“Unlocking the Hidden Value of Intangibles”

Kenan Patrick Jarboe

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New report on manufacturing, design and innovation – and service

The National Academy of Engineering (NAE) has pre-released a new report Making Value: Integrating Manufacturing, Design, and Innovation to Thrive in the Changing Global Economy.
http://www.nap.edu/napbookwrapper.swf
The report is the summary of a workshop held this summer on the state of manufacturing. According to the report:

Manufacturing is in a period of dramatic transformation. But in the United States, public and political dialogue is simplistically focused almost entirely on the movement of certain manufacturing jobs overseas to low-wage countries. The true picture is much more complicated, and also more positive, than this dialogue implies.
After years of despair, many observers of US manufacturing are now more optimistic. A recent uptick in manufacturing employment and output in the United States is one factor they cite, but the main reasons for optimism are much more fundamental. Manufacturing is changing in ways that may favor American ingenuity. Rapidly advancing technologies in areas such as biomanufacturing, robotics, smart sensors, cloud-based computing, and nanotechnology have transformed not only the factory floor but also the way products are invented and designed, putting a premium on continual innovation and highly skilled workers. A shift in manufacturing toward smaller runs and custom-designed products is favoring agile and adaptable workplaces, business models, and employees, all of which have become a specialty in the United States. Future manufacturing will involve a global supply web, but the United States has a potentially great advantage because of our tight connections among innovations, design, and manufacturing and also our ability to integrate products and services.

One of the important features of the workshop was its interactive discussion. Unlike many such meetings, only a half a day of the day and a half workshop was devoted to traditional panels. The rest of the time was spend in small group discussions and breakout sessions. As a result, there are a lot of specific insights in the report from the workshop participants. Thus, this short report deserves to be read in full.
Having said that, let me highlight a couple of points I found especially interesting. First was the discussion of the changing nature of manufacturing. This is something that can’t be stressed enough.
I was especially heartened by the workshop’s core emphasis on the linkage between manufacturing, design and innovation. I would add that the discussion also included a focus on the linkage between manufacturing and services — something that the participants apparently interjected into the discussion. As the title of the workshop states, the emphasis was on “making value” not just “making things.” It is the utilization of those things that proves value. And that value comes from both the thing and the service the thing provides. The report used the example of the smartphone — which is only smart because of the services that the apps provide.
Another point emphasized was tight linkage between research & product development and manufacturing. Designing a product and making a product are closely linked – especially in an era of shortening product life cycles. As one participant said, “The new model is that we are all producers, we are all designers.”
This led to a discussion about co-location of research, design and manufacturing facilities. Interestingly, it appears that the participants could not come to a conclusion as to whether the past trend of geographical separation augmented by advanced communications technologies and occasional air travel would be replaced by greater physical co-location. The answer seemed to be, “it depends.”
The participants highlighted four areas for action: human capital, business practices, government services and policies, and infrastructure (including information collection, IP and R&D funding). Under human capital, I was pleased to see the discussion including examples of two leading institutions that have embraced design thinking: Aalto University in Finland. and the Hasso Plattner Institute of Design at Stanford University. And without using the term “design thinking”, the discussion of business practices seemed to touch upon it as a model of the innovation process.
I would also noted that the discussion of government services and policies included the issue of permitting of new facilities and the inconsistency of various government programs. We often overlook how the various programs work together at not only the federal but the state and local level. That would be an area for further investigation.
The preface of the report notes that the workshop was a direct undertaking of the National Academy of Engineering not, as is more common, in response to a government agency request. The preface also indicated that the NAE will be undertaking follow up activities. The NAE is to be commended for its initiative in this area. I look forward to the next installment.

