Holding Intellectual Property

The collapse of WorldCom, Inc., exposed a complex web of accounting irregularities. Within that web, recent filings by Dick Thornburgh, WorldCom's Bankruptcy Court Examiner, reveal a different type of scheme that involves the holding of intellectual property. Further scrutinizing the scheme reveals that WorldCom and its tax advisors, KPMG Peat Marwick LLP (KPMG), devised a tax avoidance scheme through the creation of an intellectual property holding company (IP holding company). This type of scheme has been widely and quietly utilized in the last twenty years by many corporations with substantial intellectual property. Indeed, as state taxing authorities have become more aggressive in their auditing process, the spotlight is now on the IP holding company scheme. Due to numerous states' slow recovery from the economic downturn and the shrinkage of state tax revenues in the last few years, more and more states have directed their attention to intercorporate transactions and income shifting schemes. In doing so, many states unearthed handsome amounts of royalty income generated by the licensing of intellectual property that had never been taxed. Utilizing this taxing power, states are eager to reach the royalty income accumulated by companies holding intellectual property, but in taxing such income, states may encounter a potential constitutional stumbling block. How does intellectual property become part of a tax avoidance scheme? What is an IP holding company? What are the tax and nontax reasons that facilitate the creation of this scheme? What are the constitutional challenges states may face in their efforts to tax royalty income? What are their alternatives? This Article will address these questions and argue that the IP holding company scheme is a complex tax avoidance program requiring states to devise an approach to taxation that reflects an understanding of intellectual property rights and of the interests of intellectual property rights holders. In and of itself, a scheme that results in tax avoidance is not illegal. There are considerable business reasons behind the creation of an IP holding company for a major corporation's intellectual property assets. Part I discusses the transformation of intellectual property into valuable corporate assets. Part II identifies and analyzes the IP holding company scheme. Notable examples illustrate the widespread use of this scheme by major U.S. corporations. Part III focuses on the constitutional reach of state taxing power to royalty income received by out-of-state holding companies in light of the U.S. Supreme Court's decision in Quill Corp. v. North Dakota. Part IV discusses how states attempted to evade constitutional requirements in their eagerness to tax the royalty income of out-of-state holding companies. This section analyzes the business situs approach to intellectual property rights as employed by states to justify their fulfillment of the constitutional requirements post-Quill. This section critiques the business situs approach by providing illustrative examples of how the approach reaches beyond constitutional limits. Part V advocates balancing the interests between states and holders of intellectual property. This section highlights some fundamental aspects of intellectual property rights that may assist states in their efforts to reach royalty income received by out-of-state holding companies that license intellectual property rights for use within states. This section also provides alternative approaches states may consider that pose less risk of constitutional challenges. This Article concludes that as long as intellectual property assets are valuable corporate assets and holders of intellectual property continue to seek ways to maximize their return on such assets, uncertainties regarding states' power to tax an IP holding company's income reflect a need for guidance from Congress and a need for uniformity of state tax treatments. Regardless of these uncertainties, the potential migration of intellectual property assets offshore poses yet another problem.