We talk about being struck by ideas: like the proverbial bolt of lightning, ideas illuminate the way to new innovations. When a business can gain legal rights to those innovations, we call them intellectual property (IP). If all goes well, that intellectual property generates new profits—and also new taxes.
But how are those ideas taxed? As you're using this idea to power your next groundbreaking product or service, how can you manage the taxes on the profits? And how do you ensure you're protecting the idea from illicit use by others?
The tax challenge only increases when companies share IP across international borders. To solve this challenge, companies often depend on a segment of tax called transfer pricing.
Where does the IP actually live?
As organizations expand globally, their decisions on IP will greatly impact how profits are allocated country by country within the corporate group. This will in turn affect how much tax the global group pays. Transfer pricing professionals can help a business make decisions about its IP to help manage the group's global tax burden. Often the first step will involve deciding where the IP resides for tax purposes.
Paying related companies
Let's take the example of a Canadian tech company that expanded to the U.S. and moved its headquarters and management down south — but kept its development in Canada. This allowed it to maintain generous incentives available from the Canadian government.
Now the founders face a classic decision: Should the Canadian or U.S. company own the intellectual property developed in Canada? Whatever their decision, it will impact transfer pricing strategies for the group.
What's more, that decision rests on details that vary from situation to situation. It is tempting to think the Canadian company is a contract services provider while the U.S. manages the arrangement. If so, the Canadian company could charge a service fee for the research and development (R&D).
However, if the Canadian company is given more authority – such as if it employs a director of R&D who oversees and approves all testing or makes key strategic decisions on R&D processes, which significantly impact the outcome of the final product — it may no longer be acting as a simple contract R&D service provider. In that case, it could argued that the Canadian company is the owner of the IP, and the U.S. company may need to license it from the Canadian company. A licensing fee is very different from a service fee.
Paying the tax authorities
To minimize taxes, companies often aim to assign their IP to a low-tax jurisdiction such as Ireland. But those aims don't always align with the policies of tax authorities around the world.
One common disconnect revolves around where they register their IP. While country of registration affects companies' legal protections for their IP, it may be irrelevant in the world of transfer pricing. If employees and management who are heavily involved in the development and approval process of the IP are based in Canada, the CRA could argue that the profits generated from the licensing of the IP should be attributable to Canada and taxed accordingly, given that Canada is where the IP is developed and key personnel resides.
Similar misunderstandings sometimes arise around the key legal agreements that govern IP ownership. These agreements include well-known documents that protect IP, such as patents, trademarks, and copyrights. They also include lesser known mechanisms such as intercompany agreements, which assign IP ownership or rights to exploit the IP to specific subsidiaries in a group. In both cases, the ownership of the IP does not necessarily translate to tax liability.
As a result, companies need to examine both their business and tax needs when deciding where to place their IP. They can then take steps to manage both areas. If they want to keep the IP in a low-tax locale, they can register their IP and employ the relevant personnel there to justify being taxed there by ensuring both legal and economic substance tests are met. The key is to build a narrative in case their decision is challenged by the CRA. The same would apply when dealing with other tax authorities, such as the Internal Revenue Service for a company managed from the U.S.
Getting started with IP protection
Intellectual property is set to continue to play a growing role in the modern global business environment, but putting in place the proper policies to protect and profit from IP isn't always a simple and straightforward matter.
However, there are some basic, low-cost steps companies should consider as they get IP patents underway. Your organization can:
- Work with legal counsel to develop an overall IP rights protection strategy.
- Develop detailed IP rights language for licensing and subcontracting contracts.
- Conduct due diligence when it comes to researching potential foreign partners.
- Record Canadian-registered trademarks and copyrights with customs and border services.
- Secure and register patents, trademarks and copyrights in key foreign markets, including defensively in countries where IP rights violations are common.
IP protection, IP profits
The IP lesson for businesses is that no single component exists in a vacuum. To craft the best possible transfer pricing strategy, have IP professionals and transfer pricing professionals work together to cover both trademarks — or patents or copyrights — and taxes.