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.