Dear Friends
Many Clients are unaware of the value of their Intellectual Property Rights (IPRs), and even perhaps the varied nature of these rights. The commercial benefits that can be derived from structuring these rights into a dedicated IP holding company can be enormously rewarding, not only in ring fencing these assets, but in achieving low taxed income from inter-group and third party licensing arrangements. This month’s article is a thorough review of the issues involved in restructuring IPRs in an IP holding company, and has been written by an old friend and colleague, Kelvin King of Valuation Consulting Co Ltd, www.valuationconsultingco.com. Kelvin is a renowned expert in valuing IP rights and understanding their nature, and I am sure the article will be a fascinating insight for all our readers.
My apologies for the late arrival of this March Newsletter until the first working day in April, but I wanted to wait until the provisions of the Finance Bill had been published in the UK following this year’s Budget. Most of our readers will know about the proposed reduction in the highest rate of personal income tax from 50% to 45%, and the further reductions in corporation tax envisaged. But by far the most talked about proposal was the increase in stamp duty land tax (SDLT) from 5% to 7% for properties in excess of £2mn, and to a swingeing 15% for properties acquired by ‘non-natural’ persons such as companies (whether they be UK or non-UK resident). There is also the much talked about ‘mansion tax’ which has potentially morphed into an annual tax on non-resident, ‘non-natural’ persons who own UK property, as well as the taxation of any gains in respect of real estate owned by such companies. These provisions, taken together, could have a dramatic impact on the high end UK property market.
For many years now, non-domiciled individuals have owned UK residential real estate through an offshore corporate vehicle, often owned by an offshore trust, primarily in order to avoid having a UK situs asset on their death which would incur 40% inheritance tax. HMRC has tried to attack these structures on the grounds that the non-domiciled individual, if resident in the UK and living in the property, was in fact a ‘shadow director’ of the offshore company able to determine how the offshore company managed the property. As a shadow director, the individual would have been an ‘officer’ of the company and therefore subject to employment related benefits in kind if living rent free in the property. The principal private residence exemption available to such individuals would also not be relevant if the property were not private owned but owned through a corporate vehicle. However, this was not too much of a problem because the offshore company would not have been subject to capital gains tax on the sale of the property under UK unilateral legislation.
However, now comes George’s coup de grace. Assume that an existing offshore BVI company owned by a Trust has bought a personal home for £3mn eight years ago and it is now worth £10mn. The £7mn pregnant gain may be subject to capital gains tax from April 2013 if there are no re-basing provisions to subject only the excess gain over the value at April 2013 to CGT. Thus, the £7mn pregnant gain to date may be effectively subject to a ‘retrospective’ tax unless the company sells the property prior to April 2013. The obvious way to avoid such a tax charge is to sell the property for £10mn to the relevant individual to preserve the tax free gain, with the individual owing the offshore company £10mn to minimise the IHT consequences of owning property direct in the UK. But here comes the clever part of George’s strategy – such a sale would incur the new 7% SDLT rate, ie £700,000. Taking into account the number of high end properties owned by offshore companies, and the huge increase in their value over the past decade, the SDLT windfall could be very considerable indeed.
Subject to discussions during the consultation period, we will need to consider how to restructure property ownership without an effective disposal by way of transfer of the legal ownership of the property, which would be subject to SDLT. This is a topic that I will be reviewing at a real estate tax conference to be held at Gray’s Inn on Tuesday, 15 May 2012 (please click here for further information) and again (with more details having emerged) at the ITSAPT November 2012 conference to be held at the Landmark Hotel London, details of which will be sent to you in the April newsletter.
Easter will soon be upon us, so I wish you all a happy Easter/Passover/relaxing break – unfortunately the good weather is fast disappearing but as always in the UK we will keep our fingers crossed.
