Reporting intellectual property
Isabel Verlinden and Patrick Boone
PricewaterhouseCoopers, Brussels
Intangibles such as patents/know-how/workforce, customer relationships and unique organisational designs account for some three-quarters of the Fortune 500 total market capitalisation in the late 1990s. According to Leonard Nakamura, a Federal Reserve economist, they absorb US$1 trillion of investment funds every year – roughly the same as total corporate investment in physical assets.
The allegation is that investors systematically misprice intangible-intensive enterprises. In established sectors, the argument runs, intangibles tend to be undervalued; this burdens firms with an excessively high cost of capital, which in turn leads them to underinvest in intangibles, thereby losing opportunities for the earnings and growth investors seek. Indeed, it prevents intangible-intensive companies from raising funds in capital markets – a situation familiar to managers of science-based and high-tech companies during the post bubble years.
Even though some initiatives are taken to account for intangibles, such as under IFRS, the question remains whether investors will forever accept numbers ignoring an important part of a company and whether, to quote Thomas Gad, author of 4-D Branding (2001), “the legal system will continuously accept having the dominant part of a company value outside of the system”.
One relevant question, then, is why rational people give up large potential gains from optimal investments in intangibles. However, more pertinently to this chapter, it is also worth asking whether tax authorities will be happy to pass up the opportunity to tax (potential) income of those intangibles that are created. And, if not, how to proceed given the uncertainties identified in the proceeding chapters as to ownership and value.
The answer, as will be seen below, is that tax authorities around the world are stepping up their efforts in relation to intangibles. These efforts are fraught with difficulty for taxpayers for precisely the reasons investors and businesses find it hard to evaluate the same questions. For taxpayers and investors the central problem is that transactions in intangibles in the natural course of events only occur in imperfect markets – that is, marked by lack of information for the players.
In both cases, one needs to take into consideration that the information rational people need to make better decisions is hard to get. Generalisations about intangibles are easy to find. But for intangibles such as brands and patents to be productive, they have to be unique. Also, intangibles are not traded in active and transparent markets, as many physical and financial assets are. Markets are aggregators of information: oil prices enable investors to predict the performance of energy companies; commodities futures tell investors about the performance of the agribusiness. Unfortunately, there are no markets generating visible prices for intellectual capital.
Generally accepted accounting principles (GAAP) in most countries perpetuate the information deficiency. GAAP treats generally practically all internally generated intangibles as costs to be expensed rather than as investments. This can distort measures of enterprise profitability and asset values (note that IFRS calls for the capitalisation of certain internally generated intangibles); as noted in the introductory chapter to this section, these are the basis for much of the tax system for businesses.
A further allegation that has been laid is that GAAP does not require firms to disclose any meaningful information about intangibles investments, except for aggregate R&D expenditures, lumping the rest of them in with general expenses. This keeps investors in the dark about how, for example, companies allocate R&D budgets to basic research, product development and process improvements, software development and acquisition, brand enhancement and employee training. The financial reports likewise provide no information on revenue generated by these investments, such as patent licensing fees or the share of revenues coming specifically from new products.
Only pharmaceutical and biotech companies, operating in an intensely competitive environment, have for years disclosed the products in their pipeline, the prospective launch dates of new drugs, the life remaining on patents and the like (without apparent competitive harm).
As with most things, IP reporting and valuation have not only an investor angle but also a side effect of a tax nature. This is the very essence of the dilemma faced by taxpayers and their advisers dealing with IP. Tax authorities require taxpayers to operate at arm’s length. This means that transactions between entities that ultimately make part of the same group should set this apart and incur the associated transaction costs when dealing with their tax. As a result, members of a multinational group may be forced to adopt parochial thinking so as to unbundle transactions throughout the value chain and demonstrate to the tax authorities that unrelated parties would transact under similar terms and conditions.
If this were not difficult enough, the data which it requires may not be readily available for the simple reason that nobody is required to account for it separately. In the absence of any commercial or operational demand for the relevant data, the documentary evidence required to honour the arm’s length standard and satisfy the tax authorities will be hard to find. When such evidence is created solely for tax purposes it is prone to obsolescence as people’s roles in developing, preserving and exploiting IP can, and probably will, change over time.
