UK: Getting Intangibles Right - Tax Aligned Strategies for Intangibles and How to Get There

Last Updated: 4 May 2010
Article by Deloitte Tax Group

Most Read Contributor in UK, August 2017

Intangibles are hot right now. Tax authorities globally are reviewing their approach to intangibles while the economic crisis is bringing intangibles up the tax agenda – prompting authorities to become far less tolerant of errors and providing tax-savvy groups with a window of opportunity in which to put depressed asset values to work. Whichever way you look at it, says David Norton, tax partner, ignoring intangibles is no longer an option.

Where tax legislation is concerned, some powerful cross-currents are at play – with authorities fighting to retain taxing rights to existing intangibles whilst implementing regimes, such as patent boxes, to attract new ones. The movement of IP overseas is being challenged with legislative initiatives such as the German Relocation of Functions rules and proposals in both the UK and US to tax 'excess profits' earned by overseas subsidiaries on IP transferred from the home country.

The challenge for multinationals is to ensure that they appreciate both the opportunities and the risks within the group strategy for the ownership and exploitation of intangibles. Increasingly this requires a high level of engagement with key tax authorities around the world. Failing to take control of this agenda could lead to some painful tax exposures, and also some missed opportunities.

If it sounds like serious stuff, it's because there's a lot at stake. Intangibles – which include registered IP such as patents and trademarks and also unpatented technology, know-how, brands and customer contracts – are extremely powerful, invisible, mobile drivers of profits. They may involve upfront expenditure and commercial risk in development. These costs, and the additional profits that they may generate will be key components in estimating the future Effective Tax Rate (ETR). Let intangible value build up in the wrong place, such as a high tax sales company, and you face fiscal barriers to future tax planning and in responding to commercial developments.

Even if tax planning is not an objective, getting intangibles right is going to be important. Authorities are becoming considerably less forgiving of errors and omissions so failing to identify and value IP can be an expensive oversight. Intangibles now rank first as a source of enquiry in UK transfer pricing audits, and other countries are displaying considerable interest too.

Intangibles are a major driver of value in a business. However, many companies have yet to identify and measure them, or ensure that they are optimised from a tax perspective.

Yet there are several relatively straightforward techniques – for example, creating an IP licensing vehicle or turning an IP-rich company into a trading hub – which can add significant recurring income to the P&L, permanently boosting earnings per share and adding cash to the balance sheet each year. So what does this involve?

Short-term Opportunities to Re-Engineer Intangibles

There are a variety of approaches to re-engineer intangibles for tax optimisation, the application of which depends on the company's business structure, tax traits and specific intangible assets. Short-term transfer pricing strategies can be derived from:

  • Product Development. A US-based company needed significant capital to develop a new product. But rather than fund it all locally, it entered into a cost-sharing arrangement with a Swiss subsidiary operating under an R&D tax incentive regime and they shared the global revenues that the IP generated. This reduced the tax charge of the group overall.
  • Changes in Prices Because of the Downturn. Companies may ask themselves whether transfer prices reflect a current arms-length price for embedded intangible assets and whether royalty rates should be revisited in the event that volumes or profits are down.
  • Subtle Changes in the Business Giving Rise to New Intangibles. This may include the gradual coalescence of the global brand, the transition of group companies onto a single software platform, or the emergence of a uniform set of best practice procedures. A UK-parented group, for instance, had not previously focused on the power of its brand to generate sales. It licensed the trademarks in their current state to a Swiss subsidiary, which invested time and money in regenerating the brand. The Swiss subsidiary then licensed all group companies to use the refreshed brand. Given the lower Swiss tax rate, this produced an overall tax saving.
  • Mergers and Acquisitions. A company in the online marketing sector was acquired by a group that planned investment in both the brand and the technology. Before doing so, it set up an IP company in a favourable tax location to acquire the existing IP from the other group companies and license the newly developed IP back to them. The marketing intangibles, such as trademarks and domain names, were sold to the IP company outright and the technology was licensed to the IP company for future development. This solution works on two levels: it aligns the group's IP management with the centralised decision-making and also provides long-term tax efficiency by recognising the profits in the low tax IP entity.

