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Understanding and Planning for Intangible Property
Understanding and Planning for Intangible Property Panel 1 November 8, 2012 Panelists: Lowell Yoder, McDermott Will & Emery, Chicago Tom Quinn, PwC, Chicago Mark Martin, McDermott Will & Emery, Houston Jozef Kavuliak, PwC, Chicago Agenda • Intangible Property Planning Primer • Evolving Concepts of Intangibles ―U.S. ―OECD ―United Nations • • • • U.S. Multinational Transfers IP to Foreign Subsidiary Tax Efficient Foreign Structures for Exploiting IP Structure Minimizing Subpart F Income Case Study on Intangible Property Planning ―Permanent Subcommittee on Investigations: Microsoft Tax Executive Institute November 8, 2012 2 Intangible Property Planning Primer Tax Executive Institute 3 Offshore IP Planning • Ownership of foreign IP rights by a foreign subsidiary of a U.S. multinational, – In a foreign structure that minimizes foreign tax on income derived from exploiting the IP – Without the application of Subpart F • Topics addressed – U.S. transfer of IP to foreign subsidiary – Tax efficient foreign structures – Subpart F issues and planning Tax Executive Institute 4 Relevant Rules • Section 482—General transfer pricing rules and cost sharing • Section 367—Taxation of transfers of IP to foreign affiliates • Recent transfer pricing cases and rulings • OECD Guidelines on transfer pricing, including the potential impact of the recent guidelines • Subpart F Tax Executive Institute 5 Evolving Concepts of Intangibles Tax Executive Institute 6 U.S. Developments • Obama Administration Proposals • Expanded definition of intangible property: Work-force in place, goodwill, going-concern value • Codification of aggregation principles • Valuation taking into consideration “realistic alternatives” Tax Executive Institute 7 U.S. Developments • Veritas Software Corp. v. Commissioner • Finalized Cost Sharing Regulations • Proposed expansion of Subpart F to tax “excessive” returns from transfers of intangible property to low-tax jurisdictions Tax Executive Institute 8 OECD Guidelines Chapter VI Discussion draft • Discussion draft issued on June 6, 2012 • Comments due on Sep 14, and public consultation in Nov 2012 • Final revision release targeted in 2013 • Annex contains 22 examples that illustrate guidance from Ch. VI Tax Executive Institute 9 OECD Guidelines Chapter VI Overview A. Identifying Intangibles B. Identification of Parties Entitled to Intangible Related Returns C. Transactions Involving the Use or Transfer of Intangibles D. Determining Arm’s Length Conditions in Cases Involving Intangibles Tax Executive Institute 10 OECD Guidelines Chapter VI Closer Look Section A: Identifying Intangibles • Not a physical or financial asset and which is capable of being owned or controlled • Accounting and legal definitions are rejected • Must distinguish intangibles from market conditions • Identification of an “intangible” is “separate and distinct from the determination of the value of the item or the return attributable to the item” ― Not all intangibles deserve separate compensation (“undifferentiated intangibles”) ― Not all intangibles give rise to premium returns ― Not all R&D and marketing activities result in the creation or enhancement of an intangible Tax Executive Institute 11 OECD Guidelines Chapter VI Closer Look Section A: Identifying Intangibles • Goodwill and ongoing concern value – No specific definition (accounting/valuation measures generally not relevant), but cannot be transferred separately from other assets – In connection with business asset transfer between related parties, goodwill and ongoing concern value are treated as intangibles and should be taken into account in determining the arm’s length price • Group synergies are not intangibles (not owned or controlled), but may be comparability factors – – – – Streamlined management Elimination of duplication of effort Integrated systems Purchasing Power Tax Executive Institute 12 OECD Guidelines Chapter VI Closer Look Section A: Identifying Intangibles • No consensus on workforce in place ―Long-term contractual commitment for group of uniquely qualified individuals may be an intangible ― Draft also suggests not an intangible (¶ 124) ― Transfer of assembled workforce may require compensation for assembling such workforce ― Secondment of isolated employees generally would not constitute transfer of an intangible Tax Executive Institute 13 OECD Guidelines Chapter VI Closer Look Section B: Identification of Parties Entitles to IP-Related Returns • Relevant Factors – Legal arrangements – Functions performed, assets utilized & risks assumed – Arm’s length compensation for assistance services • Legal Arrangements – Starting point for analysis – If legal