Late in 2017, the most significant piece of tax legislation in 30 years was signed into law by President Trump.
The legislation, known to most as the Tax Cuts and Jobs Act, fundamentally altered U.S. tax policy as it relates to patents, software and other types of intangible property commonly created in the tech industry. Although the Act focused significantly on foreign income and investments in intangible property, many of the changes also apply to domestic production and sales of intangible assets. On the international side, the Act imposed new taxes affecting intangible property held outside the U.S. and reinforced and expanded certain rules relating to IP migration. Domestically, the Act limits certain tax deductions for software developers and could increase the tax rates applicable to certain IP sales.
Amortization of Research and Experimental Expenditures.
Before the passage of the Act, business owners could deduct the cost of developing software as an ordinary business expense. Thus, owners could deduct the entire cost of hiring developers for the tax year in which the work was completed. This is not so under the Act. Starting in 2022, the cost of developing software will be specially classified as a “research and experimental cost,” which must be amortized over five years. As a result, developers should carefully weigh the potential tax and cash-flow consequences of investing in new software development activities to avoid any unexpected tax liabilities.
Certain Self-Created Property Not Treated as a Capital Asset
Before the Act, an inventor could sell a patent and pay tax at capital gains rates. Following the Act, the laws guaranteeing capital gains rates to such proceeds remain in effect; but the Act added conflicting language that denies capital gains treatment to “self-created” patents, without repealing the original language granting capital gains treatment. Thus, inventors hoping to pay capital gains rates on the sale of their patents may be walking into a minefield and are best advised to seek the counsel of a tax professional.
Although the domestic changes were significant, the Act was largely focused on revamping U.S. taxation of foreign income. The changes were sweeping in this respect. Two changes particularly affect intangible property – a new tax regime known as GILTI and an expansion of existing laws regulating the export of intangible property to foreign subsidiaries.
Global Intangible Low-Taxed Income
The first major change is a new tax on “global intangible low-taxed income” or GILTI. GILTI is entirely new and is intended to incentivize U.S. companies to relocate valuable intangible property out of lower-tax countries and into the U.S., where it can be taxed at traditionally higher U.S. tax rates. Although the name is clever, business owners shouldn’t mistake Congress’s proclivity for humorous acronyms as an interest in accurately describing the tax.
The tax is not directly imposed on the income from intangible property, nor is it imposed on income that could be considered “low taxed.” Rather, the tax is imposed on the income of all foreign corporations controlled by U.S. shareholders to the extent that income is greater than 10 percent of the foreign corporation’s physical assets. So, even though GILTI is not imposed directly on intangible income, the tax liability is likely to increase as more intangible property is held in the foreign corporation.
Prevention of Base Erosion: Limitations on Income-Shifting Through Intangible Property Transfers
Another significant change in the tax law was not so much of a change as a clarification and acceptance of current IRS policies. Under prior law, a U.S. person could not take advantage of certain provisions that permitted the tax-free contribution of property to a corporation in exchange for stock if the transaction involved intangible property contributed to a foreign-controlled corporation. Instead, the U.S. would treat the transfer as the sale of the asset, resulting in a deemed royalty payment to the U.S. taxpayer.
Needless to say, most taxpayers aren’t keen to pay tax on income they never actually receive. So, there was incentive to argue that the assets transferred overseas were not the type that would generate phantom royalty payments under the law or that the value of the deemed royalty payments should be as low as possible.
Recognizing the ambiguity and potential for abuse under prior law, Congress codified a much clearer definition of intangible property subject to these rules. As a result, taxpayers can rest assured that the transfer of any asset that is not clearly tangible (for example, goodwill or workforce in place) will fall within the ambit of these rules.
The Bottom Line
In sum, the Act made significant changes to the taxation of intangible property, particularly when that property is owned, used or being transferred outside the U.S. Even if these changes do not appear to directly affect a person’s current operations, owners, developers and potential purchasers should be aware of the changes and begin planning their affairs now to avoid high tax costs later.
Attorney David Brandon is a member of Miller Nash Graham & Dunn’s tax and business teams. He regularly advises on entity choice, formation, sales and acquisitions of businesses, state and local taxation, and domestic and cross-border transactions. He can be reached by phone at (503) 205-2372 or by email at firstname.lastname@example.org.