Written by: Fernando Lopez, Partner, International Tax
Intellectual Property As a Driver of Revenue
Let’s consider a set of U.S. based businesses that are currently going through their initial formative period. Each business offers a promising product or service that will be marketed across the U.S. and abroad. For an important subset of these businesses, their ability to compete in the marketplace is powered by investments in proprietary intellectual property (“IP”), including patents, copyrights, trademarks, trade secrets, and other unique process or know-how. This carefully nurtured IP - beginning with a shining brand name – should be aimed at two key objectives:
- Distinguishing the company’s products, services and/or delivery methods from those of its competitors
- Driving more customers to buy the company’s products or services, thereby increasing market share.
Seen in this way, a company’s IP should be recognized as a unique and vibrant asset that drives market success and revenue. And continued R&D investment should help extend the life of this IP so that it can continue to positively distinguishing the company’s products or services for years to come.
How Intellectual Property Should Be Held For Tax & Cash Optimization
Where a business chooses to own and exploit its IP via a U.S. partnership, each partner will be subject to U.S. graduated income rates (max of 37%). The same U.S. tax consequences hold where a business operates as an S corporation. Conversely, if the business operates as a regular “C” corporation, the IP income will be taxed at the U.S. corporate rate of 21% and the remainder will be taxed an additional 23.8% when distributed to individual partners. If the objective is to repatriate earnings to individual owners immediately, the U.S. partnership model is slightly more tax efficient than a corporation.
But what if the objective is not to repatriate earnings, but to reinvest into the continued growth of the vibrant business? In this case, the use of a flowthrough entity (partnership or S corporation) should be avoided. The reason for this is that the flowthrough model triggers all levels of U.S. tax immediately, typically at the highest U.S. personal tax rate of 37 percent (plus state tax of 6 to 7 percent). These days, owners of such passthrough businesses find themselves in the position of having to borrow at high interest rates to finance the growth of the business when they could avoid such borrowing costs by adopting a structure that permits the owners to free up excess cash by deferring U.S. personal tax.
The following is an overview of two key options for leveraging company IP in a manner that will minimize tax cost and maximize cash flow for reinvestment into the business.
Tax Benefits of Owing IP in the U.S.
The first option is to operate the business out of a U.S. corporation that also owns and exploits relevant IP. In many cases, a partnership or S- corporation can be converted into a regular corporation without much difficulty. Once the U.S. corporation is set up, its earnings should be taxed at the federal rate of 21% (plus applicable state tax). Shareholders of the U.S. company can defer U.S. federal and state tax until they receive a dividend. By using a corporation, a company is in a position to reinvest 70 to 80 percent of its total earnings after having paid the U.S corporate federal and state tax. In comparison, if a U.S. partnership or S corporation is used to operate the business, owners of such passthrough entities will only be able to reinvest 55% of total earnings after paying their individual federal and state tax. Ideally, the U.S. corporate structure should also permit the business to qualify for the U.S. export incentive known as FDII (“Federal Derived Intangible Income”). If the FDII requirements are met, an exporting business can benefit from a reduced corporate rate of 13.125% on income generated from the export of products or services, as well as from licensing IP to foreign persons. This reduced U.S. export rate is not available for corporations.
However, there are several potential traps to consider when deciding to keep all IP in the U.S. First, although U.S. corporate rates are at a historic low, a further drop in such rates is unlikely. In fact, the most likely scenario is that U.S. rates begin to increase to pay off massive government debt. Second, even though the current U.S. corporate rate is at a historic low, it is not as low as can be found in numerous offshore jurisdictions that are commonly used to place intellectual property. Third, there will often be savvy competitors in the market that will be able to compete on price more effectively because they develop an efficient IP ownership structure that minimizes costs.
Tax Benefits of Owning IP Outside the U.S.
In light of the above considerations, for those business owners with plans to exploit their IP in a substantial way outside the U.S., strong considerations should be given to moving the IP exploitation rights to a low-tax offshore jurisdiction outside the U.S. If the IP is moved to a foreign company that is subject to a corporate tax rate higher than 13.125%, U.S. tax can be completely deferred and the remaining after-tax income can be fully reinvested into the business. If the IP is moved to a foreign tax haven, the U.S. will immediately tax the foreign company earnings as a deemed dividend, but at a low effective rate of only 10.5 percent. In most cases, such earnings can be distributed to the U.S. parent corporations as a cash dividend without any further U.S. tax consequences.
One key issue in considering the placement of IP outside the U.S. is the potential U.S. “exit tax” that is triggered on the transfer of U.S. IP to a foreign entity. In general, IP that has been commercially exploited outside the US will typically incur a higher exit tax than IP that has not been commercially exploited. In fact, the sooner IP is moved outside the U.S. after its creation, the less likelihood that a material exit tax will be triggered. The ideal situation is setting up a foreign entity to develop and exploit the IP from the beginning. This avoids any U.S. exit tax and permits the exploitation of the IP at an exceptionally low rate that will enhance a company’s competitive position.
For new or existing companies that wish to maximize the amount of earnings available for investing into further growth of the business, dramatic cash flow improvements can be realized by using a domestic or foreign corporation.