Restructuring Intellectual Property Rights in an IP holding company – Kelvin King, Valuation Consulting Co Ltd www.valuationconsultingco.com
Introduction
As intellectual property is acknowledged as the dominant asset of most companies, it also becomes the primary collateral. Hardly a day passes without headlines concerning large corporations planning to use IP structures for their intellectual property and enhancing the value of their IPRs by consolidating intellectual property rights. As reported by Business Week, Google Inc cut its taxes by $3.1bn in the three years to 2010 “using a technique that moves most of its foreign profits through Ireland and the Netherlands to Bermuda”. “It is remarkable that Google’s possible effective rate is that low, we know this company operates throughout the world mostly in high-tax countries where the average corporate rate is well over 20%”” said Martin A Sullivan, a tax economist who has worked for US Treasury Department.
As recently reported by Ocean Tomo an analysis of S&P 500 illustrates the great reversal; in 1975. 17% of company value was analysed and reported to be of an intangible asset nature; in 2010 80% is the figure for intangible assets.
The wealth creating assets of the future are the non-physical assets, and they are easily now capable of separate identification and valuation. One of the most important advances in wealth creation is in fact to introduce significant commercial IP strategies and optimise IP value. Every business has intellectual property rights and supporting intangible assets even if they are only in the name under which it trades. Just as importantly, every business uses other people’s intellectual property.
However while many companies are aware they have IP, few exploit it to its fullest effect. This is particularly so outside of the (generally well advised) Fortune 1000 and Eurotop 500 companies but the strategy is equally valuable for smaller quoted companies and SMEs.
Intellectual property are those assets whose essential characteristics are derived from the Legal System, e.g. Registered rights; Patents, Trade Marks, Registered Designs and unregistered rights; confidential information (equitable and contract), passing-off (common law), Design Right and Copyright. Miscellaneous assets include: Performance Rights, Image Rights, Moral Rights, Database Rights, Malicious Falsehood (common law), Plant Variety Rights. And of course one of the most significant worldwide wealth creators, a brand, which asset is populated by numerous of these assets as driver of ‘its’ value.
Helpfully International Financial Reporting Standards particularly led by Purchase Accounting and IFRS 3, mean that many intangible assets that would previously have been subsumed within goodwill must be separately identified and valued. In this process the Regulators and Accounting bodies have necessarily understood and agree that all of the following assets (including those mentioned above) are capable of separate recognition and valuation in a credible and robust fashion. Many may be surprised by the numerous categories which are as follows:
Marketing related – intangible assets are typically those assets associated with the market or promotion of a company’s products or services (trademarks, brands, trade names, trade dress, internet domain names, newspaper mastheads, non-compete agreements).
Customer related – intangible assets are assets which are utilised in the development, procurement, management and maintenance of a company’s customers (customer lists, order or production backlog, customer contracts and related relationships, non-contractual customer relationships).
Artistic related – intangible assets relate to artistic products or services which are protected by a contractual or legal right, such as copyrights (plays, operas, ballets, books, magazines, newspapers, musical works, pictures, photographs, videos, films, television programmes).
Contract based – intangible assets represent the value of rights which arise from contractual arrangements (licensing, royalty and standstill agreements, contracts for advertising, construction, management, service or supply, lease agreements, construction permits, franchise agreements, operating and broadcasting rights, use rights such as drilling, water, air, mineral, timber cutting and route authorities, servicing contracts, employment contracts).
Technology based – intangible assets represent the value of technological innovation or advancements, and can be protected through legal or contractual rights (patented technology, computer software, unpatented technology, databases, trade secrets).
Commercial Strategy
The range and complexity of tax issues faced by a business become exponentially greater when it becomes involved in international operations. Instead of a single tax regime one has to consider the fiscal implications of actions in several jurisdictions to comply with the tax reporting and payment obligations of multiple jurisdictions, potentially preparing financial statements in multiple currencies, and taking cognisance of the subtle interplay between the various domestic regimes and any applicable bi- or multi-lateral tax conventions.
With increased complexity, however, comes increased flexibility, which in many cases offers significant planning opportunities. Careful international structuring may substantially reduce the net overall income tax burden of a business, with rapid and often dramatic effects on profitability. For businesses reliant on cross-border licensing of intellectual property, one key concern will generally be to minimise withholding tax on royalties. In some cases, it may also be desirable to structure in such a manner as to take advantage of specific tax incentives, or to ensure the availability of a viable tax efficient exit strategy for the disposal of valuable IP.
