Fundamentals
About IP Strategy
What do we mean by “IP”?
We suggest that IP be defined in the widest sense. This keeps High Growth companies on the right side of legal compliance, and encourages a real, meaningful IP strategy resulting in rapid valuation creation, offshore.
We often hear that a High Growth company’s IP does not yet exist because it is at an early stage of development, or not yet commercially viable. This is often argued for the (fairly transparent) purpose of excluding an “IP” asset from the jurisdiction of Exchange Controls and/or South African tax. Frankly, this is almost always a waste of time and effort. The risk is that it opens the High Growth company up to being seen to breach Exchange Controls. There is almost always a fairly low reward to this risk, in our view, given the speed and effectiveness of the IP Strategy to mitigate this risk. We say this because the IP Strategy will typically result in South African “Legacy IP” becoming commercially irrelevant, quite fast. So there really is no reason to stray into the grey area of what is – or is not IP.
We like the OECD’s definition of IP, or “Intangibles” in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “Guidelines”). Simply put, IP is any asset which already has material value in the eyes of the owner; and if it was to be sold or licensed, then the owner would demand financial compensation in return for the sale or license. So yes, your existing software is indeed IP. But applying your IP Strategy will make that rapidly irrelevant, as you build and evolve your new IP offshore.
Exchange Controls and IP
South African Exchange Controls are real! They ultimately say that Treasury has control over all foreign currency reserves and that the South African Reserve Bank (the “SARB”) has control over the movement of currency and capital assets (including IP) into or out of South Africa.
Although Exchange Controls are created by a law, the actual legislation is frankly short, dry and still in the font you’d expect from a 1950’s typewriter. The real exchange control rules are located in a manual created by the scary sounding Financial Surveillance department of the SARB (Currency and Exchanges Manual for Authorized Dealers). These rules are challenging to understand, mostly because the rules aren’t written like laws or formal regulations, but resemble a manual suited to training staff on best practices. However, the rules contained in the manual are strict, and breaching them is a crime. This creates a real risk to entrepreneurs, because the rules appear to preserve a wide discretion for SARB to interpret and apply them. We’ve described the rules here and provided links to the detailed provisions of the manual, but be sure to get solid advice around how they apply to you.
Simply put, Exchange Controls state that a transfer of intellectual property to your offshore company in any way, directly or indirectly, can’t be done without SARB’s prior written approval. We’ve provided the current, detailed rule here (FN1).
(Footnote: B.2(A)(ii) Authorised Dealers should note that the transfer of South African owned intellectual property by way of sale, assignment or cession and/or the waiver of rights in favour of non-residents in whatever form, directly or indirectly, is not allowed without the prior written approval of the Financial Surveillance Department unless specifically exempted in the Authorised Dealer Manual.
However, while you can’t sell your IP to your offshore company, you can license your IP to your offshore company, on a few conditions. The first condition is that you show proof that the terms of that license are fair and comparable to the terms you would offer a completely independent third party. You also have to show proof that the license fee you are charging is market related – again, this means that you show it is comparable to the license fee that would be agreed between completely independent third parties. SARB requires some form of evidence showing that the license fees are market related, and typically this would be done through a transfer pricing analysis one kind or another. (Transfer pricing is amazingly complex, but really comes down to showing market-based evidence which proves your license fee is fair).
About IP Strategy
Tax and IP
Tax is in fact a far more significant issue than Exchange Controls, when offshoring IP. That is why most countries don’t bother with Exchange Controls or trying to restrict the movement of IP over their borders. The tax tools are powerful – under international tax laws, SARS can tax your offshore company on the revenue it earns from its IP, if that IP was in fact created in South Africa (regardless of which company actually owns the IP). This is because international tax law takes a special interest in company groups which have entities in different countries. This is the feature of international tax law described as transfer pricing.
This is highly relevant to South African High Growth companies because they almost always have a company overseas and also a local South African operating company. Their goal is to own IP created by the group, in the offshore jurisdiction. The typical legal mechanism to do this, is for the South African company to merely legally assign all IP which it creates to the offshore company. In return for this, it may be paid for the cost of delivering the R&D services. However, the fee paid to the South African company could well be far too low, relative to the value and profitability of the IP sold to the offshore company. Indeed, that will definitely be the case if the offshore company has no human resources, performs no meaningful functions and takes none of the investment risk which led to the creation of the “offshore” IP.
To illustrate this, here is an extreme example. High Growth Company A sets up a company in the UK, which is the group’s offshore company. The offshore company is a mere shell with no employees. The offshore company enters into an agreement in terms of which the South African company develops IP for the offshore company. In return for this IP, the offshore company pays the South African company R5 million, to cover all its R&D costs. A few months later, the offshore company receives funding at a pre-money valuation of R100 million. In this fairly extreme example, the offshore company has no personnel and adds no value to the IP developed by the South African company. Therefore, the offshore company’s entire R100 million value will be attributable to the services delivered to it by the South African company. If the South African company was paid only R5 million for creating R100 million of value, the South African tax authorities could have a claim against both companies for the tax on another R95 million worth of fees, because, in essence, the South African company created the full value of the offshore company.
In this example, the offshore company was a complete shell with no genuine human resources. However, if the offshore company was in fact a legitimate company with a real authentic business establishment, then this risk would be mitigated or even removed entirely. If the offshore company performed the functions, took the decisions and took its own investment risk, then the offshore company could demonstrate that the R100 million pre- money value was in fact attributable to its own value- added functions, decisions and investment.
Accordingly, from a strategic perspective, our goal is to identify exactly what functions, decisions and investments would be required, so that the offshore company can demonstrate that it created its own value, revenue and profit (avoiding the risk that the South African tax authorities may claim that it under-compensated the South African R&D company.)
Tax and your offshore company
Placing IP offshore is one of the typical conditions for setting up an offshore company capable of attracting funding. However, tax planning is also a fundamental task of international structuring. The goal of most international structures is to empower a group to create and retain value offshore, in their target jurisdiction. This requires you to legitimately establish and manage the offshore company outside of South Africa. If your offshore company is effectively managed from South Africa, it could be taxed as a tax resident of South Africa, probably defeating the whole point of an international structure. Then, if the offshore company has no authentic business establishment in the offshore jurisdiction and South Africans own the majority of that company, then the South African shareholders may be liable for tax on any profits retained in the offshore company. Finally, if the offshore company relies on the South African company for all or even most of its real strategic functions, risk management decisions and investment, then it may have to pay the South African company much of the value created offshore.
Bear in mind that this is a very brief summary of a very complex body of law, but if you’d like to explore this further, do reach out to the team at Dommisse Attorneys for a more detailed understanding of how international tax affects you.
