As a policy matter, some aspects of traditional IP tax planning have come under increasing scrutiny by local governments and the broader international community, which may have an impact on the parameters of effective IP tax planning. Meanwhile, profit drivers associated with IP continue to evolve from classic brand and technology-oriented assets, as personal services-oriented assets such as trade secrets, know-how, and data analytics provide tax departments both an opportunity and an obligation to work closely with business leaders to craft sustainable IP tax planning structures.
What is IP and what is its significance to tax planning?
Before a discussion of the evolving IP and IP tax planning landscape, an overview of the concept of IP and its potential relevance to a business enterprise's tax planning is necessary.
What is IP – a business executive's view
Intellectual property is often viewed differently by different people. The traditional view of IP includes assets such as patents, trademarks, brands, and copyrights – all assets that are usually registered and/or published, and are protected through various statutes, laws, and treaties by governments around the world.
IP also includes trade secrets – the nonpublished and protected capabilities, designs, or formulas of companies or individuals that are closely held and maintained by the organisation. Each of these components of IP has a potential for great value that must be considered by executives, business leaders, and tax professionals. In fact, workaday know-how – the experience an executive or a workforce has in getting the job done – can often qualify as the most important IP asset within many companies. Understanding these categories, along with other forms of IP, is important when preparing plans to measure, protect, and profit from the intangible assets within an organisation.
IP is not a static commodity. The role it plays, the costs it imposes, the benefits it offers, and the associated risks – all change over its lifespan. IP may enter an organisation at the moment of its invention, as a result of a joint venture agreement or partnership, or as a direct purchase via an acquisition that includes IP assets. Like other assets, the value of IP can depreciate over time without appropriate investments, although calculating that value erosion is not always as clear cut as with a tangible investment. In the end, an organisation can retire an IP asset, much like it would a building or a piece of equipment. For example, IP can become obsolete as technologies advance or change. The concept of the IP lifecycle is significant because it adds a time dimension to the way an organisation considers and manages its IP assets. This is not a decision an organisation makes once, but a long-term strategic plan that requires foresight, agility, and constant evaluation.
What is IP – a tax professional's view
There are many different definitions of IP. For example, there are different definitions for accounting, legal, and tax purposes, to name just a few. And these definitions may differ depending on what jurisdictions a multinational enterprise operates in.
The US transfer pricing regulations, under section 482 of the Internal Revenue Code, define an intangible (a term that is broader than traditional intellectual property) as an asset that comprises any of the following items and has substantial value independent of the services of any individual:
- Patents, inventions, formulae, processes, designs, patterns, or know-how;
- Copyrights and literary, musical, or artistic compositions;
- Trademarks, trade names, or brand names;
- Franchises, licenses, or contracts; and
- Methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data.
The OECD, recognising that varying definitions exist, has taken a broader approach, defining intangibles as either marketing intangibles or trade intangibles. A marketing intangible is an asset used in business operations that is customer facing (trademarks, trade names, customer lists, customer relationships, etcetera). Trade intangibles are commercial assets other than a marketing intangible.
The OECD provides the following examples of its broad definition, although the OECD states that these are not intended to be comprehensive or to provide a complete list:
- Know-how and trade secrets;
- Trademarks, trade names, and brands;
- Rights under contracts and government licenses;
- Licenses and similar limited rights in intangibles; and
- Goodwill and ongoing concern value.
There is considerable overlap between the OECD's examples and the US transfer pricing definition, with one notable difference: the OECD treats goodwill and going concern as intangibles. The OECD believes goodwill and going concern cannot be separated from other assets within a firm; as a result, a significant part of the payment for IP transfers among third parties may reflect goodwill and going concern value. Thus, such value should be taken into account when valuing related-party transfers. It is worth noting, however, that proposed international tax reform measures in the US, if enacted, could expand the scope of the definition of intangibles to include goodwill, going concern, or workforce in place.
