Intellectual Property Tax Implications & Planning
The Organisation for Economic Co-operation and Development (OECD) and the G20 decided to address intellectual property taxation within the Base Erosion and Profit Shifting project by means of discussing appropriate transfer pricing rules. One has, therefore, to be aware of the potential intellectual property tax risks and challenges that could be made by the tax authorities in respect of any intellectual property (“IP”) related transactions. These risks can be avoided with proper intellectual property tax planning and advice.
Nowadays, companies are spending more and more time on not only protecting, but also on creating and developing their IP such as trademarks, patents, know-how, trade secrets, copyrights and designs. Transactions involving the transfer of IPs and/or the licensing of IPs to affiliated/unrelated parties with genuine commercial purposes are then also not uncommon.
Regrettably, abuse of such IP related transactions between/among affiliated parties for the purpose of obtaining tax benefits also take place, causing a big ‘headache’ for most tax authorities which subsequently led to the OECD to advance on intellectual property taxation.
Intellectual Property Tax Income from Selling
Hong Kong does not impose tax on capital gain. Hence, gain derived from the sales of IP is generally not subject to Hong Kong profits tax provided that it can be proved to the Hong Kong Inland Revenue Department (HK-IRD) that the gain is capital in nature. One has to note that in determining whether the gain is capital in nature, the HK-IRD will look at several factors such as length of period of holding the IP, frequency of similar transactions, the way of financing the acquisition of the IP as well as the reasons for acquiring and disposing the IP.
In view of the potential non-taxability of the disposal gain and the well-developed legal system for protecting IP in Hong Kong, one may consider to have IP to be owned by a Hong Kong company, provided that there are also commercial reasons/justifications for the Hong Kong company to hold such IP.
Intellectual Property Tax Income from Licensing
Intellectual property taxes in Hong Kong are mostly linked to royalty income. This royalty income is usually earned when licensing the rights to use the IP to other parties. The tax chargeability of royalty income in Hong Kong can be classified in two areas:
- In case the royalty income is earned by a person carrying on business in Hong Kong
Pursuant to the territorial source system adopted by Hong Kong, income including royalty income earned by a person shall be subject to profits tax under the general charging provision when it is derived from business carrying on in Hong Kong and arising in or derived from Hong Kong (i.e. sourced in Hong Kong). In other words, in case a person is considered as carrying on business in Hong Kong, its royalty income will only be taxable in Hong Kong when this income is sourced in Hong Kong.
It is however not straight forward to determine whether or not an income including royalty income is sourced in Hong Kong, and disputes on the source of income between taxpayers and the HK-IRD do incur quite frequently. Some cases are appealed to the Board of Review or even to the Courts for ruling.
In determining the source of royalty income from licensing the IP rights in Hong Kong, it is necessary to ascertain whether:
- The IP is created/developed by the taxpayer himself
- The IP is acquired by the taxpayer from other parties
- Only the rights to use the IP (but not the legal ownership of the IP) is obtained by the taxpayer from the owners and then sub-licensed to other parties for use.
In particular, the HK-IRD adopts the totality of facts approach in determining the source of income and the factors relevant for determining the source of royalty income include but are not limited to the following:
- the place of creating/developing the IP
- the place of using the IP by the licensees
- the place of the sellers/licensors/licensees of the IP
- the place of negotiating, concluding and signing the purchase/license agreements of the IP
- the place of acquiring the IP (if applicable)
- the place of acquiring and granting the rights to use the IP rights (if applicable)
- In case the royalty income is earned by a person not carrying on business in Hong Kong
According to the specific charging provision, even if a person is not carrying on business in Hong Kong, its royalty income might still be treated as deemed taxable trading receipts in Hong Kong and the relevant factors are:
- whether or not the IP in question are used in Hong Kong
- whether or not the royalty expenses have been claimed as tax deductible in calculating the assessable profits of the payee in Hong Kong
In case the royalty income is deemed to be taxable in Hong Kong, the deemed profit rate of the royalty income is either 100% (effectively 16.5%) or 30% (effectively 4.95%) depending on the following:
- whether or not the royalty payee is an associate of the royalty recipient
- whether or not any person carrying on a trade, profession or business in Hong Kong has at any time wholly or partly owned the IP in question
It should be noted that in case a double taxation treaty applies, lower rates may be available.
Common Intangible Assets Tax Implications Pitfalls
A great deal companies have business strategies around intellectual property monetization. Their well-thought designed business model creates, builds up and protects these intangible assets from competitors. Unfortunately, many fail to properly manage the revenue generated from those IP. Some other costly global taxation mistakes could be a consequence of the following:
- Inefficient IP management generates costly global tax liabilities in especially heavily taxed jurisdictions.
- Transfer pricing liabilities due to careless movement of IP between different entities and across jurisdictional borders.
- Intangible assets assignments from mergers and acquisitions that incurs in high costs with little profitability or business value.
- Improper suitability of the tax planning with the business nature and/or structure that trigger tax field audits, challenges or government investigations.
Anti-Avoidance Tax Rules & Intellectual Property
Under Hong Kong’s transfer pricing rules, income or loss arising from transactions between associated persons should be computed on an arm’s length basis. Otherwise, the HK-IRD is empowered to impose transfer pricing adjustments to either income or loss that gives rise to Hong Kong tax advantage. For this, arm’s length pricing documentation should be put in place, especially for substantial IP transactions among group companies e.g. charging of royalties, transfer of IP rights, cost sharing arrangement for developing IP.
Hong Kong tax laws also contain general anti-tax avoidance provisions. In case the HK-IRD is of the opinion that a transaction(s) is artificial or fictitious for the purpose of reducing the tax liabilities of a person(s), it may invoke the general anti-avoidance provision and disregard such transaction(s) in assessing the tax position of that relevant person(s).
In addition, even if a transaction(s) may not be “artificial” or “fictitious”, but is considered as being conducted for the sole or dominant purpose of enabling a person(s) to obtain a tax benefit, the HK-IRD may also invoke another general anti-avoidance provision and assess the tax liability of that relevant person(s) as if the transaction(s) or any part thereof had not been entered into or carried out, or in such manner as it considers appropriate to counteract the tax benefit which would otherwise be obtained. In light of the above, it is important for the transactions involving IP to have commercial purposes/justifications.
Advance Ruling & Taxability of Royalty Income in Hong Kong
The HK-IRD has been more and more stringent in assessing an offshore claim in recent years. In case one would like to have certainty on the taxability of the royalty income in advance and avoid the potential disputes with the HK-IRD in the future, he may consider to apply for an advance ruling with the HK-IRD.
HKWJ Tax Law & Partners Limited, a group of international tax advisers, can provide the relevant advice in connection with the intellectual property taxes and planning under Hong Kong, Mainland China and international tax. In addition, Triple Eight Limited, our sister company and part of the HKWJ Group, is able to assist you in applying for the registration of the IP. If you have any questions, please do not hesitate to contact us.