Thus it is necessary to consider the key issues around valuation and licensing in establishing a holding structure which effectively addresses the relevant IP tax requirements.
However, tax structuring without commerciality will fail. Creating an IP holding company in a specific jurisdiction without substance will not create the tax savings intended, either on the grounds that the company is managed and controlled elsewhere (normally in a higher tax jurisdiction), or on the grounds that the company is merely a conduit without beneficial ownership rights required under relevant double tax treaty arrangements. But if the IP holding company employs relevant personnel to manage the IP rights, ensuring their protection internationally, arranging beneficial licensing agreements, dealing with all relevant legal, valuation tax and other issues, and monitoring royalty receipts, then the substance requirements can be fulfilled with the consequent tax benefits.
In transferring IP to such a company, an independent valuation is fundamental to confirm what would be the value of such rights in a hypothesised sale in an open market at a price that may reasonably be expected to represent an exchange transaction between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Judicial decisions frequently state, in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and also the market for such property.
Generally therefore the tax led concept (eg open market in the UK and fair market value in the US) is an objective basis of valuation, which entails a depersonalised approach. This means that one may not necessarily be able to endow the hypothetical purchaser and vendor with the actual characteristics of any parties. Valuation principles used throughout Europe vary from a market approach to a formula approach as in Germany and sometimes in Denmark.
Thus the valuer in fiscal situations is confronted with concept of value in major jurisdictions far removed from reality. There is rich ground for argument and dispute, principles have been tested by the Courts and it is essential for the valuer to be acquainted with the major decisions.
Capital Values on Exit: Stage 1
The preparation of a robust, justifiable valuation, ideally by an independent expert valuer independent to tax advice, is at least as important, if not more so, in preparing for an intra-group asset transfer or a holding company migration as it is with respect to intra-group royalty rates.
The Income Approach, as applied using the Discounted Cash Flow (“DCF”) Method, measures the value of an asset by the present value of its future economic benefits. These benefits can include earnings, cost savings, tax deductions, and proceeds from its disposition. When applied to IP valuation, value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the risk-free rate, the expected rate of inflation, and risks associated with the particular investment. The discount rate selected is generally based on rates of return available from alternative investments of similar type and quality as of the date of valuation. Capitalisation of earnings may be applied exclusively if a DCF approach is not tenable, or used as a cross-check.
Brand valuations for example principally rely on two typical methodologies to drive out the expected cashflows; royalty relief and brand contribution. Royalty relief hypothesises the cost saved through the ownership of the IP, rather than the necessity of licensing in exclusive use of the IP, and in this regard a valuer would undertake a study to ascertain royalty rates in the sector, which he would compare with an analysis of the financial performance of each business line of the subject IP.
A method often described as excess earnings or earnings split, attributes earnings in excess of those solely driven (or necessary) to service, without distress, non-intangibles such as fixed assets and plant and machinery, to IP.
The Market Approach measures the value of an asset through the analysis of recent sales or offerings of comparable property. The two primary market approach methodologies are the market multiple method and the similar transaction method.
The Market Multiple Method focuses on comparing the subject asset to guideline publicly traded IP and similar IP owning companies. In applying this method, valuation multiples are: (i) derived from historical operating data of selected comparables; (ii) evaluated and adjusted based on the strengths and weaknesses of the subject asset relative to the selected IP and companies; and (iii) applied to the appropriate operating data of the subject IP asset to arrive at an indication of value.
The Similar Transactions Method utilizes valuation multiples based on historical change of control transactions that have occurred in the subject company’s industry or related industries to arrive at an indication of IP value. These derived multiples are then adjusted and applied to the appropriate operating data of the subject asset to arrive at an indication of value. This method is useful in deriving royalty rates (for relief from royalty calculations) for similar IP.
