“From IP to IC: why intangible capital matters”

IAM Magazine Kenan Patrick Jarboe

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Adding the patent box and intangible transfers to the tax debate

Earlier this week I posted an piece on Senator Baucus’ draft tax reform legislation. Interestingly the proposal does not contain a so-called “patent box” that would lower the tax on royalty income from patents. As I’ve noted before, the idea of a lower tax rate on patent royalties 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.
A recent OECD report on tax modernization (see earlier posting) highlighted the issues around intangible, although they did not address the patent box directly. They did warn that such “ringfencing” of specific forms of income could lead to a “race to the bottom.” Having said that, I still believe (as outlined in our our Intangible Asset Monetization report) 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. 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.
My recommendation 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. Tying a reduction in the tax rate on the fruits of innovation with a domestic production requirement and disincentives to harbor IP elsewhere would accomplish those goals.

Baucus tax proposal includes intangibles

Senate Finance Committee Chairman Max Baucus has released his draft tax reform legislation that includes provisions on intangible assets (see press release with links to discussion documents). Specifically, the draft legislation contains a provision to place limitations on income shifting through intangible property transfers. The technical explanation of the provision (from the Joint Tax Committee) is as follows:

The provision addresses recurring definitional and methodological issues that have arisen in controversies137 in transfers of intangible property for purposes of sections 367(d) and 482, both of which use the statutory definition of intangible property in section 936(h)(3)(B). The provision revises that definition and the authority to require certain valuation methods. It does not modify the basic approach of the existing transfer pricing rules with regard to income from intangible property.
The definition of intangible property in section 936(h)(3)(B) is amended to specify that workforce in place, goodwill and going concern value are intangible property. The residual category of “any similar item” is defined to be any other item the value of which is not attributable to tangible property or the services of an individual. Finally, the flush language at the end of that subparagraph is removed, to make clear that the source or amount of value is not relevant to whether property that is one of the specified types of intangible property is within the scope of the definition.
The provision also clarifies the authority of the Commissioner to specify the method to be used to determine the value of intangible property, both with respect to outbound restructurings of U.S. operations and to intercompany pricing allocations.138 First, in the case of transfers of multiple intangible properties in one or more related transactions, valuation of such intangible property on an aggregate basis is explicitly permitted if the Commissioner determines that an aggregate basis achieves a more reliable result than an asset-by-asset approach. The provision is consistent with the position that the additional value that results from the interrelation of intangible assets can be properly attributed to the underlying intangible assets in the aggregate, where doing so yields a more reliable result. This approach is also consistent with Tax Court decisions in cases outside of the section 482 context, where collections of multiple, related intangible assets were viewed by the Tax Court in the aggregate.139 Finally, it conforms with the position taken in the recently issued cost-sharing regulations.140
The provision also codifies the realistic alternative principle with respect to intangible property. The realistic alternative principle is predicated on the notion that a taxpayer will only enter into a particular transaction if none of its realistic alternatives is economically preferable to the transaction under consideration. As a result, the existing regulations provide the IRS with the ability to determine an arm’s-length price by reference to a transaction (such as the owner of intangible property using it to make a product itself) that is different from the transaction that was actually completed (such as the owner of that same intangible property licensing the manufacturing rights and then buying the product from the licensee).
137 Veritas v. Commissioner, 133 T.C. No. 14 (December 10, 2009), non-acq., IRB 2010-49 (December 6, 2010).
138 Sections 367(d) and 482.
139 See, e.g., Kraft Foods Co. v. Commissioner, 21 T.C. 513 (1954) (thirty-one related patents must be valued as a group and the useful life for depreciation should be based on the average of the patents’ useful lives); Standard Conveyor Co. v. Commissioner, 25 B.T.A. 281, p. 283 (1932) (“[I]t is evident that it is impossible to value these seven patents separately. Their value, as in the case of many groups of patents representing improvements on the prior art, appears largely to consist of their combination.”); Massey-Ferguson, Inc. v. Commissioner, 59 T.C. 220 (1972) (taxpayer who abandoned a distribution network of contracts with separate distributorships was entitled to an abandonment loss for the entire network in the taxable year during which the last of the contracts was terminated because that was the year in which the entire intangible value was lost).
140 See Treas. Reg. sec. 1.482-7(g)(2)(iv) (if multiple transactions in connection with a cost-sharing arrangement involve platform, operating and other contributions of resources, capabilities or rights that are reasonably anticipated to be interrelated, then determination of the arm’s-length charge for platform contribution transactions and other transactions on an aggregate basis may provide the most reliable measure of an arm’s-length result).

