December 29, 2016 - Haoshen Zhong

Running Your IP Licensing Subsidiary

Today’s post is a followup to a post I made back in May. The setup is this:

I own 40% of a BVI corporation, and a nonresident alien owns the other 60%. The BVI corporation owns an operating subsidiary in country X. We set up a 2nd subsidiary in the Cayman Islands to hold IPs (software copyright, trademarks, domain name) and license them to the operating subsidiary.

We got into a lawsuit, and we settled it by having our IP licensing subsidiary grant a license to the other party for a modest royalty. Do we need to worry about anything?

In the previous post, we concluded that before the lawsuit, the IP licensing subsidiary was not a PFIC, because under an exception for collecting royalty from related persons, the royalties the IP licensing subsidiary collected from the operating subsidiary was not passive income, and the software was not a passive asset as a result.

In this post, we will examine the effect the lawsuit settlement has on the passive foreign investment company classification of the licensing subsidiary.

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

  1. Income test: At least 75% of the corporation’s gross income is passive income.
  2. Asset test: At least 50% of the corporation’s assets are passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad.

To determine if the licensing subsidiary becomes a PFIC as a result of the lawsuit settlement, let us look at whether the royalty income causes it to meet the income test or the asset test.

The related party rule does not exclude the lawsuit royalty

Royalties are normally passive income. IRC §§1297(b), 954(c)(1)(A). But in the previous post, we used a related person exception to exclude the royalties collected from the operating subsidiary from passive income.

Specifically, section 1297(b)(2)(C) tells us that passive income does not include royalty from a related person. The operating subsidiary is a related person for the IP licensing subsidiary because the same parent company owns all shares of both. IRC §954(d)(3). Therefore, the royalty collected from the operating subsidiary was not passive income.

And because the IP produces royalty that is not passive income, it is not a passive asset. Notice 88-22.

The result is that when the IP licensing subsidiary only collected royalties from the operating subsidiary, it was not a PFIC.

The third party to whom a license was granted in the settlement was not a related party, presumably. Therefore, the royalty collected from the lawsuit license does not qualify for the related party rule.

The active business exception does not apply

There is an active business exception for royalties:

Foreign personal holding company income shall not include rents and royalties which are derived in the active conduct of a trade or business and which are received from a person other than a related person… IRC §954(c)(2)(A).

There are 2 requirements:

  1. The royalty must be derived from the active conduct of a trade or business; and
  2. The payer must not be a related person.

The IP subsidiary is not engaged in an active business in the ordinary sense, but as it happens, active business in this context includes a category that is not normally thought of as an active business:

Royalties [are] derived in the active conduct of a trade or business if [the royalties are derived from licensing] property that the licensor has developed, created, or produced, or has acquired and added substantial value to, but only so long as the licensor is regularly engaged in the development, creation or production of, or in the acquisition and addition of substantial value to, property of such kind… Reg. §1.954-2(d)(1)(i).

Putting it in another way, if a company regularly develops IP of a similar kind, either because its normal business requires it to develop IP (for example, a pharmaceutical company) or because it is in the business of developing IP (for example, a software developer), then the royalties from licensing the IP is derived from active business.

Here, the IP subsidiary most likely does not develop the IP, nor does it make derivative works or add value once it has been assigned the IP. The royalties are not from an active business.

The royalties do not fit the active business exception to passive income. After the lawsuit, it is clear that the IP licensing subsidiary has passive income.

The IP licensing subsidiary may still have more nonpassive income than passive income

To determine if the licensing subsidiary is a PFIC under the income test, we must compare its passive income to its total income. But we run into a question of what goes into the total income.

Under the related party rule, the royalty collected from the operating company is not passive income. But there remains a question of whether the related party royalty should be included in the income test as nonpassive income. For example, the IRS has said if a parent company liquidates a subsidiary, the gain from the shares is not included in income at all for the income test. See PLRs 200604020, 200813036. This might suggest that related party royalties should be excluded from gross income for the income test.

Fortunately, Congress and the IRS told us why the gain from liquidating a subsidiary is not included in a parent company’s income, and the same reasoning cannot be applied to related party royalties.

For a 25% subsidiary, the parent company is supposed to look through the subsidiary to the underlying income to determine if it has passive income or not. IRC §1297(d). It makes sense to disregard shares in the 25% subsidiary and gains from them–otherwise the gain from the assets of the subsidiary would be double counted during a liquidation: Once as passthrough from the subsidiary’s income and once for the parent company’s own income. See H. Rpt. 100-1104 at 268.

The situation is different for sister companies like the IP licensing subsidiary and the operating subsidiary: There is no rule that requires the IP licensing subsidiary to take into account the income of the operating subsidiary. There is no double counting if we include the related party royalties in the IP licensing subsidiary’s income. So we should not ignore the royalties from the operating subsidiary for the income test. The royalties are included as nonpassive income.

It is still possible for the IP licensing subsidiary to avoid being a PFIC, but you have to compare how much royalties are collected from the operating subsidiary vs from the lawsuit license, and you have to compare the values of the IPs.

Be careful with the asset test

While the assets of the IP licensing subsidiary have not changed, the type of income they produce has. Some (or all) of the IP now produce passive income.

The IRS has said that intangible assets are classified as passive or nonpassive based on the income they produce. Notice 88-22. But it has not said what happens when the same IP produces both types of income. Presumably, you can allocate the total value of the IP based on the proportion of passive and nonpassive income it produces.

For example, if the IP licensing subsidiary collects $8,000,000 of royalties a year from the operating subsidiary for a software and $2,000,000 of royalties a year from the third party from the lawsuit for the same software, then presumably 80% of the software copyright’s value is nonpassive, and 20% of its value is passive.

But be careful when valuing the IPs, because each IP has an expected useful life. For example, if patent 1 produces $20,000,000 of royalties a year, but it is in the 20th year of its life; while patent 2 produces only $15,000,000 of royalties a year, but it is in the 4th year of its life, which is more valuable?

Patent 1 expires next year, so its value is probably only $20,000,000, but patent 2 may produce 16 additional years of income (not necessarily $15,000,000 per year), so patent 2 is likely more valuable than patent 1. This is where you need to be careful in assigning values to the assets.

Maybe it is better to make a check the box election for the IP licensing subsidiary at the start

A Cayman company may elect to its tax classification. Reg. §§301.7701-3(a), -2(b)(8). The IP licensing subsidiary may choose between a disregarded entity or a corporation. Reg. §301.7701-3(a).

If the IP licensing subsidiary chooses to be a disregarded entity, then its income and assets would be treated as those of the parent company to begin with. Under the 25% subsidiary lookthrough rule, the parent company would aggregate the business income and assets (presumably nonpassive) of the operating subsidiary with the royalty income and IP. The chance of having a PFIC is significantly reduced with the election.