arrangements are consistent with the conduct of the parties, such arrangements should generally be respected Tax Executive Institute 14 OECD Guidelines Chapter VI Closer Look Section B: Identification of Parties Entitles to IP-Related Returns • Functions, Risks and Costs – The party contractually entitled to intangible related returns will either perform or control functions, e.g., R&D and sales/marketing. – Some functions can be outsourced to related/unrelated – However, “important” functions cannot be outsourced • Design and control of research or marketing • Management and control of budgets • Control of strategic decisions, protection of rights, and quality control over outsourced activities Tax Executive Institute 15 OECD Guidelines Chapter VI Closer Look Section B: Identification of Parties Entitles to IP-Related Returns • Functions, Risks and Costs (contd.) – Important Risks • • • • Costly R&D or marketing will be unsuccessful Product obsolescence Infringement, including defense costs Product liability – Role of Cost • It is important to consider which entities have borne relevant costs • It is important to recognize that bearing costs does not, alone, create entitlement to intangible related returns • In case of distribution, R&D, and manufacturing services, incurring non-routine cost or risk or performing incremental functions, may entitle service provider to intangible returns Tax Executive Institute 16 OECD Guidelines Chapter VI Closer Look Section C: Transactions Involving the Use or Transfer of Intangibles • Use of IP in sales of goods & services (C.1.) • Transfer of IP (C.2.) – Transfer of IP or rights in IP – Transfer of combinations of IP (stand-alone vs. combined values) – Transfer in combination with other business transactions (e.g., business franchise arrangement) Tax Executive Institute 17 OECD Guidelines Chapter VI Closer Look Section C: Transactions Involving the Use or Transfer of Intangibles • Must identify the nature and rights of intangibles transferred – All rights (sale) or Limited rights (e.g., a license or similar right which may be subject to geographical restrictions, future use restrictions, or limited duration) – Consider combination of intangibles (aggregation) – Not all intangibles transactions require complex valuations or use of profit split methods Tax Executive Institute 18 OECD Guidelines Chapter VI Closer Look Section D: Determining Arm’s Length Conditions • Must consider realistic alternatives • Must consider both sides of transaction • Section D.1.(vi) Intangibles – Intangibles that “are not similar to intangibles used by or available to parties to potentially comparable transactions” – When present, comparability adjustments required or method less dependent on comparable intangibles or transactions • Strict Comparability Requirements for CUTs exclusivity, legal protection, geography, stage of development, rights to enhancements, revisions, and updates, etc. (D.1.) Tax Executive Institute 19 OECD Guidelines Chapter VI Closer Look Section D: Determining Arm’s Length Conditions • Must consider how intangibles interact with global business, including market characteristics, location, business strategies and group synergies • Use of discounted cash flow analysis encouraged, although considerations required may discourage use • Use of methods based on intangible development costs discouraged • Although not stated, two-sided analysis and strict guidance on comparability and income methods, suggest preference for use of profit split Tax Executive Institute 20 OECD Guidelines Chapter VI Comparison with 482 (valuation technique) Tax Executive Institute 21 OECD Guidelines Chapter VI Comparison with 482 (valuation technique) Tax Executive Institute 22 United Nations—TP Manual • Intangibles limited discussion in Chapter 5 and Chapter 10 – Location Specific Advantages (LSAs) • Location savings • Market premium • Local intangibles – When LSAs are present, profit attribution depends on • realistic alternatives • competitive factors – access to LSAs • Respective bargaining power – Recognized distinction between legal and economic ownership of intangibles Tax Executive Institute 23 U.S. Multinational Transfers IP to Foreign Subsidiary Tax Executive Institute 24 Alternative IP Transfer Scenarios • Transfer IP for stock • Transfer existing IP for declining royalty (foreign subsidiary bears cost of future development) • Transfer IP for cash/debt • Cost sharing arrangement • Note: For IP law purposes, U.S. often maintains legal ownership and foreign subsidiaries have beneficial ownership of IP (e.g., transfer ownership using a royalty free license) Tax Executive Institute 25 §367(a) and §367(d) • §367(a) applies to the outbound transfer of all stock and assets • §367(a) makes a tax-free