Intellectual property (IP) can be an incredibly valuable driver of business operations for many companies in the technology sector. In addition, US businesses earning worldwide income face many US federal corporate income tax (US tax) and international tax considerations that impact the operations of global technology companies.
IP Tax Considerations
US companies may approach international expansion in different ways, but all could benefit from these three considerations:
- IP development and purchase providing opportunities to improve global operations
- Potential tax incentives and benefits associated with IP ownership
- Detailed analysis to identify the existing locations and ownership of IP as well as planning to determine an efficient structure for holding and exploiting it on a go-forward basis
IP planning considerations begin with determining ownership jurisdiction in the United States, a foreign jurisdiction, or through a split ownership model. IP can be incredibly valuable and a driver of business operations in the technology sector, and for federal corporate income tax purposes, can be impacted by:
Tax Cuts and Jobs Act (TCJA) and US IP Ownership
Passage of the Tax Cuts and Jobs Act (TCJA) in 2017 enacted various changes to US tax rules and regulations, including lowering the US corporate tax rate to 21%, which may influence companies to consider holding their IP in the United States instead of other foreign jurisdictions.
The TCJA implemented an export incentive where a US corporation may claim a foreign-derived intangible income (FDII) deduction of 37.5% on foreign derived income, such as:
- Sales of intangible or tangible products manufactured or purchased for resale by the corporation to a foreign person for use outside the United States
- Broad range of services provided to a person or property outside the United States
Prior to 2017, US shareholders could generally defer US taxation on the earnings of a foreign corporation until a repatriating distribution was paid to the United States. However, the global intangible low-taxed income (GILTI) regime implemented as part of the TCJA requires applicable US shareholders to subject the residual earnings of their foreign subsidiaries to US tax (generally at a 10.5% preferential effective tax rate) regardless of actual distributions. Therefore, income earned from overseas IP may be subject to tax in the United States under the GILTI regime.
R&D tax credit is an additional benefit for companies with their IP in the United States. The R&D tax credit is a dollar-for-dollar tax savings that directly reduces the US tax or payroll liability for qualifying taxpayers. The R&D credit is available to companies developing new or improved business components that result in new or improved functionality, performance, reliability, or quality.
As part of TCJA, for tax years beginning after December 31, 2021, certain research and experimental (R&E) expenses are required to be capitalized for US tax purposes. If the research activities are performed in the United States, the expenses must be capitalized and amortized over five years. Expenses related to research conducted outside of the US must be amortized over a 15-year period. Expenses related to foreign R&E activities will therefore be recovered over a longer period than US R&E activities.
Foreign IP Ownership
IP held in a foreign country may also be eligible for certain local country incentives, such as enterprise zones, IP or patent box reduced tax regimes, and R&D tax credits. Note that each foreign country will have specific IP incentives available with different requirements.
Split IP Ownership
IP ownership may also be bifurcated between the United States and the rest of the world. Both the United States and the foreign country would receive rights to the IP. However, there may be a US or foreign country exit tax applied to the value of the IP that’s considered transferred to another country. The US IP may be eligible to benefit from the FDII export incentive. Appropriate cost sharing arrangements (CSA) need to be entered into with respect to the intangibles.
Economic Versus Legal IP Ownership
Another key factor in IP planning is the distinction between legal and economic ownership.
- Legal ownership establishes who has ownership rights of the IP.
- Economic ownership refers to the company who assumed the risks involved in the development and exploitation of IP.
Understanding this distinction may help a company determine the applicable tax regimes, benefits, and incentives available in the United States and local countries.
A development, enhancement, maintenance, protection, and exploitation (DEMPE) analysis often allows both taxpayers and authorities achieve an accurate assessment of ownership. Significant implications may also arise when IP is unexpectedly determined by foreign tax authorities to reside in a different country.
Taking a proactive planning approach would help a company plan and know what risk exposure may exist, such as licensing arrangements, royalties, or availability of tax treaties.
Purchased Versus Developed IP
Whether the IP owned by the company was purchased or developed internally may also impact the IP location.
Internally Developed IP
When IP is developed internally, a company may have more initial control over its location.
If the company would like a different entity or jurisdiction to own the IP besides the one where the development takes place, appropriate transfer pricing agreements and arm’s length intercompany payment will be needed to transfer of IP ownership. Otherwise, there’s a risk that the country where development activities occur will be considered to be the jurisdiction that owns the IP.
