The Tax Implications of Holding Intellectual Property in a U.S. Parent or Israeli Subsidiary (and Vice-Versa)

Written by: Oz Halabi, Esq

Abstract
In a globalized economy, intellectual property (IP) is a critical asset for multinational corporations (MNCs), especially in the high-tech sector. Given diverse tax regulations in jurisdictions like the United States and Israel, these corporations face complex decisions around structuring IP holdings optimally. This article provides a comprehensive analysis of IP tax implications, focusing on recent U.S. tax reforms under Section 174 of the Internal Revenue Code of 1986, as amended (the “Code”), Israel’s Tax Ordinance (the “Ordinance”) Israeli Innovation Authority policies, and the strategic impacts of transfer pricing, withholding taxes, and cross-border R&D. Through an examination of relevant tax rulings, case law, and regulatory changes, this study aims to provide some guidance to tax efficiency optimization while ensuring compliance.

1. Introduction

The strategic location of intellectual property (IP) assets has significant tax implications for multinational corporations (MNCs), especially those operating in jurisdictions with distinct tax regimes, such as the United States and Israel. In both countries, unique tax policies shape the financial landscape for holding and developing IP. Key legislation like the Section 174 of the Code and Israeli tax incentives through the Encouragement Law and Innovation Authority, require detailed tax planning to optimize cross-border IP ownership. This paper evaluates critical tax implications and the strategic choices available to corporations in the context of evolving international tax landscapes.

2. Overview of Intellectual Property Taxation

Intellectual property (IP), including patents, trademarks, copyrights, and trade secrets, is a critical asset for multinational corporations (MNCs). However, its intangible nature allows for mobility, raising regulatory concerns regarding tax liabilities across jurisdictions. Governments have implemented numerous regulations to ensure fair taxation and prevent profit shifting, which has led to the establishment of frameworks like the Organization for Economic Co-operation and Development or (OECD)’s Transfer Pricing Guidelines and national rules such as the Section 482 of the Code and Section 85A of the Ordinance.

The following sections examine the nuanced benefits and limitations of holding IP in either a U.S. parent company or an Israeli subsidiary, or vice versa, highlighting specific tax treatments relevant to each jurisdiction.

3. Holding IP in a U.S. Parent Company

3.1 Section 174 of the Code: R&D Amortization and Capitalization Requirements

Historically, Section 174 of the Code allowed U.S.-based corporations to immediately deduct research and experimentation (R&E) expenses, offering a tax advantage for companies heavily invested in R&D. However, under the 2017 Tax Cuts and Jobs Act (TCJA), Section 174 of the Code was amended to require that R&E expenses be capitalized and amortized—over five years for domestic research and 15 years for foreign research. This shift affects U.S. corporations with R&D activities abroad by delaying deductions and increasing the tax burden of holding IP in the United States.

For U.S. corporations, this change incentivizes a reassessment of IP holding structures. For example, if significant research is conducted abroad in an Israeli subsidiary, the delayed amortization of R&D costs may diminish immediate tax benefits. The changes affect cash flow, financial projections, and overall tax strategy necessitate an analysis of alternative IP locations.

3.2 Transfer Pricing Compliance: Section 482 of the Code

Transfer pricing regulations under Section 482 of the Code are essential for U.S. companies engaged in IP transactions with foreign subsidiaries. U.S. transfer pricing rules mandate that transactions, including IP licenses and royalties, be conducted at arm’s length to ensure fair profit allocation across jurisdictions.

In Veritas Software Corp. v. Commissioner (2009), a landmark case, the IRS challenged Veritas’s IP transfer valuation to its foreign subsidiary, ultimately losing in court. The Tax Court emphasized the importance of precise valuation methodologies in IP transactions to prevent double taxation or inflated adjustments by the IRS.

In Veritas, the U.S. Tax Court addressed critical issues around the valuation of IP transferred between a U.S. parent company and its offshore subsidiary. Veritas, a technology company, had transferred valuable IP to its foreign subsidiary as part of a cost-sharing agreement. The IRS argued that Veritas’s valuation of the IP was understated, asserting that the transfer price did not adequately reflect the long-term economic value of the IP. As a result, the IRS issued an adjustment, claiming that Veritas owed additional taxes due to what it considered an improperly low valuation.

