The perils of overlooking IP issues in tax structures

Richard Spearman QC

Two cases reported on BAILII this week emphasise the importance of dealing with IP issues when you set up companies to save tax.

Both cases were heard by a deputy High Court judge, Richard Spearman QC. IP Draughts had not heard of him before now, but apparently he is a go-to barrister for gagging orders (also known as super-injunctions). Based on these two cases, he is fast becoming a specialist, albeit part-time, judge on the subject of implied IP terms in contracts.

Chadwick v Lypiatt

The first case, Chadwick & Ors v Lypiatt Studio Ltd & Anor [2018] EWHC 1986 (Ch) (31 July 2018), concerns the estate of the late Lynn Chadwick, a respected British sculptor and artist, who is particularly known for his work during several decades after the Second World War. On the advice of his accountant, and for tax reasons, he formed a company, Lypiatt Studio Ltd in 1973. He transferred certain existing assets into the company in 1973 and thereafter conducted most, if not all, of his artistic activities through that company.

Will the Chadwick case go to the Court of Appeal?

The dispute before the court was essentially whether Chadwick’s sculpture and artwork, and the copyright in them, belonged to the company or remained with the artist’s estate. Specifically did he transfer existing copyright into the company in 1973, and was he an employee of the company thereafter such that the company would be the first owner of any copyright that he created after 1973? The answer to these questions determined which of Chadwick’s descendants would benefit from these assets and in what shares.

Unfortunately, the documentation to address these issues was scanty.

There was no formal written transfer of property to the company in 1973, such as a deed of gift or a written contract, and certainly no formal assignment of copyright. There was no written employment contract between the company and Mr Chadwick for the period after the company started trading, but some payslips and other indirect evidence were before the court.

Ultimately, the judge agreed with the company’s barrister that the evidence was sufficient to indicate an oral transfer of assets, including beneficial ownership of the copyright existing in 1973. A beneficial owner may call for a formal assignment. And there was sufficient evidence to indicate that Chadwick was an employee of the company from 1973 onwards. Thus, the company owned the post-1973 works in dispute and the copyright in them.

IP Draughts’ reaction is that, while this may be the right decision, it is rather a stretch on the basis of the evidence mentioned in the case report.

Sprint Electric v Buyer’s Dream

The second case before deputy judge Spearman, reported this week, is Sprint Electric Ltd v Buyer’s Dream Ltd & Anor [2018] EWHC 1924 (Ch) (30 July 2018).

This case is a dispute between shareholders in a software business (SEL). The minority shareholder, Dr Potamianos, alleged that his service company, BDL, owned the copyright in the source code of some software that he wrote, which was being commercialised by SEL. He also alleged “unfair prejudice” by the majority shareholder in its conduct of the business of SEL, to his disadvantage as minority shareholder. This article will focus on the copyright aspects.

When Dr Potamianos joined SEL, the founder of SEL had invited him to form a company through which he would provide services to SEL. The founder pointed out that he and his co-founder had done this some years earlier, for tax reasons, and that “we have been using our service companies since 1989 with no problems”. As an aside, IP Draughts finds this an unpersuasive argument that he hears too often from commercial parties in relation to legal issues. What it really means is that the Revenue had not critically examined the arrangement from a tax perspective – so far.

As well as the service company, the parties entered into various agreements with a view to ensuring the benefit of “rollover” tax relief under the Enterprise Investment Scheme. The judge was distinctly unimpressed with some of the evidence he heard on tax issues, and spent some time considering how the tax avoidance activities of the parties should affect his analysis of the contractual relationships.

In the end, he decided that Dr Potamianos was, from a legal perspective, an employee of SEL despite there being no written employment contract between them and, to the contrary, an agreement between SEL and BDL for the latter to provide his services to SEL. The judge held that copyright created by Dr Potamianos in the course of his employment with SEL belonged to SEL, and not to BDL.

Lessons

In both of these cases, the parties established companies with a view to obtaining favourable tax treatment of income, and with little attention being given to the ownership of intellectual property. Partly, this is down to the fact that they took advice from accountants and not from lawyers. IP Draughts hopes that any competent commercial lawyer would have thought about the ownership of IP in work done by, in the first case Mr Chadwick, and in the second case Dr Potamianos, and would have ensured that appropriate agreements were in place to ensure that the IP was held by the correct legal entity. In this way, the parties might have avoided lengthy and expensive litigation.

Unfortunately, some parties are not prepared to spend time and money in getting the contractual details right, or to focus on IP issues. More fool them.

 

 

Royalty transfers: are you an evader, an avoider, or just “immoral”? Or none of the above?

Margaret Hodge MP: are you seriously telling me that…?

