Minimizing taxes with offshore transactions? Watch out for your IP!

It is reported that Google pays only 2.4% taxes on its offshore profits – made possible through a web of transfer pricing transactions. Transfer pricing allows a corporation to transfer profits to lower tax countries by cleverly choosing where to house its intellectual property “IP”.
It’s that simple to save millions in taxes! If your revenues are in the US, by transferring your IP to a subsidiary in a country with low tax rates, you will pay royalty to the offshore subsidiary, thus effectively transferring out profits and minimizing taxes. Google, has its IP in Mountain View, CA and therefore, has the incentive to pay as little in royalties to the US parent.

Although tax law requires royalty rates to be set as in an arm’s length transaction, it is extremely difficult to challenge the rates that companies set, since no market exists to determine fair market value of highly company specific IP assets, such as algorithms and customer lists. If the IP is housed in a high tax country, such as in the case of Google, companies intentionally understate the royalty rate. On the other hand, if paying royalty to a subsidiary in a low tax country, the incentive is to overstate the royalty rate.

It works perfect, when tax minimization is your main concern. However, it is important to understand the implication on your IP rights when those rights are contested. Here’s why.

Assume you understate the intercompany royalty rate to minimize taxes; in the event your IP is infringed upon and you sue for damages, the intercompany royalty rate will be used to determine the damages you are owed. In effect, reducing your tax liability significantly reduces recovery of damages, and hence your valuation.

Another issue relates to your ability to sue an infringer. Only patent owners and exclusive licensees have the standing to sue infringing parties, but non-exclusive licensees do not. Transfer Pricing structures almost always rely on non-exclusive licenses. Exclusivity will prevent other subsidiaries of your company from using the IP, and therefore is never used.

Furthermore, where non-exclusive licensees lack standing, the patent owner's recovery may be limited to reasonable royalties — even though the entity seeking injunctive relief or lost profits damages is part of the same wholly owned corporate family as the patent owner.

Therefore, it is crucial to assess the impact of intercompany transfer pricing agreements on a company’s ability to defend its intellectual property. Unfortunately, transfer pricing is done by tax professionals with the sole purpose of minimizing taxation.

Transfer pricing policies that create non-exclusive relationships can compromise IP protection. Thoughtful coordination among tax professionals, business leaders and law departments can prevent these problems, but care must be taken up front - once an issue is revealed in litigation, it is usually too late.