7. Basic International Tax Planning Considerations.
a. Need for Good International Tax Planning Upfront.
It can be important to plan for U.S. international tax consequences early in a company’s life due to the lock-in effect of the anti-inversion rules (§ 7874) that prevent domestic corporations from moving to a foreign residence and the IRS’s aggressive interpretation of the transfer pricing rules to limit the migration of intellectual property outside of the United States (§ 367(d) and the § 482 cost-sharing rules). Once a company is formed and established as a U.S. business, these rules can make it difficult to transfer the valuable functions of the business abroad. By contrast, if a start-up keeps its eye on international tax issues early, it can avoid being locked into the U.S. tax system.
The following discussion provides an overview of the U.S. international tax planning considerations that affect a start-up company (“NewCo”) in the software business.
NewCo has both U.S. and foreign employees that perform software development and sales functions; NewCo has significant U.S. sales and anticipates significant foreign sales. NewCo has both U.S. and foreign shareholders. U.S. shareholders may or may not have a controlling interest in NewCo. A significant amount of NewCo’s software development work will be done outside of the United States (e.g., China). A foreign company will be formed in China as well as a holding company jurisdiction (e.g., Hong Kong).
The questions of choice of entity in the international setting are as follows: (1) forming the U.S. and foreign Newcos as corporations or subsidiaries for U.S. and/or local tax purposes; (2) which entity should be the parent and which other entities the subsidiaries; and (3) where should IP ownership for tax and/or legal purposes be
92 TAM 9527003.
located. The outline below discusses some of the major tax planning issues that should be considered in making these decisions.
b. IP Ownership; Importance of Location of IP.
i. Concept of the IP Entrepreneur.
There are principally three ways of IP ownership between US NewCo and Foreign NewCo: (1) US NewCo owns the worldwide rights; (2) Foreign NewCo owns the worldwide rights; or (3) the foreign and U.S. companies divide ownership by territories through a “cost-sharing arrangement.” In either scenario 1 or 2, IP may be The location of the IP in a foreign entity as opposed to a U.S. entity for U.S. and foreign markets is a fundamental premise to determining where the ultimate residual profits of the business are earned. This can be accomplished either by vesting all markets’ IP in the foreign entity, or by cost-sharing or some divided ownership between the U.S. and foreign markets.
The first and second scenarios would centralize the ownership of the IP in a single legal entity for tax purposes. In the first scenario, the U.S. and foreign rights are owned by a US NewCo, so the Foreign NewCo cannot legally make and sell the software without paying a royalty to US NewCo. Any R&D performed by Foreign NewCo would be reimbursed by the US NewCo in this scenario would be reimbursed through an R&D services arrangement akin to work-for-hire. Foreign NewCo would then make and/or sell products under a license from US NewCo and derive a smaller share of any residual profits since it did not bear the risk of developing a successful product. Conversely, if the venture fails, then the U.S. NewCo would bear the R&D expenses and losses. Thus, US NewCo would need to retain a larger share of the profits through royalties to compensate it for bearing the risk.
Conversely, if Foreign NewCo owns all of the worldwide IP, it would bear the development costs and reimburse the R&D performed by the U.S. on a cost-plus basis.93 Any profits from the foreign or the U.S. market would be earned by Foreign NewCo, and absent subpart F, would be not subject to U.S. tax until actually distributed to Foreign NewCo’s U.S. owners.
The foreign company would also own the rights to exploit the U.S. market With respect to the U.S. market. The foreign company could attempt to exploit the U.S.
directly by sale of product or performance of services to U.S. customers. It also could license IP to a related U.S. entity. The tax consequences of such a structure depend on U.S. inbound tax rules, discussed below. Also, if the foreign company is owned by U.S. individuals or a U.S. corporate parent, the subpart F and PFIC rules will also
93 In the case where the Foreign NewCo owns all of the IP and reimburses US NewCo’s expenses, those expenses are no longer deductible under § 174. However, the expenses may still be eligible for the § 41 R&D credit. See JCX-37-10 (July 20, 2010), discussing “Bravo Company.” The reason US NewCo may still be eligible for an R&E credit with respect to the reimbursed expenses is § 41(f), which aggregates members of a controlled group (US and Foreign). As a result of the aggregation, the reimbursement would seem to be disregarded for § 41 purposes.
need to be considered, as discussed below. Generally, a foreign owned business will find it easier to exploit the U.S. market through a foreign as opposed to a U.S. entity.
ii. Cost-Sharing Arrangements.
