The BNA Tax and Accounting Center is the only planning resource to offer expert analysis and practice tools from the world's leading tax and accounting authorities along with the rest of the tax...
By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC
For decades U.S. multinationals have attempted to create structures that allow them to allocate income from intangible property (IP) to low-taxed CFCs. Over the same period, the IRS has fought to move much of that income back to the United States. This struggle is why the §482 regulations are as long and complicated as they are. It has spawned a sizeable cadre of transfer pricing economic experts and lawyers.
Taxpayers generally try to allocate most IP income to the jurisdiction where legal rights, contractually allocated risks, and sometimes the source of capital and top-level, risk-taking, decision-making reside. The IRS generally prefers to allocate IP income to the jurisdiction where the research or development of the IP takes place. There is also, as part of this battle, considerable disagreement over what constitutes income from IP. Billions of dollars of tax are at stake. Scores of millions of dollars in fees for lawyers, accountants, and economists are spent.
With the possibility of the enactment of a so-called "patent box" in the United States, it is possible this long and often wasteful struggle could end, or at least be reduced to a small skirmish. It is also possible, however, that each side will simply adopt some of the theories of their opposition, change directions, and continue the battle with as much verve and the expenditure of as many resources as before. It depends on the technical approach taken by the patent box legislation that is enacted.
A Very Brief History of IP Transfer Pricing
If clearly valuable IP is simply sold or licensed (or, since the mid-1980s, transferred in a capital contribution or reorganization) to a low-tax CFC, §482 (and §367(d) in certain circumstances) will require that the value of that IP essentially be paid back to the U.S. transferor. Because of this, taxpayers typically transfer IP before it is clearly highly valuable and/or incur the costs and risks of the development of IP in the low-taxed CFCs.
For many years, one of the more popular means for accomplishing this was through cost sharing. The low-tax CFC would make a "buy-in" payment for existing IP and then pay a share of the research and development (R&D) costs (typically predominantly spent in the United States) proportionate to its expected benefits. The theory was that, by sharing the costs of both the successful and the unsuccessful R&D, the CFC should be in the same place as if it developed the IP (or its limited geographic rights therein) itself. By contractually incurring the risk of the R&D from the get-go and supplying capital, the CFC obtained the right to earn IP income attributable to the resulting IP. A taxpayer's use of cost sharing was not without considerable upfront cost, however. The buy-in payment and the ongoing cost sharing payments reduced the domestic tax benefits for R&D. In the long-run this was often worth it, particularly for blockbuster IP, since the profit earned in the future in the low-tax CFC could be many multiples of the costs.
Particularly since cost sharing participants could be CFCs with very few employees and little substance (a situation the IRS itself allowed in amending the first detailed proposed cost sharing regulations of 1991), the IRS grew to dislike cost sharing. Rather than simply requiring cost sharing participants to be manufacturers or otherwise have significant substance, however, the IRS (among other things) decided to double down on complicated economic arguments it had been making in litigation and amended the §482 regulations to vastly increase the size of buy-in payments. The new theory for buy-ins was that existing IP need not be able to be sold or licensed to be highly valuable but that it was valuable because it formed the platform for all future R&D. The low-taxed CFC cost sharing participant was no longer a co-developer—it was an investor. Its buy-in payment (now called a platform contribution transaction (PCT) payment) generally had to be enormous and its return on its investment in the R&D a great deal smaller. Predictably, cost sharing, at least cost sharing that qualified under the §482 regulations, became less popular.
In the last decade, other methods of locating substantial IP income in low-taxed CFCs have become more popular. One, not that dissimilar to cost sharing, is a contract R&D arrangement. Rather than simply sharing the costs of U.S.-based R&D, however, the low-taxed CFC takes responsibility for all the funding and high-level direction of the R&D. In exchange for the greater substance required in the CFC, the CFC claims all of the income attributable to the use of the resulting IP, minus a cost-plus fee paid to the contract R&D facility. The IRS attacks this method by, among other things, challenging the taxpayer's claims regarding where the R&D risk-taking decisions are really made. The IRS appears wedded to the idea that residual IP-related returns (all profit after stripping off routine activities earning routine profits) should be allocated to the jurisdiction where R&D occurs—typically the United States. Disputes regarding what activities and risks in developing IP should earn what amount of income continue unabated.
Patent or Innovation Box
In response to the enactment in several EU countries of so-called patent or innovation boxes, the movement to force more substance into "principal company" structures induced by the OECD's BEPS project, as well as the perception that the current U.S. tax system creates general competitive disadvantages for U.S.-based multinationals, Congress is talking seriously about a patent or innovation box for the United States.1 Such a measure would provide a significantly lower tax rate on IP income. Unlike its counterpart in various EU countries, it might go hand in hand with a repeal of deferral, albeit at a low tax rate, often referred to recently as a "minimum tax" on CFC earnings. There is no necessary technical or policy linkage, however.
Consistent with the OECD's recent consensus regarding a "modified nexus approach," it is to be expected that some requirements for relating the favored income to the R&D giving rise to it would be included. By making the migration of IP income to low-taxed CFCs modestly less attractive, and markedly reducing the tax on IP income reported in the United States and allocable to U.S. R&D, the theory is that such a measure would encourage the retention (or importation) of R&D-related jobs in the United States.
I leave to economists a large portion of the job of commenting on whether this will work, or will work efficiently. Instead, my interest is in how the income attributable to the innovation box (and granted the lower rate) will be determined. How do assets get into the box and how is the income generated by those assets determined? It should be obvious, however, that if the patent box is relatively simple in operation and avoids the use of the §482 rules, it may be a useful method to avoid the costly disputes inherent in the current scheme for policing the proper amount and location of profits attributable to IP.
