Tax Planning for “Inbound” Licensing of Intellectual Property

Tax Planning for “Inbound” Licensing of
Intellectual Property
TTN Miami
May 12, 2011
Jeffrey Rubinger
Holland & Knight

U.S. Inbound Intellectual Property
Transactions
– Typical Features
• FCo. “licenses” IP to USCo. on an exclusive and worldwide
basis (or for a particular territory) in exchange for cash in the
form of:
– down payment at closing
– regulatory milestone payments
– royalty payments
– sales milestone payments
• Sale for a fixed payment is not a typical way to transfer IP --
owner can usually maximize value by making payments
contingent on the level of exploitation/use of the property
• Agreement labeled “assignment” may be a license for tax
purposes, and vice versa, depending on whether all
substantial and valuable rights in the IP have been
transferred for the legal life of the IP
2

Key Aspects of U.S. Federal Tax
Scheme
– 30% gross withholding at source on FDAP, including “royalties”
• 30% rate may be reduced by treaties – many provide for 0%
– 30% gross withholding on gain element of U.S. source
contingent payment sales of IP (§871(a)(1)(D)/§881(a)(4))
• Contingent payments sourced under “place of use” rule for royalties
• But fixed payments in a “sale” are sourced under general “residence
of the seller” rule
• Contingent payments subject to §871(a)(1)(D)/881(a)(4) are
generally treated as “royalties” for treaty purposes
– 30% withholding never applies to fixed payment sales of IP, but
if “effectively connected” with conduct of U.S. trade or business,
income taxed on a net basis (§871(b)/§882)
3

U.S. Inbound Intellectual Property
Transactions
– Key Characterization Issues
• Sale vs. license ?
• If sale – portion of payments considered
“contingent on the productivity, use or disposition”
of property ?
• If license – “place of use” of IP ?
• Permanent establishment ?
4

Treaty Issues and Opportunities
• As noted earlier, U.S.-source royalties are
generally subject to 30 percent withholding tax.
• Most modern U.S. income tax treaties
substantially reduce or eliminate the U.S.
withholding tax on royalties.
• To qualify for treaty benefits, foreign person
needs to be (i) resident of treaty jurisdiction, (ii)
needs to satisfy limitation on benefits (LOB)
provision, if any, contained in treaty, and (iii)
needs to qualify for treaty benefits under Section
894, if applicable.
5

Resident and LOB Provisions
• A foreign person generally will be considered a resident for treaty
purposes if such person is "liable to tax therein by reason of its
domicile, residence, citizenship, place of management, place of
incorporation, or any other criterion of a similar nature.”
• Under most "modern" income tax treaties, a corporate resident of a
treaty country can satisfy the LOB provision if, among other things,
(1) on at least half the days of the tax year at least 50% of each
class of shares in the corporation is owned, directly or indirectly, by
residents of the jurisdiction where the corporation is formed (the
"ownership test"), and (2) not more than 50% of the gross income of
the foreign corporation is paid or accrued, in the form of deductible
payments, to persons who are residents of the U.S. or residents of
the jurisdiction where the corporation is formed (the "base erosion"
test).
6

Section 894 and Payments to
Hybrid Entities
• Regulation Section 1.894-1(d) denies treaty
benefits on payments of FDAP income to foreign
persons unless the income is “derived” by a
resident of a treaty jurisdiction.
• For this purpose, an item of income paid to an
entity will be considered derived by the entity
only if the entity is not fiscally transparent under
the laws of the entity’s jurisdiction with respect to
the item of income.
7

Section 894 and Payments to
Hybrid Entities (cont.)
Treaty benefits denied because royalty not derived by Lux Co.
Treaty benefits allowed, even through Lux Co disregarded for U.S. tax
Purposes, because royalty derived by Lux Co for Section 894 purposes.
Luxembourg
Company
Cayman
Company
dividend
hybrid instrument
Cayman
Company
Luxembourg
Company
royalty
license
royalty
license
United
States
United
States
8

