Untaxing your Intellectual Property
01 March, 2013
Every business that possesses intellectual property should look at whether it is feasible to reduce its tax burden through international tax planning.
Intellectual Property (IP) is the term given to the legal rights attached to certain assets which are not tangible. Examples are: ideas, concepts, inventions, written works.
The inventor or originator of an idea possesses the legal right to exclusively use, enjoy and benefit from the idea.
However, one could develop the idea for someone else under a contractual arrangement where the other person becomes the owner. This is the default arrangement for instance when employees develop something for their employer during the course of their work.
The owner can sell the idea or license its use. A license is, simply stated, the permission to do something the granting party (the licensor) has the right to otherwise prohibit. As the original owner, the licensor can attach certain terms and conditions to this right to use the IP.
Because intellectual property is intangible it is easier to move these assets offshore, in order to benefit from a low or no tax regimes then a trading or manufacturing operation.
As intangible property cannot be geographically pinpointed in any one jurisdiction (given its very nature), the situs of the IP would normally be where the owner of the IP is resident.
Once the IP is held offshore it can be licensed to the, typically onshore-, jurisdictions where the IP is used. In order to maximise the tax advantages, several aspects need to be taken into account:
- The IP should be sold to the low-tax jurisdiction when the value is still low. Once IP has shown a consistent history of profits the value will be considerable, so ideally the transfer is done well before that.
- Ideally, the low-tax jurisdiction has the professional infrastructure to develop the IP further, further enhancing future royalty income streams.
- The payments of the licensee to the licensor in the low tax jurisdiction should be subject to low or no withholding tax. A few countries such as Cyprus and the Netherlands do not have withholding taxes on royalties but most do. In those cases the tax treaty network of the licensor country becomes important, because if the incoming royalty payments are covered by a tax treaty the withholding taxes that the licensee country levies will normally be reduced.Within the EU, the Interest and Royalties Directive is relevant where the owner licenses IP to an associated company in the EU. The Directive eliminates withholding taxes on these payments within the EU. If direct royalty payments to a zero-tax jurisdiction would attract withholding taxes then a company in an intermediate jurisdiction that does have access relevant tax treaties, or the EU directive, can be interposed.
It is essential that this intermediate country does not have any withholding taxes on royalties itself. This company would receive a license from the IP-owner located in the zero-tax jurisdiction and license it to the users.
Cyprus is ideal as an intermediate jurisdiction because it has no withholding taxes, is part of the EU, allows a thin spread on royalty income, and advance tax rulings can be obtained.
- The controlled foreign corporation (CFC) legislation in force in the country of residence of the owners of the licensor company needs to be checked. CFC legislation normally entails that passive income arising in a low or no tax jurisdiction is taxed as it arises in the country of residence of the owners. Royalty income is often considered passive income, although an exception would be when it is actively managed an developed. If CFC legislation is in place and the royalty income is qualified as passive then transferring the IP offshore doesnt gain any tax advantages.
Googles and Starbucks use of licensing structures to reduce their otherwise substantial tax burden has been well publicised. What is not well known is that small to mid-sized entrepreneurs, which are our bread and butter, have access to the same tax reduction strategies. Your company might have IP, or be in the process of developing IP, while you do not even realise this!
The main categories of IP are the following:
- Copyright: This is typically granted for the creation of a literary or artistic work: eg. books, song-texts, movies, software. Generally there is no requirement to register a copyright.
- Patent: This is granted to the creator of an invention which generally has some form of commercial or industrial purpose. A detailed application is required to be made for a patent in order to be granted, with the application examined critically to ensure that the creation is a novel invention. A patent can be registered on a national level or, in Europe, on a pan-European level through the European Patent Office.
- Trademark: This is a distinctive sign, logo or symbol used which distinguishes a firms product or services. Although in some countries rights are attached to unregistered trademarks, it would be advisable to register a trademark to ensure protection against infringements. Trademarks can be registered domestically or, within Europe, through the European Trademark Organisation.
There are lesser known forms of IP as well, which can equally effectively be transferred to low tax jurisdictions, eg:
- Designs, models, and plans
- Secret formulas or processes, trade secrets.
Most businesses, even smaller ones, will possess one or some of the above. In case the IP is potentially of use to third parties who would be willing to pay for access to it, but the profits are still uncertain, then it could be viable to transfer it offshore. If it needs further development then this can be subcontracted to the original creator or third parties.
Which jurisdiction is best to use to hold the IP?
If an offshore jurisdiction is feasible as owner then Dubai would fit the bill. Ideally the low-tax jurisdiction has the professional infrastructure to develop the IP further, further enhancing future royalty income streams.
Besides, transferring the IP to a zero tax jurisdictions with a substantial professional infrastructure and access to a diverse and highly skilled work force in a word class city as Dubai in the UAE will make much more economic sense then , say, transferring it to any far-off traditional offshore jurisdiction. Whatever the structure is, non-tax reasons are all important nowadays.
Cyprus has the advantages outlined above as an intermediate jurisdiction for royalty routing. However, since 2012 it has also been a top jurisdiction for holding IP. The reason is that it now exempts royalty income for 80%. Considering that the tax rate is 10% this means an effective tax burden of 2%.
If access to the EU Royalty and Interest Directive is necessary then Cyprus is the best option in any case, and now, depending on the amounts involved there is no need for another company to hold the IP and sublicense it to the Cyprus company.
The advantage of taxing the income with 10% and then exempting it for 80%, rather than just taxing it with 2% is that what this achieves that in most countries the income accruing to the company will not be considered CFC income, considering that a minimum tax rate of 10% is normally the threshold required to be met in order not to consider the income low-taxed, which would then bring it into the remit of CFC legislation, and render the structuring useless from a tax perspective.
In short, no tax is still the best if it is feasible and if an intermediate jurisdiction can be avoided, for the simple reason that compliance costs and absence of VAT make it more cost effective, but otherwise for European entrepreneurs Cyprus fits most bills.
It is essential not to take short-cuts when transferring IP offshore. Particularly when the future royalty streams are significant, tax authorities will like to see how these were arrived at and why they are justified.
It is essential that you therefore document the value of the IP before you transfer it to a more benign jurisdiction. We can do an initial assessment for you and arrange for valuation of the IP and preparation of the proper documentation and set up the appropriate structure for you. Contact www.freemontgroup.com
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