IP Draughts has been enjoying the re-runs, on the BBC Parliament TV channel, of the House of Commons Public Accounts Committee taking evidence on 12 November 2012 from representatives of Starbucks, Google and Amazon.  A recording of the session also appears on the Parliament website here.  The subject of their questioning was whether these companies pay enough tax in the UK, or enter into tax avoidance schemes, sometimes involving royalty payments for use of intellectual property, to transfer revenue to a jurisdiction where tax rates are lower than in the UK.

Let’s get the tempting clichés out of the way before we start.  Starbucks was given a roasting by the Committee, Google was asked some searching questions, and Amazon, well, the book was thrown at them.  Ahem.

The representatives of these companies (which seemed to have been chosen as symbolic of big international groups that sell to consumers in the UK) were keen to emphasise that they complied with the law in all jurisdictions in which they did business.  In other words, if they did engage in tax planning, it was tax avoidance (legal) and not tax evasion (illegal).  Committee Chair, Margaret Hodge MP, was keen to emphasise that they were looking not at whether the practices were legal, but whether they were moral.

From the tone of the questioning, it was obvious that the Committee thought some of these companies’ behaviour was immoral.  The general theme of the Committee seemed to be that if you run a large business in the UK, employing thousands of people, and successfully selling stuff to many people in the UK, you should pay tax in the UK, and not transfer revenues to group companies in other jurisdictions with lower tax rates.

It was difficult to glean the precise details of these companies intra-group revenue allocations from the Punch and Judy show that is a House of Commons Select Committee hearing.  In a nutshell, it seems that Google runs its European operations out of Ireland, Amazon is based in Luxembourg, and Starbucks in Switzerland and the Netherlands.

The evidence of Starbucks was particularly interesting, given its subsequent announcement (discussed later in this article).

How many beans make 4.7?

Starbucks has apparently made a loss in the UK for 14 of the last 15 years, despite being a major presence in most towns and cities.  The Starbucks group makes its profits in Europe, it seems, partly from its coffee trading operations in Switzerland and the subsequent sale of coffee from Switzerland to the UK.  According to the oral evidence before the Committee, it also charges a 6% (reduced to 4.7% after discussion with the UK tax authorities) intra-group IP royalty from the Netherlands to the UK.  There was some discussion by Committee Chair, Margaret Hodge MP, of the practice of other international groups that apparently charge lower rates of royalty, in the region of 4%, to their operations in the UK.

In response to her question, the Starbucks representative confirmed that the royalty paid from Starbucks UK to Starbucks Netherlands is subject to a low tax rate in the Netherlands, but he would not publicly disclose what it was, because of a confidentiality obligation to the Dutch tax authorities.  It seems that Starbucks has a special “low tax ruling” with the Dutch tax authorities.

Since getting its roasting by the Committee, Starbucks has announced that, in future, it will voluntarily pay tax in the UK.  The full text can be found on the Starbucks UK website here. An extract from the announcement follows.

 Specifically, in 2013 and 2014 Starbucks will not claim tax deductions for royalties or payments related to our intercompany charges.

In addition, we are making a commitment that we will propose to pay a significant amount of corporation tax during 2013 and 2014 regardless of whether our company is profitable during these years.

We are still working through some of the calculations, but we believe we could pay or prepay somewhere in the range of £10m in each of the next two years in addition to the variety of taxes we already pay.

What IP Draughts finds most interesting in this story is the idea that paying intra-group royalties should be considered immoral, and that political pressure can result in tax avoidance schemes being abandoned, even though they may be fully compliant with the law.

Dutch sandwich

Since IP Draughts started in practice, national tax authorities have steadily and relentlessly clamped down on international tax avoidance schemes that involve royalty payments.  Old editions of books on IP taxation made much of schemes such as the “Dutch sandwich”, in which royalty payments were made to the Netherlands and then on to the Netherlands Antilles, in the Caribbean, resulting in very low tax rates being paid.  Over the years, IP Draughts has heard tax advisers recommend other “tax havens”, such as Cyprus, Ireland, the Isle of Man and, for American companies, Bermuda.  More than one transaction that IP Draughts’ clients have had with North American companies have ended up being with a Bermuda company rather than the onshore company that the client was originally expecting.  Drafting tip: make sure you get a parent company guarantee from the onshore company, so that there is a company with assets that can be sued in the event of breach of contract.

Nowadays, it seems to be more difficult to make such schemes legally effective.  If the Public Accounts Committee has its way, not only will tax avoidance schemes be difficult to make work legally, but they will be difficult to justify to customers.

Is the practice of intra-group royalty transfers coming to an end, or does it still have life in it?  What are you seeing?