The third scenario would divide IP ownership between U.S. and foreign markets, with each of the foreign and U.S. entities bearing their respective shares of the development costs and earning profits from their respective markets. This has typically been effected through a “qualified cost-sharing arrangement” (CSA) under former Treas. Reg. § 1.482-7, and in years after 2009, under Temp. Treas. Reg.
§ 1.482-7T. Under the 2009 temporary regulations, it has become more difficult to enter a CSA where technology of substantial value is located in the United States.
In a CSA, each party enioys exclusive rights to exploit the technology in a certain geographic or other territory, and bears a share of R&D expense based on the projected value of the intangibles within each territory. For example, assume that the projected sales of NewCo’s product are expected to be 40% Foreign / 60% US.
Under the CSA, Foreign NewCo would bear 40% of the R&D expense. To the extent Foreign NewCo did not incur 40% of the R&D costs, it would make a reimbursement payment to US NewCo. This projection is periodically reviewed and the sharing of R&D expense adjusted accordingly.
One significant benefit of a CSA is that there is no requirement to mark up the cost of development by a participitant in the CSA, since the parties are seen as co-venturers in the development of a jointly owned intangible property.
On entry into the CSA, each party that contributes pre-existing intangibles to the agreement must receive arm’s-length compensation for the value of these pre-existing intangibles. This can be in the form of a lump-sum payment, or a royalty that is a declining percentage of sales. In 2009, the IRS issued temporary regulations on CSAs that deviate from traditionally accepted transfer pricing methods in valuing intangibles contributed to a CSA.94 These new pricing methods tend to place a very high value on any pre-existing intangibles contributed by US NewCo to a CSA.
Therefore, the best time to enter into a CSA is when the venture does not have any proven intangible property in existence.
The CSA must also be recorded in a contract between the participants that is contemporaneous with the formation of the CSA and describes the scope and nature of the CSA in some detail.95 The parties must document certain matters pertaining to the CSA, meet record-keeping requirements, and file tax return disclosures with
94 See Temp. Treas. Reg. § 1.482-7T(g) (promulgated in 2009). In Veritas Software Corp. v.
Commissioner, 133 TC No. 14 (2009), the Tax Court rejected the IRS’s reliance on some of these valuation methods in a case predating the current temporary regulations.
95 See Treas. Reg. § 1.482-7T(k)(1).
respect to the CSA on an annual basis.96 The requirements of Treas. Reg. § 1.482-7T should be carefully reviewed in connection with forming a CSA.
iii. Authorities Regarding Ownership of Intellectual Property.
It is fairly well accepted, at least in the United States, that the ownership of intangibles may be assigned by contract among different entities that are related parties. If the related entities act consistently with their allocated ownership of intangibles, the contractual arrangements generally must be respected by the IRS.
The following are authorities that bear on this question:
1. Treas. Reg. § 1.482-1(d)(3). Generally, if the parties agree in writing to the allocation of risks and ownership arising from a transaction before the transaction occurs, that allocation will be respected if “consistent with economic substance.” The regulation states that “In evaluating economic substance, greatest weight will be given to the actual conduct of the parties, and the respective legal rights of the parties . . . .” If there is no written agreement between the parties, the IRS is free to impute a contractual arrangement that is consistent with the parties’ actions.
Therefore, it is important to document the intended tax treatment through intercompany agreements.
2. Treas. Reg. § 1.482-1(d)(3)(iii)(C), Example 1. The parties can also agree on the allocation of risks (other than IP development and ownership), which will also be respected if consistent with economic substance. For example, the manufacturing entity and distributing entity can decide in an intercompany distribution agreement whether the distributor bears the risks of obsolescence, inventory damage / transportation, currency, etc. All of these would influence what level of profit the distributor would need to earn at arm’s-length. As Example 1 illustrates, if the contract spells out the risks beforehand, it will generally be respected even if subsequently results in a windfall or unexpected loss to one party to the contract.
3. Claymont Investments, Inc. v. Commissioner, 90 T.C.M. 462 (2005).
This case dealt with the foreign currency gain associated with an intercompany financing arrangement. The IRS argued that the gain had to be recognized currently because the transactions could be recast. The Tax Court rejected the attempted recast, concluding that under Treas.
Reg. § 1.482-1(d)(3), supra., the IRS was barred from recasting transactions inconsistent with economic substance.
