IP Structuring and its implications

LES South Africa Afternoon Discussion

Andre Visser

What are we talking about?

• What is Intellectual Property (IP)?• What must be done with it when created?• Does it have value?• How can further development or commercialisation be

funded?• Can it be taken offshore?

Focus

• Some of my own practical experiences• Loose thoughts• Not intended as a whitepaper on international tax structuring• Some recent tax changes highlighted

The concept IP for this discussion

• Very wide concept• Registered IP: Trade Marks, Patents, Designs• Also unregistered: client lists, formulas, know-how

• It is an asset• It has value (in most instances more than is appreciated)• Valuation difficult (reason for strict control)

Tax definition• Section 25I of the Income Tax Act (ITA)

“means any(a) patent as defined in the Patents Act, 1978, including

any applications for a patent in terms of that Act;(b) design as defined in the Designs Act, 1993;(c) trade mark as defined in the Trade Marks Act, 1993;

Tax definition(d) copyright as defined in the Copyright Act, 1978;(e) patent, design, trade mark or copyright defined or

described in any similar law or that in paragraph (a), (b), (c) or (d) of a country other than the Republic;

(f) property or right of a similar nature to that in paragraph (a), (b), (c), (d) or (e); and

(g) knowledge connected to the use of such patent, design, trade mark, copyright, property or right”

Exchange Control

• Always relevant in any discussion on South African tax or structuring

• No specific definition of IP, but it is accepted that the same approach is followed as SARS

• Accordingly wide meaning• Knowledge of Reserve Bank on nature of IP however

problematic

Where does it begin?

• Invention, idea, concept, design• Usually an individual/s• Also in a corporate environment e.g. researchers• The individual quite often takes no further steps – leaves

IP where it is• Cost often the determining factor as well as the unknown

factor – will it work?

Employee / Contractor

• Employment agreement NB• Even if legislation and common law may provide

assistance, better to address IP and ownership in a proper agreement

• Contractors / consultants: more often than not, no arrangement. IP accrues to contractor

• To transfer later, becomes a difficult process, together with tax and other costs

Transfer of IP

• IP is an asset• There is always a cost involved in transferring an asset• On disposal: CGT

Natural person 0 – 13.3%Companies 18.65%Trusts 26.64%

• Donation: donations tax 20%

The individual

• Separate IP into a vehicle• Risk• Structuring• Raising of finance• Commercialisation and disposal • Tax advantages

• Problem: transfer will incur CGT or donations tax• However, Section 41 to 47 of the ITA provides for rollover

relief

Receives shares Transfer IP

• No CGT, donations tax or other taxes• No money has to flow

Mr A

Company

In the Company

• IP may be further developed, commercialised and utilised• Various options to consider

• Where is the IP owned?• Should it be sold or licensed?• What funding opportunities exist?

• Should we go offshore?

Research and Development

• R + D comes at significant cost• Realisation that some incentives required to stimulate R +

D growth in South Africa• Section 11D of the ITA (introduced in 2006)• Basic principle: Deduction of up to 150% of expenditure

incurred• General principle: expenditure (costs) may be deducted

for tax purposes• Section 11D allows additional 50% deduction

• Recent changes to tighten control and requirements• Tax payer must

• Be carrying on trade • Have actually incurred the expenditure• R + D in South Africa• Directly and solely for R + D

• “trade” – pre-production expenses may be deducted once trade commences

• Activity must be• Discovery of novel, practical and non-obvious

information• Creation of patent, design or computer program• Creation of knowledge essential to the above

• Not eligible• oil, gas or mineral exploration or prospecting;• administration, financing, compliance or similar

expenditure;• the creation or enhancement of trade marks or goodwill;• development of internal business processes;• market research, market testing or sales or promotion;

or • social research, including arts and humanities.

Funding

• To develop IP, funding is essential• In broader terms * loan funding

* equity• Equity is provided by investors or owners. Usually

evidenced by a share certificate• If an offshore investor involved, share certificate must be

endorsed for exchange control purposes (often forgotten)• Capital is fixed and investors earn dividends• Dividends are subject to 15% dividends tax. SA Companies

excluded• To repay requires a process (usually share repurchase)

• Some flexibility if an instrument such as preference share is utilised

• Loan funding: could be from shareholders, financial institutions or government

• From shareholders – capital is advanced subject to repayment. Usually no, or limited interest

• From financiers – interest will be payable. Security? • IP could be provided as security, deed of security

registered in appropriate registry.• Interest payment will be deductable by the company,

reduces taxable income • If offshore funder – exchange control approval required

Thin Capitalisation

• Recent changes to Section 31 of ITA• One single anti-avoidance provision under the ITA• The principle is that transactions between residents and

non-residents must be on an arms-length basis• If not, SARS may impose arms-length provisions and tax

accordingly• For instance, if capital is regarded as insufficient, portion

of loan funding interest, may not be deductable for tax purposes

Transfer Pricing

• “affected transaction”• Transaction, operation, scheme, agreement

understanding between connected resident and non-resident parties

• Any term or condition different to that which would have existed between arms-length parties

• Accordingly, loan transactions may be adjusted to arms-length terms

• Previous safe harbour rules no longer applicable

Exchange Control

• Thin capitalisation also relevant for exchange control. If 75% or more of shares held by non-resident, then local borrowing restrictions may apply

• Reserve Bank will also scrutinise loan arrangements • repayment terms • Interest payable (excessive interest not allowed)

Government Funding

• Number of government research grants and facilities are available

• However, in terms of Intellectual Property Rights from Publicly Financed Research and Development (IPR Act), such IP must be commercialised for the benefit of people of South Africa

• Description of IP very wide (excludes copyright)• Cannot deal with such IP without consent• National IP Management Offices (NIPMO) established for

this purpose

• NIPMO operates in a similar manner to the Reserve Bank insofar as control of IP is concerned

• Also strict requirements for transfer of IP (especially offshore)

• In our experience, stricter than Reserve Bank

Should IP be separated from the business?