A commentary is too short a vehicle for discussing these points with even a hint of thoroughness. It is not too short, however, for pointing out the irony of the possible spectacle of the IRS and taxpayers swapping positions on the proper amount and location of IP income in a patent box regime if a patent box regime uses the current §482 rules and related theories regarding the amount and location of IP income. At first glance, at least, it seems quite possible that the historical IRS arguments summarized above would give rise to very taxpayer-favorable results in many cases. That would be the case, for instance, if a U.S. patent box regime simply left it up to the current §482 rules and current IRS litigation theories to determine what income should get the favorable treatment. IP income would generally be allocated to the place where R&D takes place. And "IP income" would be all income after assigning routine returns to other functions and risks.
The innovation box regime recently proposed in the discussion draft of the Innovation Promotion Act of 20152 ("IPA 2015") uses an approach that appears to avoid this potential spectacle. It nevertheless may provide a similarly taxpayer-favorable result. And it may do so in a manner at least moderately less fraught with potential controversy.
Instead of relying on transfer pricing, IPA 2015 would provide benefits for an amount of innovation-related income determined under a formula. The formula multiplies "tentative innovation profit" by a fraction, the numerator of which is five years of domestic R&D and the denominator of which is five years of "total costs." This formulary approach, while certainly not free from complexity and the potential for disputes, avoids the likely irresolvable problem of separating intangibles income from other income using a transfer pricing regime. It also may make the regime compliant with the OECD's requirement that an innovation box regime have a requirement that there be a substantial nexus between the benefits and the location of performance of R&D.
"Tentative innovation profit" is very inclusive. It starts with "qualified gross receipts." Qualified gross receipts include gross receipts from the sale, lease, license or other disposition of "qualified property" in the ordinary course of a U.S. trade or business.
"Qualified property" includes any §936(h) intangible and any product produced using such IP (whether the IP relates to the product itself or to its production process), as well as movies/videos and computer software. It apparently does not matter that the IP content in a product produced using a §936(h) intangible might be very small; the formula's fraction summarized above and described below controls the amount of benefit without delving into this thorny area. "Qualified property" does not include any marketing IP. Nor does IP related to the provision of services allow the qualification of services income. While this exclusion may be motivated by revenue loss, it seems odd that innovation in the provision of services, the most rapidly growing sector of the U.S. economy, would be left out of any innovation-promotion scheme.
Whether or not gross receipts are derived in a "U.S. trade or business" is not defined, but an example in the Technical Explanation makes it clear that they can include receipts from foreign sales made by a foreign branch. It also appears that such foreign sales can be of foreign-manufactured goods so long as they incorporate or are produced using U.S.-developed IP. Such receipts do not, however, include receipts from CFC sales, though query whether a U.S. shareholder's Subpart F inclusion from a CFC's foreign base company income might not properly be qualified gross receipts. Qualified gross receipts do not include receipts from sales to related persons except where the product sold is sold to a related foreign distributor which resells it to unrelated persons. There is no explanation of the reason for this restriction. It is unclear whether this exception applies where the related buyer performs further processing or manufacturing, as is so often the case in supply chains for foreign sales.
To obtain tentative innovation profit, qualified gross receipts are reduced by costs of goods sold and other expenses, losses, or deductions properly allocable to such receipts. While the significant breadth of the definition of "qualified gross receipts" will make this allocation task relatively simple for some (i.e., properly allocable costs may include most costs a pharmaceutical or other high-tech company incurs), for multinationals with a mixture of product sales, provision of services, and financial income it will be a challenge. For those accustomed to the intricacies and vagaries of the §861 regulations and their use in separating foreign-source income from U.S.-source income for foreign tax credit limitation purposes, the challenge will be a familiar one.
As noted, tentative innovation profit is then multiplied by a fraction the numerator of which is five years of domestic R&D and the denominator of which is five years of "total costs." The result is "innovation box profits" which obtain the benefit—generally a 71% deduction—designed to result in an effective rate of tax on such income of approximately 10%.
The numerator—domestic R&D—is defined by reference to §174 (without regard to §41 or §280C). While a continuing area of controversy at the margins, at least there are several decades of experience in determining what is a §174 expense and what is not. While §174 is not itself limited to domestic expenditures, the §41 credit is, so experience there should also be relevant.
The denominator—total costs—includes all of a taxpayer's global costs minus cost of goods sold, interest, and taxes. It appears that "total costs" include all costs, regardless of whether or not they are incurred to earn "tentative innovation profit." Thus, not only is services income not included in tentative innovation profit, the costs of earning such income reduce the benefit for earning sales, license, and leasing income that is included in tentative innovation profit. It is unclear why taxpayers who earn a mix of sales and services income should suffer this double whammy.
In sum, the authors of the discussion draft of the IPA 2015 should be congratulated for proposing an innovation box that avoids the enormous potential for controversy inherent in a regime that relies on transfer pricing concepts to separate IP income from other income. As noted at various places above, however, there are still some serious kinks to wring out of the proposal. And other interested parties will undoubtedly find more issues than this commentary could address in the space allotted. Nevertheless, the draft IPA 2015 is a good start.
This commentary also appears in the October 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Fox, Bowers, Shanahan and Maselli, 556 T.M., Research and Development Expenditures, and in Tax Practice Series, see ¶2430, Research and Experimental Expenditures.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to email@example.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to firstname.lastname@example.org.
Put me on standing order
Notify me when new releases are available (no standing order will be created)