1Q 2013 GDP numbers

This morning BEA released their advanced estimate of the U.S. GDP for the 1st quarter of 2013. The 2.5% rate of growth was both better than last quarter (0.4%) but less than economists had expected (3.2%). Once again, government spending was a drag as was the trade deficit. On trade, exports rebounded from a drop in the last quarter – but so did imports and at a greater level. Business investment slowed, with investment in equipment and software rising only 3% compared with the 11.8% gain in the 4Q 2012 and investment in business structure actually declining. Investment in information processing equipment and software slowed dramatically, although it was still positive. Investment in industrial equipment and transportation equipment actually dropped.
This general discussion of business investment highlights an ongoing problem with the GDP numbers. The statistics measure investment in various forms of tangible investments: structures, ICT equipment, off-the-shelve software, industrial equipment, transportation equipment and “other” equipment. It does not give us any guidance on investment in intangibles. So we do not know whether companies have increased or decreased their investments in important areas such as knowledge, human and organizational capital.
That is partly going to change soon. As I’ve also mentioned before, BEA is making a major revision in the GDP calculations later this year. Two of the big changes will help make the GDP data more accurate: capitalization of research and development (R&D)and capitalization of entertainment, literary, and artistic originals (movies, music, books, art work, etc.) Currently, both R&D and the cost of creating entertainment, literary, and artistic originals are treated as a direct expense. Under the new system, they will be treated as investments, as they should be since they have long paybacks not just immediate returns. As part of this shift, investments in these items will be specifically captured in the nonresidential fixed investment data. There will be separate data for software (now a subcategory of equipment), R&D, and entertainment, literary, and artistic originals. These changes will occur on July 31 with the release of the advanced estimate of GDP for the 2nd quarter of 2013 and will include revisions going back a number of years (in some cases to 1929). This should allow us to get a better picture of the I-Cubed Economy.
Note: the second estimate of 1Q GDP will be released on May 30. So today’s GDP number is still subject to significant later revision.

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Creating the Accounting System for the Factory

Great story over on Bloomberg about how Josiah Wedgwood created the modern accounting system for the factory era: “How a Potter Took Accounting Into the Industrial Age”.

Wedgwood’s products became so popular that he could charge high prices and the profits rolled in. But during an economic downturn in 1772, demand for the vases slackened. With serious cash-flow problems and an accumulation of stock, Wedgwood turned to his accounting books to solve this dilemma: Should he cut production or reduce prices?
And so he made a “price book of workmanship,” which included “every expence of Vase making” from the crude materials to the cost of the retail counter in London. This led him to discover the distinction between fixed and variable costs. The greatest manufacturing costs were modelling and molds, rent, fuel, bookkeepers, and wages. “Consider that these expences move like clockwork, & are much the same whether the quantity of goods made be large or small,” he told [his business partner Thomas] Bentley. “You will see the vast consequence in most manufactures of making the greatest quantity possible in a given time.”
Wedgwood used the findings of his cost analysis to make management decisions. He revised his policy of soliciting special commissions and made-to-order sales; lengthened his production runs for certain products; varied his usual high- price policy; reduced his stock in market downturns; and kept a careful eye on sales and marketing costs.
Many successful businesses failed during the financial crisis of 1772 — but Wedgwood’s survived, thanks to his innovation.

Now we have to create a new accounting system that differentiates between tangible and intangible assets – and, more importantly, among the various types of intangibles. Each industry and company has its own set of drivers. The accounting system needs to help management understand and manage those specific set of value drivers.

