As Benjamin Franklin wrote in 1789, “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” It’s Tax Day and all the little people have to pay their taxes by today to the Internal Revenue Service. Well, at least April 17 is Tax Freedom Day! Just think, you only had to work 107 days to pay your share of taxes to the government.

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The Baristas, of course, are sunning themselves and sipping Long Island Iced Tea in the beautiful Cayman Islands. (There are no taxes in the Cayman Islands – government revenue comes from indirect taxes such as customs duties, stamp duty and annual fees levied on corporations.)

As we’re enjoying the proceeds of all the money we make off our Patent Baristas blog – which have been deposited in an Offshore Holding Company – we thought this would be a good time to ponder a few items about taxes.

The first U.S. income tax was in 1862 when the federal government was raising money for the Civil War. The first permanent U.S. income tax didn’t come along until the 16th Amendment in 1913. The deadline for paying taxes, though, wasn’t on April 15 until 1955 when it was moved later in the year to give the Tax Man more time to hang on to your money.

It’s funny to imagine that a system designed so that only the wealthy paid taxes currently puts middle-class taxpayers in the rich category. Now, the alternative minimum tax, originally designed to catch just 155 super-wealthy Americans who paid no taxes at all, will hit nearly 3 million taxpayers, up from fewer than 200,000 in 1990. Unless something is done, some 20 percent of taxpayers will be caught in the AMT net next year, up from 4 percent currently.

“Worried about an IRS audit? Avoid what’s called a red flag. That’s something the IRS always looks for. For example, say you have some money left in your bank account after paying taxes. That’s a red flag.” — Jay Leno

But the Baristas are not the only ones who can benefit from traveling to the Caribbean. Intellectual property is often the principal source of value and revenue for pharmaceutical and biotechnology companies. To lessen the tax burden, companies should consider whether to place their intellectual property rights in a holding company outside the United States.

Typically, this is a subsidiary intellectual property holding company in a tax-free foreign jurisdiction. The offshore holding company then grants a license to the parent company or other third parties in exchange for royalty payments. The goal, of course, is to minimize the parent company’s tax burden and limit taxation on revenue. Not only should the royalties generated by this offshore subsidiary be tax-free, but also generally the profits made abroad aren’t taxable in the United States until they’ve been repatriated.

Sound good? Consider these tidbits:

1. You need to establish the holding company early in the development of your intellectual property — before the IP has significant value (presumably prior to commercialization). You will be taxed on the transfer of the IP offshore, so you’ll want to soften the bite. Consider seeking the advice of a valuation expert to help substantiate the IP’s value.

2. Once IP rights are transferred, you usually pay royalties to the holding company in exchange for use of the IP. When you deduct these royalties from your company’s taxable income, the royalty rates become subject to scrutiny by U.S. taxing authorities. To lessen such scrutiny, establish a royalty rate as if it were between third parties in an arm’s-length transaction. Due to the complexities of setting royalty rates for IP — especially noncommercialized IP — seek advice from an independent expert.

3. Depending on which foreign jurisdiction you choose, your subsidiary may be required to withhold a percentage of the royalty payments for tax purposes. This is why you want to choose a tax-haven country with a favorable U.S. tax treaty — or no treaty at all. Jurisdictions with no U.S. tax treaties and no corporate tax infrastructure may appear the best choice, but in this post-Enron* business climate, U.S. tax authorities have heightened inspection of offshore holding companies.

Note: In the past few years, the Caymans have adopted information-sharing with the U.S. government, which makes it a bit tougher to launch that offshore corporation.

Warning: Do not make this kind of move without seeking adequate legal and tax advice for your jurisdiction in order to pass scrutiny from the IRS.

Enjoy the weekend. You deserve it!

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*Enron had about 800 Offshore Companies set up in the Cayman Islands for tax purposes. This was not the reason, by the way, that Enron had problems, in fact, it saved them millions of dollars in taxes. It was reported that Enron has not paid Federal income taxes for five years (since 1997) due to the tax credits, etc.

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