Tax planning for intellectual property after tax reform
There’s no question that U.S. taxation of intellectual property has become amazingly more complex after the Tax Cuts and Jobs Act. For many of our clients, especially those in the technology and life science sectors, global intellectual property represents not only the most significant component of their economic value but also a significant portion of their global tax expense. Proper global IP planning remains a terrifically valuable tool for them to remain competitive in the global marketplace.
For multinational taxpayers, significant changes related to U.S. IP taxation include a new tax on global intangible income earned by foreign subsidiaries and a new tax incentive for certain foreign-derived income earned by U.S. corporations. The TCJA also reduced the corporate tax rate to 21 percent from the previous 35 percent. This in theory makes the U.S. a more competitive location in which to operate and own IP than in the recent past. In practice, it may be an entirely different outcome.
The U.S. has historically had a worldwide system of taxation where income earned by a U.S. taxpayer is subject to U.S. tax regardless of where it is earned globally. Most countries do not tax worldwide income but instead have what is called a territorial system that only taxes residents on the income earned in the country. It was originally envisioned that the TCJA would move the U.S. toward a territorial system to better align with international taxation norms and to make the U.S. a more attractive place for multinational businesses to operate. However, the reality is the U.S. still taxes worldwide corporate income unlike all other major countries.
Historically, the comparatively higher U.S. corporate income tax rate combined with its system of worldwide taxation made IP structuring an integral part of almost all U.S. multinational tax planning strategies. Multinationals would transfer certain IP rights, via sale or license, to lower-taxed jurisdictions outside the U.S. Within these structures, IP-generated income was taxed at the lower local tax rate and, provided compliance was maintained with U.S. anti-deferral rules such as Subpart F, this income was not taxed in the U.S. until the cash was actually repatriated to the U.S. parent. These IP planning structures, coupled with indefinite offshore reinvestment outside the U.S., served to both lower overall effective tax rates and increase its global cash flow. The TCJA removed certain provisions that supported these structures and added completely new rules forcing U.S. multinationals to reexamine their approach to global IP tax planning.
Significant Changes to the U.S. IP Taxation Regime
The TCJA’s substance and breadth touch IP taxation in a number of ways. The three most significant pieces of IP taxation that we see impacting global taxpayers are the Global Low-Taxed Income Tax (GILTI) regime, the Foreign Derived Intangible Income (FDII) regime and new provisions that increase the costs of moving U.S. IP offshore. The GILTI and FDII rules were enacted together to form a “carrot and stick” approach to U.S. taxation of global IP. In theory, the GILTI rules seek to tax IP located outside the U.S., while the FDII rules incentivize U.S. IP ownership.
GILTI, aka “the stick,” creates a new U.S. tax at the U.S. shareholder level on the excess of a foreign subsidiary’s net income deemed return on their tangible assets. Basically, the GILTI inclusion is calculated as the excess of a U.S. shareholder’s “net CFC tested income” over its “net deemed tangible income return.” This deemed tangible income return is 10 percent of the CFC’s “qualified business asset investment” (QBAI), generally defined as income-producing tangible assets reduced by certain interest expense. GILTI subjects U.S. CFC shareholders to a minimum U.S. tax if the CFC’s foreign income is taxed at a rate below 13.125 percent. GILTI generally results in a 10.5 percent minimum U.S. tax, which can vary based on any foreign taxes paid.
The upshot is U.S. taxes rise for U.S. taxpayers with foreign subsidiaries that have high income attributable to IP ownership and negligible tangible assets. Even one with an untrained eye can see the bullseye on U.S. taxpayers with offshore IP structures.
FDII is intended to be “the carrot” inducing taxpayers to locate, or relocate, global IP in the U.S. In addition to reducing the overall U.S. corporate tax rate to 21 percent, the TCJA lowered the U.S. tax rate on foreign income generated by U.S.-based IP to 13.125 percent. Rather than simply applying to licensed or patented IP, FDII is defined as certain income derived in connection with property that is sold, leased, licensed or otherwise exchanged or disposed by the U.S. taxpayer to a non-U.S. person for a foreign use. It also applies to services provided by the U.S. taxpayer to a person located outside the U.S. Thus, all U.S.-based exporters of goods or services would receive a new and significant U.S. tax incentive.
Another less publicized part of the TCJA makes it more expensive to transfer certain IP outside the U.S. Previously, an offshore transfer of U.S.-based patents, know-how, copyrights, trademarks, franchises, licenses and similar IP triggered a taxable deemed royalty to the U.S. transferor, resulting in an imputed tax expense. The TCJA adds goodwill, going concern value and workforce in place to the list of U.S.-based IP that is punitively subject to the deemed royalty provisions, creating an additional tax cost for moving IP offshore — another significant disincentive for U.S. taxpayers to create an offshore IP structure.
How Should U.S. Multinationals Perform Post-TCJA IP Tax Planning?
Even with new rules reducing U.S. income taxes for IP income below the already reduced 21 percent U.S. corporate tax rate, U.S. multinational corporations generally do not benefit from repatriating offshore IP back to the U.S. In addition to existing anti-deferral rules such as Subpart F, the U.S. tax rate on GILTI income from offshore is approximately 10.5 percent. IP that is U.S. based is taxed at a higher 13.125 percent under the FDII regime.
Another important factor that is much less publicized is that FDII is simply not likely to be a reliable long-term planning tool to justify a tax planning strategy of siting global IP in the U.S. In addition to likely being a future target for U.S. legislators seeking offsets to non-revenue neutral legislation, FDII may also end up being classified as an illegal trade subsidy by the World Trade Organization following in the well-worn footprints of the old and similarly structured Domestic International Sales Corporation (DISC) and Foreign International Sales Corporation (FISC) regimes. Any U.S. taxpayer who bases their global tax strategy on FDII benefits assumes the risks of its ultimate dilution or demise.
Most foreign countries have successfully modeled their local IP transfer rules after those of the U.S. This means that any appreciated offshore IP repatriated back to the U.S. will be treated as having been sold to the U.S. from a local tax perspective and will be taxed as such. The result is a potentially significant local country exit tax that must be economically modeled into any IP re-shoring analysis. Also, as noted above, the costs of transferring U.S. IP offshore have risen, which means the IP will be more expensive to move out of the U.S. if the FDII benefits are diluted or eventually go away.
IP tax planning is complex and is influenced by a number of factors longer than those above. At the same time, it remains the most important tax issue for investors, board leadership and related stakeholders of technology, software, life sciences and other U.S. taxpayers with crown jewel IP. These taxpayers must continue to seek the optimum IP tax-planning structure and, perhaps more importantly, continue to refresh that strategy as global IP-related tax laws continue to evolve.