Federal government budget and intangibles

In a couple of previous years, I did a rough overview of the federal government’s investment in intangible assets. Today I am releasing my analysis of the President’s FY2014 budget request: Federal Investments in Intangibles: A Look at the President’s FY 2014 Budget
Below is a table from the report showing an Overview of Federal Investment in Intangible Assets
Overview of Federal Intangible Assets.png
As the table shows almost a quarter of the discretionary part of the federal budget is devoted to investments in intangibles. That rises to a third for nondefense discretionary spending. The overwhelming intangible investments are in education and R&D. However, many of the more modest investments are of great importance. For example, food and drug safety activities are vital to the brand reputation in those areas. Successful programs such as the Manufacturing Extension Program have returned far more back to the economy that their costs.
The analysis does not include all expenditures in a particular category of intangible, especially government training and community/company capacity building. Nor does the analysis include all possible intangible assets. While there are is an argument to be made that a health workforce is a more productive workforce, I have not explicitly not include funding for health, safety and environmental protection. Note also that the government can create an intangible asset for others, without investing in it, through granting monopoly rights: IP, landing slots, water rights, mining rights, broadcast rights, etc. In some cases, the government actually makes money from these intangibles, such as spectrum and broadcast licenses, certain mineral rights, etc. Another major area of intangibles are contracts and legally enforceable business relationships. I have not, however, included either the costs and revenues associated with government created assets nor the cost to the government of enforcement of civil legal actions.
Gathering information on intangibles investments in the federal budget is both easy and difficult. The federal budget, as prepared by OMB, has included a crosscutting capital budget for a long time in the Analytical Perspectives, Budget of the United States Government. Over time, this has come to be expanded into an investment budget covering physical capital, R&D, and education and training. The budget documents also include a separate R&D budget and a separate analysis of funding of statistical agencies, which is not included in the investment budget. However, other investments in intangibles need to be teased out of the budget. For example, there is no crosscutting analysis of the federal budget for arts and humanities, which is spread across the government with many agencies sponsoring their own arts projects. Likewise, the size of the federal commitment to capacity building is unclear. And the size of federal promotion (branding) activities is unknown. Thus, the government’s activities in promoting and managing intangible assets is visible in the high-ticket areas of science and education while next to invisible in all other areas.
The analysis highlights the hidden examples of intangible assets that developed as part of the standard operations of the government. The federal government seems to have a makeshift set of policies for managing these intangible assets and generating revenues based on these intangible assets. As a result, the federal government does not know what intangible assets it has, does not know how much it spends on developing intangible assets, and does not know the value of those intangible assets (either to the internal operations of the Federal government or in the external marketplace).
A few other nations have taken steps to better manage their intangible assets. For example, the UK Intellectual Property Office offers advice to government agencies on managing their intangible assets through their Intangible Assets Network. The most advanced version of government management of intangible assets is the French Agence du patrimoine immatériel de l’Etat (APIE). APIE acts as an internal consult to help agencies of the French government generate value from their intangible assets. This includes licensing of public-sector know-how and the trademarks (such as the Louvre museum and the museum management expertise), generating revenue from commercial repackaging of government information, and use of national buildings and monuments as film locations or for hosting events.
We need a better system for tracking investment in and then managing our governmental intangible assets. A first step would be the creation of a cross-cutting budgetary analysis of federal investments in intangible assets. The capital budget analysis already undertaken by OBM can serve as the starting point. Second would be a comprehensive study, possibly by the Government Accountability Office (GAO), of federal government intangibles assets and the policies in place to effectively utilize those assets. Earlier this month GAO released a report on the duplication and overlap among STEM education programs. A comprehensive look at government policies and investments in intangible assets would be a follow on to existing GAO activities. The result of such studies would be a better understanding what intangible assets we have — and how best to manage them.

Consultation Draft on the International Integrated Reporting Framework now available

For the past six months or so, I have been serving as an advisor to the International Integrated Reporting Council (IIRC). The goal of the IIRC is “to create the globally accepted International Framework that elicits from organizations material information about their strategy, governance, performance and prospects in a clear, concise and comparable format.” The Consultation Draft on the International Integrated Reporting Framework now available. The framework utilizes a model of six forms of capital: financial capital, natural capital, manufactured capital, intellectual capital, human capital and social & relationship capital. While this is somewhat different that the Intangibles Capital framework that I use, it is a useful construct to move toward greater acceptance of an expanded and integrated form of corporate reporting. The IIRC is now soliciting comments on the Framework. The comment period runs to July 15. I urge everyone to take a careful look at the framework and submit their comments.

Reorganizing STEM programs – and going beyond

Today we continue with our look at the President’s budget proposal (see earlier postings). One of the budget’s themes is “educating a competitive workforce.” Within this overall framework are a number of programs to improve human capital, including a focus on science, technology, engineering, and mathematics (STEM) education. Part of this focus is a proposal for consolidating the federal government’s programs.

