TEI School - Houston Intangible Property ( IP ) - Basics in IP Planning May 3, 2017
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Speakers Kelly Hales Principal, Transfer Pricing Ernst & Young LLP + 1 713 750 8141 kelly.hales@ey.com Kristy Ton Senior Manager, International Tax Services Ernst & Young LLP + 1 713 750 4942 kristy.ton@ey.com Page 3
Agenda Intangible Property ( IP ) Definition and Common Characteristics IP Planning IP Transaction and Techniques IP Planning Considerations IP Risk Management Transfer of IP Sale versus License Types of IP Transfers Section 367 and Intellectual Property Sourcing Income/Expenses Page 4
Intangible Property Definition & Common Characteristics Page 5
Intangible Property Definition Patent, copyright, secret process or formula, goodwill, trademark, trade brand, franchise, or other like property Noncompetition agreements Section 936(h)(3)(B): Intangible property income (i) patent, invention, formula, process, design, pattern, or know-how (ii) copyright, literary, musical, or artistic composition (iii) trademark, trade name, or brand name (iv) franchise, license, or contract (v) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data, or (vi) any similar item where value is derived not from physical attributes but from intellectual content or other intangible properties Page 6
Intangible Property Definition Transfer pricing perspective See Sections 936 and 367, Treas. Reg. 1.482. An intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual (similar to definition in Section 936(h)(3)(B)(i)). New cost-sharing regulations provide an expanded definition over Section 936 to include resources, capabilities and rights reasonably expected to contribute to profits. Page 7
Common Characteristics of IP Specific identification and recognizable description Subject to legal existence and protection Tangible evidence of existence, e.g., contract, license Subject to right of private ownership and private ownership should be legally transferable Created or has come into existence at an identifiable time or result of identifiable event Subject to being destroyed, termination of existence at an identifiable time or result of identifiable event Page 8
IP Planning Transaction, Techniques, Considerations & Risks Page 9
IP Transactions and Techniques Existing intangibles: Sale or license = Treas. Reg. 1.482-4 and 1.482-7 Contribution = Section 367(d) Section 1031 exchange (see Treas. Reg. 1.482-1(f)(1)(iii) and TAM 9222005) Developing intangibles: Cost-sharing (with or without contributions, options) Contract R&D, marketing services Real options Acquired intangibles: Initial ownership Transferred through transaction Page 10
IP Planning Considerations Transfer pricing perspective Commercial purpose and rationale for the transaction (income follows key activities), including the tax benefits Rights and income to be migrated by functional and economic analyses: Foundation or platform IP Use rights Make or sell rights Market risks attributable to IP development and ownership (income follows risks) Tax planning (e.g., supply chain structuring, financing and TP planning to benefit from lower effective tax rate) Page 11
IP Risk Management Anticipate tax authority challenges: Demonstrate and support business purpose (e.g., change, facility closure, relocation, expansion) Should test pre- and post- results with current and multiyear data Document realistic alternatives Make sure intercompany agreements concerning rights, obligations and flexibility for changing terms are in place Provide that risk transfers are more than just contractual Demonstrate subsequent behavior follows form Backup analysis on permanent establishment (PE) to avoid catch-22 Section 367(d) regulations on current IRS business plan Page 12
IP Risk Management (cont d) Consider international tax reform: Trump Administration Anti-base erosion options: Offshore IP profits likely subject to higher tax rate Expansion of anti-deferral rules (Subpart F): Excess IP profits (return in excess of 150% of costs) Low-tax income Patent box for IP income (offshore or onshore) Minimum tax approach Transition rules: Automatic or elective taxation of deferred earnings Foreign tax credit considerations ability to use? Future model US rate and territorial system? How low is US corporate tax rate? What is lockout effect for offshore earnings? Page 13
Transfer of IP Page 14
Transfers of IP Sale v. License Transfers of IP can be either treated as a sale or a license. US federal income tax treatment is based on the terms of the transfer irrespective of the legal arrangement. Several factors are considered in determining whether a transfer constitutes a sale of a license. In general, a transfer constitutes a sale if all substantial rights of the IP are transferred in an agreement. Sale License for the full life of IP Exclusive rights No field of use restriction License License for less than full life of IP Non-exclusive rights Field of use restriction Page 15