Treaties without LOB Provisions that Substantially
Reduce or Eliminate U.S. Withholding Tax on
Royalties
• Norway – 0 percent withholding tax on royalties
• Greece – 0 percent withholding tax on royalties
• Pakistan – 0 percent withholding on royalties
• Poland – 10 percent withholding tax on royalties
• Morocco – 10 percent withholding tax on
royalties
• Romania – 15 percent withholding tax on
royalties
9

Favorable Treaty Jurisdictions to Hold Intellectual
Property from U.S. Treaty Perspective
• Luxembourg – 0 percent withholding under U.S. income tax treaty;
low corporate tax rate on royalties; LOB provision less restrictive
than newer treaties as Luxembourg company can be owned by
residents of the U.S. or Luxembourg under ownership/base erosion
test; LOB provision has derivative benefits article; however, treaty
has anti-triangular provision for royalties allocated to low-tax third
country branch.
• Netherlands – Same as Luxembourg
• Ireland – Same as Luxembourg
• Switzerland - 0 percent withholding under U.S. income tax treaty;
low corporate tax rate for royalties; LOB provision requires Swiss
company generally to be owned by Swiss residents (as opposed to
U.S. or Swiss residents) although LOB provision does has derivative
benefits article; treaty has anti-triangular provision for royalties
allocated to low-tax third country branch.
• Belgium – Same as Switzerland.
10

Conduit Financing Issues
• If cannot obtain low corporate tax rate on royalties
received in foreign jurisdiction, would back-to-back
license arrangement work?
• Prior to the enactment of Section 7701(l), the IRS
typically would challenge a back-to-back license
arrangement under Aiken Industries, Inc., or Rev. Rul.
80-362.
• In Aiken, the Service successfully argued that a
Honduran corporation, while a valid resident under the
U.S.-Honduras treaty, had no "dominion and control"
over the funds and was a mere collection agent or
"conduit for the passage of interest payments" from the
U.S. entity to the Bahamian entity.
11

Conduit Financing Issues (cont.)
• In Rev. Rul. 80-362, a resident of a non-treaty
jurisdiction licensed a patent to a Dutch corporation,
which in turn sublicensed the patent to a U.S.
corporation for use in the U.S. The royalties paid from
the U.S. to the Netherlands were exempt from
withholding tax under the Netherlands-U.S. income tax
treaty. The IRS ruled, however, that the royalties paid
from the Netherlands to the non-treaty jurisdiction were
U.S.-source royalties under Section 861(a)(4) because
they were paid in consideration for the privilege of using
a patent in the U.S. Therefore, those royalties were
subject to a 30% withholding tax in the U.S.
• But see SDI Netherlands where different result reached.
12

Conduit Financing Issues (cont.)
• Conduit financing regulations under Treas. Reg. Section 1.881-3
allows the IRS to disregard the participation of one or more
intermediate entities in a financing arrangement where such entities
are acting as conduit entities, and to recharacterize the financing
arrangement as a transaction directly between the remaining parties
to the financing arrangement for purposes of imposing tax under
Sections 871, 881, 1441, and 1442.
• For this purpose, a financing arrangement is defined as a series of
financing transactions by which one person (the financing entity)
advances money or other property, or grants rights to use property,
and another person (the financed entity) receives money or other
property, or rights to use property, if the advance and receipt are
effected through one or more other persons (intermediate entities).
13

Conduit Financing Issues (cont.)
• A "financing transaction" means (1) debt, (2) any lease or license, or
(3) any other transaction (including an interest in a trust described in
Sections 671 through 679) pursuant to which a person makes an
advance of money or other property or grants rights to use property
to a transferee who is obligated to repay or return a substantial
portion of the money or other property advanced, or the equivalent
in value.
• If the IRS determines that the participation of a conduit entity in a
financing arrangement should be disregarded, the financing
arrangement is recharacterized as a transaction directly between the
remaining parties to the financing arrangement (in most cases, the
financed entity and the financing entity) for purposes of Section 881.
14