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Keep in mind however that the Baucus draft is just one more step on the road. As a story in the Wall Street Journal on business reaction to the proposal notes, there is a lot of concern over aspects of the proposal. The inside-the-Beltway maneuvering over the is likely to be fierce and long. Earlier this year, Senators Levin (D-MI) and Whitehouse (D-RI) introduced their own legislation to curb what they see as abuses of the intangible transfer process — the Cut Unjustified Tax Loopholes Act (see earlier posting).
It should be noted that House Ways & Means Committee Chairman David Camp had circulated his own draft proposal back in October 2011 that also addressed the issue of intangible transfers (see earlier posting). He has been working to refine his overall package since then (see Ways & Means Committee website on their activities). And the Obama Administration’s tax proposals submitted as part of their budget routinely addresses the issue of transfer of intangible assets (see earlier posting). In addition, this summer the OECD has published their own proposals on the transfer of intangibles — which the G-20 formally endorsed at their September summit (see earlier posting).
We will have to see whether all this attention to the issue results in any action. Taxation of intangibles is one small part of a very large discussion on tax reform. The timing of any action on that larger package is somewhat problematic. Chairman Camp had hoped to move his legislation in 2013, but that appears to not be possible. Senator Baucus has that comments on his draft proposal be sent in by January 17. That sets up an interesting election year fight over tax reform. Stay tuned!

Major new UK report on intangibles financing

The UK Intellectual Property Office has released its final report on Banking on IP? The role of intellectual property and intangible assets in facilitating business finance. A summary of the findings is also available.
The report provides a comprehensive description of the state-of-play on the role of intangibles in financing in the UK. It covers not only the current status but also the problems and barriers. In that regard, the report offers two overarching conclusions:

• A ‘resource toolkit’ must be put in place, aimed at helping SMEs, lenders and other financiers to make more effective use of the value IP and intangibles represent within businesses.
• The programme must build on existing initiatives.

The report also offers 10 specific recommendations:

1. IP and intangibles must be identified during the financing process. For IP and intangibles to be given any consideration within credit decision-making, tools to identify and describe the actual assets (not merely evidence of expenditure) need to be embedded within the lending process. Businesses must use them, and lenders must understand and take note of them. This step will have the wider benefit of boosting IP awareness amongst the business community as a whole.
2. The value of IP needs to be taken into account. The most important step in harnessing IP value is to realise that this value is not nil, and therefore requires active consideration. Robust approaches to determine the value of intangibles exist in the same way as for tangible property and are now included alongside them within the Royal Institute of Chartered Surveyors’ Red Book, regarded as a banking industry reference point.
3. Due diligence guidelines can help to control costs. Checks will be needed in order to create confidence that the ownership and quality of the IP and intangibles are understood, that they contribute to serviceability and cash flow (particularly in the case of debt finance), and that their maturity is in line with what it would be reasonable to expect, given the development stage of the business. This will require templates, training and/or access to professional advice, at a cost that lending margins can support, within a turnaround time that meets business requirements.
4. More effective charges should be part of the lending package. Once knowledge assets are captured and verified, it becomes possible to create a proper interest over them. Legal templates and the resource toolkit will help lenders to achieve this at modest cost, firstly by providing appropriate wording for the instruments, and secondly by providing guidance on the procedures which must be followed when recording them.
5. IP markets and IP financing could be facilitated through infrastructure improvements. The development most likely to transform IP and intangibles as an asset class is the emergence of more transparent and accessible marketplaces where they can be traded. This is a domain where services must stand or fall on their commercial merits; however, the available infrastructure needs to support rather than impede their establishment.
In particular, as IP and intangibles become clearly identified and are more freely licensed, bought and sold (together with or separate to the business), the systems available to register and track financial interests will need to be improved. This will require the co-operation of official registries and the establishment of administrative protocols.
6. On-going management of IP and intangibles should also be supported. IP does not stop being important once credit is granted. The asset class is unfamiliar, and lenders will need assistance in understanding it, monitoring it and encouraging businesses to use and protect it so that risk is reduced. There could be a role for the introduction of ‘milestones’ (as used in equity and venture debt) and impairment tests to ensure that businesses are well informed and motivated to adopt appropriate IP management practices.
7. Affordable risk mitigation strategies are to be encouraged. Alongside certain guarantees, access to appropriate insurance policies to guard against unforeseen events could greatly increase banking confidence in adding further weight to IP and intangibles within the lending decision. There is private sector appetite to provide these if lenders are willing to create the demand; more detailed dialogue on the requirements of both parties is urgently required.
8. Asset-based financing techniques should be adapted for IP and intangibles. Recent financial upheavals have triggered something of a return to first principles in lending and a greater emphasis on assets for business finance (reflected, for example, in ‘challenger’ bank activity). This greater emphasis on assets needs to be extended to include IP. Alongside mainstream lending, where EFG is an obvious area of focus, asset-based finance and alternative financing methods should therefore be targeted for IP-backed finance interventions; these are the parts of the finance industry most accustomed to understanding and assessing individual assets and their value.
9. Steps to stimulate private investment need closer study. IP rights

