U.S. Taxation of Intangible Property – Yet Another Stick but Still No Carrots?

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By James J. Tobin, Esq.

Ernst & Young LLP, New York, NY


Americans like to think we are the most innovative people on earth. Perhaps that's a good thing if it inspires more young people across the country to head out to mom and dad's garage, roll up their sleeves, and create something that will change life as we know it. They won't be alone in this endeavor as today there are young people with ideas in garages all around the world. Americans have always dreamed big and we should continue to encourage that.

When it comes to multinational companies, however, the U.S. approach seems to be less one of encouragement and more one of suspicion. U.S. multinationals invest heavily in R&D and in today's global economy are able to leverage their investment by using the fruits of that research to deliver new and better products to markets everywhere. This is good for America and it's good for the world. But there is a tendency in the U.S. to view globalization as a threat rather than as progress. That view seems to underlie many of the international tax proposals we are seeing advanced in the United States. And it is particularly evident in the Obama Administration's newest international tax proposal, which calls for a new provision that would tax "excessive returns" from an intangible transferred to a foreign subsidiary that is subject to low tax.

From a tax policy standpoint, as described below, I question the need for yet another tool aimed at the taxation of income from intangible property. But perhaps more troubling from a bigger picture standpoint, the underlying premise of the proposal seems to be that IP that originates in the United States in a U.S. multinational somehow must forever remain economically owned here no matter how and where that IP evolves in the future. This seems to me a narrow view of the global realities, where R&D is not one guy in one lab with one invention but is a collaborative effort involving people around the world and inventions that build iteratively in rapid succession. In today's world, the narrow view risks discouraging the conduct of R&D activity in the U.S. and has the potential to create a real competitive advantage for non-U.S. multinationals.

Before exploring how the proposal fits into the existing U.S. tax law in this area and how the proposal might impact the global economic landscape for U.S. multinationals, we should start by asking exactly what does the Administration have in mind here. The Treasury Green Book description of the Administration's FY 2011 budget proposals is particularly cryptic in the case of this proposal. What we know is that the proposal would apply if there is an "excessive return" associated with a transfer of intangible property from the United States to a related controlled foreign corporation (CFC) that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting.  If these conditions are present, then an amount equal to the excessive return would be treated as Subpart F income that is subject to current U.S. tax. In addition, a separate foreign tax credit limitation basket would apply to this Subpart F income.

At this point we have very few details as to how the proposed measure is intended to operate. The Treasury Green Book description of the proposal does not indicate what would be considered a "low foreign effective tax rate" and what circumstances would "evidence excessive income shifting." Moreover, no information is provided as to what level of return would be considered to constitute an "excessive return" or how one would calculate such an amount. In addition, what exactly is the measure of performance that is intended as the focus of the "excessive or not" inquiry? A return on equity? A return on assets? Either approach would introduce a new concept into our already paralyzingly complex international tax system. Consider some of the potential issues in a return-on-equity calculation. Should equity be calculated under U.S. GAAP or U.S. tax rules? If U.S. tax is the answer, would the equity measure be limited to tax basis or would it include retained earnings/E&P at the time of transfer of the IP? Would all equity of the CFC be taken into account? What if the CFC conducts multiple activities only some of which are related to the IP? What if the CFC is an upper-tier entity that holds other CFCs? On the other hand, if it is a lower-tier CFC, would the determination be based on its equity or on the proportion of the equity of the first-tier CFC that is related to the second-tier CFC? Would equity be adjusted on an annual basis? How would foreign exchange issues be dealt with in doing the return-on-equity calculation? How would the IP-related profit be computed in a return-on-equity calculation? Similar open questions abound if the excessive return determination instead is focused on return on assets.

One thing we can say for sure: The proposal would not simplify the U.S. tax treatment of income from IP. Based on comments from Treasury officials, this proposal is not intended to replace or modify existing rules regarding the taxation of IP income but rather is intended to apply in addition to those existing rules.  So it seems appropriate to pause and ask the question: Do we really need another tool in this area? There already are a lot of U.S. tax rules to prevent U.S. businesses from being able to send their crown jewels offshore without proper compensation in the United States.