The Cost Approach measures the value of an asset by the cost to create an asset, or perhaps the cost to replace the asset with another like it. This approach is frequently used in valuing investment companies or capital intensive firms. It is not necessarily an appropriate valuation approach to use when valuing IP or an IP business. It is a useful consideration for assets such as software and a workforce.
There are numerous objections to the cost approach, and an ultimately successful technology should probably reflect the cost of past failures for example R&D costs for IP failures may run at more than 5 times the cost for R&D successes. Nevertheless time and time again you find cost analysis in negotiations in setting a proposed licence royalty rate (see next section).
Extraction of Profits: Stage 2
The final piece of the structuring puzzle is the effective extraction of profits to the IP holding company.
When the structure has been established, one may consider the highest (if appropriate) defendable royalty rate for the charge by IP Co reducing taxable profits elsewhere in the Group. That again also needs to be considered by the independent IP valuation expert.
Licensing involves a licensor, the owner of the intellectual capital, or intellectual property right, availing another, the licensee, of some form of permission to utilise one or more rights associated with the property which the licensee would not otherwise have access to, in exchange for some form of consideration.
Key elements for consideration include the amount of the potential income (for both licensor and licensee) to be derived from the arrangement, the duration of that income, the risk of the anticipated benefits not being achieved, together with the costs of achieving the potential payments.
Value may vary according to whether the form of license (internal or external) granted is exclusive, or non-exclusive. Many licensing deals can involve a myriad of rights in different countries or territories. This leads to a situation where a single royalty rate can be agreed for the whole package, without regard to the individual economics of particular aspects of the deal. This is a relatively delicate area in view of the continuing tension between the concepts of protection for intellectual property and the advantages of free competition.
Competition law in general is suspicious of blanket arrangements, although this is changing. A trend can be identified whereby the courts and enforcement authorities are coming to recognise that even from the licensee’s perspective it can be beneficial to have an easily understood and relatively straightforward method of calculation royalty payments.
Notwithstanding this trend it is desirable to analyse and appraise each facet of an intellectual property licensing package, for example, if a license comprises rights to utilise patented technology, know-how and trademarks, a diminishing royalty for the IP could be argued to be appropriate, say as a patent’s life terminates.
Intellectual property is usually utilised as part of a business enterprise, where the intellectual capital, tangible assets, such as plant and machinery and working capital are together utilised to achieve a return on the sum total of those assets. This then provides a basis for calculating the element of the return that can be attributed to the intangible assets or intellectual property. This in turn then provides the starting point for the quantification of the appropriate royalty rate.
Transfer Pricing
Economic analysis is also necessary for tax purposes where business transactions between related parties are subject to the international “arms length” pricing standard. For example this standard applies under both the US and OECD transfer pricing rules.
A function and risk analysis takes place for the proposed transfer. Thereafter the valuer will determine the best method to analyse the proposed related parties’ transfer pricing practice regarding a royalty rate. As well as market and comparability from uncontrolled transactions, this may involve an analysis of transaction-based and profit-based methods in the regulations. Some of the comparisons are: return on cost, return on sales and return on assets. Based on the analysis, as appropriate, he will evaluate the relative reliability of the transaction net margin method and/or comparable profits method, taking into account the availability of accurate and reliable data for application of the methods, the degree of comparability between controlled and uncontrolled transactions or companies discovered to which the methods are applied, and the number, magnitude and accuracy of adjustments required to apply methods.
Thus concerning Intra-group royalty structures and Groups exploiting intellectual property internally, the use of royalties can serve as a powerful tool for the tax-efficient extraction of income from relatively higher tax operating jurisdictions to more tax efficient holding jurisdictions. In this case arm’s length royalty pricing will be of enormous importance to groups seeking to extract profit in this manner, and an independently prepared “highest defensible” valuation will in many cases be invaluable.
