Why U.S. Life Science Companies Need to Rethink Global IP Holding Structures

April 2017

By Yosef Barbut and Todd Berry

Recent global international tax developments, coupled with potential U.S. tax law reform require a rethinking of current intellectual property (IP) holding structures used by U.S.-based life science companies, including big pharma.


Changing Tax Laws and Accounting Rules Landscape

In late 2015, the Organisation for Economic Co-operation and Development (OECD), an umbrella organization of 20-plus countries that recommends tax law, commerce and trade guidelines to its member states, issued its Base Erosion and Profit Shifting (BEPS) guidelines. The BEPS guidelines are a set of 15 actions concerning global tax rules related to transfer pricing, permanent establishments, aggressive tax planning including use of IP holding structures, and more. These actions are designed to combat aggressive international tax planning that has caused significant erosion in the tax revenue base of major industrialized countries, and to promote greater transparency around transfer pricing and the use of certain tax-driven structures. 

Many countries have already begun implementing BEPS-compliant tax laws. The United States has recently implemented BEPS guidance related to country-by-country reporting, which will require the disclosure of certain critical information that can be accessed by the taxing authorities of all member states. Additionally, the European Union (EU) has been pushing to eliminate certain tax benefits in its member countries that, under EU state aid law, are considered anti-competitive and unfair.  

This article explores a confluence of global tax law developments, changing U.S. accounting rules, and a U.S. tax law environment ripe for major tax reform—the likes of which has not been seen since President Reagan. These developments, both individually and collectively, could force the modification of current IP holding structures and a new approach to global tax planning.


The Current U.S. Environment

The U.S. market continues to exhibit high demand for healthcare services and medical drugs. This trend is likely to continue as more medical drugs and therapeutically administered treatments are discovered to support a growing retirement population. Historically, the United States has been considered a desirable location to undertake research and development activities, and register and own patents and intellectual property (IP), due to advanced patent and IP laws. However, for income tax purposes, the economic ownership of IP is typically divided, putting the non-U.S. market rights to exploit the IP in tax-favorable jurisdictions. For example, Ireland, Singapore, the Cayman Islands and other low-tax jurisdictions might own the economic rights for sales of medical drugs and devices in non-U.S. markets. The benefit is a favorable industry global average effective tax rate ranging from 20 to 25 percent, which is much less than the U.S. federal rate of 35 percent. 

A low effective tax rate is achieved because foreign income is generally taxed at an average rate significantly lower than 35 percent, and U.S. tax rules allow tax deferral of foreign business income until the income is repatriated as dividends or gains. The FASB’s longstanding accounting rule related to foreign earnings also works in favor of U.S. companies with significant foreign operations. Management of U.S. corporations can represent that foreign income is indefinitely reinvested outside the United States, provided sufficient evidence of reinvestment plans exist. This intent-based accounting rule effectively allows management to indefinitely avoid recognition of the deferred U.S. tax liability that would be incurred if low-taxed foreign earnings were repatriated to the United States.   

To implement a tax-efficient global IP holding structure, U.S. companies generally transfer the non-U.S. IP rights to controlled foreign subsidiaries. The transfers can take many forms and be taxable or tax-deferred transactions. Currently, a taxable outbound transfer of IP would trigger taxable income (measured on the fair market value at the time of transfer) but not tax expense for financial reporting under historic U.S. GAAP, and in some cases, no cash tax outlay assuming an appropriate utilization of net operating loss and tax credit carryforwards. The rule addressing intercompany transfers of property requires the current and deferred tax from an intercompany transfer of IP to be deferred until the income is recognized in the consolidated income statement, which can be many years into the future. The rule is considered an accounting exception to the comprehensive recognition of income taxes. It effectively spreads the tax consequence over the periods the income is earned and recognized for financial reporting purposes.


