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The International
Taxation of Goodwill
and Other Intangibles
Willard B. Taylor
Attorney Advertising
Prior results do not guarantee a similar outcome.
Copyright ©2011 Sullivan & Cromwell LLP
What are intangibles for tax
purposes?
• Intangible assets are generally divided between
• Intangibles, such as patents or intellectual property, that are
legally owned or controlled by an enterprise and can be
transferred separately from any other asset, and
• “Residual” intangibles, such as goodwill or going concern
value, that ordinarily can be transferred only as part of the
transfer of an entire business
• There are also “intangible” liabilities or responsibilities
that may be transferred or assumed, such as market,
supply, warranty or financial risks
• For example, the risk that a customer will default or that a
product is defective and its repair is covered by a warranty
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Copyright ©2011 Sullivan & Cromwell LLP
Why are the tax rules for intangibles
important?
• Huge growth in multinational trade and also in the percentage of
business assets represented by intangibles
• This is the reason for the OECD intangibles project
announced in December 2010
• Also, growth in the extent to which multinationals purposefully
locate intangible assets and liabilities in low-tax countries
• i.e., countries in which the rate is lower than in the home
country or the country of use
• And, finally, the rules and definitions are in flux – thus, e.g., the
OECD intangibles project, the on-going revisions to the U.S.
regulations, legislative proposals and court decisions
• Uncertainty
with
restructurings”
respect
to
so-called
“business
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What are the tax issues?
• In the case of intangibles that are owned or controlled and are
transferable separately, such as patents or other intellectual
property, as opposed to goodwill
• What is the jurisdictional basis for taxing income from
intangibles?
• Country of the owner’s residence? Or also country of use (or
“source”)?
• In cross-border related-party transaction (e.g., a trademark
license), how is the amount of income determined for tax
purposes?
• By the use of the “arm’s length” standard? By “formulary”
apportionment?
• And if there is disagreement between tax jurisdictions, how is
double taxation avoided?
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What are the tax issues?
Continued
• And at least in the U.S., the tax issues also include
• The application of subpart F (or anti-deferral rules) to income
derived from intangibles by foreign subsidiaries of a U.S.
parent
• Is the subsidiary’s income currently taxed in the U.S. ?
• Or is the tax deferred until the cash is repatriated to the parent?
• And when is there a repatriation?
• The application of the foreign tax credit rules, particularly in
the case of royalties
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What are the tax issues?
Continued
• In the case of residual intangibles, such as “goodwill”, or going
concern value, which is generally not transferable except as part of
an entire business
• In the U.S., the recognition of gain when a business of a U.S.
corporation is transferred to a foreign corporation in a
“reorganization” or otherwise
• Gain may also be recognized when ownership of a transferable
intangible is transferred to a foreign corporation in a
reorganization or like transaction
• Likewise, transfers of intangibles by foreign corporations that are
“successors” in certain expatriation transactions result in the
recognition of gain or income
• That is, where the former shareholders of the U.S. corporation own
60% or more by value of the expatriated foreign corporation
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What are the tax issues?
Continued
• How should so-called “business restructurings” be
treated?
• In such a transaction, for example, an enterprise may be
stripped of responsibilities and its income correspondingly
reduced (e.g., it becomes a “contract” manufacturer or
distributor)
Before
After
Foreign
Parent
Foreign
Parent
U.S. mfg.
subsidiary
U.S. “contract” mfg.
subsidiary
U.S. and Foreign
distribution
subsidiaries
Debt
Low-taxed Foreign
subsidiary
• business and
distribution risks
• intangible property
“Low-risk”
distribution
subsidiaries
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Jurisdictional basis for taxation
• In the U.S. and other OECD countries the income is
taxed to the owner (or owners) of the intangible property
– it is “portfolio” not “business” income
A Country
parent
Parent taxed in A Country
B Country withholding on the royalty
and B Country subsidiary allowed a
deduction
royalty
license
B Country subsidiary
• Jurisdiction given to the owner’s country of residence by
Article 12 of the OECD Model Treaty
• Provides that income for the use of intangible property is
exempt from source country tax if the owner is a resident of
the other country
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Jurisdictional basis for taxation
Continued
• Article 12
• It does not apply to all payments –
• just those made for the use of specified intangibles,* and so it
would not cover payments for distribution rights, for the
development of designs that do not yet exist, or for services
• Endorsement and like fees paid to athletes and entertainers is an ongoing issue – for services or the use of property?