Evolution of IP tax planning
Many readers will be familiar with the idea of foreign-based corporations, usually organised in tax-efficient jurisdictions aided by rulings that facilitate base erosion, that participate in arrangements to share in the cost of developing IP, and in turn reap the potential upside benefits of such IP. Tax-related IP planning has captured a significant amount of attention lately from the OECD, as evidenced by Working Party No 6's study on intangibles and the base erosion and profit shifting (BEPS) project. The upshot of these initiatives is that substance in the IP holding company is of increasing interest.
The basic principle behind IP tax planning is that business enterprises can reduce their global tax burden by earning the profits attributable to IP in low-tax jurisdictions. The profits attributable to IP can be captured by having the IP owner utilise the IP, license rights to others (related or unrelated parties), or sell the IP.
Sustaining the benefits of an IP tax structure depends critically on the firm's ability to put operational substance into the legal entity that owns the IP. Stated differently, success depends on the firm's ability to align the business model with the IP structure. According to the OECD's discussion draft on intangibles, if the legal IP owner is to be entitled to all residual IP profit, then it must perform the functions related to developing, enhancing, maintaining, and protecting the intangibles – or it must arrange to have such functions performed under its control by related or unrelated parties. Naked IP structures that have little operational substance yet capture all the residual IP profit are therefore susceptible to challenge under OECD guidance.
Traditional tax structures, whereby the IP is centrally located at the parent company, are also susceptible to challenge if the business model is not aligned with the structure. For example, under OECD guidance, if the IP owner (the parent company) outsources key operational substance to related parties, and those parties have significant control over their activities, then the entity performing the outsourced activity is entitled to a portion of the profits attributable to the IP. Many early-stage multinational enterprises that have centralised their IP at the parent company treat offshore affiliates as routine service providers that earn limited-risk returns. Under OECD guidance, those entities may be entitled to a portion of the residual IP profit to the extent they exert significant control over their activities.
In Europe, the US, and other locations, headlines highlighting claims of international corporate tax abuses have become common. The general theme of these claims is a perceived lack of actual substance in the pertinent jurisdiction. Frequently, these stories are not even covering the extreme cases – such as a post office box in Bermuda or the Cayman Islands supporting an offshore paper company. More often, they discuss companies in jurisdictions in Europe or Asia where a multinational enterprise has actual operations that involve personnel and sometimes manufacturing. These claims highlight a tax fairness policy debate that has become more relevant as nations experience credit defaults and the resulting austerity measures to combat economic recession.
While the end result of calls for international tax reform remains uncertain, the trend for the evolution of IP tax planning is clear: business operational substance should be supportive of IP tax planning. This means tax departments must connect with business leaders to stay abreast of IP initiatives and development, and propose and maintain structures that are fluid and capable of responding to developments in a timely manner.
The consequence of not staying informed is that IP strategy and business operations may not be aligned, potentially leading to:
- Income generation in entities that lack substance;
- Operational challenges when a tax structure does not support operations, often resulting in excessive operating costs and/or tax risks such as the creation of a permanent establishment, or the application of subpart F in the US;
- Poorly structured IP asset management leading to profits build-up in high-tax jurisdictions;
- M&A activity that leaves IP assets in entities or jurisdictions where owning it costs too much and/or too little value is realised; and
- Poor planning related to IP management and IP capabilities, or poor documentation of the IP inventory and its use, thus inviting regulatory challenges.
The result can be not only a higher global tax burden, but also limited ability to make effective critical business decisions on an after-tax basis.
IP tax planning today – what does it all mean?
The definition of IP for tax purposes is broad and may include items not traditionally considered intangibles. Before engaging in IP tax planning, business enterprises should take stock of their intellectual assets, cataloging and documenting the following to avoid unnecessary challenges by the tax authorities:
- P the firm owns (both acquired and developed, legally protected and not);
- IP that is licensed in or licensed out;
- Which legal entity owns the assets, legally and/or economically; and
- Which entity or entities have responsibility for the development, enhancement, maintenance, and protection of those assets, and whether those entities have operational control over their activities.
