Eye on the (IP) prize

Have you ever wondered if there was another way to increase cash flow and borrowing capacity in connection with an acquisition? Intellectual property (IP) planning is a proven strategy which is used by many multinational companies to manage effective tax rates and earnings per share. Some of these IP planning techniques are beginning to enter the private equity playbook specifically to increase cash flow and borrowing capacity of acquisition targets.

TRANSFER PRICING FOUNDATION

The economic underpinning of modern transfer pricing law and practice is that transfer prices for intercompany sales, services, rents and royalties may be inferred from the companies’ arm’s-length profits, which are driven by their functions, assets and risks. The more functions, assets and risks any entity employs in its business, the greater its arm’s-length returns and profits. In theory, a multi-national group of companies may shift its global profit among group members by moving functions, assets and risks among its members. Of course, theory and practice are two different things. Transfers of functions, assets and risks are seldom without cost: operational changes, additional complexity, advisor fees, and sometimes, taxes on the transfers themselves all figure into the cost-benefit analysis.

COST-BENEFIT ANALYSIS OF IP PLANNING

Based on the authors’ experience, the most attractive returns on investment often are available from IP planning. This is because a company’s IP, whether technology, brands, customer lists or specialised know-how, is often its most valuable asset, and as such, the primary driver of revenue and profit.

Rob Schmidt

Moreover, IP rights may be transferred contractually with relative ease. (In contrast, shifting a manufacturing function involves the complexity and cost of buying or leasing a new facility, transporting or replacing machinery and equipment, personnel costs, start-up costs, etc.) That said, the benefits of transferring IP rights to a tax-favoured jurisdiction must be compared with the costs of the transfer. The US and many other countries impose tax on an otherwise tax-free outbound transfer of IP rights. For example, generally, a US corporation may contribute business assets to a foreign corporation tax free; however, a contribution of IP rights is taxable as if they had been licensed. Such an outbound toll charge often quells corporate management’s interest in pursuing IP migration. In addition, the cost, complexity and risk of implementing and maintaining the IP structure must be considered.

The US Internal Revenue Service (IRS) has broad authority to re-determine the value of IP, which is transferred offshore after-the-fact, and make adjustments to the US taxpayer’s income long after the date of transfer. For this reason, US taxpayers must proceed with caution when transferring IP offshore. An IP valuation based on transfer pricing regulations should be conducted and fully documented at the time of the transfer. This risk is best managed by structuring the acquisition to avoid the offshore transfer of IP altogether.

ASSET ACQUISITIONS

The purchase of business assets creates a natural arm’s-length valuation event that may allow for the acquisition of IP into a tax-favourable structure without triggering additional tax to the seller or buyer – minimising the risk of a future IRS challenge (because there is no post-acquisition outbound transfer of IP rights by the taxpayer). Private equity groups purchasing target assets might consider forming IP acquisition subsidiaries in tax-favoured jurisdictions and using the purchase transaction as an opportunity to increase the target’s post-transaction cash flow. With sufficient pre-transaction modeling, it may also be possible to demonstrate to lenders that the increased cash flow of the restructured target business warrants an increase in lending, allowing increased leveraging on the deal. 

Bert Hawkins

BIFURCATED STOCK ACQUISITIONS 

Where a target’s IP is owned by the target, or its subsidiaries, and the private equity group is purchasing the target stock, there are still opportunities to structure the acquisition to migrate the IP to a tax-favorable structure. In this case, a special purpose entity may purchase the valuable IP assets from the target, or its subsidiaries, immediately prior to the transaction. This two-step acquisition will likely result in corporate tax to the selling target subsidiary and may increase the acquisition costs of the business but, in many cases, the post-acquisition cash flow and leverage opportunities will outweigh the costs.  

CONCLUSION

As private equity strives for increased performance from its portfolio companies it should consider proven IP planning and structuring techniques to immediately impact a business’ cash flow.  A common misconception is that if the target is a US company, the foreign aspects are secondary. In fact, if the US target has foreign earnings and some of those earnings are derived from intellectual property that is located in the US or other high-tax jurisdictions, with proper planning, modeling and implementation, there may be significant cash flow and leverage opportunities to be had from structuring the deal to move valuable IP to low-tax jurisdictions. 

Bert Hawkins and Rob Schmidt are international tax partner and international tax director respectively at accounting, tax and business consulting firm McGladrey.

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HOW IT WORKS 

The following example illustrates how the movement of IP to a low-tax jurisdiction can increase cash flow and leverage opportunities. Private equity group A intends to purchase the assets of target company B.  Target company B’s IP assets support worldwide sales. In fact, for each $100 of foreign earnings $50 of that value is derived from B’s IP. The remaining $50 of foreign earnings is derived from functions performed outside the US.  

If A had C, a US acquisition company, acquire B’s worldwide IP rights, A can expect that C would pay US corporate tax on the $50 of value arising from the use of the IP in foreign sales, or $17.5 in tax leaving an after-tax cash balance of $32.5. This is because C would require compensation for the use of its IP in non-US sales.

On the other hand, if A had D, a foreign acquisition company located in a jurisdiction with a 5 percent corporate tax rate, acquire B’s foreign IP rights, A can expect that D would pay foreign corporate tax of $2.5 leaving $47.5 of after-tax cash. Here, since D owns the non-US IP rights, with proper planning and implementation, the IP stays outside of the US tax nexus. 

Some of the $15 of incremental cash flow would be used towards enhanced interest and principal payments on higher debt financing, having demonstrated to lenders that the enhanced cash flow from the restructuring allowed the business to safely handle higher financing payments.

Disclaimer
The information contained herein is general in nature and based on authorities that are subject to change. McGladrey LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. McGladrey LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.