The Budget proposes a comprehensive reorganization of Federal STEM education programs to enable more strategic investment in STEM and more critical evaluation of outcomes, reflecting an Administration priority on using Government resources more effectively to meet national goals. This reorganization is designed to increase the impact of Federal investments in four areas: K-12 instruction; undergraduate education; graduate fellowships; and education activities that typically take place outside the classroom, all with a focus on increasing participation and opportunities for individuals from groups historically underrepresented in these fields.

In the “Cuts, Consolidations and Savings” section of the budget document they propose eliminated 78 programs: 6 in Agriculture; 6 in Commerce; 6 in Defense; 8 in Energy, 10 in HHS; 1 in Homeland Security; 2 in EPA; 38 in NASA and in the Nuclear Regulatory Commission [Note: the number does not add up to 78 but to 77]. They also propose reorganizing 11 programs in NSF and one in NASA. Unfortunately there is no narrative summary describing what programs are begin eliminated and what programs they are being folding into. It appears they will be all moved to the Department of Education.
The proposal appears to come out of the work of the Committee on STEM Education of the National Science and Technology Council (part of the White House Office of Science and Technology Policy). Back in December 2011, the Committee published a report on the Federal STEM Education Portfolio which inventoried all the programs. That was followed in February 2012 with an progress report to Congress on Coordinating Federal STEM Education Investments. The Committee’s promised 5 year strategic plan does not yet appear to be published.
Bringing the numerous STEM programs into a coherent strategic plan is an important initiative. But there is a need to move beyond STEM to embrace other knowledge-based areas as well. We are moving to a post-scientific economy where, to quote Dr. Christopher Hill, former Vice Provost for Research at George Mason University:

the creation of wealth and jobs based on innovation and new ideas will tend to draw less on the natural sciences and engineering and more on the organizational and social sciences, on the arts, on new business processes, and on meeting consumer needs based on niche production of specialized products and services in which interesting design and appeal to individual tastes matter more than low cost or radical new technologies.

To thrive in this new environment, education needs to move from the classroom to the living room. Life-long learning should not be a slogan but an ingrained part of everyday life. And as important as STEM is, our economic future is not solely in the hands of our scientists and engineers. Our future prosperity rest on raising the skills and knowledge level of everyone. Productivity no longer comes just from new machines, but from new ways of organizing work. And as I’ve noted in an earlier posting, Professor Jamie Galbraith said it well when he said “American competitiveness depends at least as much on style, design, creativity and art – and especially on the liaison between technology and art.”
So it is my hope, therefore, that the STEM strategic plan will go beyond just coordinating STEM programs. It should also include the role of other area, such as design and social sciences, and the tie in between STEM and these other fields. That would be a major step forward.

Once again, a budget request for entrepreneurial training

As part of last year’s budget request (for FY2013), President Obama included a provision to create a Community College to Career Fund (see early posting). The Fact Sheet on the program published last year notes:

The Community College to Career Fund will support pathways to entrepreneurship for 5 million small business owners over three years through the nation’s workforce system and its partners, including: a six-week online training course on entrepreneurship that could reach up to 500,000 new entrepreneurs and an intensive six-month entrepreneurship training program resulting in entrepreneurship certification for 100,000 small business owners.

Unfortunately, this program was never funded. But the Administration keeps pushing for the program. It was including in the manufacturing initiative announced in February and is included in President’s budget for FY2014 released yesterday (an $8 billion request in the Departments of Labor and Education budgets).
I strongly support this initiative. However, I would suggest one addition: the training courses needs to include intangible asset management. As Mary Adams and I noted in our paper Intellectual Capital Management and Entrepreneurial Mentoring and Education, entrepreneurship mentoring and training needs to move beyond technical assistance:

Many such technical assistance resources already exist: legal, accounting, financial etc. In fact, an important part of the mentoring process is connecting the struggling entrepreneur with the appropriate technical resources. However, there is one set of technical assistance resources that are yet to be fully developed and deployed to help entrepreneurs: intellectual or intangible capital (IC) management. Economy-wide, IC comprises a large part of corporate value. In some high-growth companies this percentage can often approach 100% and successful management of IC is often the key to their success.
. . .
While large companies can afford the consulting expertise required to undertake IC management, such assistance is not available in an accessible, cost-effective form to high-growth start-ups. Intangible assets are basically all most start-ups have. It is critical therefore that entrepreneurs are able to visualize and articulate what are the start-up’s intangible assets and how they work as a system. This is especially important for investors but also for recruitment and strategy. Start-ups need to thinking carefully about their business models: how to get paid for what they know-including navigating between free and paid aspects of a value proposition. Keeping track of intangible investments is an important way of backing up the story of the company’s development. Finally, entrepreneurs need to understand that the ultimate reputation of their organization will be earned as a result of good intangibles management.

