For companies with significant Intellectual Property (IP), it may be beneficial for tax purposes to consider transferring its IP to a controlled foreign entity. The rules and regulations are complicated, so we thought it would be of value to outline the common methods used to transfer the assets and the related pitfalls.
If a U.S. person transfers property to a foreign corporation in connection with an exchange, then the foreign corporation generally isn’t considered a corporation for purposes of determining gain on the transfer. As a result, subject to certain exceptions, transfers of property to a foreign corporation that would otherwise be tax-free are treated as taxable exchanges. The law sets out special rules relating to transfers of intangibles. If a U.S. person transfers intangible property to a transferee foreign corporation, then the U.S. transferor is treated as having transferred the intangible property for annual deemed payments contingent on the productivity or use of the property, which the transferor must annually include in gross income over the property’s useful life.
IP transfer through a sale.
One option a U.S. parent can undertake is to sell some or all of its existing IP to a foreign subsidiary for cash or a note. In this case, the law will require that an arm’s-length price be paid for the IP and the payment in consideration for the IP must be commensurate with the income attributable to the intangible. Additionally, if the intangible asset is transferred for longer than a period of one year, then IRS has the authority to make periodic adjustments to ensure that in each year, the payment continues to satisfy the commensurate with income standard.
However, as with all rules, there are some exceptions. First, where there are no adjustments in the first five years after the payment agreement is in place (and payments are being made) then the IRS will not be permitted to make adjustments after the 5-year window closes. Second, under the extraordinary events exception, IRS will not be permitted to make an adjustment if the benefits associated with the transfer were realized because of extraordinary events beyond the control of the taxpayer and could not have been reasonably anticipated when the agreement was entered into. Both exceptions apply to lump-sum and periodic payments, but that there were some compliance requirements that needed to be satisfied in order for them to apply.
The U.S. parent will generally recognize gain on the sale of the IP to the extent that the purchase price exceeds the basis of the asset. The gain will generally be recognized in the year of the sale unless it qualifies for installment treatment. To the extent the U.S. parent can successfully navigate the anti-churning rules there may be a possibility for it to amortize the IP that is transferred to the foreign subsidiary for U.S. and foreign tax purposes.
The source of the income will depend on whether or not the sale is contingent upon the productivity of the IP, in which case of the source like the royalty (depending on where the IP is used) will usually be foreign. If the sales price is not contingent on the use or productivity of the IP, then the gain is generally considered U.S.-sourced. A foreign subsidiary will generally enter into a research and development (R&D) agreement with the U.S. parent and will begin bearing the cost of developing the IP. Practically speaking, this means that the U.S. parent will no longer be able to deduct R&D expenses in the U.S. This, of course, is a small setback for some potentially large tax savings associated with shifting the intangible offshore.
IP transfers for stock.
Instead of transferring IP to a foreign subsidiary as a sale, the U.S. parent may elect to transfer the IP to the foreign subsidiary for stock.
The outbound transfer of all assets, and it generally causes an otherwise tax-free asset transfer to be taxable by disregarding corporate status of the transferee foreign corporation. An exception exists, however, for assets used in an active trade or business outside of the U.S.
Where a U.S. parent transfers intangible property to a foreign subsidiary, then the U.S. parent is considered as selling the IP in exchange for deemed annual payments. The deemed annual payments must satisfy the commensurate with income standard. Additionally, the deemed payments are included in the U.S. parent’s income over the life of the IP but limited to 20 years. The payments are also deductible from the foreign subsidiary’s E&P. Finally, the deemed payments are considered ordinary income, foreign-sourced, and general basket—thereby permitting the foreign subsidiary to pay the U.S. parent in cash up to the amount of the deemed payment without incurring any additional U.S. tax.
Alternatively, a U.S. parent may decide to license IP to the foreign subsidiary in exchange for an arm’s-length royalty. In this case, the income generated will be considered foreign-sourced and can be offset with foreign tax credits. The foreign subsidiary should be entitled to a return on the IP based on its functions and contribution to the IP value (e.g., building the market or conducting R&D). As the foreign subsidiary takes over the R&D functions and expenses, it would own the future developed value of the asset and the U.S. parent could expect the value of the royalty to diminish over time.
Cost-sharing arrangements are another technique that U.S. parent companies have often used to shift IP offshore. A cost-sharing arrangement is essentially a contract between two or more related parties where one of the parties is a U.S. entity and there is at least one other foreign related entity. The foreign related subsidiary will make R&D payments to the U.S. entity for territorial rights to the intellectual property that in many ways resembles a joint venture with respect to the intangible assets that the U.S. parent and the foreign subsidiary will be co-developing. A cost-sharing arrangement is typically accompanied with a buy-in for existing IP that is usually owned by the U.S. parent (and thus, the payment is generally from the foreign entity back to the U.S. parent). One benefit of this arrangement is that the IRS does not generally make income allocations out of the co-developed intangible. Therefore, the parties agree to co-develop the interest in the IP based on territory (with the U.S. retaining the U.S. territory and the rest of the world will be assigned to the foreign affiliate(s)). The U.S. parent and the foreign subsidiary will share the future IP expenses in proportion with the reasonably anticipated share of benefits.
IP transfers to a foreign partnership.
Under this structure, a U.S. parent maintains several CFCs (controlled foreign corporations). U.S. parent, along with one of its CFCs (HoldCo CFC), form another entity that is considered a partnership for U.S. tax purposes (and a corporation for foreign tax law purposes). The U.S. parent then puts some of its IP in the foreign partnership (and HoldCo CFC may transfer businesses, branches, CFC stock or even the IP that it may own or have rights to). Under this structure, each of the partners (U.S. parent and HoldCo CFC) receives an undivided interest in the other partner’s assets, thereby shifting a portion of the IP’s ownership to the CFC from an economic perspective. In return, the U.S. parent receives a preferred type of interest in the partnership which he referred to as a common interest. Thus, the U.S. parent is able to fix the value of the IP with all future value of the IP accruing to the CFC.
All of the previously discussed structures for shifting IP offshore came with an immediate tax cost. However, by shifting the IP to a foreign partnership, the U.S. parent can transfer the IP and have the CFC share in some of the increased asset value without any tax costs.
If you have any questions regarding the transfer of IP or the best structure for your situation, please do not hesitate to contact us.