This typically involves two components – (1) a transfer of the IP to a CFC in exchange for consideration (a platform contribution or buy-in) and (2) a development arrangement. Though there are several methods to transfer IP, the following are prevalent: a lump-sum transfer; a transfer for payments contingent on the IP's productivity and use; and a payment or fixed payments over a period of years. The transfer pricing surrounding these arrangements is governed by either Treas. Reg. §1.482-7, a qualified cost-sharing arrangement (QCSA) or Treas. Reg. §§1.482-4 (transfer of IP) and -9 (inter-company services). In the context of a QCSA, the transfer of rights to utilise preexisting IP is referred to as a platform contribution transaction (PCT), and the regulations have very specific requirements governing a PCT that may impact the tax consequences of the transfer – Treas. Reg. §§1.482-7(c) and -7(g).
The focus of this article is the collateral US tax and accounting consequences to the US transferor in such an IP transfer, including the following treatment:
- Sale versus license;
- Capital versus ordinary;
- Source of income;
- Research and experimentation (R&E) expensing;
- Foreign tax credit basketing;
- Timing of income inclusion; and
- US GAAP ("book") treatment.
Sale versus licence
Whether the PCT is a sale or a licence depends generally on whether, in view of all the attending facts and circumstances, substantially all rights to the IP have been transferred to the transferee. See, for example, Rohmer v. Commissioner, 153 F2d 61 (2nd Cir. 1946) (movie rights); Tomerlin Trust v. Commissioner., 87 T.C. 876 (1986) (trademarks); Lawrence Lokken, The Sources of Income from International Uses and Dispositions of Intellectual Property, 36 Tax. L. Rev. 235, at 247 (1981); cf. Treas. Reg. §1.1235-1(a). If the PCT involves the transfer of all substantial rights to the IP, then the PCT is treated as a sale or exchange of property. If less than all substantial rights are transferred, the transaction is a license that generates royalty income. The manner and method of payment are irrelevant. See Commissioner v. Wodehouse, 337 US 369 (1949). Thus, regardless of whether the consideration is paid in a lump sum or over a period of years, the transfer will be characterised as a sale or a licence depending on the nature of the rights transferred.
Capital versus ordinary
Royalty income is ordinary income. However, proceeds from the sale of IP may be ordinary income or capital gain.
IRC §1239 is an anti-abuse provision meant to prevent related parties from recognising capital gains on the sale of assets between said related parties when the related purchaser would be entitled to depreciation or amortisation deductions with respect to the stepped-up basis. IRC §1239(a) recharacterises as ordinary the gain on the sale of IP to a related party if such IP would be amortisable under IRC §167 for US federal income tax purposes in the hands of the related-party purchaser. See IRC §1239(a); see also IRC §197(d)(1), IRC §197(f)(7), and Treas. Reg. §1.197-2(g)(8). Because the transferor and transferee in a QCSA are related persons under IRC §1239(b), the transferor's gain on the PCT generally will be recharacterised as ordinary income to the transferor.
When goodwill, going concern value, or any other intangible asset that was not amortisable before the enactment of IRC §197 in 1993, forms part of the IP, the anti-churning rule in IRC §197(f)(9) could preclude the PCT transferee from claiming an amortisation deduction under certain circumstances. If the IRC §197 anti-churning rule applies, then IRC §1239 would not recharacterise the transferor's gain on the PCT as ordinary; thus, the gain to the transferor on the PCT may generate capital gain.
Royalties paid in exchange for the right to use or exploit IP outside of the US are typically foreign-source income – IRC §862(a)(4). In contrast, the gain from the sale of IP – patents, copyrights, secret processes or formulas, goodwill, trademark, trade brand, franchise, or other like property – is generally sourced under IRC §865 according to the residence of the seller. When the transferor is a U.S. resident, the gain on the sale of IP is US-source income. However, to the extent that the gain on a sale of IP is contingent on the productivity, use, or disposition of the IP, the gain is sourced in the same manner as royalties. Generally, foreign-source income is preferred to increase allowable foreign tax credits.