If purchased as part of a transaction, the IP will already be considered established in a jurisdiction, and the company will need to analyze:
- How the newly acquired IP will be used by the overall organizational structure
- How the acquired IP will be incorporated into any existing IP
- Whether any further development to the acquired IP is expected by the company to determine if it may be advantageous to move the IP to another jurisdiction
If intangible assets are acquired in a stock transaction, it may be beneficial to consider if applicable US tax elections such as Internal Revenue Code Section 338(g) or entity classification elections may be appropriate.
If applicable, these elections can step up the basis of intangible assets to the fair market value (FMV) for purposes only. Then the assets, with the stepped-up basis, can be amortized to offset income subject to US tax. Note that these elections don't impact the legal or local country tax treatment of the intangible assets.
If IP is determined to be inbounded to the United States from a foreign country, there may be local country gain and tax recognized on the transfer if the FMV exceeds the basis in the IP. This gain may also be subject to US tax under the GILTI or Subpart F tax regimes.
Note that if the US company is considered to purchase the IP from a foreign related party, the transaction may be considered a base erosion tax payment and the related amortization expense in future years may be considered base erosion tax benefits for base erosion and anti-abuse tax (BEAT) purposes. BEAT was enacted as part of the TCJA and was created to discourage certain multinational companies, subject to certain threshold requirements, from making base erosion payments to foreign related parties by working as a minimum tax of 10%.
If the US company acquiring the foreign IP is considered an applicable taxpayer subject to BEAT, it should consider the impact of the IP purchase on its BEAT liability before executing the transaction. IP may also be inbounded under other methods such as distributions, liquidations, or reorganizations. Modeling and detailed analysis is generally required to determine the appropriate methodology or alternative options for inbounding IP to the United States.
If the company would like to outbound the IP from the United States to a foreign jurisdiction, the company must recognize gain on the transferred IP, essentially a disincentive to transfer US IP to foreign countries.
Before IP is relocated to another jurisdiction, companies should consider both the US and foreign country tax implications of any proposed transactions.
Exploiting the IP
Once a company has determined the ownership jurisdiction of the IP, it will need to establish how the IP will be exploited within the organizational structure and establish any required agreements and intercompany charges to support the operations.
Sales and Marketing Service Provider
If a related party has sales related to IP, the related party may act as a sales and marketing service provider. The related party acting as a sales and marketing service provider will recognize limited risk on the transaction. The service provider will then recognize an appropriate amount of cost-plus return for the service it provided.
A cost-plus arrangement is where a markup percentage is added to a good or service based on the expenses incurred in providing said good or service. A cost-plus markup should be documented and supported by intercompany agreements. Not only is this often required in certain countries, but having a cost-plus arrangement in place allows for a predictable return for services or goods provided across borders.
The cost-plus return will lead to the service provider having net profit, which is subject to tax in the local country. If the service provider is a foreign subsidiary of an applicable US shareholder, the income may be subject to US tax as Subpart F or GILTI. Foreign tax credits may be available to offset the impact of the income inclusion for US tax purposes.
R&D Service Provider
As described above related to internally developed IP, if an entity provides IP development services to another related party who owns the IP, an appropriate markup percentage should be added to the cost of the service based on the expenses incurred in providing said good or service. This markup should be documented and supported by intercompany agreements.
A related party may license the IP from the IP owner as part of its function as a distributor. In this intercompany arrangement, the related party would need to remunerate the IP owner for the use of the IP by paying a royalty over the length of the useful life of the IP.
The owner of the IP will recognize royalty income, which is treated as ordinary income for US tax purposes. Note that a license of IP may be considered to be a sale of IP if it involves the transfer of an exclusive right to use an intangible asset, subject to certain considerations.
If the royalty payment is paid as part of a related party hybrid transaction or paid to a hybrid entity, the deduction for the licensee may be disallowed. A hybrid entity is an entity that is classified as a different entity type by different countries. The deduction is disallowed if the royalty income isn't included in the taxable income of the related party or if the related party can claim a deduction for the amount. These anti-hybrid rules are consistent with the US tax regulations as well as the OECD’s action plan on base erosion and profit shifting.
Cost Sharing Arrangements
For the IP to have split ownership between two related parties, each party must receive the rights to the IP under a qualified CSA. CSAs are commonly used by multinational entities when developing IP. A CSA provides an arrangement between entities whereby expenses incurred by one company may be allocated to another entity for accounting or tax purposes.
As the development of IP in the technology industry often accounts for one of the company’s biggest expenses, initiating a CSA for the development, production, acquisition, or intercompany services performed may provide additional tax and cash flow opportunities.
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Special thanks to Hugo Ortega and Shane Stoike, senior associates in International Tax Services, for their help with this article.