The recognition of the importance of accurate qualification of royalty rates and the like is a relatively recent phenomenon. One may examine carefully royalty rates established by the proposed licensor in previous licence agreements using similar IP. This approach examines specifics such as:
- How other licences were negotiated
- The IP and IP support
- The length of the agreement
- Exclusivity
- Special terms for special deals
- Geography
- The sector in which the IP is licensed
- Special relationships
Even if previous licensing practice is comparable, it can only provide a benchmark. IP by its nature is unique and it is often a thankless task making numerous and required adjustments to allow a fair comparison.
Many industries have built up a folklore of average royalty rates. This information is accessed by valuers from sector analysis, experience and essentially from your own proprietary database. That database of information will summarise main terms and conditions, lump sums and rates in order that valid comparative data can be withdrawn.
When a licensor and potential licensee sit down to negotiate a licence of IP right, if well advised, they would normally complete two tasks. First they must identify the range of exclusivity defined by the IP and second they must assign to that exclusivity an economic value limit. A licensor views his economic limit as the least amount it would be willing to accept for sharing with a licensee the exclusivity or degree of exclusivity, afforded by the IP. A licensee meanwhile would view his economic limit as the most he would be willing to pay for access to the IP led technology, brand etc.
Another method is described as general business profit approach. The idea is to rely on the general knowledge of those in business and to cover the lost R&D to produce the IP that would otherwise have been available. Costs are established as a percentage of sales for the total business.
Structuring the deal will thus have an important impact on the royalty rate agreed upon and there are various forms. Lump sums or running royalties may be agreed as a percentage of a licensee’s gross income from the IP. While a gross sales and turnover base introduces less room for argument, many licences and licensing agreements use a royalty base of net sales.
Conclusion
IP rights are of utmost importance and provide the bulk of the value of many businesses. Given their value and mobility, and the fact that IP rights can and probably should now be divorced from manufacturing and day to day operations, the development and management of IP rights should be at the forefront of financial planning in the modern world. That has tax consequences.
Managing capital values income from IP in a tax efficient way is vital. Valuation is an integral part of such management. By choosing to license intra group rights of varying length and intensity for default periods a series of incomes streaming into one or more favourable jurisdictions can be achieved, and IP valuations increased.
Some IP is mobile, while others are less mobile. They are not like land, plant, or machinery, which tend to be fixed to the location where they are to be found.
What is apparent from the outside looking into a group and its IP, is equally apparent internally. While it is obvious that owners need to protect their IP against external users, what is less obvious, but can be equally damaging is where the use of IP is unregulated within a group of companies. Competing rights, with all of the problems that can arise are thereby set up.
Once the process of identification is complete, the next stage is to decide on the location of the company which will be designated to hold the IP. The first step to realisation is due diligence. This is required to identify all IP and related rights (including any rights which have been applied for but not yet granted), which companies in a group have used those rights, what licences if any exist, and whether any of the rights are registered. It is important to understand what existing structures exist and any fragmentation of the existing IPR within the business. There may be non-trade mark use of company names, for example.
The location of an IP holding company is more open, choice is driven by tax considerations and by the existence of an appropriate treaty network. The result of a due diligence exercise is often that many different parts of a business each own a small part of the total IP rights that enable an end product or service to be sold.
Because final tax treatment is different from the IP treatment of these rights, it is often possible to move the IP rights to a holding company in a favoured jurisdiction without incurring much capital gains tax or corporation tax liability.
The final step is for the IP holding company to grant back to all of the group members an IP licence. The licence would ordinarily be granted for a running royalty or similar and be granted to all operating companies. Once the licensing scheme is in place, and the IP holding company has licensed all of the operating companies, it will receive a steady income stream. There are then a number of possibilities, as there now exists the ability to securitise the income stream. Since the income stream for the duration of the licences will have a capital value, the licences can be sold. This is often done by putting them into a special purpose vehicle.You need to ensure that the structure survives an insolvency of the underlying business. That is one reason for using an intellectual property or trade mark holding company; as it may be able to be ringfenced in a way which is not so easy for a trading company. Furthermore, the use of special purpose vehicles for holding the bundle of licences also creates its own ring-fencing. Intellectual property rights provide a simple and effective means of creating a vehicle which can also be used for increasing value and for actual or potential borrowing purposes.