Over the past several decades, companies have taken advantage of technology like telephones and the internet to greatly increase international operations. This has led to developing and exploiting more intellectual property offshore. When services are not performed for a company in the United States, it is called “offshoring.” It considers the “where” services will be performed. This is different from “outsourcing” which considers the “who” will provide the services to the company. They are not performed by the company, but by a third party and may be done domestically or offshore. Offshoring is considered a subset of outsourcing.
There are two main business strategies of offshoring, called the captive form model and independent contractor model. The captive firm model is when a company hires their own employees and managers in the foreign country, train the local people and have exclusion control and responsibility over those people. The foreign entity works for the single firm and requires a very large investment and the liability falls on that firm to open the office. As a result, the firm has greater control over the people and personnel, training, and confidentiality.
In the independent contractor model, there is almost no commitment from the domestic firm because the work is done by an independent contractor who usually accepts work from multiple parties.
An example of offshoring is when assets like IP are held in a foreign jurisdiction, often with a lower or zero worldwide income tax rate. As an IP strategy, the process is relatively simple: incorporate an offshore company and then transfer to it the title to the IP with the right to sub-license and exploit in other countries. The new offshore holding company can then receive franchise fees and royalty payments from, for instance, the US parent company, accumulating income in that low-tax jurisdiction.
When a company is deciding where to offshore, it should match the operational goals of the company to the location being exploited. This simply means that if the company has ownership rights in Europe they would likely want to transfer them to a European IP company. Additionally, it may not be enough that a country is a signatory to TRIPS, since that agreement only provides the minimum standards for protection and typically enforces the national laws of the foreign country. Other considerations will come into play.
Some advantages to offshoring include lower taxes, increased confidentiality and a lower capital requirement. However, to achieve these benefits significant planning is required to avoid pitfalls like double taxation, illegality and incompatible foreign laws.
Taxes: One of the most beneficial advantages to offshoring is minimizing taxes. Non-resident companies can often be tax exempt or get lower levels of taxation. Yet, foreign governments may require a tax ruling to get the favorable breaks. Often the IP has to be exploited and maintained – meaning developed and marketed — within the foreign country. On the down side, double taxation occurs when revenues, let’s say royalty payments, are taxed in the offshore jurisdiction and are also subject to withholding taxes in the domestic country. As a result, they are taxed in both countries. One solution to this problem would be to incorporate the offshore holding company in a country with a double tax treaty network where dual resident companies pay taxes in only one country, such as Switzerland, Holland, Ireland, Malta and Luxembourg.
Confidentiality: Another advantage is that in some countries companies are not required to publish financial information or facts about directors and shareholders. A majority of the offshore jurisdictions will not disclose information to third parties unless there is a suspicion of terrorist or criminal activities. Furthermore, many countries have laws that are similar to British law and provides duties on the employees with penalties for misappropriating information. Unfortunately, however, when confidential information is sent to a non-U.S. attorney who is not subject to U.S. privilege law, the action could be considered a waiver of privilege or confidentiality. This is particularly the case with the independent contractor model when the independent contractor has access to confidential technology and is highly motivated with no legal requirement to preserve secrecy.
Costs: Costs can also be reduced with an offshore strategy. Although the IP company would need to have employees maintaining, improving and exploiting the IP, the staff or physical office costs may be less, minimizing overhead and expenses. For example, work can be billed at a lower rate of $30/hour in India as opposed to $300/hour for a junior associate in the United States. This can free up scarce domestic resources, like attorneys who have hefty workloads. Also, setting up an offshore company can be relatively fast and easy, and usually registration costs are less than in the domestic country. Furthermore, having these employees typically satisfy treaty residence requirements that permit reduced withholding tax rates on royalties, dividends and interest.
Legality: Another hazard to avoid is ensuring the offshoring strategy is not illegal. High-tax countries, like the United States, monitor offshore jurisdiction IP dealings and it is obvious to them when the main goal of the company is to save on taxes. The domestic company must pay royalties at an arm’s length (what a hypothetical, independent third party would pay) so if it charges royalties in excess to the lower taxed holding company, it may be illegally reducing the tax base of the higher-tax domestic jurisdiction. This may be mitigated if the offshore company is made a foreign partner or financial supporter during the creation of new IP which would allow it to register as an owner or co-owner. If the offshore holding company does not participate in the creation of the IP and later buys or becomes an assignee, transfer pricing regulations may apply which requires a fair market price and the possible payment of capital gains taxes.
Additionally, when using an offshoring strategy, the company may not use the IP as though it were still in the domestic country because the holding company is considered an independent business entity. This means that the domestic company should look to see what the offshore country laws require. For instance, several countries have compulsory licensing laws, which could force a patent owner to grant licenses to third parties with terms and conditions mandated by the foreign state.
Quality: Another consideration is the quality of the work product of foreign labor. For instance, when it comes to patents, every word in the patent can matter and could have an effect in enforcing it. One way to ensure a positive outcome would be to make certain the labor is properly trained and that their work is then carefully reviewed by a U.S. attorney. Finally, from a valuation standpoint, the foreign IP may be perceived as a lower quality product which may not justify the cost savings.
If done properly, an offshore IP strategy can have major benefits. But, a company must carefully consider the pros and cons in order to ensure the potential cost savings, which can be huge.