A biotech firm’s intellectual property assets often constitute the cornerstone of the company’s value. As a result, biotech companies tend to deploy considerable resources to build up, protect, and enforce their IP assets. However, one area that biotech companies frequently delay in their IP planning and development process is structuring the tax ownership of their IP assets.
A wait-and-see approach to international tax structuring for a U.S. biotech can have significant implications for both established businesses as well as start-ups. In particular, the failure to optimize tax structuring with respect to IP ownership can place a U.S. biotech at a major disadvantage to its competitors. Additionally, sub-optimal tax structuring may limit the company’s future international tax structuring options, and if not adequately resolved, it may also unnecessarily impede the value realized from the company’s IP in terms of its commercial exploitation or eventual sale.
For tax purposes, IP has a broad application. Importantly, IP is not limited to legally protected intangible property. Rather, in certain circumstances, U.S. tax law broadly defines IP to include both patented and unpatented IP. Thus, the term IP can include early-stage development concepts before such ideas are protected by any patent filing.
General Overview of U.S. Taxation of International Structures
The U.S. federal government taxes all sources of income realized by its citizens, regardless of where they reside in the world. Similarly, a U.S. corporation is subject to U.S. taxation with respect to all income directly received by such corporation, regardless of its source.
In contrast, a foreign corporation, including one that is wholly owned by a U.S. parent corporation, is not subject to direct U.S. taxation provided the foreign corporation is not engaged in a U.S. trade or business. The delayed application of U.S. taxation with respect to the income that is earned by a foreign subsidiary of a U.S. corporation is referred to as a “tax deferral” benefit. Provided the earnings of a foreign subsidiary are not required to be remitted back to the U.S. parent, those funds can be left offshore and deployed pre-U.S. tax liability, which can lead to a significant savings.
Base Case U.S. Parent Structure
Consider the following fact pattern as a Base Case for purposes of comparison to the other alternative structures discussed. Assume, for purposes of the Base Case, that the U.S. corporation at issue, Biotech Co, is incorporated under the laws of the U.S. and is subject to a U.S. federal income tax rate of 35% with respect to its taxable income.
Biotech Co developed Product X via R&D performed in the U.S. Product X completed clinical testing and is approved for commercialization. Biotech Co is considered the sole owner of the IP associated with Product X. Biotech Co manufactures Product X at its facilities in the U.S. Product X is sold to patients for use in both the U.S. and outside the U.S. Assume that Biotech Co realizes a pretax profit of $1,000 per dose on all U.S. and foreign sales of Product X.
Because Biotech Co is incorporated under the laws of the U.S., its U.S. and foreign-source profits are subject to direct taxation by the U.S. Thus, regardless of whether the sale is to a U.S. or foreign patient, Biotech Co incurs a $350 U.S. federal tax liability with respect to the sale of each dose of Product X, resulting in an after tax profit of $650 per dose.
Basic Deferral Platform
U.S. companies with profiles similar to that outlined in the Base Case should consider, at a minimum, the deployment of a basic deferral planning structure to reduce U.S. tax exposure with respect to foreign sales.
Working with the facts outlined in the Base Case, assume for purposes of illustrating the application of a deferral planning strategy, Basic Deferral Platform, that Product X has a fairly substantial foreign market. To better serve the non-U.S. markets, Biotech Co decides to form a wholly owned subsidiary in Switzerland, Swiss Sub. Swiss Sub is incorporated under the laws of Switzerland, and pursuant to an advanced ruling with the Swiss federal and cantonal officials, Swiss Sub secures a tax holiday that provides it with a 10% effective tax rate for a 10-year period.
Swiss Sub enters into a nonexclusive license with Biotech Co to manufacture and sell Product X in all markets outside the U.S. Due to the U.S. transfer pricing rules, the license allowing Swiss Sub to manufacture and sell Product X must be made at a market rate—or at arm’s length.
Under the U.S. transfer pricing rules, the arm’s length standard, which is the test typically applied in transfer pricing, provides that the terms of a transaction between related parties will satisfy the arm’s length standard if the results arising from the transaction are consistent with the results that would have been realized if unrelated taxpayers had engaged in the same transaction under the same circumstances.
Assume, for purposes of illustration, that under the Basic Deferral Platform it is determined that the arm’s length pricing on a nonexclusive license with respect to Product X should be $300 per dose. Employees of Swiss Sub, based in Switzerland, perform all manufacturing, testing, packaging, labeling, and storage of Product X for the non-U.S. markets. Further Swiss Sub supervises and incurs all marketing and distribution of Product X to non-U.S. patients.
