IP asset valuation and IRS scrutiny.
There are any number of reasons that a corporation might structure its operations in this way. Some engage in multiple kinds of businesses, and it makes economic sense to run them separately. Others may want to maintain multifaceted corporate structures so as to operate most effectively and efficiently, such as a company that has a separate division for its product line, a subsidiary for transportation, and a division for financing.
An increasing trend in recent years has been for some U.S. corporations to establish subsidiary operations overseas. In some cases, it may be simply because it's more effective to have a subsidiary manage their operations within the country or region. However, a growing tactic among corporations is to use overseas subsidiaries to take advantage of lower foreign tax rates. This concept--often known as tax avoidance--has been an increasing part of some companies' strategy to minimize tax obligations and calls for moving revenue and profits into locations that have lower tax rates. Unlike tax evasion, which is illegal, tax avoidance is the use of legal strategies and systems within the tax laws of both the home country, such as the U.S., and the overseas country. However, this has become a political and business controversy as a number of large companies, particularly major information industry companies such as Google, Facebook, and Apple, have been criticized for using these strategies to avoid or reduce their U.S. tax obligations.
There are a number of mechanisms that a company can use to set up an overseas tax avoidance strategy, but they generally involve establishing a subsidiary company in a country with low tax rates. In some cases, the goal is to generate and/or funnel profits through the offshore company by paying the lower tax rate to the country, but keeping more of the profit on the corporation's books. Another technique involves transferring assets to the offshore corporation. The IRS is charged with investigating these tax avoidance techniques to ensure that they don't cross the line to tax evasion.
Facebook IP Assets
An ongoing IRS investigation involving a Facebook asset transfer may have unique implications for the information industry. The IRS is looking into the transfer of some of Facebook's intellectual property (IP) assets to a foreign subsidiary and whether Facebook improperly valued those assets in order to avoid, or evade, taxes (pdfserver.amlaw.com/ca/FacebookSummons.pdf).
In 2009, Facebook established a subsidiary operation in Ireland in order to manage all of its operations that were occurring outside of North America. Ireland's corporate tax rate is 12.5%; the U.S. rate is 35%. Facebook's setup could allow the profits earned outside of the U.S. to be taxed at 12.5% by Ireland, with the U.S. getting no tax revenue. If the Irish subsidy transfers profits to the U.S. parent, then the parent must pay U.S. taxes, but only at a 22.5% rate, as it would receive a credit on the taxes paid in Ireland.
Facebook transferred a number of IP assets to its Irish subsidiary. In turn, these assets--now "owned" by the Irish subsidiary--can be licensed back to Facebook, but the licensing income may be taxed at the lower Irish rates. However, in order to transfer the rights, Facebook needs to assign them a value for tax purposes. IRS rules require that the value of this type of asset transfer be the same as if it were an "armslength" sale of the assets to an unconnected party. If the value is understated, less profit is made by the higher-taxed U.S. company, but the value to and profit from the IP assets would be higher for the lower-taxed Irish company.
Standalone Asset Groups
According to a court filing (pdfserver.amlaw.com/ca/StoneDeclaration.pdf), the IRS is investigating whether Facebook may have undervalued IP assets covering three areas: its userbase, its online platform, and an agreement to share "intangible marketing" costs and risks of the online platform. In figuring out the value of these assets, Facebook evaluated the asset groups individually, determining the value of each one as a standalone group.
However, as it investigated the transfer, the IRS came to believe that the three categories are "interdependent and ... difficult to isolate from one another" in that the online platform can't function without the userbase and vice versa, and marketing relies on both the platform and userbase. In a case of the whole being more valuable than the sum of its parts, the IRS took the position that because of the interdependence, the three asset areas are worth far more than Facebook claimed.
Information Document Requests
The IRS sought more information from Facebook about the assets, how they are used, and, most importantly, how they interact with each other. It issued a number of information document requests (IDRs) to Facebook asking for "business information ... that may be relevant to valuing transferred intangibles." Facebook has not provided any documents in response to the IDRs, and, on July 6, the IRS sued Facebook to force it to do so. Facebook asserts that it is complying "with all applicable rules and regulations in the countries where we operate."
To be clear, the IRS has not determined that Facebook has violated U.S. tax law and may only find that it incorrectly valued its assets, which would require it to pay back taxes and not criminal or civil penalties. However, some commentators are seeing the IRS's move as a crackdown on tax avoidance strategies. Bloomberg BNA's World, Intellectual Property Report described it as "signaling a shift in enforcement tactics" and a "tougher stance" against companies that make money through IP assets.
Additional IRS Scrutiny
It would be up to Congress to make any changes in existing tax avoidance strategies, which is unlikely to happen in an election year. But additional IRS scrutiny under existing law, including how IP asset valuations are to be determined, may require companies to rethink their current strategies.
George H. Pike is the director of the Pritzker Legal Research Center at Northwestern University School of Law. Send your comments about this column to firstname.lastname@example.org.
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|Title Annotation:||LEGAL ISSUES|
|Author:||Pike, George H.|
|Date:||Sep 1, 2016|
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