Thinking outside the box: tax focus

Brand owners have many incentives to file their IP rights in foreign jurisdictions. One motivator is that some countries have tax reduction schemes designed to attract innovation from overseas businesses.

One example is the patent box scheme, used by several countries to promote research and development (R&D). This is achieved by taxing patent revenues at a lower rate than other commercial revenues. The initiative was first introduced by Ireland, when the country’s 1973 Finance Act provided royalties and other income tax relief from patents licensed there.

Other European countries that have since adopted varying versions of the scheme include France, the Netherlands, Belgium, Hungary, Spain and the UK.

Fabrizio Lolliri, global head of transfer pricing at Hogan Lovells, explains that patent boxes were designed to promote innovation.

“A patent box offers a lower corporate rate on income attributable to patents,” explains Lolliri.

“In order to test whether this regime might be beneficial for a business, it is important to value the patents and estimate the amount of income attributable to them, versus brands and other functions across the supply chain (as in most cases, these are not covered by the patent box).

“It is also very important to consider the cost of moving patents versus the potential benefits.”

In March, the Luxembourg government voted to approve a new IP regime that will allow an 80% tax exemption on eligible net income for qualifying IP rights. The regime was created in an effort to promote R&D activity within Luxembourg.

Under the regime, corporate taxpayers based in Luxembourg City with eligible net income will be taxed on that income at an overall effective tax rate of 5.202% during the 2018 tax year.

The main IP assets that are eligible to benefit from the new regime are: inventions protected by patents, utility models and other IP rights that are equivalent to patents; and software that is protected by copyright. Other IP, such as trademarks, is not eligible to benefit from the scheme.

A fading approach

While these schemes are created to encourage R&D and innovation, another major issue in the area of tax and IP is that of so-called tax havens.

Lolliri discusses base erosion and profit shifting (BEPS) which, according to the Organisation for Economic Cooperation and Development, is a tax avoidance strategy that exploits gaps in tax rules to artificially shift profits from high-tax countries to low or no-tax locations.

“The world of using tax havens to hold IP is quickly fading away since the introduction of BEPS,” explains Lolliri. “Moving legal ownership of brands with no substance is no longer an option and businesses that have done this in the past are now facing aggressive tax audits with potentially high adjustments.”

Lolliri describes IP with no substance as businesses that don’t have anyone to manage the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangible rights.

Staying at home

Last year, US Congress approved the Tax Cuts and Jobs Act 2017, partially in an effort to incentivise US companies to do business in their home country.

Steve Eichel, partner at Saul Ewing Arnstein & Lehr, says that the act may change IP owners’ approach to offshore tax jurisdictions.

“The act made a lot of fundamental changes to the US tax system in general and particularly to the US taxation of international business,” he says.

Prior to the new act, the US was one of the few developed countries in the world that had a purely worldwide taxation system rather than a territorial regime for taxing income earned abroad, according to Eichel.

“All US taxpayers were taxed as both individuals and entities on their income from all sources throughout the world, and then provided a foreign tax credit for foreign taxes paid on the same income to the extent that it was foreign source income,” he explains.

Another “fundamental piece of the puzzle” under the prior law was that, if a US taxpayer conducted a foreign business, the general rule was that income earned by a foreign corporation did not have to be recognised as taxable in the US until that foreign corporation paid a dividend to its US shareholders, Eichel says.

Even under prior law, however, there were exceptions to the ability to defer US tax on income earned through a foreign corporation. For example, certain types of income earned by foreign subsidiaries (including most royalties for the use of offshore patents, trademarks and other IP owned by foreign corporations) would be taxed regardless of whether the income was actually distributed in the form of a dividend.

While that income tended to mostly be passive income, such as rents, royalties, dividends or interest income, it also applied to certain types of income that arose from inter-company transactions where “transfer pricing games” might be played, according to Eichel. The aim of this would be to keep the income outside the US, where that income was either not taxed at all in the source country or taxed at a materially lower rate than in the US.

The new US tax regime is designed to bring that income into the US as earned and not allow it to be deferred, says Eichel.