The offshoring of IP – and finding ways to promote US growth

Last week, the Senate Permanent Subcommittee on Investigations held a hearing on offshore tax avoidance issues – as part of a long running series of hearings on the subject. Part of last week’s hearing was on the offshoring IP, mostly patents (the hearing also looked at how issue of companies report and shelter their offshore profits). In his opening statement, Senator Carl Levin, the Chairman, highlighted one of the concerns when companies transfer their IP to low-tax countries:

Under U.S. tax rules, a subsidiary must pay “arm’s length” prices for these assets, but valuing assets such as intellectual property is complex, so it’s hard to know what an unrelated third party would pay. These transactions transfer valuable intellectual property to wholly owned subsidiaries. Multinational companies and the legions of economists and tax lawyers advising them take full advantage of this situation to set an artificially low sale price to minimize the U.S. parent company’s taxable income. The result is that the profits from assets developed in the United States are shifted to subsidiaries in tax havens and other low tax jurisdictions.

According to the staff report:

Current weaknesses in the tax code’s transfer pricing regulations, Subpart F, and Section 956, and in the Financial Accounting Standards Board’s (FASB) accounting standard, APB 23 relating to deferred tax liabilities on permanently or indefinitely invested foreign earnings, encourage and facilitate the shifting of intellectual property and profits offshore by multinational corporations headquartered in the United States.

Part of the hearing specifically looked at Microsoft’s offshoring of IP to Ireland, Singapore and Puerto Rico. The Subcommittee questioned the initial transfer pricing of these assets and the amount of taxable profits coming back to the US from these three Regional Operating Centers (ROC). In Microsoft’s testimony it was noted that:

The foreign ROC compensation payments are computed in compliance with the applicable Treasury Regulations under Internal Revenue Code Section 482. Microsoft complies with the requirements of the Treasury cost sharing regulations contained in Treas. Reg. section 1.482-7.

[Note the hearing also looked at at HP’s use of loan facilities to, according to the Subcommittee, de facto repatriate offshore profits.]
None of this is specifically illegal. As the Economist‘s summary (“Corporate tax avoidance: The price isn’t right“) pointed out, “companies are bound to exploit weaknesses in the rules.” The question is what the rules should be.
Transfer pricing for intangibles is a long standing problem, which I have blogged on too many time to count. Both the Obama Administration and Congressman Dave Camp, the Chairman of the House Committee on Ways & Means have included proposals to address the issue in their respective tax packages (see earlier postings). The OECD has an ongoing project on transfer pricing of intangibles. And over a year ago, the anti-tax haven group known as the Task Force on Financial Integrity called for stricter accounting rules on transfer pricing, among other reforms (see the Economist “Avoiding tax: Havens above”).
Tightening up the transfer pricing rules will help. But there will always be people trying to find ways around the rules. It may be that a carrot and stick approach is called for. In our Intangible Asset Monetization report, I suggested that we should explore lowering the tax rate on intangible asset royalties, in conjunction with stricter regulations on international transfer-pricing mechanisms and cost-sharing arrangements and on passive investment companies:

Providing a more direct tax incentive to the licensing of intangibles by lowering the rate on intangible asset royalties, such as to the capital gains rate, is a more controversial proposal. This lower rate could be crafted to apply only to royalties for new licenses for a limited time, such as a sliding scale for three years. In crafting such an incentive, safeguards would need to be established to prevent the incentive from being used for simply transferring existing licenses to SPEs and to ensure that the incentive went to new licensing activities only.
In conjunction with such a tax incentive, the problem of tax havens should be addressed. Transfer pricing mechanisms and cost sharing arrangements need to prevent those transfers that, as the IRS describes, are “for inadequate consideration.” The issue (some would say the abuse) of “passive investment companies” should also be handled.
The notion of tax havens and loopholes is often a matter of perspective. One person’s loophole is another person’s incentive. However, there is a growing concern that the tax code has become overly complex and that rates could be lowered in conjunction with the elimination of certain specific provisions. Any such tax reform, including the possibility of closing loopholes currently applied to intangibles and lowering the tax rate on royalties, should be looked at very carefully in the context of the impact on the creation and utilization of intangible assets.

