How the Deemed Royalty Regime for Intellectual Property Operates in Cross-Border Transactions

Whenever a U.S. person decides to establish a business abroad that will be conducted by a foreign corporation, it will be necessary to capitalize the foreign corporation with a transfer of cash and other property in exchange for its stock. When appreciated property, such as equipment or intangible property rights (e.g., foreign patents, knowhow and trademarks), is transferred to a foreign corporation, gain will often be realized by the U.S. person. This gain will be recognized and subject to U.S. tax unless one of the tax-free-exchange provisions of the Internal Revenue Code applies. The imposition of U.S. tax on a transfer of appreciated property to a foreign corporation is a substantial deterrent in many cases. Accordingly, tax planning is necessary to ensure that the transaction is structured in a way to minimize or eliminate the initial U.S. tax burden associated with transfer.

If a U.S. corporation is liquidated and its assets are distributed to foreign shareholders, U.S. tax will be imposed on the gain realized by the distributing corporation except to the extent that a tax-free-exchange provision provides otherwise.

If the stock or assets of a U.S. corporation are acquired by a foreign corporation in exchange for stock of the foreign corporation in exchange for stock of the foreign corporation, or if, conversely, a foreign corporation is acquired for stock of a U.S. corporation, gain realized by U.S. shareholders and the U.S. corporation will be subject to tax, except to the extent that the gain is sheltered by a tax-free-exchange provision.

Under the Internal Revenue Code, gain or loss realized in exchanges of property in connection with a variety of transactions involving only U.S. corporations will go unrecognized if the requirements of the applicable tax-free-exchange provisions are met. Such transactions include transfers of property to a controlled corporation, liquidation of a controlled subsidiary into its corporate parent and certain corporate reorganizations.

The basic roadblock for anyone involved in cross-border transfer or merger transactions planning is Internal Revenue Code Section 367. Section 367 requires U.S. persons transferring appreciated property to a foreign corporation to recognize a gain on the transfer. Section 367 stands sentinel to ensure that (with certain exceptions), a U.S. tax liability (sometimes called a “toll charge”) is imposed when property with unappreciation is transferred beyond U.S. taxing jurisdiction. The character and source of the gain produced by the outbound toll charge is determined as if the transferor had sold the property to the transferee in a taxable transaction. For example, if the outbound transfer involves inventory that the transferor purchased for resale, any resulting taxable gain would be soured under the title passage rule applicable to inventory sales in general. In addition, the U.S. transferor must recapture and recognize as ordinary income any depreciation deductions claimed on depreciable property that was used in the United States. Finally, the U.S. transfer’s basis in any shares received in an outbound transfer equals the U.S. transferor’s basis in the property transferred, increased by the amount of gain recognized on the transfer.

Deemed Royalty for Intangible Property

For a number of tax and business reasons, U.S. companies transfer intellectual property to foreign corporations. Congress has enacted special rules to tax the transfer of intellectual property offshore. The market value of patents, trademarks, and other intangibles often is highly uncertain, due to the inherent uniqueness of these assets. This uncertainty significantly weakens the deterrent effect of a one-time toll charge imposed at the time of the transfer, since new technologies and products can turn out to be far more successful than originally anticipated. As a consequence, a specific deemed royalty regime for intangibles treats an outbound transfer of an intangible as a sale in return for a series of royalty payments that are received annually over the useful life of the intangible and that are contingent on the productivity, use, or disposition of the intangible. This income is characterized as royalty income that is foreign source income.

Below, please see Illustration 1 which provides an example of the deemed royalty rules.

Illustration 1.

Pear (a domestic corporation) incorporates Jamsung, a manufacturing subsidiary incorporated in a foreign country by transferring a patent to Jamsung in exchange for all of Jamsung’s shares. Pear had a zero basis in the patent because it had deducted the related research and development expenditures as these expenditures were incurred.

Ignoring Internal Revenue Code Section 367(d), Pear’s outbound transfer to Jamsung is not subject to U.S. tax because it is part of a tax-free incorporation transaction. However, Section 367(d) recharacterizes the transaction as a sale in return for the foreign-source royalty payments received annually over the life of the patent.

The deemed royalty regime applies to a U.S. person’s contribution of intangible property to a foreign corporation in exchange for shares of the foreign corporation, where immediately after the exchange the U.S. person controls the foreign corporation. The deemed royalty regime also applies to a U.S. person’s transfer of intangible property to a foreign corporation as part of a corporate reorganization. For purposes of the deemed royalty regime, intangible property includes any patent, invention, formula, process, design, pattern, know-how, copyright, literary, musical, or artistic composition, trademark, trade name, brand name, franchise, license, contract, estimate, customer list, technical data, or other similar item. See IRC Section 367(d)(1). However, a copyright, literary, musical, or artistic composition transferred by a taxpayer whose personal efforts created the property is exempted from the deemed royalty requirement and can be transferred to a foreign corporation tax-free. See Treas. Reg. Section 1.367(a)-1(d)(5) and IRC Section 1221(a)(3).