Assuming Swiss Sub also realizes a pretax and preroyalty profit of $1,000 per dose under the Basic Deferral Platform, its net profit after the royalty and Swiss taxes are considered would be $630 per dose ($1,000 profit per dose, less the royalty of $300, less Swiss tax of $70 on the after-royalty profit). Provided the activities and investments of Swiss Sub are properly structured to avoid triggering the U.S.’s antideferral provisions, the profit of $630 may enjoy deferral from U.S. federal income tax until a later date when such profits are distributed by Swiss Sub as a dividend to Biotech Co.
The $300 royalty per dose paid to Biotech Co under the Deferral Platform would give rise to a U.S. federal income tax of $105. Thus, the net profit after taxes to Biotech Co with respect to the royalty income would be approximately $195 per dose.
Under the Base Case, Biotech Co realized an after tax profit of $650 per dose on all foreign sales. In contrast, the after tax profit realized on the foreign sales under the Deferral Platform would be $825 per dose (Swiss Sub’s after tax profit of $630, plus Biotech Co’s after tax profit of $195). As illustrated by this simple example, basic deferral planning can give rise to substantial tax savings for a U.S. biotech with respect to its foreign sales. Those savings can then be utilized by the foreign sub in a myriad of ways such as funding further R&D, the expansion of the foreign business, or a foreign acquisition.
Deferral Platform with Cost-sharing
While there are substantial tax savings to be realized from basic deferral planning, there are increased savings available to the extent the IP associated with the product is not exclusively owned by a U.S. company. Unfortunately, once IP is developed, there are limited planning opportunities available for transferring any portion of such IP to an off-shore entity.
The fact that IP is the central value driver in the U.S. economy has not been lost on the U.S. government, which obviously has a vested interest in protecting the U.S. ownership of such IP. As such, the U.S. government, like most governments throughout the world, has established laws that effectively prohibit the tax-free transfer of IP outside the U.S. A taxable sale of fully developed IP between related entities can be prohibitively expensive, in terms of the tax liability generated from such sale.
Further, any such sale by a U.S. company to a related party will be scrutinized in hindsight by the IRS to determine whether the sale produced an arm’s length result. Thus, once IP has been developed, transferring all or a portion of the ownership from a tax perspective can be problematic.
“Cost-sharing” is an alternative structuring technique that can be employed to allow a foreign subsidiary to participate in the development of any IP, and therefore, own, for tax purposes, a portion of the rights associated with such IP. A cost-sharing arrangement is a contractual agreement between two or more related parties to share the costs and risks of an R&D project in exchange for a specified ownership interest in the resulting IP.
For U.S. tax purposes, the parties to a cost-sharing agreement are considered to jointly own the IP that is developed pursuant to the agreement. The foreign ownership of the IP is generally only applicable for tax purposes. From an IP law perspective, the IP could be owned exclusively by the U.S. entity, if desired, which is typically the case.
The use and anticipated benefits from a cost-sharing structure can be illustrated using the same basic fact pattern discussed above. Assume for purposes of this example the same facts as set forth in the Basic Deferral Platform example, with the exception that there is no license of IP from Biotech Co to Swiss Sub. Instead, Biotech Co and Swiss Sub enter into a qualified cost-sharing agreement, pursuant to which Biotech Co and Swiss Sub agree to share all the costs associated with the development of Product X.
Under the Cost-Sharing Platform, there is no royalty due from Swiss Sub to Biotech Co. As such, Swiss Sub will realize a pre-tax profit of $1,000 per dose, which will trigger a Swiss tax liability of $100 per dose under the assumed facts. As such, Swiss Sub’s after-tax profit would be $900 per dose. Provided the activities and investments of Swiss Sub are properly structured to avoid triggering the U.S. antideferral provisions, the after-tax profit of $900 per dose may enjoy deferral from U.S. federal income tax until distributed by Swiss Sub as a dividend to Biotech Co. The Cost-Sharing Platform provides a significant savings when compared to the after-tax profits realized from foreign sales under the Base Case ($650 per dose) and the Deferral Platform ($825 per dose).
Cost sharing generally is most effective from a tax-planning standpoint when deployed early in the development of newly created IP because the foreign subsidiary does not have to compensate the U.S. parent company (in the form of either a royalty or buy-in payment) for the use of any preexisting IP. Nonetheless, cost sharing can also be effectively deployed with respect to future refinements of existing IP.
International tax planning is not always a primary focus when a biotech is in the process of developing, building, and protecting its IP assets. Nevertheless, a U.S. biotech’s strategic structuring of its IP assets can lead to substantial tax benefits and savings and, as a result, can provide the biotech company with competitive advantages. For these reasons, a U.S. biotech should not defer consideration of its IP asset ownership structure indefinitely. Rather, the options available and the potential benefits that may be derived from such planning are maximized when a U.S. biotech considers its various IP asset ownership options early in its life cycle.