The tax traps
New Zealand companies are becoming adept at developing valuable Intellectual Property (‘IP’). This IP is often sold or licenced to larger offshore companies, especially where the New Zealand owner lacks the funds to deploy the IP independently. Protecting the developed intellectual property is a primary concern. In addition, structuring the ownership of IP should be a high priority as it can play a significant role in preserving value. Structural planning is necessary due to the number of tax issues which arise when trading offshore. These issues are less relevant when trading domestically. It is important that the correct structure be put in place at the outset to avoid future pitfalls and headaches. It should be considered at the earliest opportunity and certainly before the development stage.
During the development phase, companies often invest heavily in research and development (‘R & D’). Generally speaking, research expenditure is deductible in the year incurred while development expenditure (costs incurred after a profitable product has been identified) is capitalised and amortised over the assets life. In certain cases, the expenditure may fall into the “black hole” category and be neither deductible nor depreciable. The potential impact of this can be costly.
In the early development stages there will be no income to offset these deductions and therefore companies will generally return losses during this stage. The losses will be carried forward until the company makes a profit, unless they are forfeited due to shareholder changes. In many cases this can be at least partially mitigated by using the R&D carry forward provisions. Put simply, these provisions allow companies to carry forward R&D deductions until they can be offset against future income. It is a simple choice process for the taxpayer, dealt with via the income tax return.
Once the IP has been developed a decision has to be made on how the company is going to commercialise the opportunity. There are three main options when commercialising IP, leasing, outright sale or direct deployment in the market. In the absence of effective structuring, tax leakage may arise, especially where commercialisation is offshore.
Leasing the IP
If the company leases the IP overseas, income will generally be received by way of royalties. Most countries with which New Zealand businesses trade will impose withholding tax on royalties paid to a foreign company. Tax is usually withheld at a rate of 5-10% depending on New Zealand’s double tax agreement with the country in question, or even higher for non-treaty countries. This is not a problem in itself as a New Zealand company can usually claim these foreign tax credits against any New Zealand income tax payable. The problem arises if the company is carrying tax losses which are sufficient to offset the royalty income. Zero net income results in no New Zealand income tax being payable and therefore foreign tax credits are lost. Unlike losses, foreign tax credits cannot be carried forward and utilised in a later year, they are simply lost.
Even if the foreign tax credits can be utilised, they do not give rise to New Zealand imputation credits and therefore full distribution to shareholders of the royalties received will create tax inefficiency, unless an alternative structure is considered.
Outright sale of IP
When selling IP, a number of tax considerations need to be taken into account.
- Companies need to be careful not to fall into the royalty trap and derive income as discussed above. It is therefore important that any sale of IP needs to be an outright sale. Proceeds from the sale will then be on capital account and as such non-taxable. If the purchaser is a non-resident, they will most likely prefer to buy the IP assets rather than the company in which they are held. The issue to address is how to access the capital gain given it cannot be paid out as a tax free dividend. Access of the capital gain by the shareholders is only available by way of winding up the company and distributing the gain. This may not be desirable, depending on the level of other activity in the company. As such, it is important to ensure that IP is held separately to facilitate the subsequent liquidation to access the capital gains. The use of Look Through Companies may be desirable to allow capital gains to be passed to shareholders without the need for liquidation
- Care needs to be exercised with the categories of IP being sold. For example, the outright sale of copyrights and trademarks should be on capital account, but the sale of patent IP is always treated as assessable income. Given the ability of the purchaser to depreciate patent expenditure (unlike copyright and trademark expenditure), it is important to understand the different tax treatments to ensure that the expectation of a capital gain does not become a taxable gain.
- A non-resident purchaser may be prepared to acquire the shares of a New Zealand company which owns IP. The New Zealand company may be acquired with consideration in the form of shares in a foreign holding company. The New Zealand vendors who previously held shares in the New Zealand company now own minority interests in a foreign company. The issue is how the shares in the foreign company will be taxed in the hands of the New Zealand vendors. The New Zealand Foreign Investment Fund rules provide some exemptions but they do not have wide application. Care needs to be exercised to avoid unintended consequences.
Many complex and costly tax problems can arise as New Zealand companies firstly develop and subsequently commercialise their IP, especially where foreign parties are involved. Most of these can be resolved or at least mitigated with early structural planning. A small investment of time and cost at the outset can pay huge dividends in terms of saved frustration and unnecessary tax costs. It is advisable to plan ahead and be prepared for the tax traps which will inevitably catch the unwary.
Further enquiries, please contact:
Colin De Freyne
T +64 (0)9 308 2573
T +64 (0)9 308 2570