R&E allocation and apportionment
The foreign tax credit limitation is based on net income. Accordingly, deductions must be allocated and apportioned between US-source and foreign-source income. See Treas. Reg. §1.861-8T(c). R&E expenses are subject to specific allocation and apportionment rules under the regulations (the -17 Regs). See Treas. Reg. §1.861-17(a)(1). R&E expenses are deemed allocable to all gross income items (including income from sales and royalties) as classes that are related to product categories (Treas. Reg. §1.861-17). The apportionment rules under the -17 Regs apportion the R&E expenses over (1) a specified exclusive apportionment rule that provides for an arbitrary percentage of total R&E expenses to be sourced in the jurisdiction where the R&E activities occur; and (2) the remaining amount is apportioned based on either the sales method or the gross income method, whichever is applicable to the taxpayer (under Treas. Reg. §1.861-17(e), the taxpayer can elect to use either the sales method or the gross income method). See Treas. Reg. §1.861-17(b)(1). Apportionment under the sales method is dependent on the relation of domestic and foreign sales within each product category to the total amount of sales within that category. Treas. Reg. §1.861-17(c)(1). Taxpayers that utilise the sales method must include not only the taxpayer's sales, but also those of unrelated and related persons when the taxpayer's IP is utilised by such persons. Treas. Reg. §1.861-17(c)(2) and -17(c)(3). However, expenses incurred subject to a QCSA need not be included as expenditure subject to apportionment. See Treas. Reg. §1.861-17(c)(3)(iv). Hence, a QCSA may have a positive impact on foreign-source net income.
Timing of the income inclusion by the US transferor is dependent on the method of IP transfer and the taxpayer's method of accounting. If the taxpayer is an accrual method taxpayer, then income attributable to the PCT is typically taken into account when all events have occurred that fix the taxpayer's right to the income and the amount of such income can be determined with reasonable accuracy. Treas. Reg. §1.446-1(c)(1)(ii).
Foreign tax credit basket
Section 904 limits the total amount of foreign tax credit that can be claimed. For taxable years beginning after December 31 2006, income is divided into two separate income baskets for purposes of the foreign tax credit limitation. Passive category income is defined generally as dividends, interest, royalties, rents, annuities and the gain or loss from the sale or exchange of property that generates income of that nature. However, the sale of IP (described in IRC §936(h)(3)(B)) that is used in an active trade or business is general income (defined below). Section 904(d)(2)(A); Treas. Reg. §1.954-2(e). Thus, in the context of a sale for a lump sum or contingent consideration, the basketing of the proceeds will depend on the use of the IP by the transferor.
General category income is any income that is not passive income. IRC §904(d)(2)(A)(ii). Section 904(d)(3) provides that, in relevant part, royalties received or accrued by a US shareholder (as that term is defined for purposes of Subpart F principles) from a CFC is to be treated as general income to the extent it is properly allocable to general income of the CFC.
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.
Principal, international tax
Gretchen Sierra is the partner-in-charge of Deloitte's Washington National Tax-International Tax Services group. She advises US-and foreign-based multinationals on a broad range of international tax matters, including supply chain structuring, IP migrations, US income tax treaties, inbound planning, financing transactions, cross-border mergers and acquisitions, and e-commerce transactions.
Before joining Deloitte in January 2009, Ms Sierra was deputy international tax counsel in the Office of Tax Policy of the US Treasury Department. In this role, she had responsibility for a broad spectrum of US tax treaty and international tax regulatory and legislative matters, including the contract manufacturing regulations. Prior to joining the Treasury Department in 2005, she was legislation counsel for the Joint Committee on Taxation of the US Congress, where she advised the House Ways & Means Committee, the Senate Finance Committee, and other members of Congress on proposed international tax legislation, including the American Jobs Creation Act of 2004.
Ms Sierra is an adjunct professor at the Georgetown University Law Center. She is also a co-author of the Bloomberg/BNA Tax Management Portfolio Planning Matrix for US-Based Multinational Corporations.
Manager – International Tax
Douglas Cowan is a manager in Deloitte Tax's Washington National Tax Office – International Tax Services Group. He assists US and foreign multinationals on a broad range of international tax issues in both inbound and outbound planning.
Mr Cowan is a graduate of St Mary's University School of Law (JD) and the Georgetown Law Center (LLM Taxation). He is admitted to practice law in Texas and the District of Columbia. Mr Cowan speaks fluent Spanish and French.
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