asset transfer taxable by disregarding corporate status of transferee foreign corporation • Exception for assets used in trade or business • Excludes §936(h)(3)(B) intangibles from exception • §367(d) carves out §936(h)(3)(B) intangibles from the scope of §367(a) Tax Executive Institute 26 Scope of Section 367(d) • Section 936(h)(3)(B) Intangibles – patents, trademarks, license, contract, etc – value independent of personal services • Same reference as used in §482 • Property for purposes of §351 and §361 • Excludes Foreign GW and GCV – Section 936(h)(3)(B) Intangible? – Subject to section 367(a)? Tax Executive Institute 27 §367(d) Annual Payments • Treated as sale of the property in exchange for deemed annual payments • Commensurate with income – § 482 • Over the life of IP, but limited to 20 years • Foreign source ordinary income Tax Executive Institute 28 Cost Sharing Arrangements • Parties agree to share the costs of IP development In proportion with anticipated share of the benefits • CFC makes R&D payments to U.S. affiliate and receives rights to IP for region or product • Typically accompanied with buy-in for existing IP (treated as a taxable transfer) • Principal U.S. tax benefit is that IRS will not make income allocations with respect to co-developed intangibles Tax Executive Institute 29 Cost Sharing Arrangements • A CSA refers to a specific contract between 2 or more related parties One U.S. entity and at least one other foreign related entity CFC makes R&D Payments to U.S. Affiliate for territorial rights to IP Similar in concept to a joint venture Typically Accompanied with Buy-in For Existing IP (treated as a taxable transfer) – Potential Benefit: IRS does not make income allocations w/r/t codeveloped intangibles – – – – • Parties agree to: – Divide the economic interests from the IP on a territorial basis – Share in future IP development expenses in proportion with anticipated share of the benefits Tax Executive Institute 30 Sample CSA Buy-in Payment USCo • Owner / developer of IP • Global HQ • R&D, marketing, and manufacturing operations US Territorial Rights Tax Executive Institute SwissCo IP Cost Sharing • International HQ • Developing manufacturing and R&D operations Non-US Territorial Rights 31 Practical Considerations: Transfers of Foreign IP to CFC • Significant Value May Be Transferred to a CFC in the Form of Foreign Goodwill and Going Concern Value (and business opportunity and “risk”) Without U.S. Taxation • Transfers of Taxable IP Offshore for Cash/Debt Are More Controllable Than Transfers for Equity Treated as Deemed Sale, i.e., Character (sale v. royalty), Timing and Amount of Income (and provides consistent foreign treatment) • Foreign Tax Credits Often Can be Used to Reduce U.S. Tax on Transfers Resulting in Royalties (but recent legislation limits availability of FTCs) Tax Executive Institute 32 Minimize U.S. Tax on Outbound Transfer • Develop and support conservative valuations • Maximize value attributable to foreign goodwill & going concern value qualifying for the section 367(d) exception • Effectively use U.S. tax attributes (e.g., basis or capital losses) or special tax status to reduce taxable income • Cost sharing with buy-in structured as withering royalty • Outbound reorganization of acquired business Tax Executive Institute 33 Tax Efficient Foreign Structures For Exploiting IP Tax Executive Institute 34 Considerations in Selecting Foreign IP Structure • • • • • • Low tax rate on royalty income Strong IP protection laws Extensive treaty network Minimal substance requirements Low administrative costs Stability Tax Executive Institute 35 Irish IPCo Company X (US) Foreign HoldCo I (Ireland) Foreign HoldCo II (Ireland) Owns IP Royalties Foreign OPCo Tax Executive Institute • Foreign HoldCo II “owns” IP and licenses to OPCos (or exploits the IP in its own trade or business). • So long as Foreign HoldCo II is engaged in active business, income qualifies for 12.5% rate in Ireland. • Rate can be reduced to approximately 2.5% through amortization of IP. • Need employees in Ireland to qualify as active business. 