A company's failure to document its IP holdings and align its existing (or future) tax structure to its business model may result in unnecessary risks. The taxing authorities will be only too happy to adopt their version of what IP exists and how that IP should be valued – and the applicable rules change frequently. The company that fails to identify, value, and strategically align its IP within the supply chain opens itself up to either excess risk and/or the failure to extract value from these assets. To take advantage of the potential IP that assets create long-term, a company's IP strategy must include components of proper tax planning and direct alignment to overall corporate business strategy.
Beyond patents, tax, and government reform: Integration of IP tax and business planning
Most multinationals understand that effective tax planning can enhance the financial benefits derived from IP. What may not be as well established or developed is how IP itself may be an undermonetised asset. Companies spend years, internal and external resources, and financial resources developing and purchasing IP assets, with the goal of having large IP portfolios to control. Today, what matters is not the number of IP assets a company owns, but the return on investment related to those IP assets. So IP owners are assessing what IP assets they need, which are core assets and non-core assets, and what might be the monetisation strategies for their specific set of circumstances. For example, value extraction strategic options include:
- divesting non-core IP assets;
- outlicensing IP to different industry verticals;
- forming joint ventures to further develop orphaned technologies/IP; and
- developing and implementing enforcement licensing for assets being used without proper authorisation.
Let's now look at how the convergence of tax structuring and increasing business value associated with IP come together in various scenarios. IP owners have evaluated the benefits of establishing IP holding companies for years. Similar considerations inform the strategic choice of centralisation or decentralisation of IP management and IP structures. With choices like this come the decisions to license-in or purchase IP in certain jurisdictions and by specific legal entities, or have all those decisions default to one centralised entity or holding company in a beneficial tax jurisdiction. Other structuring considerations exist, but those should be evaluated on a case-by-case basis.
When two organisations merge together, many parts must mesh, and the longer that integration process takes, the less effective the deal may be from a shareholder value perspective. It is not surprising that in such deals many leaders focus their attention on the tangible assets, working to integrate people and talent efficiently. A merger or acquisition also has the effect of potentially forcing two separate IP regimes to evolve into one go-forward strategy. If the resulting IP structure does not receive deliberate attention, it may be haphazard or even create less value than the status quo. It might not support the tax planning and business strategies that brought the entities together in the first place, and it might become locked into place over time.
If handled properly, the integration of IP assets and IP capabilities post-merger can provide significant benefits both in the near and long terms. The new entity has the ability to have IP assets in the right jurisdictions and entities, so that these assets can help generate value, and there will be a clear understanding of the potential tax implications. This will confirm that the location – both in terms of jurisdiction and/or legal entity – and utility of the IP assets will be aligned with the organisation's operating and enterprise resource planning (ERP) structure.
Conversely, if handled poorly, post-M&A IP strategy could enhance risk, decrease efficiency, contain redundancies, increase costs, and elevate the global tax burden. There are decisions in the integration process that an entity gets to make only once – and if an inefficient IP strategy is baked into the deal, it may be difficult to overcome in the future.
In an M&A transaction, IP tax, legal, and business planning must be front and centre – not only in integration, but as part of the transaction due diligence process. IP assets and related IP considerations are most likely major factors in the overall transaction, and therefore must be given the proper attention.
Mergers and acquisitions can challenge a company's strategy by adding new IP assets, new IP initiatives, and new structures into the mix – at various points in their lifecycles, and in ways that seldom align with the strategic decisions that already govern other intangibles. Thus, assessing the potential value of the IP assets, analysing the associated risks, and quantifying the opportunities the assets represent are critical factors. There will always be plenty of work to do during post-merger integration, but ideally the important IP strategic decisions will be evaluated and assessed during due diligence and contribute to critical transaction-related decisions before the transaction closes.
