Recently, there have been significant discussions regarding government crackdowns on tax havens related to multinational organizations moving profits offshore. From a tax perspective, any financial planning that involves moving profits offshore by multinational organizations is justifiable if the corresponding functions, assets, and risks borne to earn these profits are also shifted offshore. The incentive to minimize taxes by shifting these functions, assets, and risks to low tax jurisdictions is to be expected. After all, the world economy has become increasingly globalized and the need to minimize after-tax profits is not only advantageous to improving corporate profits, but is also necessary in order to stay competitive. While implementing such a framework is a long and complex process, if done correctly, it is beneficial for all involved.
II. How and Why Opportunities for Migrating Intangibles Exist
As previously stated, firms have an incentive to structure their internal affairs in such a way that profits are migrated to tax jurisdictions imposing lower tax rates. Tax authorities around the world have begun to target these structures and as a result, multinational companies need to ensure that documentation is sufficient to support the migration of valuable intangibles and the profits they drive.
Three methods commonly used to migrate these intangibles assets include:
- cost sharing agreements;
- buy-in payments; and
- sale of intangibles.
Cost Sharing Agreements (CSA)
CSA's are one of the most effective ways to migrate intangibles. A CSA is an agreement between two parties, which states the contributions each party will make in terms of costs expended, and the associated benefits that will be returned for such an investment. In order for a CSA to be effective, it must:
- make business and economic sense;
- include upfront and well-documented terms;
- indicate costs incurred by each party relative to the reasonability of expected profits; and
- if providing entry, exit, or termination of a CSA, involve arm's length prices.
Failure on the part of companies to draft effective cost sharing arrangements serves only to increase audit risk. In this respect, great care must be taken to ensure that CSAs make both economic and business sense.
CSA's are often found in industries that require substantial research and development ("R&D") activities, such as the pharmaceutical industry. In such an industry, some of the costs associated with performing the R&D activities are performed in low tax jurisdictions. Given that these related parties pay for a portion of the R&D, they are entitled to exploit an interest in the intellectual property that was developed. As a result, no royalty on the CSA will be required to be paid.
Buy-in/buy-out payments are another way to migrate intangible income offshore. Buy-in payments require a party in a related party setting to "buy-in" to a cost sharing agreement or "buy-out" of one. In order to do so, the buy-in/buy-out payments must be payments that represent arm's length prices. Buy-in options are very valuable given they provide many opportunities with associated risks, which must be reflected in the price. Subsidiaries must pay fair market value to buy-in. Failure to do so will increase the firm's audit risk for an unfavourable audit.
Suppose a drug company is attempting to produce a drug that will effectively treat a disease. Additionally, the company wants to mitigate its tax liability by shifting the costs and therefore the profits that are generated from these costs, to a low tax jurisdiction. Also assume that the pharmaceutical drug company has passed stage two of clinical testing. One way the drug company can achieve tax savings is by having a subsidiary in a low tax country buy into the R&D activity. By doing so, the subsidiary has mitigated its risk of failure by buying into a promising process. Given the subsidiary is paying through a CSA, it will not have to pay a royalty for the right to sell the drug in its jurisdiction. As well, the profits associated with the subsidiary's contribution will be taxed only in the low tax jurisdiction.
However, given the subsidiary has bought into a process that will likely result in success, it should pay an adequate sum of money that reflects this fact. If the subsidiary does not pay "market value" for such a promising process, the question arises, and rightfully so, of why the parent company would have shared such a process when it has not been adequately compensated for it. Tax authorities can never successfully challenge the buy-in/buy-out payment as long as the price represents an "arm's length" standard.
Sale of Intangibles
The final approach I will discuss regarding the migration of intangibles is through the sale of intangibles. Intangibles are a large source of profits and selling them to offshore affiliates will assure that profits that are generated from these assets are taxed in these offshore jurisdictions. It is important, as in the other two cases above, to ensure that this is done at arm's length prices. Determining the arm's length sale price of intangibles is very complicated. The most common way of determining the price at which this should be transacted involves the Comparable Uncontrolled Price ("CUP") methodology. This requires that we find external comparables that involve the sale of very similar intangibles, which is often difficult to achieve.
Migrating intangibles to low tax jurisdictions is beneficial in order to minimize corporate taxes that multinationals pay. However the migrating process should be done such that the functions, assets and risks borne are found in the tax jurisdiction where the intangibles are migrated. Migrating the intangibles in such a way that the transfer represents arm's length prices is important in order to defend against a potential audit by tax authorities
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.