Adding an intangibles management module to the course would be a huge step forward.

President's FY2014 budget again includes intangible transfer tax proposals

Right now, every policy wonk in Washington is focused on this morning’s release of President Obama’s FY 2014 budget. I will have more on the budget and investments in intangible assets later. But right now I would draw your attention to an often overlooked accompanying document from the Department of the Treasury: the General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals. [For an overview of the tax provisions, see the WSJ story “Obama Seeks Overhaul of Corporate, Personal Taxes.”]
In what has become an annual ritual, the Administration once again proposes to tight up the regulations on the transfer of intangibles. This year’s proposal (below) is identical to last year’s proposal, which was a slightly modified version from the previous year’s proposal and the proposal from the year before that and the year before that.
As I’ve described before, the proposals go to the issue of companies transferring their intellectual property to subsidiaries located in countries where the royalty income is tax at a low rate or not taxed at all. The parent company “sells” the IP to the subsidiary and then pays royalties to that subsidiary for the use of the IP. The key question is the fair market value of that transfer. US law requires that the transfer be valued at the same level as if it was an arms-length transaction between two independent entities. The parent would then pay US taxes on that income. There is concern that companies are low balling the value of the IP, “selling” it cheaply so as to minimize the amount of US taxes they have to pay on the income from those sales. The US loses in two ways, the tax on the income from the sale and the tax on the income from the royalties.
The proposals go after a couple of issues with transfer pricing. The first proposal deals with imposing a tax on excess income from intangibles transferred to low-taxed affiliates. The second proposal goes to the enforcement powers of the IRS Commissioner under Section 482 to place his/her own value on a transfer whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” The proposal would allow the Commissioner to value the intangible on an aggregate basis. This appears to go after the well-know issue that portfolios on intangibles are more valuable than the individual items taken separately. The next issue is related. The proposal would expand the definition to include workforce in place, goodwill and going concern value. Those three intangibles are essentially “whole-enterprise” assets. They cannot be split off from the enterprise. As such, they are generally not transferred from entity to another as individual components like a patent or a trademark could be. Thus, the proposal allows the IRS to value the package rather than the parts. The proposal also goes after the issue of valuation by setting the standard as “taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative.”

