In recent years, the world has been hearing a lot more about Intellectual Property (IP), trademarks, patents, copyrights, etc. Still, the thing is that it is not the creation of a few years back, and companies holding IPs have been established forever and making vast amounts of profits.
Interestingly, this subject is the relation between IP Holding Companies (IPHC) and taxes since there are always speculations about tax avoidance schemes when establishing IPHC. That’s what we are going to be addressing in this article.
Why is there a connection between IPHCs and tax avoidance schemes?
One of the many things that all companies have in common is their aspiration to gain the maximum profit possible. One way of doing so is by choosing tax-friendly rules or known as “tax havens.”
When talking about IPHCs in particular, Delaware and Michigan are known to be two of the best jurisdictions to hold IP since they don’t impose taxes on royalties. Here is where the interesting story begins.
Knowing this fact, most of the companies owning IP do the following: they establish an operating company in a given field to operate and establish another parent or sister company whose main objective is to hold the IP in a domain that does not impose taxes on royalties, like Delaware for instance, and then, enters into a license agreement, granting the operating company the right to use such IP in return of royalties.
Royalties that are to be paid by the operating company will be deducted from the latter’s profit, and that will be subject to taxation by the state where it is established. In this way, the IPHC will receive the royalties tax-free.
Now, why is this considered as a potential tax avoidance scheme?
Looking back to many lawsuits that took place at a particular time, we realize that:
Certain companies established IPHC to transfer the royalties from the operating company to the IPHC and avoid paying taxes. They hold them for a while and then transfer them back to the operating company. In this manner, the royalties were returned to the operating company as dividends, without paying a dollar for taxes.
Besides, all matters related to IP management and taking adequate steps to protect it were done by the operating company.
As a result, it was crystal clear that this was all a sham to avoid paying taxes by the operating company and that the IPHC had no real “economic substance.”
In this regard, it is essential to mention that states were made aware of this scheme and filed lawsuits that they won, proving that the IPHCs had no “economic substance.” Therefore, the operating companies had to pay taxes on the royalties and could not get away clean.
On the other hand, companies that proved that they had economic substance and business purpose when it comes to their IPHCs won in their battles with the states and did not pay taxes on their royalties.
Another critical point to talk about is how states managed to tax out-of-state IPHCs by implementing the economic nexus clause and/or the due process clause. This is further to be discussed in the following article.
Because of all the mentioned above, many states have become more and more fierce when it comes to IPHCs and impose strict rules. They always keep an eye out as if they are ready to catch them in action at any second given.
