The tax benefits and obstacles to U.S. businesses in transferring foreign intellectual property to foreign affiliates.

• Author: Barrett, James H.
• Position: TAX LAW

It is quite common that a single business operates through the use of multiple entities such as partnerships, corporations, and, in the international context, through foreign corporations or partnerships. For tax purposes, the intercompany transactions by and among commonly controlled entities may be scrutinized by the IRS and the income, deductions, credits, and other allowances among two or more organizations, trades, or businesses may be reallocated under Internal Revenue Code [section] 482. The transfer of foreign intellectual property to foreign operating companies by a U.S. multinational business is an area that has been the subject of much discussion. The structure can often result in a foreign corporate subsidiary reducing its effective foreign tax rate to below 15 percent. Thus, a U.S.-based company that generates income and operates outside the United States, whether publicly traded or closely held, can be greatly benefitted by such a structure.

In 2000, the world's gross domestic product (GDP) was $32 trillion. (1) At that time, U.S. GDP accounted for about $10 trillion (or about one-third) of the world's GDP. (2) Ten years later in 2010, U.S. GDP had climbed to $14 trillion, and the world GDP had climbed to $63 trillion. (3) As such, in 10 years, the U.S. share of world GDP went down from one-third of the world's GDP to one-quarter. Similarly, the number of cell phones in the world has increased from 15.5 per hundred in 2001 to 86.7 per hundred (i.e., 4.6 billion) in 2010. (4) Computers and telephones permit much easier access to individuals around the world. Thomas L. Friedman and Michael Mandelbaum illustrate how a multinational, closely held business can be readily formed in their recently published book That Used To Be Us. (5) In their example, they discuss a company named EndoStim. The example discusses how six people from three continents readily formed a cutting edge company in the medical devices field to develop a sophisticated device based on a heart pacemaker. Through the Internet, they were able to obtain financing, develop a prototype, and supervise the manufacture of the device.

Over the last 30 years, U.S. companies have significantly increased their international operations. These companies now have more significant marketing, research and development, and sales operations outside the United States. Inevitably, this has led to a greater number of employees working outside the United States. It also has led to a greater amount of intellectual property being developed and exploited offshore. Moreover, companies headquartered outside the United States account for a greater share of the world's sales.

The tax world has followed this trend. The increasing international presence of U.S. multinationals has resulted in a significant amount of public scrutiny. Feature articles on these ownership structures have been the subject of extensive articles in the New York Times, (6) The Wall Street Journal, (7) and 60 Minutes. (8) Also, with regard to the legislative discussions concerning the future of U.S. income taxation of U.S. corporations, the taxation of internationally held intellectual property has constituted a significant portion of the tax debates in the U.S. Congress. This article describes how U.S. multinational corporations have held their intellectual property, the U.S. and foreign tax consequences to this ownership, and how the tax benefits of this ownership can be utilized by closely held businesses.

Description of Basic IP Ownership and Tax Benefits

The ownership structure is designed to mirror the increased international nature of the U.S. company. Thus, a company that, initially, may have managed all of its IP in the United States is now managing its foreign IP outside the United States. The structure reflects that managerial reality. The U.S. parent contributes, sells, or licenses its current IP for a note and/or cash. Under current law, the contribution of foreign goodwill, and going concern value should be exempt from U.S. federal income tax. The balance of the transfer is subject to U.S. federal income tax.

Future foreign IP that is developed is developed by the foreign subsidiary. As such, the new IP is not taxed in the United States. The foreign subsidiary typically is in a low-tax jurisdiction paying tax at a top marginal rate of 12.5 percent or less (e.g., Ireland, Switzerland, or Singapore). With the IP offshore, the foreign subsidiaries in higher tax jurisdictions are required to license the IP from the IP holding company.

The royalty deduction in the high-tax jurisdiction offsets a portion of the income tax in the high-tax jurisdictions. Tax is paid in the home country of the IP holding company at a low-tax rate. Thus, the overall effective tax rate for the group outside the United States is reduced.

To prevent taxation in the United States, profits generally are not immediately repatriated to the U.S. parent. Care must be taken not to generate income that is effectively connected with the conduct of a U.S. trade or business or business profits that are attributable to a U.S. permanent establishment, as the case may be. The structure generally is accomplished through the use of one holding company in a typical holding company jurisdiction (e.g., The Netherlands or Luxembourg) owning an IP company and also owning other foreign subsidiaries. The use of the holding company typically facilitates the payment of interest and dividends among the companies by reducing the foreign withholding tax that can apply. The IP company and the operational subsidiaries typically make check-the-box elections to be treated as disregarded entities. Thus, from a U.S. income tax perspective, they are considered to be one foreign corporation. This allows the foreign group to avoid the application of the U.S. subpart F rules that could otherwise cause the royalty income to become immediately taxable in the United States. The income from the operation that is earned by the IP company typically is royalty income paid by foreign subsidiaries to the IP holding company. The other foreign operational subsidiaries are typically performing services or selling goods that utilize the IP.

The IP ownership structure basically balances a tax cost in the U.S. from the sale or license of the foreign IP (excluding nontaxable foreign goodwill and going concern value) with a future benefit of a lower foreign tax...