• Article 12 seems to have no bearing on goodwill, going concern
value, workforce-in-place and the like
*
Payments for the “…use of, or the right to use, any copyright of literary, artistic or scientific work
including cinematogaph[ic] films, any patent, trade mark, design or model, plan, secret formula or
process, or for information concerning industrial commercial or scientific experience”
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Jurisdictional basis for taxation
Continued
• Article 12 is not accepted in all treaties – e.g.,
• U.S.-India treaty allows 15-20% withholding tax on royalties
and “fees for included services”, and the U.S.-Canadian treaty
allows a 10% withholding tax and exempts altogether
payments for motion pictures and for reproductions used in
television
• For the Article 12 exemption to apply, the recipient of the
income must be the “beneficial” owner
• in U.S. treaties this is supplemented by limitation on benefit
articles and by rules with respect to payments made to hybrid
entities
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Jurisdictional basis for taxation
Continued
• Income that falls outside of Article 12 would be dealt
with in the OECD Model Treaty by
• the permanent establishment articles (Articles 5 and 7),
• the capital gains article (Article 13), or
• in the case of athletes and entertainers, by the separate treaty
article that applies to their compensation (Article 17)
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“Simple” transfer pricing
• If the owner and the user (or users) of a transferable
intangible asset are related (or “associated”) and in
different countries, there is a transfer pricing issue
• Is the owner’s compensation too little? Or too much?
Parent
royalty
license
Foreign Subsidiary
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U.S. transfer pricing regulations
• The OECD transfer pricing guidelines and the U.S.
regulations have consistently used the arm’s length
standard to determine the way income is divided
• “a taxpayer dealing at arm’s length with an uncontrolled
taxpayer”
• and thus they
apportionment
have
consistently
rejected
formulary
• But the absence of comparables is a serious problem in
applying the arm’s length standard
• and the increasing emphasis on “profit split” methods may
signal a gradual move towards something like formulary
apportionment
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U.S. transfer pricing regulations
Continued
• Under U.S. regulations, there is a broad definition of
intangibles – in addition to patents, copyrights,
trademarks and the like, includes methods, programs,
systems, procedures, studies, and so on
• but only if the item has substantial value independent of the
services of individual persons
• unclear whether intangibles in the transfer pricing context
include goodwill, going concern value or workforce-in-place
• The owner of an intangible is the person who is the legal
owner under local or contract law or, failing that, the
person with “control”
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U.S. transfer pricing regulations
Continued
• Absent “sufficiently comparable” transactions, use the
“best” method to determine what is comparable – the
“most reliable measure” of an arm’s length result
• Methods are the
• comparable uncontrolled transaction,
• comparable profits,
• profit split methods, and
• an “unspecified” method – a method that is not listed but which
provides the most reliable measure
• Regulations contemplate cost-sharing arrangements in which
related parties agree in advance to share costs of developing,
and the benefits of, intangibles
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U.S. transfer pricing regulations
Continued
• Apart from regulations, the U.S. has an advance pricing
agreement program which seeks to resolve the choice of
a method in advance
• the results, however, are not public
• Services are dealt with separately by “controlled” service
regulations, which have their own “methods” for
determining what is at arm’s length
• generally, except for routine services, they reject the cost-plus
method
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OECD transfer pricing guidelines
• OECD has transfer pricing “guidelines” – not rules, as such – with
respect to intangibles
• Revised and reissued in July 2010, but with an
announcement shortly thereafter that there would likely be a
project on intangibles to further update that part of the
guidelines
• U.S. and OECD rules converge in many ways – e.g., the arm’s length
standard, emphasis on comparability, permitted methods
• The U.S. would say it is in this regard the leader
• But there are important differences – e.g.,
• The deference given by the OECD guidelines to the terms
of contracts between related parties and the separate rules
on “business restructurings”
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Income tax treaties
• OECD Model Treaty (Article 9) and U.S. treaties allow
the tax authorities to adjust profits – to “re-write the
accounts of the enterprises” – where transactions are not
at arm’s length
• thus the U.S. regulations, as well as what is contemplated by
the OECD transfer pricing guidelines, are consistent with
treaty obligations
• If there is an adjustment by one state, and it results in
double taxation, the other state is to make an
appropriate adjustment, but it need do so only if agrees
with the adjustment
• If not, the only resort is to the mutual agreement or
competent authority provision of the treaty (Article 25 in the
case of the OECD Model)
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Do the current transfer pricing, subpart F and
related foreign tax credit rules “work”?
• At least in the U.S., there is a seeming consensus that the
transfer pricing, subpart F and foreign tax credit rules
are, from the tax administration’s point of view, “broken”
• If so, intangibles are a major reason –
• because of their mobility, the difficulty under the arm’s length
approach of finding comparables, and the lack of clear
definitions and rules
• Together with the “stripping” of income through deductible
payments, this has led to the accumulation of a huge amount
of untaxed cash in low- or no-tax foreign subsidiaries of U.S.
corporations – more than $1 trillion
• Resulting in the so-called “lock out” effect
• And the rules with respect to the circumstances in which the cash
will be treated as repatriated to the U.S. parent, and taxed, are
also imperfect
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Do the current transfer pricing, subpart F
and related foreign tax credit rules
“work”?
