Many questions arise when consider a sale of Intellectual Property to a Foreign Entity. Especially in terms of valuation. For these cases, Internal Revenue Code Section 432 applies.
Transfer pricing is the action that occurs when two related companies trade within each other. When these related companies set the price for the goods and/or services to be traded or sold, transfer pricing is taking action.
Think of this example for a second, assume XYZ Corp. makes a transaction with one of its subsidiaries, XYZ Sub., and transfers intellectual property so XYZ Sub. can produce a new service within its area. In this scenario, transfer pricing occurred between the two related companies, which is a taxable event in many cases.
The IRC section 482 states that transactions between two related companies will be subject to special scrutiny to determine whether or not a common control is being used to reduce, avoid, or escape taxes. To determine the true taxable income in transfer pricing the IRC Section 482 states that when related companies trade or sale within each other, they must set a market price for the transaction in accordance to the “Arm’s Length” Principle. The “Arm Length” Principle aims to replicate genuine negotiation in the market to produce equitable agreements even when parties share the same interest.
Explained simply: The Arm’s Length principle tries to reconcile the fact that bias on value can occur when the transaction takes place between related parties. The principle intends to emulate the transaction as if both parties are independent and on an equal footing. Specifically in taxation law, authorities pay close attention to related party transactions, in order to corroborate the agreement’s validity and “fairness”… and more importantly, that parties are not skipping on their tax liability. In other words, that parties are not manipulating the value in order to avoid taxes. Penalties for wrongfully valuing the asset are high and can range from 20% to 40% over the marginal tax liability assessed, on top of interests.
In order to obtain the closest to an “Arm’s length” transaction, sellers must obtain an IP Appraisal from a reputable professional. Think about the previous example. If those companies followed the “Arm’s length” principle, XYZ Corp. must had set a market price for its transaction with XYZ Sub. (a related party) as if it were dealing with ABC Inc. (an unrelated party). This is what an appraisal will provide, the fair market value as if an unrelated party was the purchaser of the asset.
IRC Section 482 not only applies in the context of intellectual property, but for most assets, including stock and other financial instruments.
If you have a question, or comment related to IP or any other asset transfer between related parties, feel free to send me an email to the contact information below. Maybe I can help.