Wednesday, August 3, 2011

Big Corp Tax Loophole Closer #37: Intercompany Royalties

Big Multinational Corps spend a lot of their time with tax strategies that result in shifting as much income into foreign subsidiaries located in foreign countries with lower corporate income taxes rates, and at the same time, lowering taxable income in the higher taxed US parent and US subsidiaries.

And the same tax strategy is used to reduce overall US state income taxes, by shifting income into states with lower, or even no, state income tax, and at the same time, lowering state taxable income in higher income taxed states.

There is nothing wrong with this tax strategy as long as it is not abusive, and is consistent with the Economic Substance Doctrine (i.e. economic substance over legal form).

With the rapid growth and increased value of Intellectual Property, the amount of Royalties received in the US has grown markedly.

My recommendation here relates to the substantial amount of Intercompany Royalty Fees between a US Parent or a US Subsidiary and a foreign Subsidiary.

To minimize its worldwide income tax burden, it is in a US Big Multinational Corp’s best interests to minimize the amount of the Royalty Fees it receives from its wholly-owned, and substantially-owned, Foreign Subsidiaries.

Thus, my proposal is that the monetary amounts in all royalty agreements of Intellectual Property between a US Parent or a US Subsidiary and a wholly-owned Foreign Subsidiary are based on terms that are at arms’ length, and consistent with the Economic Substance Doctrine.

To be a bit more specific, if a royalty agreement currently entered into with a wholly-owned foreign subsidiary is at 1% of revenues, and the average royalty rate for its current similar Intellectual Property royalty agreements related to its foreign licensees, that it has no ownership interest in, or an ownership interest of 50% or less, is at 3% of revenues, then the US Parent or US Subsidiary should impute royalty income for an additional 2% of revenues, for US federal income tax purposes.

And when a royalty agreement is extended, the royalty income as a percentage of revenues should be stepped up to current prevailing rates of current royalty agreements with independent foreign licensees.

Also, the above provisions would also apply to Foreign Corps entering into royalty agreements with US Subsidiaries. Thus, in this situation, the US Subsidiary could have its royalty expense federal income tax deduction reduced, if the royalty agreement is not consistent with the Economic Substance Doctrine.

And frankly, I think it would be wise for US States to adopt similar tax rules on intercompany interstate royalties.

The money raised here should be used to reduce the US Deficit.