Pharmaceutical companies and other companies that develop and use valuable intangible property and plan to expand their activities to the United States may wish to consider some U.S. tax planning opportunities. Some important considerations are described below.
Research and Experimentation Credit
The credit for increasing research activities permits a credit against U.S. tax for incremental research and experimentation costs, over and above the taxpayer's historic levels, incurred in connection with the taxpayer's trade or business. The research and experimentation activities must take place in the United States for the expenses to be eligible for the credit. To qualify for the credit, the expenses must be incurred as part of a process of experimentation for a purpose of discovering information of a technological nature (i.e., information that relies on the physical or biological sciences, engineering or computer science) that would be useful in developing a new or improved business product, process, formula, technique or invention. Included as research and experimentation costs are all costs related to the development or improvement of the function, performance, reliability or quality of a product, including the costs of obtaining a patent. Given the incremental nature of the credit, firms that are initiating new or expanded research programs in particular may obtain significant benefits from the credit if they plan to use the results of the research in a future trade or business.
Orphan Drug Credit
The Orphan Drug Credit permits a credit against income taxes of 50% of "qualified clinical testing expenses" incurred with respect to any drug for a rare disease or condition. To the extent that a credit is not used in a taxable year, it may be carried back one year and carried forward for 20 years beginning after the year in which the expenses are incurred. Expenses eligible for the credit are normally limited to wages paid to employees performing clinical testing or clinical testing support or supervision activities, the cost of supplies, or payments to independent contractors for clinical testing services. Generally, only expenses for clinical testing that occurs in the United States are eligible for the credit, although a limited exception applies if a sufficient testing population does not exist in the United States.
Intercompany Ownership and Use of Patents and Manufacturing and Marketing Intangibles
Ownership of the various intangibles, i.e., any patents, know-how, trademarks and other marketing or manufacturing intangibles, is an important tax issue because, under U.S. tax rules, the amount of a royalty that must be paid by a licensee that is related to the owner of the intangible must reflect not merely a market rate, but an amount that is "commensurate with the income" generated by the intangible throughout the license term. Under this requirement, the amount of the royalty payment that a U.S. licensor must report for tax purposes as received for its non-U.S. affiliates' use of intangibles in most cases must be adjusted throughout the license term to reflect the income earned from the sales of the product for which the royalty is paid. A similar rule applies to sales of intangible rights by U.S. taxpayers to related foreign purchasers.
Generally, where a multinational group holds intangibles that may be used both within and outside the U.S., it is best from a U.S. perspective to have a U.S. company own outright the U.S. rights to the intangibles and have a foreign company own the non-U.S. intangible rights. This structure is likely to reduce the group's global effective rate of tax on income attributable to intangibles, minimize cross-border transfer pricing issues, and avoid the withholding taxes that are imposed on royalty payments from or to residents of countries that do not have tax treaties with the U.S. that eliminate those taxes.
Cost Sharing Arrangements
One technique for minimizing U.S. tax concerns from cross-border use of valuable intangibles is a "qualified cost sharing arrangement (QCSA)." Under a QCSA, ownership of intangibles being developed can be divided on a geographic basis in consideration for payment of an appropriate share of development costs, thus assuring that U.S. members of a multinational group are not taxed on income generated by non-U.S. intangible rights. Because most other industrialized countries have adopted cost sharing regimes similar to the U.S. rules, QCSAs can minimize, if not avoid, disputes with tax authorities concerning the appropriate intercompany royalty for the use of intangibles.
A QCSA must be in writing and must provide that each participant will share the costs of developing one or more intangibles in proportion to its share of the benefits reasonably anticipates from exploitation of the rights assigned to it. A QCSA must also satisfy certain other requirements, including specification of the conditions under which the arrangement may be modified or terminated and the consequences to the participants from any modification or termination. An affiliate may participate in a QCSA even if it does not use the developed intangibles in a manufacturing or service business, but merely licenses the rights it receives.
A QCSA may be established for development projects after they have begun, although such arrangements are most efficient when established at the commencement of development. Any new participant joining an arrangement after development activities have begun must make a "buy-in payment," i.e., a payment to the existing participants to compensate them for their previous costs of development and to compensate for the value of intangibles developed (even if incompletely) prior to the new participant's involvement. Such a "buy-in" therefore may raise some of the valuation issues that a cost sharing approach is designed to avoid, although those issues are likely to be less critical than issues relating to the appropriate value of intangible rights that are fully developed outside of a QCSA.
Advance Pricing Agreements
Multinational groups that engage in intercompany transactions involving the sale or lease of property or the provision of services are potentially subject to disputes, not only with tax authorities, but between tax authorities, as to the appropriate transfer price payable in such transactions. Entering into a bilateral Advance Pricing Agreement ("APA") with the relevant tax authorities can be a useful tool for preventing tax audit issues and potential double tax problems during the manufacture and sales phase of operations.
As the name suggests, an APA is a ruling, in advance of a tax return filing, from a tax authority that the transfer pricing method used by a taxpayer in one or more transactions with its affiliates will be acceptable for income tax purposes. Although the IRS does issue unilateral APAs in certain situations, much greater certainty of results can be obtained through bilateral APAs, under which the IRS and the country in which the affiliate is resident agree on the appropriate transfer price method.
APAs, particularly bilateral APAs, may not be available in every situation and require an intensive and often time-consuming analysis of the intercompany transactions at issue. In appropriate cases, however, the time and effort involved in securing an APA may be justified by the savings in time and money from avoiding having to defend a transfer pricing audit or a dispute between U.S. and foreign tax authorities.
Intangibles Holding Companies
One technique a multinational group may use to reduce U.S. state corporate taxes is to create a holding company to own the group's U.S. intangible rights. Establishment of such a company to own, and charge sales affiliates a royalty for use of, such intangibles may minimize or eliminate state taxation of income attributable to intangibles. Such a holding company could be incorporated in one of the several states (such as Delaware) that either exempts from its corporate income tax royalties received from out-of-state sources or has no corporate income tax. Proper structuring of the holding company and its transactions with operating affiliates is important because state taxing authorities have increasingly taken the position that the use by sales corporations of intangibles held by holding company affiliates subjects the affiliates to tax where the sales that trigger the royalties occur. Generally, any separate U.S. intangibles holding company should be owned by a U.S. corporation in order to take advantage of the U.S. federal income tax consolidated return rules.