Sale and leaseback of IP

Leaseback of tangible assets is a financing arrangement, mainly to freeup working capital as well to be the economic owner of the asset. Leaseback is an option/tool to divest certain risk associated with the asset. In an IP leaseback, IP is sold by the first owner (FO) to another person (second owner/SO). The SO leases back the IP to FO in consideration for royalty payment. While leaseback is familiar to fixed assets, it is viewed skeptically w.r.t. IP.

A recent US ruling in case of Skechers held IP leaseback as a sham transaction, basis its facts. Though the ruling was regarding transactions between domestic entities, ruling is relevant from a transfer pricing perspective as the court analysed from a economic substance perspective.

Skechers USA LLC (Skechers) incorporated Skechers USA Inc.II (SKII), a Delaware Corp.. Skechers transferred to SKII all IP for the domestic market (trademarks, copyrights, patents). SKII leased the rights back to Skechers. Skechers was to pay all of its operating margins in excess of 2% as royalty to SKII. During field audit tax authorities noted:

1. Post above structuring , ETR was lower by 1.25%, which was the primary objective.
2. Simple interest on unpaid royalties due to be paid by Skechers. All interest & royalties computed were journal entries for deduction of income for tax purposes.
3. . No detailed workings were available for royalty, management fees and interest paid and they varied from 1.7% to 3% of domestic sales.
4. All money transfers between Skechers and SKII began & ended in the same Skechers bank account.

In case of IP leaseback, anything without substance is viewed as entered only for tax purposes and below aspects needs to be evaluated:

• Is there a circular movement of funds. Are revenue streams taxed in low tax jurisdictions and expenses are booked in high tax jurisdiction -net reduction in effective tax.
• Does the SO have the substance and capability to assume economically significant risks transferred by the FO.
• Post IP transfer, is there any change in actual groundwork on the DEMPE activities regarding IP or the course of activities is based on earlier plan / strategy or only minor modifications in reporting just to check the box for review of work by SO. Consequently, if there are no DEMPE activities by SO and all of that is outsourced to the FO.
• How is it documented in the intercompany agreement – Is there an economic reasoning/rationale for transfer of IP or is it for purpose of paperreality.
• Does the IP transferred have huge market potential and difficult to replicate by competitors. Is the IP transferred during its development–Hardtovalueintangibles (HTVI). Is there significant variance (>20%) between the assumptions made during the transfer from FO to SO and the actual outcomes.