Company systems changes
Whether it's an update or an overhaul, a revamped ERP system will fundamentally alter the way a supply chain moves through an organisation. If a company's IP tax strategy is not aligned with changes to its supply chain, this could result in undesirable tax consequences due to such a misalignment.
As far as supply chains are concerned, businesses need to apply a tremendous amount of transfer pricing logic to the design of their business processes. That means knowing the rules of the road in and among the jurisdictions where the business operates. For example: who owns the IP, how does the IP drive value, which entity posts the profits, and how aggressive are the relevant taxing jurisdictions involved?
When an ERP project takes IP into account, people ask these questions early in the process and build the answers into the logic of the new system. At a minimum, that adds clarity that can help ward off excess taxation and risk. However, the potential benefits do not stop there, as building in sound IP components to an ERP change can identify areas of opportunity as well.
As with the "garbage in garbage out" principle of information systems, an ERP structure that does not have an IP strategy baked in may end up generating results that are inconsistent with industry IP leading practices. A company's risk will most likely go up as different governments compete for the company's tax dollars, and if the company doesn't have the proper documentation to sort out the potential liability this may create unmanageable risk.
When related parts of a business use each other's resources, tax authorities expect them to charge each other as if they were separate companies operating at arm's-length. Failure to plan effectively can lead to significant tax liabilities and risks of double taxation. Anticipating and easing the transfer pricing obligation starts with understanding the way different parts of a business relate to one another legally and the ways in which ownership of the relevant IP assets are parceled out.
For example, a business unit in one country may perform manufacturing functions for a business unit in another country that imports the goods and sells them. The plans and specifications, technical trade secrets, and know-how that go into the manufacturing process all constitute important IP assets. Under this scenario, who owns the IP – the parent company or the manufacturing arm? Does the manufacturing unit owe the other unit a royalty for using the IP or do they own it jointly under a cost-sharing agreement? These are critical questions that must be adequately addressed.
Today, the ability to transfer and utilise IP instantly around the globe using the internet adds complexity to these issues. Because this high-speed, high-volume information flow exists in the digital cloud rather than in a distinct physical location, it invites questions about where the IP actually resides and whether or not it has actually traveled across a border.
Complying with the law starts with knowing the law, and the applicable laws are changing fast in many jurisdictions. To keep a company's profits in a tax favourable entity and jurisdiction and its IP creating value instead of costing the company money, its information systems must not treat IP as an afterthought.
Changes to the company's business model
Sometimes change comes as evolution: A computer hardware company might find itself emerging as a software leader or as a cloud service provider. Sometimes it's revolution: for example, health care reform in the US has many hospitals and insurance companies evaluating changing business models. Whatever the pace, a shift in business model changes everything, and if a business doesn't account properly for IP as part of that process, the potential tax implications can be detrimental.
Once again, the answer is to include IP tax planning from the outset. A multinational enterprise should conduct an IP assessment and take inventory of its IP portfolio and related business model. What are the IP assets, where are they located, how is the business utilising the IP assets, etcetera?
It will be important to weave a consistent plan regarding IP strategy that considers all the various constituencies and their interests. The legal and business teams will likely have IP strategies that are not necessarily focused on legal entity considerations. The tax professional must nonetheless be able to develop, determine, document, and support IP on a legal entity basis both from a proactive planning as well as a risk management perspective.
If a company's go-forward business model involves mobile or virtual services, it might be unclear where the IP assets that support those services are located for tax purposes, or where the transaction driving the value actually took place. The physical location of servers and other elements of an IT infrastructure can be key considerations, but not the only factors; contracts and customer relationships also matter. In addition, shared services centers that support operations in multiple jurisdictions can make the picture even more complex.