4. Westreco, Inc. v. Commissioner, 64 TCM 849 (1992). Westreco, Inc. was a U.S. subsidiary in the foreign-owned Nestle group that provided R&D and engineering services to the Swiss parent. Westreco, Inc. earned a fee
96 See Treas. Reg. § 1.482-7T(k)(2) – (4).
determined according to a cost-plus formula for its R&D services. The IRS made an adjustment under § 482 to Westreco’s income to reflect its conclusion that Westreco should have earned a larger fee for its services.
The case is notable for two conclusions. First, the IRS did not challenge the bona fides of the intercompany R&D services agreement under which the Swiss parent owned the intangible property created by the U.S.
subsidiary’s research engineers. The case is precedent for respecting an R&D services agreement. Second, on the facts and circumstances, the taxpayer defended its plus formula from IRS attack. Thus, a cost-plus fee for R&D services may be appropriate under the facts and circumstances. In regard to the different methods for charging for intercompany R&D, see Treas. Reg. § 1.482-9 (pricing for intercompany services).
5. Bausch & Lomb, Inc. v. Commissioner, 933 F.2d 1084 (2d Cir. 1991), aff’g 92 T.C. 525 (1989), the taxpayer transferred IP to its Irish subsidiary, and subsequently imported sunglasses produced by the Irish subsidiary using the transferred IP. The IRS argued that the price charged for the sunglasses should not exceed the price the U.S. taxpayer would have paid if, instead of transferring IP, the taxpayer had hired the Irish subsidiary as a contract manufacturer. The court disagreed, concluding that the IRS could not determine the transfer price by restructuring the terms of the parties’ arrangement.
6. Treas. Reg. § 1.482-1(f)(2)(ii)(A). Consistent with the rules above, the IRS will “price the transactions as it finds them” and not restructure the transaction unless it lacks economic substance. However, in determining the appropriate price to be charged, the IRS will consider the other alternatives realistically available to the taxpayer and whether an uncontrolled taxpayer seeking to maximize value would make the same choice of an alternative.
iv. Tax Ownership vs. Legal Ownership of IP.
Generally, under the same principle as set forth above, the party with ownership of the relevant intellectual property under IP law will be treated as the owner of property for tax purposes.97 Ideally, the party that owns the IP for tax purposes will be the same party that registers the patents, TMs, etc., for IP law purposes. In cases where neither applicable IP law nor the parties’ contracts assign ownership of the IP for tax purposes, the tax owner of the intangible will the party that has “control” over the intangible.98
97 See Treas. Reg. § 1.482-4(f)(3).
98 See Treas. Reg. § 1.482-4(f)(3)(ii), Example 2 (ownership of customer list, absent a contractual provision, resides in the distributor whose efforts created the customer list).
Despite the general rule that tax ownership of IP follows legal ownership, the regulations provide that such legal ownership can be overridden if the “economic substance” of the parties’ arrangements is to the contrary. For example, a nominee arrangement, under which it is clearly agreed that one party holds the IP solely for the benefit of the other party, should be respected for tax purposes if the nominee
relationship is clearly disclosed to third parties.99 Similarly, the parties should be able to allocate beneficial ownership of IP for tax purposes in a manner inconsistent with the holding of legal title.
v. Consequences of Migrating Existing Intangibles.
If IP is initially developed and owned in the U.S., it may be difficult to reverse course later and migrate ownership of that IP to a CFC or other foreign party. § 482 of the Code requires that the price paid for the intangibles be “commensurate with the income” generated by the intangible. This requires that the price paid be equal to what an unrelated party would have paid for same IP in the year in which it was transferred. Moreover, the initial amount paid can be subsequently adjusted in any of the five years following the transfer if the transferee’s total profits differ more than 20% from what was projected in setting the initial price, and the difference is not due to an “extraordinary event . . . that could not have been reasonably anticipated” at the time the initial transfer was made.100
Setting a transfer price for intangibles consistent with the arm’s-length standard requires a valuation and transfer pricing report to comply with the requirements of
§ 6662(e) of the Code. Absent such a report, it becomes much easier for the IRS to assert penalties in addition to a transfer pricing adjustment.