Transfers of IP Sale v. License (cont d) Other factors considered in determining whether an agreement for transfer of IP constitutes a sale or a license are listed below: Retention by the transferor of the right to prevent unauthorized disclosure of the IP by the transferee has generally been viewed as indicative of a license The ability of a licensee to assign or transfer its rights under the agreement to another party is indicative of a sale Retention by the transferor of the right to control the prosecution of patent infringement suits is indicative of a license Whether the rights retained by the licensor had, at the time of the original agreement, any value. The ability of a licensee to sublicense the patents and related rights is indicative of a sale Page 16
Types of IP Transfers Method of IP transfer Description of transaction Form and timing of payment Tax ownership (amortization) Source of income (to transferor) 1. License (fixed or contingent consideration) Less than all substantial rights in IP (or an undivided interest therein) are transferred. Fixed = lump sum or installments; contingent = declining or fixed royalty and/or milestones; nonlump sums paid over useful life Transferor Place of use 861/862(a)(4) 2. Sale for fixed consideration All substantial rights in IP (or an undivided interest therein) for a defined geographic area (country or countries) are transferred. Lump sum or installments paid over useful life Transferee Residence of transferor 865(a) 3. Sale for contingent consideration All substantial rights in IP (or an undivided interest therein) for a defined geographic area are transferred for an amount contingent on use or productivity. Royalty (flat or declining rate) and/or milestones paid over useful life Transferee Place of use subject to US amortization recapture 865(d) Page 17
Types of IP Transfers 1. License (fixed or contingent consideration) 2. Sale for fixed consideration IP Licensor IP IP owner IP license Licensee Royalty payment (e.g., percentage of net sales) IP sale IP Related party Lump sum or installment payments Third party Licensee produces products for sale to third-party customers Third party Licensee produces products for sale to third-party customers Page 18
Types of IP Transfers Method of IP transfer Description of transaction Form and timing of payment Tax ownership (amortization) Source of income (to transferor) 4. Contribution to controlled corporation in exchange for shares IP rights are contributed to controlled corporation in exchange for (actual or deemed) shares 351. Deemed license payments made to transferor for up to 20 years 367(d) Transferee (assuming no rights are retained) Place of use 861/862(a)(4) 5. Contribution to partnership in exchange for partnership interest IP rights are contributed to partnership in exchange for common interest or for common and preferred interests 721. Depends on terms of partnership interests and partnership profits; no time limits but 482 principles likely apply to total consideration Transferee (assuming no rights are retained) Look to distributable share of partnership income (foreign IP rights typically generate foreign-source income) 6. Contingent services arrangement; option pricing IP is developed under contract, and consideration depends on future contingency. Small up-front fee (premium) + larger success-based fee if future contingency met/option exercised (strike price) Transferor initially; transferee if exercise or future contingency met Place of performance likely location of R&D services Page 19
Intangible Property Within Scope of Section 367(d) Purpose prevent US persons from taking advantage of US tax incentives for R&D to develop intangible property and then transferring intangible property free of US tax if property becomes profitable. General rule US transferor treated as having sold intangible property in exchange for deemed annual payments. Intangible property defined by cross-reference to Section 936(h)(3)(B). Exclusion of foreign goodwill and going concern value. Exclusion of intangible property described in Section 1221(3) (e.g., copyrights). Page 20
Deemed Annual Payments Amount Section 482 principles, including commensurate with income requirement No basis-offset provision Timing deemed received last day of taxable year Duration generally, lesser of useful life or 20 years Character ordinary income Source place of use of intangible property Page 21
Deemed Annual Payments (cont d) Establishment of annual A/R Amount equal to deemed payment Can be paid without further US tax consequences If not paid by last day of third taxable year following year to which it relates, unpaid portion deemed paid and treated as capital contribution to foreign transferee corporation with stock basis increase Effect on foreign transferee corporation Reduce E&P for purposes of Chapter 1 of Code (Sections 1-1400) Reduce Subpart F income if CFC Page 22