The Tax Court, however, rejected the IRS’s proposal to value the transfer using an aggregate or “akin to a sale” approach, which would consider the IP’s future income potential.. Instead, the court found that Veritas had reasonably applied the Comparable Uncontrolled Transaction (CUT) method, comparing the transaction to similar IP transfers between unrelated parties. The Tax Court noted that “the Commissioner’s determination… was arbitrary and capricious” and stated that the IRS’s valuation approach ignored the actual market value derived from comparable, independent transactions. The ruling in Veritas has had lasting implications for transfer pricing, particularly in IP valuations within cost-sharing agreements. The court emphasized the importance of using reasonable, comparable valuations rather than hypothetical models or projections that may not align with the transaction’s actual economic context. As the court noted, “a one-size-fits-all approach does not properly reflect the unique nature of the property or the transaction,” thus reinforcing that each IP valuation requires specific, context-based analysis.

Another important case on IP transfer valuation is Amazon.com, Inc. v. Commissioner (2017), where the IRS similarly attempted to apply a transfer pricing adjustment on Amazon’s IP transfer to its Luxembourg subsidiary. The IRS used a discounted cash flow (DCF) approach, suggesting that Amazon’s cost-sharing arrangement should have factored in the full future earnings potential of its IP. The Tax Court, however, rejected this approach, concluding that the IRS’s valuation was excessive and inconsistent with Amazon’s actual business practices and comparable transactions. The court held that “valuation must be based on what was actually transferred,” not hypothetical projections, reiterating that the CUT method was more appropriate than DCF for Amazon’s specific IP.

In Xilinx, Inc. v. Commissioner (2009), the court again emphasized that transfer pricing valuations should align with realistic, comparable data, particularly in R&D cost-sharing agreements. Here, the Tax Court found that Xilinx’s methodology was more aligned with the arm’s-length standard, rejecting the IRS’s attempts to impose an alternative valuation that did not match the economic reality of the transactions. These cases collectively underscore the necessity for precise, context-sensitive valuations in IP transfers, with the courts cautioning against speculative methods and reinforcing the significance of arm’s-length standards based on actual market data.

3.3 Global Intangible Low-Taxed Income (GILTI)

The Global Intangible Low-Taxed Income (GILTI) tax, introduced by the U.S. TCJA, aims to tax U.S. shareholders on certain types of income earned by foreign subsidiaries. Designed to prevent profit-shifting, GILTI taxes earnings from intangible assets, such as intellectual property, that are held in low-tax jurisdictions. Essentially, GILTI applies a minimum tax on foreign earnings that exceed  10% return on a company’s tangible assets abroad (e.g., factories and equipment), focusing on  income that may otherwise go untaxed or face minimal taxation outside the U.S.

GILTI requires U.S. shareholders of controlled foreign corporations (CFCs)—foreign subsidiaries where U.S. persons hold over 50% ownership—to include  any GILTI, in their taxable income, regardless of whether it is repatriated to the United States. Corporations are taxed at an effective GILTI rate of 10.5% (13.125% after 2025) on this foreign income, with the option to claim a foreign tax credit up to 80% of foreign taxes paid. While this partial credit can reduce GILTI liabilities, it often does not fully offset them.

The GILTI tax regime has significantly impacted multinational corporations, especially in sectors like technology and pharmaceuticals which have an influx of intangible assets. To reduce GILTI liability, companies have employed strategies such as shifting more tangible assets to foreign jurisdictions, increasing foreign tax payments to boost credits, or restructuring operations to mitigate the income defined as GILTI. This tax framework continues to shape how U.S. multinationals structure their international holdings and value cross-border intellectual property.

While Israel’s corporate tax rate is relatively high at 23%, U.S. companies holding IP in Israeli subsidiaries may still be subject to GILTI if the effective rate falls below a specified threshold, depending on tax credits and deductions taken in Israel. The Israeli tax regime applicable to technology companies,[1] imposing 6%-12% tax, may trigger GILTI tax if the Israeli company is held by a U.S. parent (thus making the Israeli company a CFC). Also, the calculation of the “effective tax rate” ignores carry forward losses, the GILTI exposure is significant.