TAX CURRENTLY EXCESS RETURNS ASSOCIATED WITH TRANSFERS OF INTANGIBLES OFFSHORE
Current Law
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” The regulations under section 482 provide that the standard to be applied is that of unrelated persons dealing at arm’s length. In the case of transfers of intangible assets, section 482 further provides that the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets.
In general, the subpart F rules (sections 951-964) require U.S. shareholders with a 10- percent or greater interest in a controlled foreign corporation (CFC) to include currently in income for U.S. tax purposes their pro rata share of certain income of the CFC (referred to as “subpart F income”), without regard to whether the income is actually distributed to the shareholders. A CFC generally is defined as any foreign corporation if U.S. persons own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that own at least 10 percent of the corporation’s voting stock.
Subpart F income consists of foreign base company income, insurance income, and certain income relating to international boycotts and other proscribed activities. Foreign base company income consists of foreign personal holding company income (which includes passive income such as dividends, interest, rents, royalties, and annuities) and other categories of income from business operations, including foreign base company sales income, foreign base company services income, and foreign base company oil-related income.
A foreign tax credit is generally available for foreign income taxes paid by a CFC to the extent that the CFC’s income is taxed to a U.S. shareholder under subpart F, subject to the limitations set forth in section 904.
Reasons for Change
The potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules. There is evidence indicating that income shifting through transfers of intangibles to low-taxed affiliates has resulted in a significant erosion of the U.S. tax base. Expanding subpart F to include excess income from intangibles transferred to low-taxed affiliates will reduce the incentive for taxpayers to engage in these transactions.
Proposal
The proposal would provide that if a U.S. person transfers (directly or indirectly) an intangible asset from the United States to a related CFC (a “covered intangible”), then certain excess income from transactions connected with or benefitting from the covered intangible would be treated as subpart F income if the income is subject to a low foreign effective tax rate. In the case of an effective tax rate of 10 percent or less, the proposal would treat all excess income as subpart F income, and would then phase out ratably for effective tax rates of 10 to 15 percent. For this purpose, excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from such covered intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. For purposes of this proposal, the transfer of an intangible includes by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement)). This subpart F income will be a separate category of income for purposes of determining the taxpayer’s foreign tax credit limitation under section 904.
The proposal would be effective for transactions in taxable years beginning after December 31, 2013.
– – –
LIMIT SHIFTING OF INCOME THROUGH INTANGIBLE PROPERTY TRANSFERS
Current Law
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” Section 482 also provides that in the case of transfers of intangible assets, the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets. Further, under section 367(d), if a U.S. person transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the property that are commensurate with the transferee’s income from the property. The payments generally continue annually over the useful life of the property.
Reasons for Change
Controversy often arises concerning the value of intangible property transferred between related persons and the scope of the intangible property subject to sections 482 and 367(d). This lack of clarity may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.
Proposal
The proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal also would clarify that where multiple intangible properties are transferred, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. In addition, the proposal would clarify that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
The proposal would be effective for taxable years beginning after December 31, 2013.

The first provision would raise $24 billion over 10 years and the second would raise $2.1 billion over 10 years.
There is also a provision included this year to simplify the treatment of intangibles by repealing certain anti-churning provisions.

REPEAL ANTI-CHURNING RULES OF SECTION 197 OF THE INTERNAL REVENUE CODE
Current Law
In 1993, Congress enacted section 197 of the Internal Revenue Code to allow the amortization of
certain intangibles (such as goodwill and going concern value). Prior to the enactment of section
197, such intangibles were not amortizable. To “prevent taxpayers from converting existing
goodwill, going concern value, or any other section 197 intangible for which a depreciation or
amortization deduction would not have been allowable under [prior] law into amortizable
property,” Congress enacted section 197(f)(9), which excludes an intangible from the definition
of amortizable section 197 intangible if (1) the intangible was held or used at any time on or after
July 25, 1991, and on or before August 10, 1993 (the “transition period”), by the taxpayer or
related person; (2) the taxpayer acquired the intangible from a person who held it at any time
during the transition period, and, as part of the transaction, the user of the intangible does not
change; or (3) the taxpayer grants the right to use the intangible to a person (or a person related
to that person) who held or used the intangible at any time during the transition period.
Reasons for Change
The rules under section 197(f)(9) are complex. Because it has been almost 20 years since the
enactment of section 197, most of the intangibles that exist today did not exist during the
transition period and, thus, would not be subject to section 197(f)(9). Even though the number of
intangibles subject to section 197(f)(9) may be minor, taxpayers must nevertheless engage in due
diligence to determine whether such intangibles exist and then navigate the complex rules of
section 197(f)(9). Accordingly, the complexity and administrative burden associated with
section 197(f)(9) outweighs the current need for the provision.
Proposal
The proposal would repeal section 197(f)(9) effective for acquisitions after December 31, 2013.

This provision would cost $2.3 billion over 10 years.
– – –
Our previous report, Intangible Asset Monetization: The Promise and the Reality, pointed out that taxation is an important policy tool that has not yet fully come to grips with the rise of importance of intangibles assets. For example, we have long advocated the expansion of the R&D tax credit into a knowledge tax credit by incorporating tax incentives for investments human capital as well as research. As part of a review of the intangibles and taxation, we suggest that it might be time to “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.” The report goes on to say:

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 [special purpose entities] and to ensure that the incentive went to new licensing activities only.

We have yet to have that discussion in any of the previous years when the Administration made its proposals. Maybe we can this time around. A good starting point would be some of the more recent suggestions for a “patent-box” tied to tightening of the transfer pricing rules (see earlier posting).