As I’ve noted before, the idea of a lower tax rate on patent royalties — the “patent box” — has gained acceptance in a number of countries. The rate and what constitutes “qualifying income” vary from country to country. For example, some countries allow a lower rare for income from copyrights as well as patents.
My recommendation (see earlier posting) is a version known as the Dutch “innovation box.” The Dutch innovation box is an expanded version of their earlier patent box to include credit for the outcome of research activities that have not yet resulted in a patent (referred to as a “technology intangible asset”). The tricky part is determining the amount of what income qualifies as income from a technology intangible asset. The Dutch use transfer pricing mechanisms negotiated with the tax authority. In their more limited patent box, Luxembourg uses a royalty approach assuming the income that the taxpayer would have earned if it had licensed the right to use the patent to a third party. The UK is using a “qualifying residual profit” formula for its new patent box. By the way, the UK took a year of consultations to come up with its method. And the methodology is so complicated that the UK is making their system optional – i.e. a company can elect to apply for the lower rate but are not required to go through the calculation if they don’t feel it is worth the effort.
But I would also tie the lower tax rate to domestic production. This could be done through a domestic production bonus provision where an even lower tax rate is applied to companies where over 50% of the royalty income comes from products manufactured in the US. The rate could even be on a sliding scale depending on the amount of domestic production.
The reason for such a provision goes back to the underlying goal. The public policy goal here is to promote more innovation and the utilization of that innovation (via production using that innovation) in the United States. This creates jobs and economic growth. A secondary goal is to capture the revenues from the income generated by that innovation and production activity. Tax policy should be crafted to provide an incentive to undertake innovation and production in the United States while creating a disincentive to move that activity elsewhere.
Hopefully the Senate hearings will help spur on such a change in the tax code.

Mainstreaming intangibles – not yet

Two stories in the past 24 hours are an interesting indication of how intangible assets are become part of mainstream economic activity (both macro and micro). One story in the New York Times (“With Smartphone Deals, Patents Become a New Asset Class“) looks at the business that has grown up around the monetization of patents: buying, selling, valuation services, and strategic advice. The second story in the Financial Times (“Intellectual property: A new world of royalties“) takes the macroeconomic view of how IP royalties are becoming more important in international trade (and trade agreements). However, both of those stories illustrate how far we are from having in place the economic and policy infrastructure needed for these assets to truly play a major role.
On the micro side, patents are still a volatile spot market with difficult valuations. While the Nortel patents commanded a high prices, Kodak seems unable to even come close to its asking price for its patent portfolio. And try getting a loan using your patents as collateral. As we point out in our reports Intangible Asset Monetization: The Promise and the Reality and Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance, much needs to be done before intangibles can be a regular part of the financial system. This includes regularizing both the trading process and the valuation standards.
On the macro side, royalties still play only a small part in our overall trade deficit. As we point out each month, our intangibles trade surplus is a fraction of our goods trade deficit (see previous posting). What will help the US economy is not simply more royalty income (although that would be a benefit). What will help is the utilization of our intangible assets to make our goods and services more competitive resulting in higher exports and lower imports. It is through embedding the knowledge and other intangible assets in goods and services that we will solve our trade problem. Pure intangibles trade cannot save the US economy; creating a more competitive economy using intangibles can.
So, while it is good to see stories in the New York Times and the Financial Times about the importance of intangibles, keep in mind that there is still much to be done before intangibles enter the mainstream.

Microsoft takes on design

As I noted in an earlier posting, design is taking center stage in the smartphone wars. But design is becoming more important in other IT area as well. According to Co.Design, Microsoft is paying more attention to design and the user experience. The article, “Windows 8: The Boldest, Biggest Redesign In Microsoft’s History” argues that the recent unveiling of the new Microsoft “Surface” tablet was not the main story:

what was really revolutionary at Milk Studios that day was the software driving the Surface: Windows 8, which aims to change the way we’ve been interacting with computers for the past three decades. Windows 8 could also transform the nature of the software giant’s competition with home-run king Apple, potentially reversing a string of embarrassing defeats, especially in the mobile market. Even more improbably, Microsoft is building this comeback attempt not on its traditional strength–engineering–but on, of all things, design.
. . .
Microsoft’s novel approach to interface design could cause tectonic shifts in the way software of all sorts is conceived.