36 Luxembourg IP Structure PECs • Company X Foreign, Inc. (US) • • Foreign HoldCo I (Luxembourg) PECs Foreign HoldCo II (Luxembourg) Owns IP Foreign OPCo Tax Executive Institute • Royalty • • Foreign HoldCo II owns foreign IP and licenses it to OPCos. OPCos deduct royalty payments reducing local tax costs. Royalty income taxed at effective rate of approximately 5.7% under Luxembourg IP regime. Effective rate on royalties can be further reduced through use of PECs (e.g., to less than 2%). Rely on U.S. Subpart F exception for royalties or use disregarded entities; no U.S. tax on PEC yields. PECs designed to minimize Luxembourg tax costs if the IP is ever sold or transferred out of Luxembourg. Double Irish/Dutch Sandwich Company X (US) Irish IPCo (Non-Resident) Owns IP Royalty Dutch BV (Netherlands) Royalty Irish OPCo (Ireland) Tax Executive Institute • Irish IPCo “owns” foreign IP and licenses it to Dutch BV in exchange for royalty. Irish IPCo is non-resident not subject to Irish tax. • Dutch BV sublicenses IP to Irish Principal in exchange for royalty. Dutch APA provides 3-6% tax rate, and no withholding tax on royalty payments. • Irish Principal exploits IP in its own trade or business. Structure Minimizing Subpart F Income Tax Executive Institute 39 Puerto Rico Manufacturer: Owns IP/Earns Sales Income Bermuda HoldCo (TR: 0%) Related/ Unrelated Suppliers Sells Raw Materials Puerto Rico Mfg Branch (TR: 2%) Sells Finished Products Related/ Unrelated Customers IP Income Tax Executive Institute 40 Irish Manufacturer/Non-Irish Resident Distributor IP Income TR: 0% Related/ Unrelated Suppliers Related/ Unrelated Customers Irish NR Distributor Sale of Products Irish Mfg TR: 12.5% Tax Executive Institute 41 Software Sales: No Related Person Transaction US Parent Develops Software R&D Cost Sharing Irish OpCo* Sells Software Unrelated Customers * Hires contract manufacturer to replicate software or sells software online. Tax Executive Institute 42 Case Study Permanent Subcommittee on Investigations Offshore Profit Shifting and the U.S. Tax Code Issued: September 20, 2012 Tax Executive Institute 43 Tax Executive Institute TEI Forum 44 Tax Executive Institute TEI Forum 45 Key Background Facts • • • • 3 Regional Operating Centers High-value intellectual property 85% of $9.1B R&D spend is for R&D performed in the U.S $200M of R&D tax credits Tax Executive Institute 46 Key Background Facts • R&D Cost Share: – Ireland = 30% – Puerto Rico = 25% – Singapore = 10% – U.S. = 35% • R&D Buy-in Value: – Ireland = $7B – Puerto Rico = $17B – Singapore = $4B Tax Executive Institute 47 Puerto Rico • Manufactures and replicates Microsoft Intellectual Property Pool retail software for sale in the (Over 85% Global R&D Done in U.S.) U.S. $1.2 billion $2.8 billion • Owns rights to sell in U.S. Microsoft Microsoft Singapore Ireland and the Americas (in Bermuda) • 2% Tax Rate $3 billion $3 billion • Section 936 conversion and Microsoft Microsoft cost sharing in 2006 Singapore Ireland Sales Tax Executive Institute Sales 48 Puerto Rico (contd) Microsoft Intellectual Property Pool (Over 85% Global R&D Done in U.S.) $1.9 billion Microsoft Puerto Rico $6.3 billion • U.S. entities distribute in U.S., taking title to the product in Puerto Rico • Gross profit allocation on U.S. sales: – U.S. distributors = 53% – Puerto Rico = 47% Microsoft Americas Sales Tax Executive Institute 49 Puerto Rico (contd) Microsoft Intellectual Property Pool (Over 85% Global R&D Done in U.S.) $1.9 billion Microsoft Puerto Rico $6.3 billion Microsoft Americas Sales Tax Executive Institute • “This structure is not designed to satisfy any manufacturing or business need; rather, it is designed to minimize tax on sales of products sold in the United States.” • Why? ― $1.9B cost sharing obligation v. $4B profit ― $22.5 M profit / employee ― Employees earn average of $44K 50 Ireland Microsoft Intellectual Property Pool (Over 85% Global R&D Done in U.S.) $1.2 billion Microsoft Singapore $2.8 billion Microsoft Ireland (in Bermuda) $3 billion Microsoft Singapore Sales Tax Executive Institute $3 billion Microsoft Ireland Sales • Coordinates consumer product sales in EMEA. Manufactures copies of Microsoft products for sale in EMEA • Owns IP through cost sharing • 7% ETR 51 Ireland (contd) Round Island One Microsoft Intellectual Property Pool IR (Over 85% Global R&D Done in U.S.) $1.2 billion Microsoft Singapore $2.8 billion Microsoft Ireland (in Bermuda) $3 billion Bermuda Cost Sharing Payments MIR IR $3 billion License Microsoft Singapore Sales Microsoft Ireland Sales MIOL IR Tax Executive Institute 52 Singapore Microsoft Intellectual Property Pool (Over 85% Global R&D Done in U.S.) $1.2 billion Microsoft Singapore $2.8 billion Microsoft Ireland (in Bermuda) $3 billion Microsoft Singapore Sales Tax Executive Institute • Coordinates Asia sales of consumer products • Owns IP through cost sharing. Previously a licensee with the U.S. $3 billion Microsoft Ireland Sales 53 Singapore (contd) To U.S. Microsoft Singapore Holdings Pte. Ltd. Sing. Microsoft Intellectual Property Pool (Over 85% Global R&D Done in U.S.) $1.2 billion Microsoft Singapore $2.8 billion Microsoft Ireland MAIL (in Bermuda) $3 billion Microsoft Singapore Sales Cost Sharing Payments $3 billion Microsoft Ireland Sales Bermuda Royalty MOPL Sing. Tax Executive Institute 54 This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. Tax Executive Institute November 8, 2012 55