First, there is the commensurate-with-income standard brought to us by the Tax Reform Act of 1986. For transfers of intangible property, §482 provides that the income with respect to the transfer must be commensurate with the income attributable to the intangible. Congress enacted this super-royalty provision nearly 25 years ago to address precisely the issue of transfers of high-value intangibles.

There also is §367(d). Congress enacted §367 to ensure that the inherent gain in appreciated assets held by U.S. persons does not inappropriately escape U.S. taxing jurisdiction by virtue of tax-free exchanges of property under the corporate reorganization provisions. Under §367(d), a taxpayer's transfer of IP to a foreign corporation in exchange for stock is treated as a sale of such property in exchange for annual payments contingent upon the productivity, use, or disposition of the property over the useful life of the property. The amount of these annual deemed royalty payments must be commensurate with the income attributable to the IP.

A skeptic might say that what the Obama Administration is now proposing is a "gotcha" provision. Notwithstanding the fact that the income with respect to the IP transfer must under, §§482 and 367(d), be commensurate with the income from the IP, the government can come back and argue that there is an "excessive return" on the IP in the hands of the transferee and that this income should trigger immediate U.S. taxation in addition to the U.S. tax on the transferor's income determined under §482 or §367(d).

So the U.S. government already has an arsenal of rules and regulations at its disposal to ensure proper taxation of income from IP. One common characteristic of these rules worth noting is their inherent U.S.-centric worldview: a core belief that IP originates in the U.S. and is at risk for purely tax-motivated exportation. Section 367(d) is a completely outbound concept, applicable only in the case of a transfer out of the U.S. While the commensurate-with-income standard in §482 presumably applies to both transfers out of the U.S. and transfers into the U.S., the mindset inherent in this provision is a U.S. fisc perspective. Indeed, my experience with IRS audits of foreign multinationals operating in the United States has not shown that the U.S. government considers IP income to reside primarily with the foreign head office in that context.

While we'll have to wait and see how the Administration's excessive return proposal would apply in practice were it to be enacted in some form. It clearly would be a one-sided provision because it only creates Subpart F income and therefore would not operate in an inbound situation.

Stepping back and looking at the big picture, an issue that underlies any discussion of possible income-shifting related to IP is how does one accurately and fairly determine the economic gain related to IP. That is the question that must be answered in order to determine to which party, and therefore to which jurisdiction, the income is properly attributable. This determination is central to the application of the existing tools the government has at its disposal. This determination also should be key to the application of the proposed excessive return provision, unless the intention is to use a wholly artificial approach that is divorced from the underlying economics of the situation.

We can take it as a given that valuation of IP is difficult and contentious. But there are no shortcuts here.  The bottom line is that there is no avoiding these issues in today's global economy. IP is developed on a global basis and is deployed on a global basis. This is equally true for U.S. multinationals and for their foreign competitors. The U.S. international tax system is firmly grounded in the principle that income is properly divided among entities and jurisdictions based on the economic contributions made by each entity in each jurisdiction. The tax systems of our trading partners are similarly grounded in this principle.

At a conference earlier this year, David Rosenbloom made some comments about the difficulties encountered in this area of the tax law:I think the arm's-length method as we have it today is fundamentally unworkable. This is a conclusion that I've gradually come toward. We're not smart enough to apply this method. As a nation we don't have the intellectual capital to do it. 

On this point, I have to disagree with David.  We are smart enough. We have to be. And perhaps more importantly, we can't be the only country to give up.

Because we are not alone in struggling with these difficult and contentious issues, it is instructive to consider how our trading partners are dealing with the issue of the taxation of income attributable to IP in the context of today's global economy.  Take, for instance, the case of the United Kingdom, an important U.S. trading partner.

