How have global tax rates on intellectual property stayed so low?
Much has been written in the last few years about the tax rates of multinational companies with a specific focus on their intellectual property (IP) tax planning. Almost all of this press has been critical of these companies as well as the countries that enticed them with low tax rates and favorable tax agreements. This has sparked a backlash that has created major changes to global IP planning rules particularly in the U.S. and EU. With all of these rule changes now in place, many are asking why global tax rates on IP are still so low.
This is certainly a huge issue for our client base of technology and biotech companies with much of their value and/or market capitalization attributable to IP assets. All of these companies, as well as the well-publicized Ubers and Facebooks of the world, have IP tax planning as the keystone of their global tax planning strategies. The answer to how IP tax rates have remained low is complex and the planning varies by client, but some common planning techniques have emerged to maintain favorable IP tax rates.
In the U.S., the two most prominent new rules addressing IP taxation are the Global Low-Taxed Income (GILTI) rules, which are intended to penalize U.S.-based multinational companies with offshore IP and the Foreign Derived Intangible Income (FDII) rules intended to reduce U.S. taxes on IP resident in the U.S. but used abroad, thus incentivizing placing, or “onshoring,” IP in the U.S.
In the EU, the Base Erosion and Profit Sharing (BEPS) regime focuses on aligning IP ownership with value creation and eliminating tax structures where legal IP ownership bears little to no relationship to physical IP development. Among the intended targets were the now infamous “double Dutch” and “triple Irish” structures popular in international IP tax planning for so long. The benefits of these structures were eliminated by a combination of EU tax court losses, local rulemaking and changes to transfer pricing rules where economic benefits no longer accrue for mere IP legal ownership, which was the cornerstone of many favorable IP tax regimes. As a result a multinational taxpayer may no longer rely on contractual arrangements and R&D funding to mobilize IP income streams.
BEPS seeks to tie IP economic benefits to geographies where the taxpayer has development, enhancement, management, protection and exploitation (DEMPRE) activities. The goal, in short, is to tie IP profits to physical R&D and business activities. There has been a seismic shift in global IP tax planning as numerous tax authorities have adopted DEMPRE principles in whole or in part. Even the U.S., where DEMPRE has not been officially embraced, DEMPRE is a very important component of intercompany IP profit allocation and transfer pricing.
Further, the EU has issued rules requiring zero- and low-taxed countries, i.e., traditional tax havens, to enact core income-generating activities (CIGA) rules with respect to IP development. Countries that fail to enact these rules would be blacklisted and subjected to penalties. As a result, many traditional tax havens have enacted legislation sharing tax information with other countries, eliminating numerous noncompliant tax haven IP-holding companies.
Responsive IP planning
The comprehensive global rulemaking outlined above has forced almost every multinational taxpayer with considerable IP assets and strategic IP tax plans in place to make considerable changes to their IP tax planning. At first blush, it would appear that these new rules have created a “nowhere to run, nowhere to hide” ecosystem for IP tax planning. It is certainly true that global tax rules have significantly changed, but IP tax planning has certainly not been abandoned.
These rule changes have applied to all traditional IP tax plans, if you want to call those established within the last few years “traditional.” They were severely impacted primarily by the divorce of DEMPRE and IP legal ownership. The modeled impact of these tax rule changes was material to most of these company’s overall financial results.
Many companies have elected to keep their current plans in place on the basis that the rules were evolving quickly, and it would be difficult to make significant changes on shifting sands. Those who have worked with U.S. companies on the impact of U.S. tax reform understand the difficulty of making significant changes in the absence of any regulatory guidance beyond a statute.
Companies adopting a wait-and-see approach have either stayed put or moved their IP into what we call a transitory jurisdiction. This would be a country with a favorable tax treaty where some DEMPRE exists or could be created quickly. The favorable treaty is essential here as the related IP licensing planning required favorable treaty benefits. This was always intended to be temporary until tax rules became more settled and structural business changes could be modeled. As such, a good exit plan was always key here.
The most popular and reliable tax plan has been to marry IP ownership to DEMPRE. This must be done in a country with a strong income tax treaty network because the cross-border licensing to IP users requires favorable treaty benefits. Moving the IP into a DEMPRE jurisdiction without any taxable gain or an exit tax is also a key piece of this planning. Many countries still offer preferable IP tax regimes, albeit ones that are now BEPS compliant and unlikely to draw negative EU scrutiny.
One big but underpublicized piece of these IP regimes is an immediate tax-free step-up to fair market value for IP migrated to their jurisdiction. This may not sound like much, but while valuable IP attracts considerable income, it may not have much of a tax basis, especially when it is self-developed IP. This low tax basis remains low because it generally takes a taxable event, such as a sale with taxable gain to a seller, for the basis to step up. Under these IP rules, a company migrating IP to a new jurisdiction may get a new and large tax basis in the IP to amortize against its local country tax liability. The newly stepped-up IP value is amortized over time against local country taxable income. Because the IP value is so large, it is a significant factor in tax rate reduction, offsetting the taxable royalty income the IP attracts. That’s a great cash tax savings strategy alone, but it gets much better.
Under U.S. GAAP, these companies get a huge new deferred tax asset via this step-up without a corresponding income tax expense. For companies with significant IP, this could mean a new multimillion dollar asset on their balance sheet at basically no economic cost. There is also a large income tax expense benefit associated with the creation of this asset. It’s not often that you see a tax-related item have such a large impact on overall U.S. GAAP, and corresponding earnings per share, reporting.
Considering all of the above, our clients generally utilize the following methods to manage and maintain a low tax rate related to their IP assets:
- Utilizing favorable local country IP regimes with sustainable DEMPRE and strong treaty networks;
- Amortization of newly stepped-up IP to offset the royalty income associated with the IP;
- Cost-sharing agreements to provide for cross-jurisdictional IP development;
- IP value adjustments under the OECD Hard to Value Intangibles; and
- An “evergreen” IP tax strategy that continually monitors and addresses global business and tax law changes on a constant basis.
IP tax planning remains a complex endeavor and is influenced by a multitude of factors, including a rapidly evolving tax ecosystem. However, strategic international tax IP planning is still important and possible for proactive taxpayers with valuable IP assets. Such IP tax planning is not only important for tax purposes, but as a driver of economic results.