Indeed, reality shows that IP can help a company gain competitive advantage in various ways, but in three in particular: it can provide a temporary technological lead (incumbency); protect brand names; and help form an industry standard. However, technologies change and patents expire. One way to mitigate this limitation is by developing effective combinations of IP. Patent and trademarks can be used complementarily. Bayer AG has done this with Aspirin. Its first patent expired at the beginning of the last century but the company still earns enormous revenues as a result of the strong brand value. As trademarks can, in the natural course of events, be renewed indefinitely, managers shift their focus from patents to trademarks as the former expire. Studies show that the post-expiration patent value of a drug is substantially affected by the product’s marketing during the patent’s life, despite competition from generic products.
Trying to reflect the complexities and interrelationships in the IP arena context is a time-consuming venture.
Recent case law in the tax litigation area marks an interesting study of where the tensions between taxpayer and tax authority lie.
Tax litigation and controversy
The number of transfer pricing cases filed in US federal courts for the first half of 2004 doubled from those filed during the same period in 2003 and the amounts in controversy increased more than eightfold. A similar picture is believed to be unfolding, albeit less publicly, around the world.
The total transfer pricing allocations currently at issue in federal courts have risen sharply to US$9.2 billion up from 2003’s total of approximately US$1 billion. Much of the increase relates to IP. The surge in allocations can be attributed to two large cases – one of them being an IP-related case for GlaxoSmithKline Holdings, protesting US$7.8 billion in transfer pricing allocations. Only nine cases for an amount of US$131.2 million were resolved during the same period.
More than twice as many cases brought to the US Competent Authority (for resolution of disputes between the US and foreign countries) in 2003 stemmed from foreign-initiated adjustments than from US-initiated adjustments. In 2003, 68 cases (70.8 per cent of those received by the IRS Office of Director, International) were the result of an adjustment by a foreign tax authority, while only 28 cases (20.2 per cent of those received) resulted from an IRS adjustment. IRS Director, International, Robert Green finds this unsurprising as it is the reaction of foreign jurisdictions to the US transfer pricing regime: “There is a perception that our contemporaneous documentation requirements would cause taxpayers to be overly protective of the US, to attribute more royalty or other income to the US.” Back in 1999, the number of US-initiated adjustments, 61, was almost double that of foreign-initiated adjustments, 32.
The Glaxo case
The GSK file is the largest single transfer pricing case ever filed with the Tax Court (covering 1998-1996). In its petition, the company said the IRS erred in increasing its income by US$4.5 billion for cost of goods sold, US$1.9 billion for royalties and US$1.4 billion for interest income involving inter-company transactions for Glaxo heritage products, that included Zantac, Ventolin, Ceftin, Zofran, Imitrex and Serevent. Glaxo US also asserted a claim for a US$1 billion tax refund, saying the IRS discriminated against it by granting former competitor, Smith Kline Beecham Corp, an advance pricing agreement (APA) for Tagamet, while denying Glaxo an APA for Zantac, a competing product.
The dispute centres on the respective functions performed by Glaxo US and by the worldwide operations of the Glaxo Group in creating, developing and exploiting its intellectual property.
One conclusion for an interested observer is that the tax authorities everywhere, not just in the US, are looking for a clear IP ownership trail. How was the IP created? How was this funded? Who took ownership? Documenting ownership covers not only legal title but also, and especially, the economic ownership or ability to generate profits.
Second, even though the US and the UK are often cited as the friendliest of trading partners, they seem to have come to different views in relation to intangibles which appear to be too broad to be reconcilable at this time. The IRS allocated to the US company over 80 per cent of Glaxo’s worldwide profits on sales and distribution in the US of Glaxo heritage products.
Similar differences can be expected wherever different tax authorities are involved. In general, a comparison between the OECD guidelines, the US Service Regulations and the Proposed US Services Regulations shows little or no potential for improvement and differences in understanding will remain.
Financière Meunier in France
An interesting court case on trademark royalty and marketing expenses was heard in France. The decision, Financière Meunier, was released by the Court of Appeal of Paris in November 2003.
A Swiss-based multinational licensed its trademarks to its affiliates, including its French affiliate, for a royalty assessed on the licensee’s revenue. In parallel, the licensor entered into an agreement with an independent French-based resort facility. Under this agreement, the Swiss company obtained exclusivity for the sale of its branded products in the resort facility as well as the right to use the resort references in its own advertising. The resort charged a fee to the French (and other) licensees.