Back in 2007, the U.K. government released for consultation an international tax reform package that would move the U.K. from worldwide to territorial taxation but that also included a proposal for a quite aggressive approach to the taxation of IP income of controlled companies. The discussion document in essence proposed that the United Kingdom assert taxing rights over all IP of U.K.-headquartered companies held in foreign affiliates, regardless of where that IP had been originally developed. However, in the face of serious criticism from the U.K. business community, the U.K. government backed off from this extreme view. And faced with mounting concerns about competitiveness, the U.K. government in 2009 went forward with the adoption of a territorial tax approach and deferred the controlled companies proposals for further consideration and consultation.

Earlier this year, the U.K. government released a new discussion document with proposed revisions to the U.K. CFC regime. Under this new proposal, foreign subsidiaries that actively manage IP generally would be exempt from the CFC regime if there is little or no U.K. involvement in that activity, an acknowledgment by U.K. authorities that IP can be managed for business reasons outside the U.K. tax net. At the same time, the U.K. government also proposed a new incentive for conducting IP-related activities in the United Kingdom. The budget included a new U.K. patent box, under which a reduced corporate tax rate of 10% would apply to patent income beginning in 2013. The U.K. government took a hard look at the exodus in recent years of British multinationals to more hospitable climates (such as nearby Ireland). Their tax policy response reflected a clear recognition that if the U.K. is to continue to be a powerful global headquarters and R&D center, multinational businesses based in the United Kingdom must be able to develop, manage, and deploy their IP optimally without anti-competitive tax burdens. As this article goes to press, we are awaiting the tax proposals of the new U.K. government.

Contrast these developments and this perspective in the United Kingdom to the pending excessive return proposal in the United States and the perspective that underlies this proposal.  Besides adding another layer of ever more complex rules for taxpayers and the government to grapple with, what would be the real world impact if this proposal were to be enacted? My fear is that it would add even more impetus for foreign companies to purchase U.S. companies that have high-value IP. Moreover, it would serve to promote the development of IP outside the U.S., which would send R&D and the associated high-paying jobs offshore.

A few commentaries back, I referenced the entrepreneur with his head full of ideas and his garage in California full of designs for the next big thing. I posed the question whether our international tax system demands that the entrepreneur have the foresight to hire a good international tax advisor so that when he's ready to leave the garage he incorporates his new business outside the U.S. in order to be able to grow that business globally. (See "Building Tax Walls in the 21st Century," 38 Tax Mgmt. Int'l J. 639 (10/9/09).) With this new excessive return proposal, it appears that the entrepreneur would be well served by contacting a good international tax advisor before he ever sets foot in his garage because he ought to consider finding garage space somewhere other than in the United States.

Tax policy often is about sticks and carrots, with the key being the proper balance. In the area of taxation of IP income, we have a lot of sticks already. The Administration's excessive return proposal represents a big new stick that could have the effect of encouraging the foreign acquisition of U.S. multinationals with significant IP and discouraging the future development of IP in the United States. On the other hand, the U.S. tax carrot cupboard is pretty bare. Indeed, as I write this article, we are well into 2010 without even an R&D tax credit yet in place for this year; although it is expected that the R&D credit will be reinstated for 2010, by the time that happens it will already be fast approaching another expiration date. It seems to me that tax policymakers should be turning their creative juices to the development of more carrots to encourage the development of new ideas and innovation here in the United States. Why not a U.S. patent box regime? Too few carrots and too many sticks could ultimately lead to fewer tax issues related to the global deployment of IP by U.S. companies. Unfortunately, that will be because there will be less new U.S.-developed IP to so deploy.

This commentary also will appear in the July 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Warner and McCawley, 887 T.M., Transfer Pricing: The Code and the Regulations, Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a), and Yoder, 928 T.M., CFCs — Foreign Base Company Income (Other than FPHCI),  and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers, and ¶7150, U.S. Persons — Worldwide Taxation.

 1 The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.