Prior to IRS’s revision to the transfer pricing regulations in 2009, it was common to transfer IP to an overseas subsidiary through a cost-sharing arrangement (“CSA”) with a buy-in royalty contingent on sales. The taxpayer would take the position that at the time of the transfer the existing IP was of small value due to the speculative nature of the business. Further, in software industry, taxpayers prevailed on
establishing a low valuation for existing IP in reliance on the short useful life inherent in many software products. In Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), a case decided under the pre-2009 regulations, the Tax Court upheld the taxpayer’s lump sum $166 million buy-in royalty for its existing software IP, and rejected the IRS’s assertion that the buy-in royalty should be approximately a $1.6 billion lump sum. The IRS’s theory, rejected by the court, was that the discounted future value of the entire foreign business’ cash flows, in perpetuity, should be deemed received by the taxpayer. The case illustrates the aggressive position taken by the IRS in context of IP migration. In AOD 2010-05 (Dec. 6, 2010), the IRS announced that despite its failure to appeal the decision in Veritas that it would continue to pursue the issues presented in the case.
99 See Bollinger v. Commissioner, 485 U.S. 340 (1988).
100100 See Treas. Reg. § 1.482-4(f)(2)(ii)(D).
Temp. Treas. Reg. § 1.482-7T(g) (adopted in 2009) adopts rules for valuing buy-in payments in CSAs consistent with the IRS’s position in Veritas, including
specifically:
1. § 1.482-7T(g)(2)(ii)(A) – Investor Model. In evaluating the value to P of its existing intangibles, the entire useful life of the intangibles to be developed under the CSA must be considered. This includes not only the next generation of IP to be developed, but successive generation that are indirectly derived from P’s existing IP.
Example – P owns existing Version 1 software for sequencing DNA and enters into a CSA to develop Version 2 with S. Version is expected to commence sales in year 3 and continue to be sold through year 10. For purposes of valuing P’s Version 1 software, the regulations state that P must have an interest in the CSA’s cash flows through the end of year 10.
2. § 1.482-7T(g)(2)(iii) – Realistic Alternatives. The value of the contributed intangibles and P’s returns from participating in the CSA must take into account the value of alternatives realistically available to P, such as retaining ownership of IP and licensing them to the subsidiary.
In this case, P would incur more cost and more risk, but would earn higher royalties. This principle also finds expression in the regulations’
“income method” that provides for valuation by reference to the discounted cash flow of the business’ existing technology under licensing and CSA alternatives. See Temp. Treas. Reg. § 1.482-7T(g)(4).
3. § 1.482-7T(g)(3) – Limits on CUPs, etc. The amount charged should not be less than a proportionate share of the worldwide value of the IP transferred to the CSA. Further, Reg. § 1.482-7T(c)(4) provides that the rights conveyed under a CSA are greater than mere rights to “make and sell” under existing technology. Thus, the royalty charged under a make-and-sell license may need to be adjusted to produce arm’s-length compensation under the 2009 regulations.
4. § 1.482-7T(g)(6) – Market Capitalization method. In cases where the company is publicly traded and the CSA relates to virtually all of the company’s IP, the regulations include a method valuing the parent’s contributions to the CSA by starting with the market capitalization of the entire company, removing tangible assets, and then multiplying the intangible asset value of the company by the Sub’s share of benefits from the CSA.
While the 2009 Cost-Sharing regulations do not require that the market capitalization or income method be used for IP transfers, the regulations require these methods be considered together with the other methods in determining which method most
reliably measures the price to be charged.101 If the IRS’ favored methods (income method or market cap) produce a much higher valuation for the IP than the taxpayer’s method (typically, a CUP or residual profit split), as in Veritas, then this will undermine the reliability of the taxpayer’s results. Also, as noted above, in making a comparison to an comparable unrelated-party transaction, the current regulations require the taxpayer to treat the CSA as conveying rights greater than a license to make and sell the property. See Temp. Treas. Reg. § 1.482-7T(c)(4).
While the 2009 regulations provide a higher hurdle in planning for IP migrations, there are three planning considerations that should be kept in mind:
1. Transferring IP early should still reduce the possible buy-in. The application of these methods will depend on valuation principles as applied to the facts of a particular case. If a CSA is made early, that would typically justify a lower royalty rate. Alternatively, if the IP is located in a foreign company from the outset, there would be no migration of IP to be made.
1. Transferring IP early should still reduce the possible buy-in. The application of these methods will depend on valuation principles as applied to the facts of a particular case. If a CSA is made early, that would typically justify a lower royalty rate. Alternatively, if the IP is located in a foreign company from the outset, there would be no migration of IP to be made.