• Creates planning flexibility• Isolates the risk of the business from the IP• Assists with international planning and expansion• Creates tax efficiencies through licensing arrangements

within the group• Properly manage IP

• Can spin of business and retain IP• Separates income from IP from business income• Assists with franchising• Capital raising (e.g. through a bond issue)

• However, there may also be certain disadvantages• Enforcement of IP in certain jurisdictions• Certain accounting difficulties• Proving damages

Public funding

• If IP portfolio is strong• IP may be securitised. Not common in South Africa • Require separate vehicle for this • IP is packaged into a bond, listed on the bond exchange

and traded• Cheaper than bank financing• Essentially a loan from the public in return for a return

Should we move offshore?

• Considerations• Low tax jurisdiction to minimise tax costs• Maximise royalties to move income to IP holding

entity• Maximise tax deduction for local entity• Minimise royalty withholding taxes through double

tax treaties

d

d

Difference between tax objectives and

IP objectives• Tax:

• Create optimal tax structure• Reducing tax liability• Minimise value to minimise taxes

• IP:• Protect IP (i.e. Not in risky jusidictions)• Maximise value for enforcement, and

defendable royalty rates

d

d

Basic conditions

• House IP in low tax jurisdiction • Maximise royalty flows to that jurisdiction• Ensure proper protection of IP rights and enforceability of

IP rights• Avoid liquidation issues• Ensure strong corporate law environment (e.g. Piercing

corporate veil)• “Kangaroo countries”• International treaties to enforce IP

Transfer of IP : Exchange Control

• Must obtain exchange control approval• Difficult• Must value the IP (arms-length principle)• If approved, IP may be transferred on receipt of proceeds

in South Africa • Oilwell decision seemed to create a possibility, but this

was changed by amendment on 8 June 2012

Transfer of IP: Tax

• Transfer pricing provisions relevant• Both SARS and Reserve Bank cautions of no-tax or low tax

jurisdictions• Mauritius: Popular destination from South Africa • Low Tax (0 – 3%) and double tax treaty within South Africa

and various other countries• Close to South Africa • CGT will apply on transfer

How to set up entity

• Subsidiary – with approval of Reserve Bank• Individuals – use R4 million foreign investment

allowance• Trust – cannot invest offshore

Tainted IP

• Section 23 of ITA• Tainted IP

• IP owned by connected person• Was utilised in the business of taxpayer• Transferred ownership to non-resident

• South African person, who retains use of IP, not entitled to deduction in South Africa

Controlled Foreign Company

• Income earned by CFC is taxed in South Africa (Section 9D of ITA)

• Foreign company in which South Africa residents hold more than 50% of participation or voting rights (excluding headquarter company)

• Certain exclusions, e.g. DTA or CFC pays 75% or more of tax in South Africa, in other jurisdiction

Break the link

• Connected person or South Africans should not own the IP / foreign company

• Most popular solution: foreign trust• Trust will hold the shares in the foreign company.

Beneficiaries under the trust will receive eventual benefits• Significant planning required to totally break the link due

to imputation rules• Must be set up by non-resident• Funding of the trust must be at arms-length (transfer

pricing)

• Donations will impute income to South African donors• Section 25B of the ITA:

if income accrues to an ascertainable beneficiary of a trust, income will be taxed in the hands of the beneficiary in South Africa

Royalty tax withholding

• Foreign company will enter into licence agreement/s with worldwide entities

• If to South Africa, be careful of tainted IP provisions and royalty withholding tax (RWT)

• 15% fo the amount of any royalty paid to non-resident• Royalty = right of use or permission to use IP (as defined), as well as

imparting scientific, technical, industrial or commercial knowledge or information

Management and Control

• If effective management and control is in South Africa, the entity will be regarded, from a South African tax perspective as a South African resident

• All income and capital gains will be taxed in South Africa • Practically: appoint foreign director/s• Hold board meetings in the specific country• Day to day management must take place in that country

Loop structure

• Holding of an equity interest in South African company or assets, via an offshore structure

• Prohibited by exchange control authorities• Could obtain approval, however, very rare and difficult

Mr A

Offshore entity

SA Company

Conclusion

• Proper structuring requires careful upfront planning• Tax and exchange control issues are quite often a

significant challenge• Structuring should not be to the detriment of IP

protection, or create an unnecessary administrative burden

THANK YOU

QUESTIONS?

Andrè VisserPartner PHONE +27 (0) 12 432 6206FAX +27 (0) 12 432 6544EMAIL andre.visser@adamsadams.comWEBSITE www.adamsadams.co.za PHYSICAL ADDRESS Lynnwood Bridge

4 Daventry StreetLynnwood ManorPretoriaSouth Africa

POSTAL ADDRESS PO Box 1014Pretoria0001South Africa