Using an Offshore Subsidiary to Hold IP
In many corporate groups, particularly in the internet age, the real wealth lies in the IP-patents, trademarks, computer software.
Often, it is quite tempting to look for ways to move such IP offshore, both for tax and other reasons. Stories of IP-based companies such as Google and Apple generating profits in tax havens provide intriguing examples of the possibilities.
In an ideal situation, income derived from exploiting such IP could be earned and accumulated in Forco with little or no Canadian income tax applying.
What are the key considerations that have to be considered when planning such structures?
FAPI
Income generated from IP in the form of licensing fees will be a type of income from property, which will be FAPI, unless certain conditions are met. If the income is FAPI, generally, transferring the IP to Forco will not achieve too much, at least in the short run, since such income will be taxed in Canco’s hands.
There are generally three ways that income from the exploitation of IP will be considered active business income, rather than FAPI:
- Forco’s business is to earn licensing fees from the IP, and it employs more than five full-time employees in the business[1],
- Forco earns licensing fees/royalties from another foreign affiliate of Canco, and those payments are deducted by the paying affiliate against offshore active business income [2], or
- Forco does not earn royalties or licensing fees at all, but uses the IP to generate other types of active business income, such as profits from selling software or other property that it sells, or services.
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Transfer-pricing
If the IP is currently in Canco, any transfer by Canco of such IP to Forco will need to be at fair market value. There is no tax-free “rollover” allowed on transferring IP to a foreign corporation.
If this creates a big gain in Canco, Canco can license the IP to Forco. Here again, a fair mark value fee must be charged-obviously, this will only make sense if it is believed that Forco can earn income from exploiting the IP that exceed the royalties paid to Canco.
For obvious reason, it will always make sense to transfer the IP from Canco to Forco at as early a stage as possible.
Another approach would be to have the IP owned by Forco from inception. Sometimes this will mean that Forco would pay Canco a reasonable fee for developing it on its behalf.
Accessing Treaty Networks
In the event that Forco will be charging licensing fees to customers in various jurisdictions, careful thought should be given to the choice of residency for Forco, in terms of minimizing any withholding taxes payable.
One needs to study the locations of the main customers and try to find a jurisdiction that has a favourable tax treaty with as many of those locations as possible.
In addition, if Forco is resident in an EU member country, charges to residents of other EU member countries are often exempt from withholding taxes.
In the next article in this series, I will discuss some basic issues in relation to offshore tax planning and the use of Forco as a financing affiliate.
Endnotes
[1] See paragraph “(c)” of “investment business” definition in subsection 95(1)-note that employees of other related foreign affiliates can usually also be counted
[2] Subparagraph 95(2)(a)(ii)
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