Below, please see Illustration 2 which provides an example of an exception deemed royalty rules.

Illustration 2.

Bark Dog is an artist with many hits. His music catalog is worth millions of dollars. Bark Dog writes and composes all of his music. Bark Dog wants to transfer the rights to all his music to Phony, to Phony Music, a Japanese foreign corporation in a tax-free transaction. Since Bark Dog wrote and composed all his music, Bark Dog can potentially transfer the rights to his music to Phony Music in a tax free transaction.

But Compare

Cherry Ice is a successful rapper. Cherry Ice told all of his adoring fans that he grew up in a rough neighborhood in Miami, Florida and this was the inspiration for his music.   In fact, Cherry Ice grew up in Beverly Hills, California and he purchased all of his music from Garvey Weinstein, a former music mogul who is now in jail for tax evasion. Since Garvey Weinstein needed money for his legal defense, Cherry Ice bought the rights to dozens of songs at bargain prices. Because of Cherry Ice’s success, the value of these songs have skyrocketed. Unfortunately for Cherry Ice, a former girl has told Cherry Ice she will expose him as a fraud to his fans. Cherry Ice decides to transfer the rights to his music to Phony Music in a tax-free exchange before the value of his music plummets. Since Cherry Ice did not create his music, this transaction will not be exempted from the deemed royalty requirements.

The deemed royalty must be an arm’s-length amount, computed in accordance with the provisions of Internal Revenue Code Section 482 and its regulations. The deemed royalty amount also must be “commensurate with the income attributable to the intangible.” See IRC Section 367(d)(2)(A). In other words, the royalty amounts must reflect the actual profit experience realized subsequent to the outbound transfer. To meet this requirement, the royalty amount must be adjusted annually to reflect any unanticipated changes in the income actually generated by the intangible. See Treas. Reg. Section 1.482-4(f)(2)(i). For example, if a new patent leads to a product that turns out to be far more successful than was expected at the time the patent was transferred, the amount of the deemed royalty must reflect the unanticipated profit.

Under certain circumstances, a U.S. transferor may prefer having the transfer of intellectual property or an intangible to a foreign corporation taxed entirely at the time of the transfer as a taxable sale for its fair market value at a fixed price, rather than taxed as royalties over the life of the intangible. The regulations permit an election to treat the transfer of an intangible as a sale at its fair market value if certain requirements are met. If this election is made, the individual or corporation includes as ordinary gross income in the year of transfer the difference between the fair market value of the intangible on the date of the transfer and its adjusted basis.

The regulations permit this deemed sale election in three situations. First, the individual or entity may elect if the intangible is an operating intangible. An operating intangible is an intangible of a type not normally licensed or transferred in transactions between unrelated parties for consideration contingent on use of the intangible. Examples include surveys, long-term contracts or supply contracts, customer lists, and studies.

Second, an individual or corporate entity may elect deemed sale treatment if the transfer is legally required by the government in the country of incorporation of the transferred corporation or is compelled by a genuine threat of immediate expropriation by such government.

Third, the individual or corporate entity may elect deemed sale treatment if:

1. The individual or corporation transferred the intangible to the foreign corporation within three months of the organization of that corporation as part of the original plan of capitalization of the corporation;
2. Immediately after the transfer of the intangible, the individual or business owns at least 40 percent and not more than 60 percent of the total voting power and total value of the transferred foreign corporation’s stock;
3. immediately after the transfer of the intangible, foreign persons unrelated to the U.S. transferor own at least 40 percent of the total voting power and total value of the transferee corporation stock;
4. Intangibles constitute at least 50 percent of the fair market market value of property transferred by the U.S. person to the foreign corporation; and
5. The transferred intangible will be used in the active conduct of a trade or business outside the United States and will not be used for manufacturer or sale of products in or for use or consumption in the United States.
   
   As an alternative to these rules, a U.S. transferor may prefer to enter into a license agreement with the transferred foreign corporation providing for actual royalties to the U.S. transferor for use of the intangible. Actual royalties will be subject to Internal Revenue Code Section 482, which generally authorizes the Internal Revenue Service (“IRS”) to reallocate income, deductions, credits, and allowances between related parties to reflect what the arrangement would have been if those parties had been dealing as independent parties at arm’s length. Although the U.S. tax treatment of royalties may be the same, the foreign tax consequences may differ. By licensing an intangible, the foreign transferee can ordinarily deduct the actual royalty payment for foreign tax purposes, whereas the deemed royalty amount is generally not deductible.
   
   Anthony Diosdi is international tax attorney at Diosdi & Liu, LLP. As an international tax attorney, Anthony Diosdi provides international tax advice to closely held entities and publicly traded corporations. Anthony Diosdi also represents closely held entities and publicly traded corporations in IRS examinations. Anthony Diosdi is a member of the California and Florida bars. Diosdi & Liu, LLP has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com. 

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.