Reevaluating the Intellectual Property Holding Company

Article excerpt

IN THEIR ZEAL TO SAVE ON TAXES, MANY COMPANIES ISOLATE THEIR INTELLECTUAL PROPERTY IN WHOLLY OWNED SUBSIDIARIES CALLED INTELLECTUAL PROPERTY HOLDING COMPANIES (IPHCS). THE IPHC LANDSCAPE, HOWEVER, IS CHANGING. RECENT STATE ACTIONS HAVE REDUCED THE TAX BENEFITS OF IPHCS, IMPACTING THE BUSINESS AND LEGAL RAMIFICATIONS OF MANAGING INTELLECTUAL PROPERTY THROUGH A HOLDING COMPANY.

Many companies isolate their most valuable assets-intellectual property-in wholly owned domestic subsidiaries. Known as intellectual property holding companies (IPHCs), these subsidiaries have provided companies with substantial state corporate income tax benefits. But the recent confluence of increased state challenges to IPHCs and the issuance by the Financial Accounting Standards Board (FASB) of Financial Interpretation No. 48, Accounting for Uncer - tainty in Income Taxes, (FIN 48; now codified in FASB Accounting Standards Codification (ASC) topic 740) have significantly reduced the efficacy of the IPHC as a tax-planning technique. With the tax benefits of the IPHC dwindling, companies have an opportunity to reevaluate how they deploy their intellectual property and whether the IPHC represents the best structure to carry out their business strategies.

In this article, we briefly provide some background on IPHCs, then document and analyze how recent state responses to IPHCs and FIN 48 have combined to reduce the tax and financial statement benefits that IPHCs historically provided. We also discuss the business and legal ramifications of continuing to hold and manage intellectual property through an IPHC and innovative ways in which a company can use an IPHC to facilitate structured finance and securitization or joint venture transactions.

BACKGROUND

To use an IPHC, a business isolates its intellectual property (trademarks, patents, and so forth) in a wholly owned subsidiary (the IPHC). The IPHC licenses the intellectual property to its parent and sister companies-the affiliates that actually carry out the business operations of the enterprise. The operating affiliates pay a royalty to the IPHC, taking a state tax deduction for the amount paid and reducing state corporate income tax liability. Because the IPHC is typi - cally established in a state that does not tax royalty income or does not have a corporate income tax, such as Delaware, the IPHC pays no tax on the royalty income it receives. Further, the IPHC will often lend money to other members of the affiliated group, generating interest deductions for the operating companies. In effect, IPHCs allow taxpayers to siphon profits from high-tax states to no-tax states. IPHCs thus provide cash flow benefits and, often, financial statement benefits via reduced reported income tax expense.

STATE RESPONSES TO IPHCS

Historically content to live with IPHCs, states have become more aggressive in recent years in response to fiscal pressures and press accounts of the prolificacy of IPHCs. For example, in an August 9, 2002, The Wall Street Journal article titled "Diminishing Returns: A Tax Maneuver in Delaware Puts Squeeze on States," Glenn R. Simpson listed many well-known companies that used IPHCs. As Table 1 shows, only three states with a corporate income tax-Delaware (a haven for IPHCs), Missouri, and Pennsylvania-have not enacted anti- IPHC measures. Every other state combats IPHCs in some fashion.

States can eliminate the tax benefits of an IPHC by arguing it is a sham under the economic substance doctrine. Beyond this general approach-or in combination with it-states use one or more of the following categories of anti-IPHC measures: mandatory combined reporting, add-back statutes, and economic nexus rules (see Table 1). Nexus generally means having some connection with the state, such as having employees or property in the state.

Economic Substance and Business Purpose

With the right facts, states can claim an IPHC is a sham that lacks economic substance. …