Tax Planning for Inbound Licenses of IP: What Is Left After Tax Reform?

• Author: Rubinger, Jeffrey L.
• Position: Intellectual property

Intellectual property (IP) rights broadly include, among other items, patents, copyrights, trademarks, know-how, proprietary data, and trade secrets. Although the creator of IP typically retains these rights throughout the life of the IP, in many cases, an owner of IP may want to transfer some or all of its IP rights to a third party in a transaction other than an outright sale. If the desired revenue goal is an ongoing stream of income, then licensing such IP in exchange for royalties is often the most appropriate choice, as this typically maximizes profits from the property's commercial use or exploitation. Historically, foreign owners of IP could enter into inbound U.S. licensing arrangements with minimal U.S. tax costs, and U.S. licensees could fully deduct the outgoing royalty payments on the IP. Recently, however, structuring such licensing arrangements in a tax-efficient manner in the U.S. inbound context has become increasingly difficult, thanks to several recent changes in applicable law.

Critical U.S. Tax Issues

For a non-U.S. taxpayer licensing IP for use in the United States, a number of key issues arise: 1) whether the royalty will be subject to U.S. withholding tax; 2) whether the payment or accrual of the royalty will be deductible for U.S. federal income tax purposes; and 3) how to minimize the non-U.S. income tax consequences that result from the receipt of the royalty (either through structuring or the use of various patent box regimes, the most common of which are listed at the conclusion of the article). Recent U.S. federal income tax developments have an impact on the resolution of these issues.

U.S. Withholding Tax Issues

Non-U.S. taxpayers are subject to U.S. federal income taxation on a limited basis. Unlike U.S. taxpayers--who are subject to U.S. federal income tax on their worldwide income--non-U.S. taxpayers generally are subject to U.S. taxation on two categories of income: 1) certain passive types of U.S.-source income, e.g., interest, dividends, rents, annuities, and other types of fixed or determinable annual or periodical income (FDAP); (1) and 2) income that is effectively connected to a U.S. trade or business (ECI). (2) FDAP income is subject to a 30% withholding tax that is imposed on a non-U.S. taxpayer's gross income (subject to reduction or elimination by an applicable income tax treaty). (3) ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. taxpayers.

Although U.S.-source royalties typically are subject to a statutory 30% U.S. withholding tax, many bilateral U.S. income tax treaties completely eliminate this withholding tax. For example, the U.S. income tax treaties with the following countries provide an exemption from withholding tax on certain types of U.S.-source royalties: 1) Austria; 2) Belgium; 3) Canada; 4) Cyprus; 5) the Czech Republic; 6) Denmark; 7) Finland; 8) France; 9) Germany; 10) Greece; 11) Hungary; 12) Iceland; 13) Ireland; 14) Italy; 15) Japan; 16) Luxembourg; 17) the Netherlands; 18) Norway; 19) Pakistan; 20) Russia; 21) Slovak Republic; 22) South Africa; 23) Spain; 24) Sweden; 25) Switzerland; and 26) the United Kingdom. (4)

Provisions that May Deny Treaty Benefits

To qualify for treaty benefits, a non-U.S. taxpayer must be a resident of a particular treaty jurisdiction, as well as satisfy the treaty's limitation of benefits (LOB) provision, if any. Even if a non-U.S. taxpayer qualifies for treaty benefits, however, there are two statutory provisions that may prevent the non-U.S. taxpayer from claiming treaty benefits: [section]894(c) and [section]7701(l).

Section 894(c) would deny treaty benefits when a non-U.S. taxpayer licenses IP (or otherwise invests in the U.S.) through an entity that is "fiscally transparent" under the laws of the U.S. and/or any other jurisdiction. The regulations under [section]894(c) deny treaty benefits on payments of U.S.-source royalties to the extent such income is not "derived by" a treaty resident. (5) For example, U.S.-source royalties paid to a disregarded Cayman Islands entity that is wholly owned by a U.K. parent will not be eligible for benefits under the U.S.-U.K. income tax treaty, even though the U.S. treats the royalties as being paid directly to the U.K. parent. (6) Conversely, U.S.-source royalties paid to a disregarded U.K. entity wholly owned by a Cayman Islands parent may be eligible for U.S.-U.K. treaty benefits, despite the fact that the U.S. treats the royalties as being paid directly to the Cayman parent. (7) The reason for the disparate treatment is that, in the first situation, the U.K. entity is not treated as "deriving" the royalties, whereas in the second situation, the U.K. entity is treated as "deriving" such income. (8)

Exhibit: List of Most Commonly Used Patent Box Regimes Qualifying IP Assets Tax Rate Under Patent Patents Software Other Box Regime Belgium X X 4.44% Cyprus X X X 2.5% France X X 10% Hungary X X 0% or 4.5% Ireland X X X 6.25% Italy X X 13.95% Lithuania X X 5% Luxembourg X X 5.2% Netherlands X X X 7% Poland X X 5% Portugal X 10.5% Slovakia X X 10.5% Spain X X 10% Switzerland X 8.8% to 12.6% (effective) United Kingdom X 10% Statutory Corporate Income Tax Rate Belgium 29.58% Cyprus 12.5% France 34.43% Hungary 9% Ireland 12.5% Italy 27.9% Lithuania 15% Luxembourg 26.01% Netherlands 20% to 25% Poland 19% Portugal 21% Slovakia 21% Spain 25% Switzerland 14.5%...