That is a pretty bold statement. It is unclear whether the new Bauhaus-inspired design style for Microsoft products (code named Metro) will inspire customers. But it is clear that Microsoft has learned the lessons of Apple’s success when it come to the importance of design — and are hoping to beat Apple at its own game. But given that design is only part of Apple’s success story (see earlier postings), it remains to be seen whether Microsoft has gotten it right. Still Microsoft appears to be moving into brave new world that bears watching.

High growth companies are not the same as high-tech

A new study from the Kauffman Foundation on high growth companies (The Ascent of America’s High-Growth Companies) reminds us of a very important fact:

So-called high-tech sectors constitute only about a quarter of fast-growing Inc. firms: IT (19.4 percent) and Health and Drugs (6.5 percent). Other major sectors include Business Services (10.2 percent), Advertising and Marketing (8.5 percent), and Government Services (7.3 percent). Thus, innovations and growth of firms come from a wide range of industries.

And high growth companies are located in various places. The Washington DC area has the highest concentration of high growth firms. As the study points out:

There are innovative, high-growth companies outside of the usual suspects of technology places, like Silicon Valley. Such surprise regions include Salt Lake City (second), Indianapolis (sixth), Buffalo, N.Y. (eleventh), Baltimore (fifteenth), Nashville (eighteenth), Philadelphia (nineteenth), and Louisville, Ky. (twentieth). These clusters of Inc. firms, including those in the area’s so-called Rust Belt Region, suggest that population growth in the region is not necessarily a factor for growth of firms.

One point I found very interesting is that only 46% of the Washington high growth companies are in government services. Having watched the changes in the DC area economy for a couple of decades, this confirms the fact that the Washington economy is no longer just a government town. Yes, the Federal government remains the dominant economic player in the area. But surprisingly, the DC area has a higher than expected concentration of business services and human resources related companies.
Other sectors, such as bio and life sciences, are important as well – even though they don’t seem to contribute that much to Washington’s ranking in the report. Of course, the importance of this sector may have a lot to do with the fact that the National Institutes of Health and other government bio and health related agencies are nearby — which draw people in these fields to the area.
Which brings me to another point of the report. It’s people who matter the most:

While regional development literature suggests the presence of venture capital investment, high quality research universities, federal R&D funding (such as SBIR), and patents are good sources for growth, Inc. firms had no correlations with these factors. In contrast, we find that the presence of a highly skilled labor force is important for concentration of Inc. firms.

That human capital is the most important has major policy implications. As the report points out:

we further introduced an additional measure in the university role, namely, how many science and engineering graduates reside in the population. This factor is significant, so the Inc. score is not associated with university R&D, but with how many high-skill workers the university has produced or attracted. Therefore, while the literature in economic development has called attention to the importance of research universities, we find that the university’s teaching and training role is more important.(emphasis added)

We need to start paying more attention to the teaching role, which includes community colleges and non-research intensive universities. Maybe it is time for local economic development to start to take on the issue of college affordability. Not sure what can be done at the local/regional level. But we need to start thinking creatively about this.

Shifting intangible assets

We all know that intangible assets are key to economic success. Companies and economies prosper by identifying, fostering and utilizing their intangible assets. But the the importance of intangible assets can shift from one to another. Circumstances are not fixed. An example of such a shift is illustrated in an article a few weeks ago in the Economist — “Copyright and the internet: Letting the baby dance”:

A decade ago, commercial websites featured nasty lawyerish warnings against copying the content. Now many of these same sites sport icons encouraging people to share the content as widely as possible over e-mail, Facebook or Twitter. Loosening up may make more money than locking down.

In other words, the key intangible asset has shifted to the relationship, away from the content. Clearly companies’ strategies are adapting to and driving the shift. The question is, can public policy shift as well?