U.S. companies should weigh GILTI’s impact on their tax strategy, especially as GILTI creates an additional layer of complexity in managing IP abroad. For U.S. MNCs that rely heavily on IP, GILTI’s implications may push some companies to explore alternative jurisdictions with comparable tax structures to Israel’s.

3.4 Withholding Taxes on Royalties

When a U.S. parent licenses IP to an Israeli subsidiary, royalty payments may be subject to withholding taxes, which could significantly affect the tax outcomes for both parties. The U.S.-Israel tax treaty[2] typically caps withholding tax on royalties at 10%[3] or 15%,[4] yet this rate can impact cash flow and necessitate strategic planning regarding payment timing and currency considerations. These withholding taxes may push U.S. MNCs to pursue alternative intercompany transaction models, such as cost-sharing arrangements, to mitigate tax liabilities. It is important to note that there are differences in withholding tax treatment between royalties, services and IP sales, which are outside the scope of this paper.

4. Holding IP in an Israeli Subsidiary

4.1 Israeli Innovation Authority (IIA) Restrictions on IP Transfer

The Israeli Innovation Authority (IIA) plays a key role in supporting and regulating R&D activities within Israel, particularly through its funding programs and grants to local and MNC engaging in innovation. However, companies that receive IIA funding are subject to strict restrictions on intellectual property (IP) transfer. These restrictions are designed to ensure that the economic benefits of IIA-funded R&D remain within Israel, protecting local investment in technology and innovation.

Israel’s Innovation Authority (IIA) offers grants for R&D, a major incentive for foreign companies to establish research operations in Israel. However, IIA funding comes with strict IP ownership rules. IP developed with IIA support is restricted from foreign transfer without IIA approval, with potential penalties or repayment obligations if transferred.

These restrictions require U.S.-based corporations to carefully weigh the benefits of the IIA against the potential limitations on future IP flexibility. For MNCs that anticipate global distribution or eventual IP relocation, the IIA’s restrictions may deter initial IP placement in Israel, despite the immediate advantages of R&D funding.

Key Restrictions on IP Transfer

1. Transfer Approval Requirement – IP developed with the support of IIA grants cannot be transferred out of Israel without the IIA’s explicit approval. This rule applies if a company wishes to move ownership of IIA-funded IP to a foreign entity, such as a parent company, subsidiary, or other affiliated entity abroad. The approval process involves a detailed review by the IIA, which evaluates the transfer’s potential impact on Israel’s economy, workforce, and technology sector.
2. Payment of a Transfer Fee – If the IIA approves an IP transfer, the company is generally required to pay a transfer fee. This fee is based on several factors, including Grant Repayment,[5] Royalties on Future Income,[6] or Potential Profit Multiplier.[7]
3. Alternative to Full Transfer – Licensing Options – Instead of a full transfer, companies may opt to license IIA-funded IP to foreign entities while retaining ownership in Israel. While licensing arrangements still require IIA notification and may incur fees, they are generally viewed as less restrictive and more favorable for companies that wish to retain operational flexibility.
4. Establishment of Foreign R&D Centers – If the IP transfer is tied to the establishment of an R&D center abroad, additional considerations and approvals are required. This ensures that the foreign R&D center complements, rather than competes with, local operations in Israel, and that it does not result in significant local job losses or technology migration.
5. Restrictions on M&A and Foreign Ownership – If a company with IIA-funded IP undergoes a merger or acquisition where a foreign entity gains control, the IIA must approve any resulting IP transfer. This requirement can complicate cross-border M&A activity, as foreign buyers need to consider potential IIA restrictions and fees, which may affect the valuation of the Israeli entity.

These restrictions influence how both local and multinational companies plan their R&D activities in Israel. Companies benefiting from IIA funding must carefully assess their long-term IP strategies, balancing the immediate benefits of grants with future limitations on IP mobility. For multinationals, it often makes sense to separate IIA-funded R&D from other R&D activities to ensure flexibility over non-funded IP. Overall, the IIA’s IP transfer restrictions are aimed at preserving the value generated from Israeli innovation, fostering a strong domestic tech ecosystem, and securing economic returns from government-backed R&D investments.

