Intellectual property (IP) can be a great source of passive income, i.e., income that does not require daily effort to maintain. However, such income attracts not only entrepreneurs but also tax authorities. Most countries impose high taxes on revenues generated from IP assets, thus deincentivizing their citizens to develop such assets. To illustrate, the United States levies a withholding tax of 30% on certain US-source IP royalties paid to foreign persons.
The purpose of this article is to discuss some legal tax optimization techniques that will help IP owners to reduce their tax burden. More specifically, we will discuss the use of patent boxes (Section 3), relocation to low-tax jurisdictions (Section 4), and contractual structures enabling the reduction of tax burden on IP assets (Section 5). To provide the reader with background information necessary to better understand those techniques, we will initially examine the different types of IP assets (Section 2). At the end of this article, we provide concluding remarks (Section 6).
Types of IP Assets
We can distinguish three main types of IP assets, namely, trademarks, copyrights, and patents. A brief overview of those three types will be provided below.
Trademarks are a type of intellectual property consisting of signs identifying services or products. Trademarks can be either unregistered or registered. One can become a holder of an unregistered trademark by using a mark in commerce until the trademark gains sufficient reputation and goodwill. A registered trademark is a trademark registered with a trademark authority, e.g., the United States Patent and Trademark Office, the Benelux Office for Intellectual Property, or the Intellectual Property Office of the United Kingdom. The symbol ™ can be used to indicate an unregistered trademark, whereas the symbol ® refers to registered trademarks.
Copyright is a type of intellectual property that provides its owner with the exclusive right to make copies of creative works, such as books, music, photos, and pictures. The copyright term is usually limited to a specified period of time.
Patents are intellectual property assets that give their owners the right to exclude others from using, making, or selling inventions. Similarly to copyright, patents are valid for a specific period only and that period usually cannot be prolonged. The term of a European Patent is 20 years from the date of filing an application.
In the field of tax law, the term “patent boxes” refers to special tax regimes that provide lower effective tax rates on income derived from intellectual property. The aim of the patent boxes is to encourage research and development activities that lead to the creation of new IP assets. Patent boxes usually apply to specific types of intellectual property only. Furthermore, not all countries have such boxes. For example, Germany, Norway, Greece, and Sweden lack patent boxes.
From the countries having patent boxes, it is sufficient to note Cyprus (the effective tax rate on qualifying IP assets is 2,5%), Luxembourg (5,2%), Hungary (4,5%), Poland (5,0%), Ireland (6,25%), and the United Kingdom (10%).
It should be noted that patent boxes are heavily criticized by the European Union and the Organisation for Economic Co-operation and Development (OECD). Also, some EU countries consider those boxes to be a “form of harmful tax competition”. Wolfgang Schäuble, a former finance minister and currently the president of the Bundestag, said that the patent boxes are contrary to the European spirit. Therefore, some or all patent boxes in the EU may disappear soon as a result of the pressure by the EU, individual EU countries, the OECD, and other international organizations.
Relocation to low-tax jurisdiction
Entrepreneurs who, for one or another reason, are not interested in using patent boxes can benefit from relocating to low-tax countries. By relocating to such a country, one can substantially reduce or completely avoid all taxes on his or her intellectual property assets. Below, we will analyze the tax benefits of two low-tax countries, namely, Bulgaria and the United Arab Emirates.
Bulgaria is a member of the European Union and strategically located on the crossroad between Europe and Asia. Its personal and corporate income tax rates are 10%. This means that income from intellectual property will be subject to a tax of 10%. The cherry on the pie is that physical persons who receive “author or license income” are entitled to deduct a fixed amount (40%) of expenses from their income, which means that only 60% of the generated income will be subject to tax of 10%.
The United Arab Emirates
The United Arab Emirates does not levy any tax on income generated from intellectual property. Furthermore, the Persian Gulf country is a home of many IP-related free zones which offer various benefits to IP creators. For instance, the Dubai Internet City (DIC) offers commercial and co-working spaces in the heart of Dubai. The DIC is home to large companies, such as Google, Facebook, LinkedIn, and Symantec, heavily relying on intellectual property. The Dubai Production City (DPC) is a free zone that provides facilities to media production companies, e.g., companies specializing in printing, graphic design, and publishing. Other free zones that are suitable for IP-related businesses include the Dubai Knowledge Village (educational free trade zone), Dubai Media City (home to news and tech companies), Dubai Healthcare City (a healthcare free economic zone), and Dubai Design District (an area dedicated to the design community).
Contractual structures enabling the reduction of tax burden on IP assets
By establishing the right contractual structures, IP entrepreneurs may be able to optimize their tax situation. For example, a company operating in a high-tax jurisdiction (the “Parent Company”) can register a company in a low-tax jurisdiction (the “Daughter Company”). The Daughter Company can be the owner of the trademark of the Parent Company. The Parent Company and the Daughter Company can conclude a license agreement stating that: (i) the Daughter Company grants to the Parent Company the right to use the trademark; and (ii) the Parent Company will pay monthly license fees to the Daughter Company. If this structure is applied correctly, the Parent Company can transfer (in the form of license fees) a substantial amount of funds to the Daughter Company which will be taxed in the low-tax jurisdiction of the Daughter Company. The funds will be regarded as a business expense in the high-tax jurisdiction of the Parent Company and, therefore, will be not be taxable there.
It should be noted, however, that the aforementioned structure may need to be created in such a way as to ensure that the Daughter Company is not merely a letterbox company (i.e., a company with just a mailing address), but also conducts management and economic activities. Therefore, when designing contractual tax optimization structures, one needs to take into account various non-tax related factors, such as a stable regulatory framework, an affordable workforce, and a cost-effective business infrastructure.
Bulgaria ranks well with regard to the aforementioned three factors. As a member of the European Union, it has fully implemented the EU laws which are widely regarded as detailed and comprehensive in scope. The average gross monthly salary of a Bulgaria in the third quarter of 2020 is just BGN 1321 (EUR 675). This allows entrepreneurs to easily hire many staff members in Bulgaria, thus ensuring that their companies have the economic substance required for becoming Bulgarian tax residents. Another advantage of Bulgaria relates to the low sale and rental prices of business properties. The average rental price of a business property in Sofia varies between EUR 12 and 14 per m2. The sale prices of business properties in Sofia vary between EUR 500 and EUR 2000 per m2, depending on the location of the property.
This article has indicated that the IP tax planning strategies may differ in accordance with the types of IP assets covered by those strategies. This is because the tax treatment of different IP assets may not always be the same. This is especially true for patent boxes which usually apply to specific IP assets. Entrepreneurs willing to benefit not only from an equal tax treatment of all their IP assets, but also from low or zero tax rates, can relocate to Bulgaria or the United Arab Emirates or create contractual structures using one of those two countries. Such relocations or contractual structures will provide more legal certainty than patent boxes which, as mentioned above, may disappear as a result of the international pressure.