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A company's dealings with IP may attract corporation tax, withholding tax (in the UK, income tax), or VAT.

UK corporation tax applies to the acquisition, exploitation and disposal of intangible assets by UK companies. It covers all II' assets including trademarks, patents, copyright and design rights, know-how, trade secrets and goodwill. The regime includes useful reliefs but its legendary complexity has spawned a number of anti-avoidance rules. This complexity derives partly from the parallel operation of two sets of provisions; their application depends partly upon the age and background of the relevant asset.

A tale of two taxes

The "intangible assets" corporation tax regime introduced in 2002 broadly applies to IP assets acquired from a third party or created after I April 2002 (New IP). It taxes and relieves profits and losses arising from New IP as income, generally by reference to the company's accounts. The old regime (which, generally, taxes and relieves income receipts and payments as income, and gains as either income or capital gains, depending upon the asset and its context) applies to IP outside the '2002 Regime (Old IP).

Many multi-nationals operate both regimes in parallel. This is common in sectors such as fast-moving consumer goods where group members own a portfolio of brand names and other IP assets.

How are IP licences taxed?

IP assets are often exploited by licensing rights for a royalty stream. UK companies involved in licensing should bear in mind: deductibility of royalty and other payments for the licensee; taxation of royalty and other receipts for the licensor; withholding taxes on payments made under the licence; VAT (and its recoverability); and, where the parties are connected, transfer pricing, i.e. arc the arrangements on arm's length terms?

Normally a licensee can expect to benefit from deductions for fees, royalties and other payments made under the licence and the licensor is taxable on receipts (subject to available reliefs).

The licensee may be required to withhold taxes on payments it makes to a licensor in a different jurisdiction. Relief may be available under a double taxation treaty between the two jurisdictions or under European law, subject to anti-abuse rules and obtaining clearance. Where no relief is available the parties might contract through entities in the name jurisdiction or in others which allow relief.  Ultimately a licensor will want the licensee to gross up royalty payments to protect the licensor's receipts.

At the outset parties should consider likely exit scenarios and build appropriate .termination and amendment rights into the licence. For example, a group starting a new business may offer generous terms to a licensee. However, as the business grows, it may he justifiable for the licensor to charge higher royalty. The licensor would therefore benefit from the ability to terminate or amend the licence. For tax purposes, terminating or amending a licence, otherwise than in accordance with its terms, can give rise to a taxable profit or gain where one or both of the parties gives up a valuable contractual right, creating an unforeseen tax cost.

Structuring IP acquisitions and disposals

A group of companies should consider tax and IP together from the start for each IP asset it creates or acquires. The immediate questions will he whether the asset is New IP or Old IP (i.e. which corporation tax regime will apply) and whether tax relief is available for the cost of its acquisition or development.

For New IP, it may be possible to amortise acquisition costs, increasing the shelter for taxable profits. For Old IP the main consideration will be its original cost (income cost or CGT base cost, depending upon the asset), the main amount allowable against its eventual disposal proceeds.

A disposal of IP assets may result in a tax for the seller, whether the assets are New IP or Old IP Corporation tax will be payable on the realisation of profit or gain, subject to available reliefs. Under both regimes, losses may be used to relieve other profits of the company or its group if certain conditions (which depend upon the asset and regime in question) are met.

The form of a transaction involving IP assets may depend on tax considerations. Share sales have been popular since the introduction of the UK's "substantial shareholding exemption" (SSE) in 2002. Where conditions are met, the SSE exempts gains arising on disposal of shares (though it prevents capital losses being allowable). Where a purchaser also expects to benefit from the SSE on its eventual exit, the structure will be reasonably efficient, but whether the target company's tax treatment of its IP assets (including its IP asset acquisition costs) will change depends upon the circumstances.

Many purchasers will prefer to acquire IP assets - in addition to possible tax relief for New IP acquisition costs, no stamp duty is payable on the acquisition of IP assets (compared with 0.5% stamp duty for shares) and the purchaser can leave behind historic target company liabilities.