The alignment of a company's operating model and its global tax planning enhances the opportunity for value creation, and each must adapt to satisfy the demands of the other. Business model optimisation (BMO) is the process of pursuing this balance and integrating the operating model with global tax planning into the way a business operates. Tax planning that is not based on operations can dramatically increase a company's risk profile. As a result, a business model that does not take tax planning into account may end up surrendering some or all of the profit it creates to higher taxes.
The four Rs
As businesses, tax laws and taxing authorities all change in sophistication, effective management of IP and tax planning become ever more important to multinational taxpayers. As with any IP tax planning, the four Rs should be considered.
Realigning for business transformation
Aligning IP tax planning and business strategies may or may not be part of a larger business model transformation, but every organisation should make sure its business model is capable of efficiently developing and deploying IP in the right way. This is the groundwork for everything that follows, so it is critical that management, operations, and tax professionals (whether internal, external, or both) partner in this assessment and design process.
Reconfiguring IT systems
IT systems must be able to support governance structures, supply chains, and every other part of a business in harmony. IP is an essential element of the overall framework and building this capability will touch upon access to financial data, tax policies, transfer pricing, approval processes, and other issues.
Readying human resources
Aligning strategies means changing functions, locations, and risks. That can mean moving people, which has the potential to trigger attrition, disruption, and leadership confusion. The potential talent implications of effectively implementing an IP strategy should not be ignored.
Reorganising for legal, finance, and tax structures
Changing the way valued assets move within and through a company can lead to unforeseen changes in customs, taxes (both direct and indirect), and calculations about ownership and profit. Organisations can't leave these elements to chance. Additionally, as calls for reform of the tax laws that affect IP tax planning continue, it is critical that tax planning be undertaken that fully integrates the importance of business operational substance as well as maintenance of appropriate documentation.
Maintaining shareholder value
As businesses seek new ways to drive revenue and profits while effectively managing cash flow and costs, effective IP tax planning is a critical component in creating and maintaining shareholder value. It can help companies create substantial value, protect their products and offerings, and provide a competitive advantage, all while helping them address and manage tax-related risks.
However, companies cannot consider IP strategy, tax planning, tax reform, and business strategy as separate items. These components all work together, and the way an organisation assembles its internal structure can have far-reaching effects on the tax liabilities that developing, protecting and deploying intangible assets entail.
More than anything, it's vital to have the right support. A sustainable, profitable, coherent approach to IP tax planning is too complex for almost anyone to tackle alone.
David Cordova is a tax partner in Deloitte Tax with more than 25 years of experience specializing in providing international tax services to multinational companies ranging from startups to Fortune 100 companies. He has extensive cross-border tax experience, as well as in international mergers and acquisitions, structuring foreign operations, and negotiations with tax authorities. He is one of Deloitte's global specialists in international accounting for income tax.
Mr Cordova serves as a member of Deloitte's Business Model Optimisation leadership team, and has many years of practical experience working with clients in intangible-oriented industries such as technology and consumer businesses. He recently returned to the United States after having served as Deloitte's Clients and Markets leader for the Asia Pacific tax practice, based in Tokyo.
Mr Cordova is a graduate of the University of Washington, from which he holds a BA in Accounting, as well as the Denver University Graduate Tax Program. He is a member of the American Institute of Certified Public Accountants.
Deloitte Tax LLP
Michael is Deloitte's national technology co-leader for the US transfer pricing practice. He has more than 13 years' experience consulting on transfer pricing and tax issues for several of the world's largest technology companies, providing valuation and economic consulting services involving mergers and acquisitions, international tax planning, and the restructuring and reorganisation of international operations. He has negotiated US and foreign advance pricing agreements, managed US and foreign transfer pricing audits, and met with various competent authorities on behalf of his clients.
Michael is based out of Deloitte's Silicon Valley office in San Jose, California, where he directs a team of more than 25 transfer pricing analysts across the Pacific Northwest.
Before joining Deloitte Tax, Michael was an economist with another Big 4 firm, an economist with Christensen Associates, and a graduate teaching fellow at the University of Oregon in the economics department.