These strategies are rarely a one off exercise since intangibles are constantly evolving. Many industries – electronics, software, pharmaceuticals and manufacturing – are fast-moving and the group's IP strategy and related transfer pricing policy need to reflect this.

Longer-Term Strategies

The best-managed companies often give a good deal of thought to the consequences of IP development in order to avoid unclear ownership of intangibles, weaknesses in legal protection and high compliance costs. One group company may take responsibility for owning and managing the IP created within the business. If that company resides in a low tax jurisdiction then the group tax burden will fall so businesses often consider that route.

Sometimes the superior or specialised quality of the legal protection offered by certain high tax jurisdictions, such as California, will decide the issue – but even then, a share of the economic ownership of the IP may rest with an affiliated company in a lower tax environment, be it a specific statutory regime like the Belgian, Lux or Dutch IP Boxes or a Central Entrepreneur in Switzerland.

A tax-efficient IP licensing vehicle can be part of a longer-term approach to IP tax planning, using either a licensing arrangement or a franchise model. A franchise arrangement can be an effective way to limit the profitability of subsidiaries in high tax countries and minimise withholding taxes where IP is supplied to local operating subsidiaries in combination with services, access to products or even a complete business model.

The franchise model fits well when the local subsidiaries operate a standardised business model with limited local variation. In contrast, under a licensing structure the licensee undertakes the commercial exploitation of the IP and commits time, enterprise and capital to bring the IP to bear in the market. The licensee has more business risk and contributes more to the value of the business than the franchisee who gains a ready template of a successful business model. The franchisee is less profitable and therefore attracts less tax.

Another longer-term strategy is to embed the return from the IP in the trading margin of the company by turning the IP owner into a trading hub. A UK technology/electronics company, for instance, acquired a US business with a complementary technology. This business owned a Singapore subsidiary that had obtained an attractive tax ruling from the authorities. The Singapore subsidiary was allowed to manage the production and sales of the UK technology company's considerable existing Asian production. The IP rights to the products of the UK and US groups were therefore held in Singapore giving rise to significant tax savings.

An alternative to a licensing solution, in some cases, is to consolidate the production of goods and IP ownership in a low tax jurisdiction so that profits arise from sales revenues rather than royalties. Such structures are generally less vulnerable to attack under Controlled Foreign Company tax provisions.

Sometimes the process of relocating IP profits and tax costs can be surprisingly simple. An online gaming business wished to move its trademarks and goodwill out of a high tax environment. On investigation, it was discovered that whilst the IP had been developed offshore and was still owned there, it was now being used onshore. A relatively simple transfer of function was required instead of a relocation of IP, and an expensive exit charge was avoided.

Exit charges are often problematic because they can represent a cash cost at the outset, may be difficult to quantify and might not be recouped from subsequent tax savings in an uncertain world. Occasionally the facts will permit a tax deferral, or there may be tax losses available to provide shelter; transfer pricing techniques can be used to spread the cost; improved valuation techniques have reduced uncertainty. Modelling the accounting consequences and the impact on the ETR can also help to determine whether the exit charge is a price worth paying.

Keeping a Step Ahead

Intangibles are still not always well understood, but knowledge is deepening as their importance is being recognised. Armed with a deeper understanding of the intangibles in the business, and with the current tax risks and opportunities being managed and optimised, groups are increasingly well positioned to develop forward-looking tax aligned strategies.

In many boardrooms, the penny is starting to drop that tax is a necessary early consideration in business decisions which affect the creation, development or disposal of IP. But adequate resources are critical to ensure the effectiveness of the strategy. It can be hard to find and manage these resources as it typically requires co-ordinated cross-functional teamwork between Finance (including Tax, Treasury and Accounts), Legal, HR and Operations. Tax leaders need strong project management skills to pull it off.

Intangibles promise to test corporate tax functions and their relationships with the authorities for some time to come. But some groups are getting it right, and are making substantial tax savings in the process. It pays to be at the top of your game now.

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.

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