Changing U.S. Accounting Rules (ASU 2016-16)

In 2016, the FASB issued an accounting standard update (ASU 2016-16), removing the exception for intercompany transfers. The new rule, which goes into effect on Jan. 1, 2018, for calendar fiscal years will require full recognition of current and deferred income taxes from intercompany transfers of all property—except inventory—when the transfers occur, even though the intercompany pretax profit would still be eliminated and recognized in future periods. The impact will be significant. For example, an outbound transfer of IP from a U.S. parent to a foreign subsidiary in Ireland would trigger recognition of U.S. and Irish income tax effects (tax rates of 35 percent and 12.5 percent, respectively). Assuming the fair market value of the IP on the transfer date is $10 million, a taxable transfer would result in a $3.5 million U.S. tax expense (assuming zero tax basis for internally-developed IP) and a $1.25 million tax basis step-up in Ireland (net tax effect of $2.25 million). Prior to ASU 2016-16, this net tax effect would be deferred and recognized over several years (typically more than 10 years for drugs). Under ASU 2016-16, the net tax effect is recognized when the asset is transferred. This will mean no more spreading (over multiple periods) the tax consequence from intercompany transfers of IP and other assets.

The significance of this change should be considered in the new international tax landscape. For example, a multinational entity that currently owns the non-U.S. rights in a “zero” tax jurisdiction might have to restructure and transfer such rights to another foreign country where the tax rate is more than zero but is sustainable under BEPS-compliant rules requiring operational substance.

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Looming U.S. Tax Reform

With a new administration in Washington, there are high expectations of major tax reform. Details are still scant and current ideas are speculative at best. However, there are four proposals for potential tax reform that will be deliberated extensively. First, the U.S. corporate tax would be reduced from 35 percent to 20 percent, or a potentially lower rate of 15 percent. Second, the United States would adopt a territorial system whereby foreign source business income of U.S.-based multinationals would not be subject to a U.S. tax at all. Third, export income generated from the United States would be tax exempt, while import income would effectively be taxed at a higher rate by denying a U.S. deduction for the cost of goods imported into the United States. Fourth, U.S. corporations would receive a one-time “tax holiday,” allowing them to pay reduced U.S. tax rates on profits generated and accumulated overseas.

Take a look at the chart above for a look into what’s at the top of U.S. tax executives’ wish lists, according to the 2017 BDO Tax Outlook Survey.

If any of these ideas are eventually enacted, it could create a new global tax planning environment for U.S.-based businesses. The tax policy objectives of creating a competitive U.S. tax system and enticing investments and retention of capital in the United States could lead to reconsideration of current IP holding structures and to changes in supply chains (manufacturing, distributions, sales and support). A low corporate tax rate, complete exemption of foreign income (i.e., a territorial system), and export income tax benefit (i.e., the border-adjustment proposal) combined could transform the United States into a more desirable tax jurisdiction for IP holdings. These developments may have a significant impact on global IP structures and financial reporting.

Take a look at the graphic above for an illustration of the border-adjustment concept.
 
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BDO’s Insights

Numerous global tax law changes instigated by BEPS and the EU’s state aid laws are forcing reconsideration of global tax structures that may require modifications to IP holding structures. 

Financial reporting disclosures of material-enacted changes are important to keep users of financial statements informed about current and expected tax burdens. The accounting standard change required by ASU 2016-16 will cause tax rate volatility when IP (or other property, except inventory) is transferred via intercompany transfers, which will give greater prominence to material intercompany transfers and force greater transparency of IP holding structures and tax planning. However, uncertainties about potential U.S. tax reform might necessitate a “wait-and-see” approach before current IP holding structures are significantly modified. 
 

Yosef Barbut is a national Assurance partner and the ASC 740 subject-matter technical leader. He can be reached at ybarbut@bdo.com.

Todd Berry is an Assurance partner and leader of BDO’s Life Sciences practice. He can be reached at tberry@bdo.com

Read next article, "Why Priority Review Vouchers Provide Pharma a Starting Point Worth Building Upon"

Return to BDO Life Sciences Letter - Spring 2017