4.2 Encouragement Law in Israel

Israel’s Encouragement Law, established under the Encouragement of Capital Investments Law, is a tax incentive program designed to promote high-tech innovation within the country by offering reduced corporate tax rates on income generated from qualifying intellectual property (IP). This regime makes Israel an attractive location for multinational corporations and startups seeking a favorable tax environment for their R&D and IP activities. The main features and benefits of the Encouragement Law regime are:

1. Reduced Tax Rates on IP-Related Income – Companies that qualify under the Encouragement Law regime can benefit from reduced tax rates on income derived from eligible IP. For “preferred technological enterprises,” the tax rate is 12%, while companies classified as “special preferred technological enterprises” can qualify for an even lower rate of 6%. This significantly lower tax burden applies specifically to profits generated from the exploitation of IP, such as royalties, licensing fees, and product sales directly linked to the qualified IP.
2. Eligibility Requirements – To qualify, companies must meet certain criteria designed to ensure substantial engagement with Israel’s local R&D ecosystem. These requirements include substantial R&D investment, IP ownership, and qualifying IP assets.
3. Focus on Technological and Innovation-Driven Companies – The regime targets companies involved in advanced technology, pharmaceuticals, biotechnology, and similar high-tech fields where IP is a core asset. Israel’s Encouragement Law specifically supports companies whose products are globally competitive and whose IP generates high added value, such as through royalties, licensing fees, or premium-priced tech products.

Strategic Advantages for Multinationals and Local Companies

Israel’s Encouragement Law regime provides an appealing tax environment for both multinationals and startups. This regime incentivizes multinationals to establish their IP and R&D operations in Israel, where they can benefit from the country’s rich technological expertise and talent pool, while also enjoying reduced tax rates on the profits derived from their IP. Multinationals can often leverage this alongside other incentives, such as R&D grants from the Israeli Innovation Authority.

4.3 Transfer Pricing in Israel

Transfer pricing under Israel’s Section 85A of the Tax Ordinance aligns with OECD guidelines, ensuring that related-party transactions are conducted at market value. Holding IP in an Israeli subsidiary necessitates stringent documentation to avoid tax disputes, as cross-border royalties and licenses will be scrutinized to ensure arm’s-length pricing. Compliance with both Israeli and U.S. tax authorities is essentiall, and any deviation from proper pricing could result in tax adjustments or penalties by the Israel Tax Authority (ITA).

5. Holding IP in an Israeli Parent Company with a U.S. Subsidiary

Controlled Foreign Corporation (CFC) and Subpart F Income

The U.S. Controlled Foreign Corporation (CFC) rules can apply to a U.S. subsidiary of an Israeli parent company due to the structure of Subpart F. Under U.S. tax law, a CFC is defined as a foreign corporation in which U.S. shareholders own more than 50% of the voting power or value. A “U.S. shareholder” is a U.S. person (individual or entity) who owns at least 10% of the foreign corporation’s stock. The CFC rules aim to prevent U.S. taxpayers from deferring U.S. tax on passive or easily shiftable income earned by foreign corporations.

When a U.S. subsidiary generates certain types of income(e.g., royalties, dividends, or passive income) for its foreign parent, the CFC rules under Subpart F can still apply to this income, even though CFC regulations usually focus on foreign subsidiaries of U.S. companies. This happens in cases where the U.S. subsidiary has transactions or payments with the Israeli parent or other foreign affiliates that could shift profits or income to avoid U.S. tax.

The U.S. tax system applies these rules to prevent income shifting from U.S. entity  to foreign parents or affiliates. Payments of passive income like royalties, interest, or dividends, from a U.S. subsidiary to an Israeli parent or foreign affiliates may be scrutinized by the IRS as potentially abusive, especially if such payments shift income out of the U.S. tax base into lower-taxed jurisdictions.

6. Holding IP in a U.S. Subsidiary of an Israeli Parent

6.1 R&D Tax Credits vs. Section 174 Amortization

If an Israeli parent company holds IP in a U.S. subsidiary, it may benefit from U.S. R&D tax credits, which incentivize local research activities. However, Section 174 of the Code requires amortization of these expenses, reducing immediate tax benefits for Israeli companies conducting substantial U.S.-based R&D.

The R&D Tax Credit and Section 174 Amortization are two distinct U.S. tax provisions that provide benefits for companies engaging in R&D activities, but they differ significantly in their financial impact and timing. Understanding these differences is crucial for companies planning R&D spending, to particularly for those with substantial investments in innovation.

