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How to Effectively Navigate Intellectual Property Tax Planning

By Mark R. Baran, JD, LL.M.  |  July 11, 2017

Intellectual property (IP) is often considered a critical strategic component of growing a business. While intangible, IP rights can be one of the most important assets your business owns. Understanding the legal and tax implications of IP business transactions can be daunting; and many experts consider that an understatement.

According to The World Intellectual Property Organization (WIPO), IP refers to creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce. IP is legally protected through patents, copyrights and trademarks – which enable people and companies to gain recognition, as well as financial benefit, from what they invent or create.

IP can differentiate your business from your competitors, be sold or licensed to provide revenues streams, be an integral to your brand/marketing, offer customers and prospects new benefits or even be used as security for loan.

Why It’s Smart to Align Intellectual Property Business Strategies and Tax Planning

While many companies work hard to develop, protect and monetize their IP, they often fail to integrate savvy IP tax planning into their efforts. What senior management doesn’t know about the tax implications of intangible assets like IP can really hurt them or, conversely, present value-creating opportunities that can be seized if recognized and leveraged accordingly.

On the downside, mismanaged IP can allow profits to build up in high-tax jurisdictions and adversely impact the bottom-line; or the movement of intangible assets across borders or between business entities may elevate transfer price risks and tax liabilities.

The Intellectual Property Landscape

With the ongoing upswing in the global economy, and in comparison to past years, corporations are investing more in R&D activities and enjoying the IP benefits that result. In its 2016 Global R&D Funding Forecast, R&D Magazine predicted US R&D to increase 3.4% to $514 billion – with a clear majority of firms surveyed indicating their R&D budgets have increased over the past three years, and that they will continue to do so in the future.

Discovering New Value from Existing Intellectual Property

One way to optimize IP value is to follow the global market trend of moving IP to affiliates in lower tax jurisdictions – including venues such as Luxembourg, Switzerland or Hong Kong. A reflection of this trend is the fact that patent applications have increased in Europe and decreased in the US in recent years.

Effective IP tax planning can involve transfers and licensing of IP. However, one should be mindful of heightened US and foreign government scrutiny when it comes to transfers among related entities/profit shifting, the complexity of calculating front-end tax incentives and understanding various (and often ambiguous) foreign tax rules.

Another approach to consider when managing IP is use of a Patent Box, or a special tax regime for intellectual property revenues. First introduced by the Irish government back in 2000, they are designed to encourage additional research investments. They also offer back-end tax incentives (reduced corporate rate) through a specified deduction or IP income exemption. The type of IP that qualifies varies, and may include designs, trademarks, domain names or copyrights.

Methods of transferring IP vary based on the deal structure. An IP sale is usually a taxable event, defined by a fixed sale price or installment payments. When IP is transferred between operating divisions of a multi-national company, they are subject to an “arm’s length standard,” that is: the amount charged by one related party to another for a given transaction must be the same as if the parties were not related, a price based on an open market valuation.

A license agreement can result in royalty payments that are taxable, and may be subject to withholding. Another IP deal method is “cost sharing” – with no transfer, sharing of costs and risk of developing IP with an affiliate.

Intellectual Property Tax Issues

There can be a myriad of “moving parts” when it comes to determining potential tax implications (both positive and negative) from IP transactions. IP transactions are sometimes characterized as a “bundle of sticks” deal where ownership rights can be separated and reassembled, with each stick representing, for example, an individual IP usage right.

The compensation method for an IP transaction can impact potential tax liabilities: Will the transaction be a simple one-time sale? Will there be a licensing fee that will grant permission to use a name/logo/product? Will the licensor also request royalty payments, or a percentage of sales or profit, over a specified time frame?

Potential taxes also hinge on the amount of rights transferred: Does the sale or assignment of some, or substantially all, IP rights constitute a sale? Does retaining substantial rights for a fixed payment constitute a license?

General Intellectual Property Tax Issues

The plot thickens when examining specific IP tax concepts. This list should help emphasize the need for highly knowledgeable and skilled tax planning advice when entering an IP transaction.

The IRS may recast a transaction to reflect “economic substance,” where for example a court case can analyze the amount of control reserved by the transferor, and whether the taxpayer disposed of substantially all right in the underlying IP.

Common IP tax issues include:

Contingent Payments: When the quality of the IP consideration transferred depends on uncertain future conditions, situations or sets of circumstances that actual future events will ultimately resolve?

Geographic and field-of-use restrictions: A provision in a patent license that limits the scope of what the patent owner authorizes the licensee to do in relation to the patent. These are commonly related to a defined geographic or field-of-use restrictions. Exceeding the scope of the agreement can result in patent infringement.

Reservations of control: Deals with the scope of the IP licensing agreement – from use by the licensee (and potentially affiliate companies) to manufacturing, sales and distribution rights to the duration of the agreement.

Be Sure to Watch the IRS Fine Print

The devil is in the details when it comes to IP tax planning. Take for example the wide variety of IRS Codes that can apply to IP transactions:

  • IRS Section 1221: Capital Asset Exclusions - Copyright, a literary, musical, or artistic composition, a letter or memorandum held by a taxpayer whose personal efforts created such property or in whose hands the basis of the property is determined.
  • IRS Section 1235: Safe Harbor - Transfer by an individual holder of a patent of all substantial rights treated as sale or exchange of a capital asset held for more than one year. Applies even if amounts received payable periodically or contingent. 
  • IRS Section 1253: Trademarks, Trade Names and Franchises - Any transfer of trademark, trade name or franchise whereby transferor retains “any significant power, right, or continuing interest” with respect to the subject matter is not a sale subject to capital gain tax treatment. Contingent payments are also not considered a capital gain.

Tax Treatment Depends on the Type of Intellectual Property

Patents: consists of exclusive right to “make, use, sell, offer to sell and import” the patented item. IP deals can stipulate that some rights are retained, but issues arise when less than all the rights to the patent are transferred.

Copyrights: IP taxation will depend on substance and transferor. The seller must part with “all substantial rights” in a given medium of expression (either exclusive or non-exclusive). Creators (individuals) of work are taxed at ordinary tax rates.

Trademarks, Trade Names (section 1253) are considered “sold” if transferor does not retain any significant power, right or continuing interest. Retained rights are treated as a license. Rights can include disapproval of assignment, termination, standards of quality or require the transferee to purchase supplies from the transferor.

Conclusions

If you feel like you will need the proverbial Rosetta Stone to decipher the IRS hieroglyphics around IP transactions and the US tax code, you are not alone. It is a wise idea to seek qualified professional help to navigate these treacherous tax planning and compliance waters.

For more information on our IP tax and accounting capabilities, please contact:

Mark Baran, JD, LL.M - Principal / Tax Department | Marks Paneth
Phone: (212) 503-8991 | mbaran@markspaneth.com

This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice.
Please refer to your advisors for specific advice.

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About Mark R. Baran

Mark Baran is a Principal in the Tax Department at Marks Paneth LLP. He has more than 25 years of specialized tax, transactional and legal experience advising publicly-traded and private companies, regulated financial institutions, investors, high net worth individuals, and government agencies. Mr. Baran provides specialized tax consulting and transactional services to a broad spectrum of clients and industries including the public sector. He routinely provides tax opinions on the tax implications of proposed transactions,... READ MORE +


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