Deloitte Financial Advisory Services
Don Fancher is a principal of Deloitte Financial Advisory Services (Deloitte FAS) and also serves as the national leader for Deloitte FAS' IP practice. Fancher has over 25 years of experience assisting clients and leading practices in forensic and dispute consulting, having served in a variety of geographic and practice area leadership roles. Fancher has demonstrated expertise working domestically and internationally on client service matters regarding forensic investigations, dispute consulting, IP litigation and reorganisation services across a number of industries, and has testified as an expert on numerous occasions in federal, state and bankruptcy court.
Fancher has provided consulting services in a variety of matters regarding the assessment and evaluation of IP portfolios to assist clients in the management of technology and intangible assets. He has provided assistance in licensing negotiations, technology and IP valuation, market and industry assessments, and IP portfolio management. He has also provided commercialisation, monetisation and business and IP strategy assistance to clients. These efforts have included performing analyses such as business and product planning, market studies, valuation, financial proformas, profit projections, and overall IP strategy plans and assessments.
Fancher has also evaluated and provided expert testimony in relation to various disputes for patent, copyright, trademark, and trade name infringement, as well as trade secret misappropriation. He has quantified damages analyses that include the calculation of lost profits, the determination of reasonable royalties and hypothetical negotiation scenarios, the quantification of unjust enrichment, and the assessment of the economic value of IP. Fancher has also testified in numerous commercial litigation and class-action matters and his testimony has been provided in Federal, State, and Bankruptcy court cases.
Fancher's clients include Fortune 500 companies, universities and research organisations, government departments and labs, early stage development entities and IP investment organisations. Industries served include technology, telecommunications, energy and petrochemical, life sciences, medical technology and biotechnology, consumer products, manufacturing, computer hardware and software, and others. He has also authored and delivered numerous publications and presentations regarding damages, IP, and forensic issues.
Fancher holds a BBA in Finance from Texas A&M University and a MBA from Baylor University.
Deloitte Financial Advisory Services
Hudson is a senior manager in Deloitte Financial Advisory Services (Deloitte FAS) and supports Deloitte FAS' national valuation and intellectual property (IP) practice areas. He has more than 15 years of experience valuing businesses and intangible assets, and providing dispute resolution and investigation services in the Americas and Europe. Hudson has extensive experience in the analysis, diligence, valuation and value extraction strategies of all forms of IP. He has performed a variety of IP-related engagements including valuation and strategy issues related to technology and IP, IP contracts and related analyses and investigations, IP dispute/litigation consulting, licensee identification and license negotiations support, the evaluation of internal intellectual asset and intellectual property management programmes, and technology transfers transactions.
Hudson spends the majority of his time assisting clients develop and implement IP value extraction strategies. These strategies include strategic and enforcement licensing programmes, cross-licensing, divesting of IP portfolios, cost savings via abandonment programmes, and litigation. These engagements have been in the context of mergers and acquisitions, restructuring, divesture, arbitration, mediation, litigation, securitisations, investigations, tax planning, joint venture formation and spinouts.
In addition, Hudson has performed these engagements across various industries and sectors, and for clients that include Fortune 500 companies, universities, private companies, governmental agencies, not-for-profit groups, and individual inventors. Hudson often speaks on the topic of IP valuation, IP value extraction strategies and intellectual asset/property management.
Hudson holds a Bachelor of Arts in Economics from the University of Florida.
Deloitte Tax LLP
Sam is a manager in Deloitte Tax with 10 years of tax practice experience, seven of which were in international tax. He has extensive experience with business model optimisation tax structuring and he has previously serviced high tech clients in California, including engagements involving IP migration/ cost sharing.
Sam has a JD from the University of Washington and an LL.M. in taxation from New York University.
© 2019 Euromoney Institutional Investor PLC. For help please see our FAQ.