Conduit Financing (cont). - Examples
Conduit financing regulations would deny treaty benefits
Cayman
Company
Conduit financing regulations would deny portfolio interest
exception because bank would not qualify if loan
made directly to United States
loan
royalties
(assumed
non-U.S. source
income)
Dutch
Company
license
Unrelated
Foreign
Corporation
interest
Unrelated
Bank
royalties
United
States
sublicense
loan
United
States
portfolio
interest
Related party transaction
Unrelated party transaction
15

Conduit Financing Issues (cont.)
• If cannot use back-to-back license arrangements to avoid U.S. withholding tax, what about using
disregarded entities to avoid the second payment for U.S. federal income tax purposes?
• Is this a “back-to-back” license arrangement if Dutch company disregarded for U.S. tax purposes?
• Section 894(c) regulations would allow treaty benefits, even though Dutch company is
disregarded for U.S. tax purposes.
U.S.
Sub-licensee
Cayman
Company
license
license
royalties
royalties
Netherlands
Company
16

Conduit Financing Issues (cont.)
•Prop. Reg. Section 1.881-3(a)(1)(i)(C) contains a provision that indicates that
"the term person includes a business entity that is disregarded as an entity
separate from its single member owner under §§301.7701-1 through 301-7701-
3.”
•As a result, any transaction that the disregarded entity enters into will be taken
into account for purposes of determining whether a conduit financing
arrangement exists.
sub-license
U.S.
Sub-licensee
Netherlands
Company
license
royalties
Cayman
Company
royalties
17

Use of Low-Tax Permanent
Establishments
• While the Proposed Regulations are clearly designed to
shut down conduit financing arrangements involving
hybrid entities (i.e., entities that are fiscally transparent
for U.S. tax purposes but are not fiscally transparent for
foreign tax purposes), the Proposed Regulations do not
prevent taxpayers from obtaining treaty benefits when a
non-hybrid branch is used.
• This is because the Proposed Regulations specifically
indicate that only entities that are disregarded under the
check-the-box Regulations are treated as persons for
purposes of determining whether a conduit financing
arrangement exists.
18

Use of Low-Tax Permanent
Establishments (cont.)
Therefore, it may be possible to use treaty jurisdiction without an anti
triangular provision and allocate royalties to low-tax third country
branch (instead of using back-to-back license arrangement).
U.S.
Licensee
Norwegian
Company
U.S.
Licensee
Polish
Company
license
license
royalties
Maltese
Branch
royalties
Irish
Passive
Investment
Branch
U.S.-Norway treaty has no LOB provision
0 withholding tax on royalties
No anti-triangular provision
Norway-Malta treaty exempts royalties from tax in Norway
No tax in Malta as considered foreign-source income
U.S.-Poland treaty has no LOB provision
10% withholding tax on royalties
No anti-triangular provision
Poland-Irish treaty exempts royalties from tax in Poland
No tax in Ireland if royalties treated as passive income
19

Hybrid Instruments
• If low-tax third country branch cannot be utilized to reduce corporate
tax rate in treaty jurisdiction, consider using hybrid instrument (e.g.,
CPECs, which are treated as equity for U.S. tax purposes but debt
for foreign tax purposes) to avoid conduit financing regulations.
• However, preamble to proposed conduit financing regulations
issued in December of 2008 indicates that Treasury and IRS were
considering issuing separate guidance on the treatment of hybrid
instruments under these regulations.
• One approach would be to treat all transactions involving hybrid
instruments as “financing transactions.”
• Another possible approach, according to the preamble, is to add
additional factors to consider in determining when stock in a
corporation (or other similar interest in a partnership or trust) may
constitute a financing transaction.
20

Hybrid Instruments (cont.)
Cayman
Company
interest for Lux tax purposes
dividend for U.S. tax purposes
CPEC (convertible preferred equity certificates)
Luxembourg
royalty
license
United
States
21