STRATEGIC INSIGHTS You can save a boatload of tax money shipping your IP overseas.
By Stephanie McRae
June 17, 2004 | Intellectual property (IP) rights, especially patents, are often the principal source of value and revenue for biotechnology companies. To lessen the tax liability generated from their IP rights, biotechs often consider whether to place IP in a holding company outside the United States. This can lead to big potential savings on federal and state taxes, but there are risks, too. Here's what to look at before leaping.
A U.S.-based biotech would typically form a subsidiary intellectual property holding company (IPHC) in a foreign jurisdiction that is tax-free, and then transfer its IP rights to this offshore subsidiary. The offshore IPHC would then grant a license to the U.S. parent company or other third parties to use the IP in exchange for royalty payments. The goal, of course, is to minimize the U.S. parent company's tax burden and limit taxation on IP-generated revenue.
Not only should the royalties generated by this offshore subsidiary be tax-free, but also generally the profits made abroad aren't taxable in the United States until they've been repatriated. U.S. companies that use offshore IPHCs to exploit IP may even be able to deduct license-royalty payments as expenses.
Sound enticing? Well, first determine whether the tax savings associated with an offshore IPHC apply to your particular circumstances, and whether these savings sufficiently offset costs. Forming an offshore IPHC can be expensive and impose additional administrative responsibilities. IPHCs may only be cost-effective or relevant for companies with substantial current or future income, or pre-existing offshore business activities such as foreign sales or licenses to foreign business partners.
If your company won't generate enough revenue to cover costs, an offshore subsidiary may be more burdensome than beneficial.
But if your revenue does justify the expense, then explore which foreign jurisdictions best suit your needs. Naturally, you'll want to thoroughly review the status of any tax treaties between a potential foreign jurisdiction and the United States. Also consider what type of business entity you want: wholly owned subsidiary or a division; hybrid or a joint venture. And have a clear picture of the IPHC's functions. Will it serve as a regional sales office, provide product or manufacturing support, or conduct research and development?
Once you've answered these threshold questions and decided to proceed, four additional factors will affect tax benefits: timing, structure, royalties, and location.
Timing. Establish the holding company early in the development of your intellectual property — before the IP has significant value (presumably prior to commercialization). You will be taxed on the transfer of the IP offshore, so you'll want to soften the bite. Consider seeking the advice of a valuation expert to help substantiate the IP's value.
Structure. Many U.S.-based biotechs form a subsidiary that conducts its own business activities, which helps keep it off the radar of U.S. tax authorities. The subsidiary should keep separate records and accounts, and operate as a separate organization. In addition, it may need to conduct operational activities such as hiring employees, doing R&D, and managing and commercializing the IP.
Royalties. Once IP rights are transferred, you usually pay royalties to the holding company in exchange for use of the IP. When you deduct these royalties from your company's taxable income, the royalty rates become subject to scrutiny by U.S. taxing authorities. To lessen such scrutiny, establish a royalty rate as if it were between third parties in an arm's-length transaction. Due to the complexities of setting royalty rates for IP — especially noncommercialized IP — seek advice from an independent expert.
Location. Depending on which foreign jurisdiction you choose, your subsidiary may be required to withhold a percentage of the royalty payments for tax purposes. This is why you want to choose a tax-haven country with a favorable U.S. tax treaty — or no treaty at all. Jurisdictions with no U.S. tax treaties and no corporate tax infrastructure may appear the best choice, but in this post-Enron business climate, U.S. tax authorities have heightened inspection of offshore IPHCs. Thus, choose your location with caution and with the understanding that the structure of and transactions with an IPHC could be challenged.
An IPHC strategy, if properly planned and conducted, can yield big tax savings under the right circumstances. But thoroughly explore beforehand whether it makes sense for your company. And if you make the move, take care to structure the IPHC legitimately to limit scrutiny from the U.S. taxman.
Stephanie McRae is a partner with Jennings, Strouss & Salmon, in Phoenix, Ariz., and is chair of the Biotechnology & Life Sciences Group. E-mail: email@example.com.
ILLUSTRATION BY LUC MELANSON