Many entrepreneurs begin their business with a focus on becoming successful in their current markets and eventually expanding across state lines. As time goes on, they may test their business concept across international borders. Many U.S. companies often head first to Canada and then move on to Europe as a springboard to a global business. From a U.S. tax perspective, these companies soon learn that the profits can either be taxed immediately in the U.S., or taxed when repatriated, depending on the structure they choose. For those who prefer deferral, it is often the long-term goal to use earnings generated internationally to fund growth outside of the U.S.
Although deferral is allowed, it is not just a matter of incorporating in another country and replicating there. As an example, let’s assume that a U.S. company designs and manufactures products. After creating a sales office in Europe and having some success, they decide to open a manufacturing facility in Europe. From a U.S. tax perspective, the company has likely developed intangible property (IP) by way of manufacturing and technology know-how or trade secrets. When this IP is used outside of the U.S. by a related party, the tax authorities will require the U.S. company to be compensated for the use of the IP in another taxing jurisdiction.
IP can be found in service businesses as well. For example, when an entrepreneur develops a process that differentiates them from the competition or builds a well-known brand, they have created IP. If the company takes the IP across borders, the U.S. tax authorities (IRS) will expect compensation for the IP use.
Importance of Advanced Planning
The above examples result in a surprisingly large portion of income being taxed in the U.S. prior to the company’s intention. However, planning can be used to minimize this over the long term. For example, a U.S. company can transfer the rights to use the IP outside of the U.S. to a foreign subsidiary. As a result, the income for the use of the IP outside of the U.S. will accrue to the subsidiary, going forward, and not to the U.S. company. Given that the corporate tax rate outside of the U.S. is generally lower, this results in increased cash flow. This concept is commonly referred to as an IP migration.
The initial transfer of IP is subject to taxation to the extent gain is recognized, which it often is. If a company is in a start-up phase, the income may be offset by net operating losses. A net present value calculation will likely show that the current taxation on the transfer is less than tax on a payment to the U.S. for the useful life of the IP.
As you can surmise, the younger the IP, the lower the estimated tax value, because it may not be proven or otherwise valuable in other markets. This presents an opportunity for start-up companies that have a global vision. The challenge becomes determining when benefits of an IP migration outweigh the cost of such a structure. The costs of such a structure include legal, accounting, valuation or transfer pricing, and having substance in a foreign jurisdiction to manage the use and development of the IP.
If the U.S. and/or the foreign subsidiary continue to develop IP, it is important for them to enter into an agreement to split the cost and rights to use the further development of the IP in their respective jurisdictions. This concept is commonly referred to as “cost sharing” and prevents new IP from being developed by one jurisdiction and an additional transfer needed to obtain the desired result.