Continued
• Much less focus on the effect on “inward” investment by
foreign corporations where
• There are no subpart F rules to “back up” the transfer pricing
rules
• Although
• there are rules on the deductibility of interest paid to (or on a
loan guaranteed by) a related foreign person, and
• there may in the future be rules on reinsurance premiums paid to
related foreign reinsurers
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Cross-border business restructuring
• How to treat transfers of intangible assets and liabilities
in “business restructurings” or otherwise
• Is the definition of an intangible for this purpose broader
(e.g., does it include work-force-in place, goodwill and going
concern value)?
Before
After
Foreign
Parent
Foreign
Parent
U.S. mfg.
subsidiary
U.S. “contract” mfg.
subsidiary
U.S. and Foreign
distribution
subsidiaries
“Low-risk”
distribution
subsidiaries
Low-taxed Foreign
subsidiary
• business and
distribution risks
• intangible property
Debt
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Cross-border business restructuring
Continued
• In these transactions, the financial and other “intangible”
liabilities or responsibilities of an enterprise are assumed
by a related person and the payments to the enterprise
for what it does are correspondingly reduced
• Should there be a transfer pricing adjustment, or a
taxable disposition of goodwill, so long as each
transaction is at arm’s length?
• i.e., so long as the liabilities assumed do in value offset the
reduction in profitability of the U.S. manufacturing
subsidiary?
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Other issues – subpart F and foreign
tax credit rules
• Is the income of the foreign subsidiary currently taxable
in the U.S.?
• Subpart F rules currently tax passive income of a foreign
subsidiary (a “controlled foreign corporation”), including
royalties, but many exceptions – e.g.,
• active business royalties
• royalties and certain other payments made by one CFC to
another,
• active financing income
• Ability to use the check the box regulations to create fictitious
payments
• Additionally, the foreign tax credit rules may operate to
eliminate U.S. tax on untaxed foreign income – in particular,
royalties
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Other issues – subpart F and foreign
tax credit rules
Continued
• Thus, the subpart F rules do not adequately “back up”
transfer pricing rules
• leading some to say that the present U.S. system is more
biased towards multinationals than an exemption, or
territorial, system in which no deduction would be allowed
for foreign losses or for expenses related to exempt income
• A dividend, which includes “investments” in United
States property, would be income to the U.S. parent, with
a foreign tax credit for foreign income taxes on the
repatriated earnings
• But there have been “indirect” repatriations – e.g., the use of
cash to buy U.S. parent stock for use in an acquisition –
which have avoided the repatriation rules
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Other issues – treaties and subpart F, tax
credit and outbound transfer rules
• How do income tax treaties fit into these rules?
• U.S. treaties, like the OECD Model, generally do not constrain
• subpart F and like rules that currently tax income of foreign
corporations to their shareholders, or
• rules that require the recognition of gain or income on crossborder transfers of intangible property
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Copyright ©2011 Sullivan & Cromwell LLP
What is wrong with the U.S. rules
and is there a solution?
• Move from a residence-based worldwide system to a
territorial/exemption system in which deductions
attributable to foreign income would not be allowed?
• Or just move seriously towards worldwide system, i.e.,
eliminate any exclusions from current taxation of the income
of a foreign subsidiary?
• Amend the transfer pricing guidelines and rules?
• Move towards profit split/apportionment methods?
would that be worse?
Or
• Tighten the controlled foreign corporation and foreign
tax credit rules and rely on those rules as a backstop to
transfer pricing?
• What about “inward” investment?
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What is wrong with the U.S. rules
and is there a solution?
Continued
• U.S. Administration’s fiscal 2012 revenue proposals
• Currently tax, under subpart F, “excess income” of a lowtaxed controlled foreign corporation from intangibles
transferred directly or indirectly by a related U.S. person
• “Excess income” would be income in excess of net income plus a
percentage markup
• Transfers would include transfers in cost-sharing agreements, as
well as licenses
• “Clarify” that
• Intangibles for all purposes include workforce in place, goodwill
and going concern value
• Value may be based on the prices or profits that would be
realized in a realistic alternative to the controlled transaction
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What is wrong with the U.S. rules
and is there a solution?
Continued
• U.S. Administration’s fiscal 2012 revenue proposals
• Defer the deduction for interest expenses attributable to
untaxed foreign income
• Determine the foreign tax credit on a pooling basis
• In the case of inward investment
• Further interest deductibility, but only in the case of
expatriated entities, i.e., corporations that were formerly U.S.
incorporated
• Disallow a deduction for certain untaxed reinsurance
premiums paid to foreign affiliates
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Costs of developing
• Like many countries, the U.S. provides incentives to
locate the development of intangibles in the U.S.
including
• A research and development tax credit, which the
Administration proposes to simplify, increase and make
permanent
• Expense allocation rules that in effect mitigate the impact on
the foreign tax credit of domestic research and development
costs
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