Intellectual Property Holding Companies Can Create Significant Tax Savings and Protect Valuable Assets
By: KARA K. FAIRBAIRN
April 2003
Over the last decade or so, many businesses generating significant revenue from intellectual property such as patents, copyrights, trade names and marks, software and know-how (the IP Assets) have organized intellectual property holding companies (IPHCs) to reduce federal and state taxes while separating valuable IP Assets from other corporate liabilities. Recently, states have started to aggressively challenge this tactic. However, substantial state and federal tax savings can still be realized if IPHCs are organized and operated correctly.
Structure of an IPHC
The structure of an IPHC is fairly simple. The parent corporation typically creates a corporate subsidiary in a state or in a foreign country where little or no taxes are imposed (e.g., Delaware, Nevada, Bahamas, Cayman Islands, etc.). IP Assets are created by or transferred to the subsidiary. The subsidiary enters into license agreements under which the parent corporation and non-related corporations agree to pay the IPHC royalties in exchange for an exclusive or non-exclusive right to use the IP Assets.
Tax Advantages of an IPHC
Since most IPHCs are organized in jurisdictions with no income tax, the royalties received by the IPHC are generally tax-free. In addition, the parent corporation that paid the royalty typically can deduct the payment as a deductible expense, thereby reducing the parent's income or franchise tax liability. In some circumstances, IPHCs can make tax-free dividend distributions or loans to the parent corporation. To illustrate the state tax benefits from an IPHC, consider the following:
Example: A parent company is incorporated in a state with a 10% corporate income tax rate. As illustrated below, a parent having gross sales income of $50 million has a state income tax liability of $2 million. However, if the parent corporation creates an IPHC in a state with a 0% corporate income tax rate, the total amount of state taxes is reduced to $1.6 million, thereby saving the parent corporation $400,000 in taxes. Since the jurisdiction where the IPHC is created does not impose any income tax, the $4 million of royalties it received are state income tax-free.
Tax Analysis without an IPHC
 |
Parent State | |
| Parent gross sales income | $50,000,000 |
|
| Deductions | (30,000,000) |
|
-------------------------------- |
||
| Taxable Income | $20,000,000 |
|
| State Tax Rate | x %10 |
|
-------------------------------- |
||
| State Tax Liability | $2,000,000 |
Tax Analysis using an IPHC
|
Parent State | |
| Parent gross sales income | $50,000,000 |
|
| Deductions* | (34,000,000) |
|
-------------------------------- |
||
| Taxable Income | $16,000,000 |
|
| State Tax Rate | x %10 |
|
-------------------------------- |
||
| State Tax Due | $1,600,000 |
|
| IPHC State | ||
| Royalty Income | $4,000,000 |
|
| State tax rate | 0% |
|
-------------------------------- |
||
| State tax due | $0 |
|
| * includes royalty expense ($50,000,000 x 8% royalty rate) = $4,000,000 | ||
| State Tax Savings Using IPHC = $400,000 | ||
Besides saving state income taxes, some IPHCs can save federal income taxes if they are created as offshore corporations in no-tax jurisdictions such as the Bahamas or Cayman Islands. In the above example, if the IPHC was created in the Bahamas and met certain other criteria under the Internal Revenue Code, the parent corporation would have saved an additional $1.36 million in federal income taxes. However, for an offshore IPHC to be effective for U.S. income tax purposes, the IPHC may have to be engaged in its own offshore business activities. This may necessitate transferring some of the parent corporation's intellectual property assets and business operations (e.g., research and development) to the IPHC to be performed outside the United States.
Attacks on IPHC Structures
With increased budget deficits, some states are starting to challenge IPHC structures. These states typically attempt to tax some of the revenue earned by corporations incorporated outside the state that do no business in the state under an affiliated tax nexus theory. Such states have argued IPHCs have sufficient nexus or contacts with the parent corporation state so that the state has jurisdiction to impose a corporate tax directly on the IPHC. According to this theory, the IPHC "purposefully directed its activities toward the [parent corporation state's] economic forum . by licensing intangibles for use in the state and receiving income in exchange for their use." Other states have attempted to indirectly tax the holding company by denying a parent's deduction for royalties paid to its IPHC. Some of the states that are starting to challenge these IPHC structures are South Carolina, Massachusetts, New Mexico, Illinois, Indiana and New York.
Protecting an IPHC From Challenge
With the right planning, a parent corporation can help insulate its IPHC structure from a state's attack. The most important step is to make sure the IPHC engages in significant business activity apart from merely licensing IP back to the parent. As a general rule, IPHCs with a real business purpose and with continuous business activity are more likely to withstand a challenge by the IRS or a state's taxing authority. It is the "paper" or "sham" companies that are most vulnerable to attack.
The type of business activities the IPHC should conduct will vary according to industry and market conditions; but in general, it should conduct its own administrative, legal and commercial activities with its own employees. In some situations, it is permissible for an employee to work for both the parent corporation and the IPHC. However, a cost-sharing salary arrangement should be considered to document the legal relationship of the employee with each separate corporation. Some of the business activities the IPHC should consider performing itself are IP registrations, defending and enforcing infringement of its IP Assets, R&D, licensing IP Assets to third parties, market research and commercialization of the product attributable to the IP Asset.
Is an IPHC Right for your Company?
Whether an IPHC is right for your company will depend on a number of factors, including your company's management structure and the states and/or the foreign jurisdictions where your company sells its products. Many companies have found that setting up and operating an IPHC has resulted in substantial tax savings, increased efficiency in managing IP assets, and separation of those assets from other company liabilities. In many situations - especially if an offshore company will own the IP assets - it is most beneficial to establish the IPHC before the IP assets are legally created. The attorneys at Fredrikson & Byron can help you quickly assess the risk and benefit of an IPHC for your company's operations and help organize such IPHC structures.