Editor’s Note: Christopher D. Foster is a member of the Business Section of Ward and Smith, P.A.
RALEIGH – Innovations in science and technology, along with the expansion of certain legal protections, are resulting in more and more companies seeking to create business value by the exploitation of intellectual property ("IP") rights. Any business that owns substantial IP should consider whether placing such rights into an IP holding company would result in tax or other benefits of adequate magnitude to justify the management burdens and costs of adding an additional structure to the corporate entity. Placing IP rights into a holding company may improve the business’s ability to manage the IP, while reducing the tax burdens. The use of a Delaware corporation as an IP holding company is one tax planning technique designed to minimize the state tax burden on the holders of IP.
What Is an IP Holding Company?
An IP holding company is simply a corporation into which selected IP rights are placed. The IP is the only asset of the company, and the licensing of the IP in exchange for royalty payments is the company’s only business.
Establishing an IP holding company can be done by a fairly efficient process. The owner of the IP transfers the rights into the holding company in exchange for all of the stock in the holding company, creating a wholly-owned subsidiary. This exchange may be done on a tax-free basis, with no gain or loss recognized by either the parent or the subsidiary company.
Exactly How Does Placement Of The IP Into A Holding Company Result In A Tax Benefit?
Placement of the IP into a holding company does not in and of itself result in a tax benefit. The benefit comes from incorporating the IP holding company in a state which does not have a state income tax on IP royalties – such as Delaware.
The tax benefit has two different parts. First, once the IP is transferred to the holding company, any entity which wishes to use the IP must enter into a licensing agreement with the holding company under which it agrees to pay royalties to the holding company for the right to use the IP. Since the holding company is a Delaware corporation, all of the royalties paid to it will be tax-free on the state level. Thus, for example, a North Carolina company establishing a Delaware IP holding company would avoid the 7% state tax otherwise due in North Carolina.
The second tax benefit is derived from the fact that all businesses which wish to use the IP, including the parent, must enter into a license agreement and pay royalties. Thus, in order for the parent company to use the transferred IP in a product, it will have to pay royalties in the same manner as any third party. The result is that the parent company incurs a tax-deductible business expense, while the holding company receives tax-free income. In other words, use of the subsidiary IP holding company results in a reduction of the total taxes owed by the parent both because the parent is incurring a business expense and because the parent is not paying state taxes on its subsidiary’s royalty income.
On the other hand, the Delaware holding company will be subject to the Delaware state franchise tax which is imposed annually on Delaware corporations for the privilege of being a Delaware corporation. Calculations need to be made to determine the extent to which this additional tax burden will reduce or possibly even negate the tax benefits of using a Delaware holding company.
Are There Any Other Tax Benefits?
Depending upon the tax bracket of the parent company, other strategies may be employed to provide additional tax benefits to the parent company and the IP holding company. In the event the IP holding company’s income from royalty payments is distributed to the parent company in the form of dividends (which would be included in the taxable income of the parent company), such dividends may, in turn, be deducted by the parent company. For federal tax purposes, a tax deduction is allowed for dividends received from a member of an affiliated group, which would include a parent and wholly-owned subsidiary. Thus, each dollar’s worth of dividends received by the parent company will be taxed at an effective amount of less than a dollar. Further, many states also permit a corporation to deduct some or all dividends received from another corporation within an affiliated group. Unfortunately, North Carolina is not one of them. An alternative strategy is for the subsidiary to loan the amounts received as royalties to the parent company with the parent company using the interest payments made on such loans as a tax deduction.
How Do You Structure A Delaware IP Holding Company?
In order to qualify as a Delaware holding company that will be exempt from Delaware income taxes, the Delaware entity must confine its operations solely to the maintenance and management of its intangibles (i.e., IP), and the collection and distribution of the income from the intangibles. If the corporation undertakes any other business, the tax exemption will be lost.
It is also important to understand that there must be a very significant business connection between the Delaware IP holding company and the State of Delaware in order to prevent the parent’s state of incorporation from asserting taxes against the Delaware subsidiary. In recent cases, state departments of revenue have assessed taxes on parent companies related to the income of Delaware IP holding company subsidiaries when there were significant connections to the assessing state and insufficient connections to the State of Delaware. These states argue that the parent companies are using empty corporate shells, engaging in sham transactions, and using other ruses to make it appear as if the parent has separated itself legally from its IP subsidiary.
In order to improve the chances that the tax-free status of the subsidiary IP holding company will not be challenged, the parent company should consider having the IP holding company take the following actions in order to establish a sufficient connection to Delaware:
• Locate a physical office in Delaware from which corporate activities are directed
• Execute all IP licensing agreements and related contracts in Delaware
• Maintain its original books, records, and contracts in Delaware
• Use stationary and business cards with a Delaware address
• Establish a Delaware bank account
• Obtain Delaware tax identification numbers
• Withhold Delaware income tax from the salaries of all officers and employees of the holding company
• File and pay payroll taxes in Delaware
• Use a Delaware mailing address and telephone number
• Have all officers and employees of the holding company perform their duties in Delaware, even if only on a part-time basis
• Hold board of directors meetings in Delaware
With vast amounts of financial resources being invested in the creation, protection, and enforcement of trademarks, copyrights, patents, and trade secrets, it is safe to assume IP will be a valuable corporate asset for a long time to come. In a world where companies search for ways to maximize revenues, companies with large IP portfolios should consider forming a Delaware subsidiary to hold such IP. When exploitation of IP rights is a primary source of income for a company, maximization of company profits may result from careful tax planning, including the use of a Delaware holding company.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Christopher D. Foster practices in the Business Section, where he concentrates his practice on business and corporate matters and taxation. Comments or questions may be sent to email@example.com.
©Ward and Smith, P.A., 2007
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
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