Groups

The intra-group transfer of an intangible asset between two UK corporation tax paying companies is generally tax neutral for Old IP and New IP. However, both regimes have anti-avoidance rules providing for a "degrouping charge if the transferee leaves the group within six years of the transfer.

Transfers of IP assets by UK corporation taxpayers to overseas entities generally result in a taxable event for Old IP and New IP alike, subject to available reliefs. Helpfully, the 2009 Finance Act will broaden the scope of one such relief. There are also a number of opportunities (mostly arising from the EC Mergers Directive) to structure IP-related transactions without triggering taxable profits or gains. These rules generally include anti-avoidance provisions.

VAT

VAT may need to be accounted for on the purchase of IP assets and other IP-related transactions (including licence payments). Depending upon the jurisdictions involved, the supplier may include an amount in respect of VAT on its invoice or the recipient may be required to account for VAT by a "reverse charge" at the local rate. Either way, such amounts are often recoverable, provided that the "input tax" on the incoming supply is attributable to taxable supplies made by the recipient company or its VAT group.

Transfer pricing

Transfer pricing regimes aim to prevent connected parties shifting profits offshore by entering into transactions otherwise than at arm's length. The UK regime enables HMRC to adjust the pricing for tax purposes in such situations to put the UK parties in the positions in which they would have been had they been acting at arm's length. The rules also apply to intra-UK transactions (to comply with EC law) but here they are effectively neutralised by "corresponding adjustments". The UK courts have recently heard their first substantive transfer pricing case and have interpreted the rules broadly.

HMRC is expected to work hard to increase the tax "take" through transfer pricing adjustments. Therefore, establishing and implementing an effective transfer pricing strategy is critical, particularly for multi-nationals with valuable IP assets and/or offshore IP companies. This strategy will usually include the commission of a transfer pricing report from an appropriate professional adviser as well as clear supporting documentation.

HMRC does offer taxpayers discussions and advance pricing agreements prior to submission of tax returns but many taxpayers prefer not to engage with it at such an early stage.

Effective structuring

A carefully considered structure can produce financial, legal and commercial benefits (through the separation of IP assets from other corporate liabilities) and tax savings. The optimal group structure will depend upon:

• The number and type of IP assets involved;
• The location(s) of IP rights. Is IP held centrally in one jurisdiction? Has it been created piecemeal by group companies in various jurisdictions?;
• Management structure and flexibility. Should relevant functions (e.g. R&D or brand management) be in the UK or overseas?;
• Likely sources of funding for ongoing licensing arrangements.
• The tax laws in the jurisdiction(s) where the IP is registered, owned and/or intended to be used. Is there a beneficial intangibles regime?; and
• The impact of rules affecting companies controlled by a parent company in a different jurisdiction, if an IP holding company is to be created. The UK's controlled foreign company rules are the subject of debate.

Equally, IP restructuring cannot be undertaken without a detailed analysis of the tax implications, and should not be considered seriously without confidence that a real cost saving (or other benefit) will arise and that real substance will exist in the relevant jurisdiction(s).

Notwithstanding HMRC's approach to transactions involving intangible assets in recent years, HM Treasury has announced a consultation with a view to enhancing the competitiveness of the UK for investment in intangible assets. It is to be hoped that this will improve dialogue between HMRC and corporation taxpayers in this area, but the proposals are yet to be seen: a report is expected in this year's Pre-Budget Report.

Authors

Rupert Casey joined Macfarlanes LLP in 1996 and became a partner in the commercial group in 2005. He specialises in commercial contracts and intellectual property, with his clients being predominantly major UK and global brand owners. He advises on a broad range of matters relating to the day-to-day operations of businesses, much of which involves expertise in intellectual property matters.

Hilary Barclay qualified as a solicitor in 2001 and joined the corporate tax group at Macfarlanes in 2006. Hilary works on a broad range of corporate tax matters including private and public M&A, corporate reorganisations and private equity matters. She also has experience of structured finance transactions and HM Revenue & Customs disputes.