September trade in intangibles

September’s trade numbers are out and the deficit is growing again — up $3.1 billion to $41.8 billion. Economists had predicted only a slight increase to $39 billion. The bad news is that exports dropped by $0.4 billion while imports were up $2.7 billion. That may indicate some increase in domestic demand but a slowdown in our trading partners. The deficit increased in both petroleum and non-petroleum goods.
Trade in business services followed the same pattern with imports up and exports down slightly. However, royalty receipts (exports) were up more than royalty payments (imports). The result was that our trade surplus in pure intangibles stayed roughly at $16.1 billion.
The other bad news is a large increase in the Advanced Technology deficit to $8.1 billion. It unfortunately looks like August’s decline to $5.9 billion was not sustainable — as the September deficit mirrors July’s $8.3 billion deficit. Much of the increased deficit was due to a surge in imports of information and communications technology coupled with a slowdown in aerospace exports.
Advanced Technology goods also represent trade in intangibles. These goods are competitive because their value is based on knowledge and other intangibles. While not a perfect measure, Advanced Technology goods serve as an approximation of our trade in embedded intangibles. Adding the pure and embedded intangibles reveals an overall surplus of $8 billion in September compared to $10.2 billion in August.
Intangibles trade-Sept13.png
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Note: we define trade in intangibles as the sum of “royalties and license fees” and “other private services”. The BEA/Census Bureau definitions of those categories are as follows:


Royalties and License Fees – Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term “royalties” generally refers to payments for the utilization of copyrights or trademarks, and the term “license fees” generally refers to payments for the use of patents or industrial processes.


Other Private Services – Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term “affiliated” refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise’s voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

Return of the Digital Divide

This morning’s Washington Post includes a special report on the Digital Divide — based on a forum on the subject organized by the Post last week. (Note: the online version has links to videos of the discussions as well as summary articles).
For me, the forum was a case of déjà vu all over again, as Yogi Berra once said. Athena Alliance began back in the late 1990’s with a focus on the digital divide. Our first conference in 2000 was on Inclusion in the Information Age: Reframing the Debate. That was followed by our report Extending the Information Revolution: A White Paper on Policies for Prosperity and Security. Unfortunately, after the 2000 election, the topic of the digital divide fell off the policy agenda. So, it is good to see the topic resurrected.
In truth, however, the topic never went away. It took on a different tone and vocabulary. It become the issue of access to broadband. The “divide” part was played down and the state of the telecommunications infrastructure played up. It was a technology deployment issue.
And here comes the déjà vu part. Back in the late 1990’s/early 2000, it was primarily a technology deployment issue. And as the Post’s forum highlighted, it remains a technology deployment issue. The discussion is almost exactly the same (even given the shift in IT technology). As the Editor’s Note to the special report says, “It’s time that the country that brought the world the Internet extend its access so that everyone, including the poorest, can enter the digital age.”
But as we argued over a decade ago, entering the digital age requires much more than broadband connection. Access to the technology is the starting point, not the end purpose. Let me therefore reiterate the key points that came out of our 2000 conference:

