Tightening The Tax Screws On International IP Structures

For many years prudent international tax planning for multinational enterprises has included structures designed to minimize global taxes by developing or holding intangible property (IP) in foreign subsidiaries located in low-tax jurisdictions. As the IP is exploited, royalty revenue recognized by the owner of the IP (either directly or embedded within products sold) results in little or no income tax due to special tax regimes or low statutory tax rates in the country where the IP is held. This allows for low-taxed earnings to be accumulated and redeployed for further growth of the business. Now, a confluence of pressures threatens to diminish or eliminate the attractive tax implications of such IP holding structures. These include recently finalized U.S. tax regulations, standards adopted under Organisation for Economic Co-operation and Development (OECD) global initiatives, and the prospects of significant international tax reform.

Final Regulations Modify Active Royalties Exception

For U.S. multinationals, recently finalized regulations strengthened certain anti-deferral provisions relevant to cross-border licensing structures. In particular, The U.S. Treasury and the IRS modified the active royalties exception under the so-called Subpart F rules of the U.S. Tax Code (see Treasury Decision 9792). Under Subpart F, certain types of passive income classified as "foreign personal holding company income" (including royalties) that are received by a controlled foreign corporation (CFC) are taxable to the direct or indirect U.S. shareholders of the CFC without regard to whether the income is distributed by the CFC.

As an exception to foreign personal holding company income, however, royalties derived in the active conduct of a trade or business and which are received from an unrelated person will not be taxed currently under the Subpart F rules. This exception can be satisfied either through an active development test or an active marketing test. Falling within the exception can be crucial for U.S. tax planning because IP held in a low-tax CFC subsidiary is tax beneficial only if the U.S. shareholder can defer the recognition of U.S. income with respect to royalties received by the CFC.

The recently finalized regulations modify the definition of foreign personal holding company income under Treas. Reg. § 1.954-2 so that a CFC must perform the relevant activities required to satisfy the active development test through its own officers or staff...