 K Street, NW
Washington DC 20006
US
Tel: +1 202 481-7703
Fax: +1 202 481-7764
