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Dec. 13 — The pivotal role that intellectual property and other intangible assets play in the international tax planning game could be about to change—drastically.
The unexpected Republican victories in November have elevated plans to overhaul the U.S. tax system from a distant prospect to an immediate near-certainty. No one is sure yet which of the various tax plans will be codified into law. But any overhaul may not just change the direction and destination of intangibles-based tax planning—it may alter the very nature of pricing online transactions in the increasingly all-encompassing digital world.
“The landscape is going to change, in a number of ways, particularly for IP-heavy industries, such as pharmaceuticals and the tech sector,” said Jorge Castro of Castro Strategies LLC, a former IRS official and congressional tax counsel.
As Washington lawmakers, legislative staffers, lobbyists and practitioners scramble to make sense of the post-2016 landscape, the blueprint unveiled by House Speaker Paul D. Ryan (R-Wis.) in June appears to be rising to the forefront. It competes with President-elect Donald Trump’s simpler campaign plan, as well as the comprehensive legislation unveiled by then-House Ways and Means Committee Chairman Dave Camp (R-Mich.) in 2014.
Ryan’s blueprint would transform the U.S. corporate income tax into a turnover-based, border-adjusted consumption tax, targeting imports and domestic sales but exempting exports. The effect would be to shift toward a destination-based system, in which the location of sales—not necessarily assets—becomes the key in determining whether profits should be taxed in the U.S.
By exempting exports, the system would become territorial, fulfilling a long-time goal of the conservative economic ideology—although one on which Trump wavered throughout his campaign.
If tax legislation were enacted along the lines of the blueprint, it would change the very nature of intangibles-based tax planning, many professionals said.
“The underlying principles of the blueprint are to significantly change all of the incentives that are currently in the system that motivate companies to do planning offshore,” said Ray Beeman, a principal with Ernst & Young LLP and a former staff counsel to Ways and Means, who helped write the 2014 Camp draft.
Under the plan, royalty payments from an offshore subsidiary for use of a patent, trademark, copyright or other intangible asset would become an exempt export.
“With Camp, one of our goals was to achieve neutrality, where you can get the same treatment no matter where your IP is,” Beeman said. “The blueprint goes past that to actually create an incentive to keep it here, rather than go overseas.”
Whether Congress opts for the blueprint or a simpler plan with a lower corporate tax rate, the result will be a tidal shift as tax planners reverse decades of structures that moved patents, trademarks and other valuable intangibles away from the U.S. and scramble to get, and keep, them in the country.
Indeed, companies may have an incentive to shift intangibles developed abroad to the U.S. It is a prospect that would be laughable under today’s system, as the U.S. has the world’s highest statutory corporate income tax and the only system that, at least in theory, taxes worldwide corporate income.
In the short term, unraveling the various tax structures U.S. companies have put in place to keep intangibles abroad, such as cost-sharing agreements, will likely be a daunting and potentially costly task.
The transition issue has led to speculation that tax legislation will include a provision to allow companies to repatriate their intangibles in a tax-free transaction. A similar proposal was included in a recent “patent box” bill sponsored by Rep. Charles Boustany (R-La.) and Rep. Richard Neal (D-Mass.), which would have granted IP-based income a lower tax rate.
Both Trump’s campaign proposal and the House blueprint would allow for the repatriation of deferred income at a lower rate—Trump’s proposal at 10 percent and the blueprint at rates ranging from 3.5 percent to 8.75 percent, depending on whether the deferred amount is held in cash or other investments. Neither proposal, yet, includes a provision to encourage repatriating intangibles held offshore by U.S. companies.
Shifting to a destination-based tax wouldn’t just change the direction of IP’s movement. Emphasizing the location of sales over the pricing of cross-border transactions could diminish the importance of correctly pegging the value of intangible assets.
Rather than debating the true nature of a piece of intellectual property and gauging its value, international tax planners would spend their time examining complex transactions and determining their true endpoints.
“The arguments are going to be, ‘what is the destination of goods?’ ” said Kyle Pomerleau, director of federal projects at the Tax Foundation, a conservative-leaning Washington-based think tank. “I think that’s a lot easier than determining the value of IP and whether transfer pricing is proper.”
Ultimately, the “destination” of a transaction can be related to a human customer in the physical world, not a few lines of computer code or a legal right that can be transferred at the press of a button. This is one reason the principle of destination-based taxation, if not the details of the House blueprint, have long been embraced by those on the left side of the tax debate, who have claimed it could be used as protection against corporate tax avoidance.
“You’re defining our tax base as where your customers are, and it’s hard to hide that. It’s difficult to pretend that a customer is somewhere else, when the customer is a human being and you can actually track them down,” Pomerleau said. “The destination-based system has this bipartisan coalition around it.”
But don’t expect the tax complexity to end, just yet. A destination-based system could pose interesting challenges for online service providers such as Facebook Inc. or Google Inc., where the relationship between users, customers and income could be more challenging than a traditional sales-based model.
The likelihood of such drastic changes to the tax system of the world’s largest economy leaves the $64,000 question: Just how will the rest of the world respond?
“We’re the U.S., so anything that we do will cause a reaction,” Beeman of EY said. “I don’t think the world’s just going to stand still, if they see the U.S. with an incredibly competitive tax system.”
“I think they’re surely watching, and if all a sudden the U.S. becomes more favorable from a tax perspective on IP, other countries are going to want to look at that, to see if they’re going to have to make any changes,” said Castro. “It will surely take a few years, but I think the shift is definitely going to occur.”
The importance of IP planning won’t go away, most practitioners said. The world has become far too digital.
“We continue to move towards a world where income is more and more mobile, as we de-industrialize,” Beeman said. “As a policy maker, as a tax practitioner, the planning aspect of that is always going to be relevant.”
The blueprint doesn’t eliminate the importance of intangibles and transfer pricing, he said—it flips it.
“Transfer pricing is still going to be relevant in the blueprint, but for entirely different reasons,” Beeman said. “It may focus more on incentives. You’re now more interested in where your expenses are located.”
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