Dispositions and Acceleration Events Underlying Intangible Unrelated person Deemed royalty regime ceases US transferor recognizes gain (not loss) equal to excess of FMV of intangible on date of disposition over U.S. transferor s former basis on date of original transfer US transferor allowed to establish A/R foreign transferee corporation s E&P excludes gain recognized Related person Section 367(d) royalty regime continues with new (related) owner substituted for original foreign transferee corporation Page 23
Dispositions and Acceleration Events Stock of Foreign Transferee Unrelated person Deemed royalty regime ceases US transferor recognizes gain (not loss) on hypothetical sale of intangible property at FMV Hypothetical gain reduces any stock gain Related US person related US person succeeds to initial US transferor s obligation under Section 367(d) Related foreign person Section 367(d) royalty regime continues as to US transferor Page 24
Sourcing Income/Expenses Page 25
General Rule Place of Use Royalty income for use (not sale) of property sourced based on place of use. Use of intangible property based on place where intangible is used Place of actual use and where legally entitled to use Royalties from licenses, patents, copyrights, know-how, goodwill, secret processes and formulas, customer lists, trademarks, franchises, etc. Page 26
Revenue Ruling 68-443 Foreign Corp X Exclusive Trademark License Royalty US Corp Y Manufactures in United States Sells in United States Foreign Customers Sale Royalties for use of a foreign trademark on products that are ultimately used in foreign countries are foreign-source even though the initial sale of the articles took place in the US. Page 27
Cascading Royalties SDI Netherlands B.V. Bermuda License NV Royalty for worldwide rights BV License US Royalty for US rights Is royalty from BV to Bermuda USSI (and subject to withholding tax)? Page 28
Apportionment Need to apportion royalties for the use of intangibles within and without the US Facts and circumstances determination Apportion on basis of time, value, or other appropriate base. If royalties paid in lump sum for worldwide rights, apportion between US and non-us-sources based on relative values of rights. See Wodehouse v. CIR, 178 F2d 987 (4 th Cir. 1949) Absent reasonable allocation basis or separate agreements, all royalty income will be allocated to US sources. US and foreign rights Should be covered in separate agreements Alternatively, royalty payment obligations should be clearly apportioned between US and foreign rights. If royalties paid in lump sum for worldwide rights, apportion between US and non-us sources based on relative values of rights. Page 29
Sale of IP - Personal Property General rules Gain from the sale or exchange of personal property, including intangible property, is sourced based on seller s residence Section 865(g) modifies the residency rules US-source gain for the following sellers: Any individual who is a US citizen or resident alien and Does not have a tax home in a foreign country (or US possession), or Has such a tax home but is not subject to foreign tax at a rate of at least 10% on gain from the sale of the property at issue, or A nonresident alien and has a tax home in the US Corporation, trust or estate which is a US person Foreign-source gain for sale by any person other than a US resident Partnerships Section 865(i)(5) applies source rules for personal property sales at the partner level. Page 30
Personal Property Exceptions Inventory 865(b), 861(a)(6), 862(a)(6), and 863(b) Personal property described in 1221(1), relating to stock in trade and property held by the taxpayer primarily for sale to customers in the ordinary course of business. Depreciable/amortizable property 865(c) Intangibles 865(d) Stock of 80%-owned foreign affiliates 865(f) Section 865(h) re-sourcing for intangibles and stock of foreign affiliates Sales through offices or fixed places of business 865(e) Page 31
Intangible Property Sourcing rules Section 865(d) provides an exception to the general rule on the sale or exchange of "any patent, copyright, secret process or formula, goodwill, trademark, trade brand, franchise or other like property," if the gain on such sale or exchange is attributable to payments that are contingent on the productivity, use, or disposition of the intangible property. Gain to the extent of amortization is treated as having the same source as the related deductions Same rule as for depreciable property Gain in excess of the amortization deductions: Noncontingent sale Residence of the seller rule applies Exception: Goodwill sourced in the country in which it is generated Contingent sale Sale contingent on the productivity, use, or disposition of the intangible Sourced in the same manner as royalties (place of use) Does not apply to return of basis or imputed interest Page 32
Sale of Intangibles Section 865(h) re-sourcing Gain from sale of intangible is foreign source if: Otherwise be US-source under 865 Under a treaty obligation of the US, would be foreign-source Taxpayer chooses benefit of 865(h) Sections 902, 904, 907 and 960 are applied separately with respect to such gain Also applies to liquidations of certain possessions corporations Page 33
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