Point one: Focus on the transformation, not the technology.
The issue of concern is the transformation to the Information Age. It is not simply a question of technological deployment. The end purpose is not to narrow some gap, but to ensure that everyone has access to the expanded opportunities. Our framework should be one of inclusion for all in the broader activities that make up society and the economy.
Point two: Review and coordinate efforts.
The problem has aspects of telecommunications policy, such as infrastructure and standards and elements of technology policy, such as research and development and technology deployment. But it also has aspects of policies on training and workforce development, education, economic development, housing and community development, human services and trade. Reaching our goal requires a coordinated approach — in the private, public and non-governmental sectors – that combines the various elements of providing opportunity and inclusion in the information age. To coordinate policy, the focus of governmental digital opportunity efforts should be the White House, not in any one department or agency.
It is also time to take a new look at some policy areas. For example, a comprehensive approach is needed toward all parts of managing the information commons: privacy, intellectual property rights, “right-to-know” policies and other related areas.
Point three: Work to ensure that everyone has access to the technological infrastructure.
Barriers to access to the infrastructure are many. Ways of overcoming those barriers are also varied, including public access facilities that can combine access with training and other activities, as well as home access. With respect to access in the home, we must return to the question of universal access. We also need to address the development of broadband capabilities – both at home and at work. Both home use and public access points are important. Multiple access public points are needed, such as existing public facilities, training centers, libraries, and after-school centers. For these facilities, sustainability is the key. But, it is not enough to simply provide access. We must work to weave information technology into the operations of community groups in a way that will both help individuals use the technology and will make those groups more efficient and effective in their core mission.
Some of the barriers to digital inclusion are physical: the usability of the technology. This is not, as commonly thought of, an issue only for those with disabilities. The problems of usability and human-machine interfaces affect all of us and research on ways to increase access for those with disabilities will pay off in increased usability for all.
Point four: Encourage and facilitate participation and involvement by all in the digital economy and information society.
To foster participation and involvement, the technology must meet people’s needs – not define those needs. Information technology can help people in their day-to-day lives if it is designed and structured in such a way that it helps answer their questions and solve their problems. Otherwise it becomes a barrier and a source of frustration. This is the danger of what some refer to as the “over-wired” world.
It is important to understand that individuals have different needs. A one-size-fits-all may help some – and increase their participation and involvement – but will block others. By focusing on “demand-pull,” rather than “technology-push,” we can better tailor the technology to meet individual needs.
Development of meaningful content, including more locally-based content, is one of the ways to increase the level of participation. E-government is one important form of meaningful content. But, we must also insure that those who are not on-line are not left behind. No services or information should be removed or dramatically cut back from traditional means of dissemination in favor of electronic dissemination until and unless all members of the community have access to that electronic means as easily as they have to the traditional means.
Point five: Focus economic development on the Information Economy, not the Internet Economy.
The information age will require a new approach to economic development. Key to the process is using and developing assets: financial, social, skill-based, and information assets. We must focus on building the local economy’s vitality and ability to compete in the age of globalization and help people make the switch to the new economy.
Our priorities should include:
• development of processes for identifying and assessing local assets,
• revitalizing programs for training the existing workforce,
• helping small and medium size enterprises make use of IT, and
• fostering entrepreneurship at all levels and in all sectors.
We must also develop and utilize new mechanisms for financing the transformation, including Individual Development Accounts and new ways of financing intangible assets.
Collaborative learning and sharing of information is also important in the larger process of economic development. There are a number of examples of information assets being applied within businesses and with local economies. We need to utilize new knowledge management techniques and old-fashioned communications techniques to collect, disseminate and better utilize that information.
Point six: We need a better understanding of what is going on.
We need to re-look at the data needed for economic development in the information economy. The problem of data extends beyond the scope of local economic data. We need both better data and expanded analysis of the socioeconomic aspects of the information technology. That research must be translated into policy relevant terms. For this reason, Congress should seriously consider re-establishing the Office of Technology Assessment (OTA).
Point seven: The decision making process must be open.
True inclusion and opportunity can only occur if the process of decision making is open and transparent. Information technology has a tremendous potential for opening and maintaining channels for general input and advocacy. However, decisions made about the technology can have the effect of closing off the process rather than opening it up. We must insure that all parties are at the table when decisions, including issues such as standard setting, are made.
Point eight: Innovate and experiment.
We are in a time of transformation and change. The speed of that change and the pace of economic activity will vary. Yet the change is real and will continue. In such a time, we must often invent new ways of coping with our problems and new policies for guiding our economy and society. Such experimentation will require great policy discipline, however. It requires a strong, unbiased means of evaluating programs and policies – and the political discipline to follow the guidance of that evaluation. We must also find means to ensure that the evaluations are timely for the fast moving policy arena. The goal in evaluation is not simply proving the effectiveness of an action – it is to facilitate learning. Learning is the hallmark of the Information Age. Our public policy process must embrace that concept as tightly as the rest of our economy and society already have.

The Post is to be congratulated for focusing back on the question of the digital divide. As we move forward, let us hope that our future discussions will be broadened to include the range of issues – not just a question of narrow broadband policy.

October employment data

October’s employment numbers are out and the BLS is reporting a positive growth in jobs. Payrolls grew by 204,000, far exceeding economists’ forecast of 121,000. The unemployment rate ticked back up by 0.1% to 7.3% however.
The not so good news is that total number of involuntary underemployed (part time for economic reasons) increased in again in October. Both the number of those on slack work and the number of workers who could only find part time work increased dropped slightly.
As I’ve noted before and is shown in the chart below, we are still a long way from the pre-crash levels. This especially worrisome when combined with the fact that size of the labor force continued to decline.
Involuntary underemployed October 2013.png