Outsourcing IP processes overseas will only make tangible business sense, if you pay attention to the tax issues of transferring IP, says Isabel Verlinden from PriceWaterhouseCoopers.

Offshoring IP processes can seem an attractive proposition when you consider that many authorities offer tax breaks for the creation or licensing of many forms of know-how or expertise. Yet, despite these incentives, the use or transfer of IP is still perceived as a ‘soft target’ by many tax authorities, who are becoming increasingly keen to tax intellectual capital for all its worth.

In some cases, the problem arises in how and when the tax authority chooses to tax IP. Current accounting rules and conventions provide little guidance when it comes to taxation, leaving many confused. In most countries, the Generally Accepted Accounting Principles (GAAP) go so far as to perpetuate this confusion. GAAP treats practically all internally generated intangibles as costs to be expensed rather than as investments. This can distort measures of enterprise profitability and asset values, which are the basis for much of the corporate tax system.

Tax authorities also require taxpayers to operate ‘at arm’s length’, and businesses incur separate transaction costs when dealing with tax, even if they form part of a larger group. as a result, members of a multinational corporation may be forced to adopt parochial thinking so as to unbundle transactions through the value chain and demonstrate to the tax authorities that unrelated parties would transact under similar terms and conditions.

What if I license my IP?
Licensing for tax breaks has become particularly relevant since the late 1980s, as a result of a growing tendency by companies to protect and manage IP through an intangible Property holding company (IHC). IHCs work by transferring some or all of a group’s IP, irrespective of the operating entity or entities where it currently resides, to the IHC – generally a tax-friendly climate. The entities (often including the previous owners) and third-party licensees are then granted the right to use the IP in exchange for a royalty.

Those contemplating to set up an IHC should carefully reflect first on the functions that will be performed in terms of managing the IP and properly record it and the tax implications in order to avoid problems in the future

Such structures may be scrutinised by tax authorities on several grounds: does a valid business purpose exist for entering into the structure, other than the tax advantages; is the economic substance of inter-company royalty payments supportable; and can the arm’s length character of the royalty payments be challenged? As a result, those contemplating to set up an IHC should carefully reflect first on the functions that will be performed in terms of managing the IP and properly record it and the tax implications in order to avoid problems in the future.

Will royalties be taxed?
The central question for the tax office in each jurisdiction is whether the payment made by the licensee is reasonable, but finding out what an appropriate royalty should be can often prove an onerous task. Tax offices can assess ‘the going rate’ for trademark royalties to measure fair payment; however, OECD guidelines recommend against this method as mere application of industry averages (which isn’t to say that it isn’t used by some authorities for reasons of  simplicity). Instead the office could opt for a ‘formulary’ approach, which measures the pre-license profit of the licensor and rate of return analysis for the licensee after payment.

How can I plan for tax?
Efficient IP planning is gradually being elevated to ‘boardroom status’ as a result of the Sarbanes-Oxley statute (‘SarbOx’), which was passed in the US in 2002. Under sections 302 and 906 of this, CEOs and CFOs are now required to certify in corporate reports that adequate controls and procedures are in place so as to make sure that the material disclosed accurately represents the financial conditions of their companies. Even though SarbOx does not seem to specifically refer to intangible assets, such as IP licensing, companies may have an interest to plan some aspects of SarbOx that will trigger IP and intangible reporting.

My advice to companies would be to devote attention to the tax issues of transferring ‘portable profit-generating assets’, even though it can often occur without one noticing. Companies need to monitor the transfer of all types of information, if they are to counter potential tax authority challenges – a ‘one fits all menu’ of triggers for tax counsel’s intervention does not exist and common sense in gathering information on a case-bycase basis remains the rule.

As IP continues to grow in stature, tax offices are increasingly looking to businesses to account for their intellectual assets. as a result, the tax havens of previous years do not always provide the tax- or hassle-free environments they once did.

This article first appeared in IP Review, issue 15

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