The R&D Tax Credit offers a direct credit against a company’s tax liability for qualified R&D expenditures incurred during the tax year. In contrast, Section 174 Amortization requires companies to capitalize and amortize their R&D expenses over five years for domestic R&D and fifteen years for foreign R&D, rather than deducting them fully in the year Incurred. This amortization requirement prevents companies from immediately writing off all R&D costs, spreading the tax deduction over multiple years instead.

This amortization rule affects Israeli subsidiary, potentially resulting in  taxable Subpart F income for the U.S. parent due to the limited annual deduction. For companies with large R&D investments, especially those with significant foreign R&D activities, this rule affects cash flow by deferring the tax benefit, making it a less favorable option for companies seeking immediate tax relief.

6.2 Withholding Taxes on Royalties and State-Level Taxation

Royalty payments from a U.S. subsidiary to an Israeli parent under the U.S.-Israel treaty are subject to a 10% or 15% withholding tax. Additionally, companies holding IP in U.S. subsidiaries must consider state-level tax implications, as states like California or New York impose specific rules that could affect IP-related income. This adds complexity to the decision to hold IP in a U.S. subsidiary, requiring careful planning to mitigate additional tax burdens.

7. Conclusion

In the complex global tax landscape, the strategic decision of where to hold IP significantly impacts MNCs operating in both the U.S. and Israel. As this paper has outlined, the tax implications for IP ownership and location are influenced by a myriad of factors, including U.S. provisions under Section 174 of the Code for R&D amortization, transfer pricing under Section 482 of the Code, the GILTI regime, and Israeli tax incentives such as the Encouragement Law and regulations from the Israeli Innovation Authority (IIA). Each jurisdiction imposes unique requirements and benefits, requiring companies to engage in detailed tax planning to optimize IP management and minimize tax liabilities.

For MNCs choosing to hold IP in the U.S., recent changes to Section 174 of the Code have introduced complexities by requiring capitalization and amortization of R&D expenses, impacting cash flow and increasing the tax burden on R&D conducted outside the U.S. Transfer pricing requirements, reinforced by notable court cases like Veritas and Amazon.com, Inc., emphasize the importance of precise, market-based valuations when transferring IP. Additionally, the GILTI regime imposes further tax considerations for U.S. companies with foreign subsidiaries, particularly those in low-tax jurisdictions, by aiming to curb profit-shifting and apply minimum taxation on intangible income held abroad.

In contrast, holding IP in Israel offers substantial benefits through incentives like the Encouragement Law, which provides reduced tax rates for qualifying IP-related income, and IIA funding, which supports local R&D. However, the IIA comes with strict restrictions on the transfer of IIA-funded IP, which can complicate potential cross-border transactions or IP relocations. Companies utilizing IIA grants must consider these limitations carefully, as they may incur transfer fees, require special approvals, or face operational constraints. Additionally, Israel’s transfer pricing laws, aligned with OECD guidelines, demand rigorous documentation to meet both Israeli and U.S. compliance standards.

Ultimately, MNCs must balance the benefits and challenges presented by both jurisdictions. For U.S.-based companies, GILTI considerations and Section 174 amortization may drive interest in relocating IP to Israel to take advantage of the Encouragement Law’s reduced tax rates. Conversely, Israeli companies with U.S. subsidiaries must navigate U.S. CFC rules and potential Subpart F income taxation. Each decision involves trade-offs that impact cash flow, compliance obligations, and long-term tax strategy. As the international tax environment continues to evolve, MNCs need a proactive, comprehensive approach to IP tax planning, integrating local incentives with global tax considerations to enhance profitability and compliance across borders.

[1] See below Section 4.2.

[2] Article 14 of the Israel US tax Treaty.

[3] Copyright or film royalty.

[4] Industrial royalty.

[5] The company may need to repay all grants received with an added premium, representing a return on the IIA’s investment in the R&D.

[6] The fee may include a calculated royalty percentage on future income generated by the IP if it is commercialized abroad. This ensures that Israel receives an ongoing benefit from the IIA-funded IP even after its transfer.

[7] For high-potential technologies, a transfer fee may be calculated based on projected or actual profit multipliers, effectively reflecting the IP’s economic value.