Each licensee was charged in proportion to, inter alia, its revenue and the number of visitors of the resort coming from its territory. The French Tax Administration (FTA) audited the French licensee’s operations and disallowed the portion of the charges corresponding to the resort charge on the basis that this charge duplicated the royalty paid to the Swiss MNE; that the benefit derived from that charge, if any, did not exclusively benefit the French licensee; and finally that an agreement between the resort and the Swiss MNE could not be binding on the French licensee.
The Paris tax appeal court ruled that the global agreement, although neither entered into by the licensee nor exclusively benefiting the French licensee, nonetheless allowed an increase in profitability of its operations. The court added that no provision of the licence agreement provided that in exchange for the royalty the licensor would bear all the marketing expenses related to the trademark licences. Finally, the court indicated that at no point in time did the FTA demonstrate that the marketing expenses borne by the French licensee were disproportionate to the profits actually derived. For all these reasons, the court fully dismissed the position of the FTA and confirmed the deductibility of the payment made to the licensor.
There are two lessons. First, the terms and conditions of the agreement were critical in determining the intention of the parties and therefore in deciding whether the charge is in line with the provisions of the agreement. Thinking an IP policy through and expressing it clearly in documentation is an important element of any defence.
Second, as an economic matter, benefits and costs need to be in proportion. Ensuring that this is the case is an important part of any policy.
Dutch court rules on allocating trademark purchase price
The Appellate Court of Amsterdam has held that a taxpayer’s decision to allocate the vast majority of the total purchase price for a trademark to the 10-year economic owners and a small portion to the legal owner could not be deemed incorrect.
A valuation was made based on financial projections (expected royalty streams). The report determined the value of the 10-year economic ownership of a trademark and assumed increasing royalty streams during said period. The tax inspector extrapolated the royalty income to the legal owner over the period 1992-2002 to the period after 1st October 2002 by assuming that the trademark would not stop generating income. A marketing report prepared by subject-matter experts set out that, as a rule of thumb, after a certain period of growth, the absolute growth of sales decreases, given the product lifecycle.
Moreover, it was demonstrated that the a priori assumption of a perpetual royalty is incorrect. Indeed, sales drops can only be (partly) cushioned by means of extra investments in a trademark, communication investments, extra support of sales staff, new product varieties, promotions etc.
This case illustrates that economic analysis and documentation of it can be vital in defending prices or reported asset values. The existence of a valuation report and a marketing report were key to winning the case.
Belgian court rules on know-how
In a judgment of January 2004, the Brussels Court of Appeal took a position on the deductibility of royalties charged for the use of innovative know-how by a foreign parent company.
A French group entered into a licensing agreement with its Belgian subsidiary, under which the French parent was deemed to provide the use of a trademark, technological know-how and the exclusive right to use software for composing images used in broadcast advertising. This was granted in exchange for a royalty that varied between 10 and 15 per cent of the Belgian company’s turnover. The Belgian tax authorities disallowed these royalty payments based on the argument that they were “not a normal consideration under standard commercial principles”.
The Court did not agree with the tax authorities’ position and accepted the royalty deduction, based on the following arguments:
• A valid legal agreement had been concluded between the parties, clearly stating the obligations of the parties, who had kept to it.
• The Belgian company had no R&D facilities enabling it to develop the know-how on its own.
• There was a clear need by the Belgian company to have access to the parent.
• The Belgian company needed the French company’s technology in order to be able to conduct its business.
The Court added that the contractual arrangements still left 85 to 90 per cent of income from sales available to the Belgian subsidiary and the size of the royalty was not abnormal in light of the nature of the product.
This case, unhappily, demonstrated that the tax treatment of intangibles in a transfer pricing context by tax authorities and courts can be casuistic where there is a lack of empirical data to support arm’s length values.
More happily, this judgment can be seen as an important milestone in the recognition by the Belgian courts of both the importance and the specific nature of intangible assets in general and access to know-how in particular within multinational company groups. More widely, it illustrates that know-how can be as important as any other form of IP.
Cases outside the US and Europe
In June 2004, Honda reported that it had been assessed on income under-reported over six years starting in 1997 and totalling some US$119.5 million in corporate tax and surcharges. The company appears to be preparing to request competent authority negotiations in this case, which involves royalties Japanese authorities say should have been paid by Honda’s Brazilian subsidiary. Brazilian rules restrict payments of royalties, allowing only those for patented technologies and other intellectual property of a “high level”. The Brazilian authorities seem to have believed that as the Brazilian entity was not using advanced technologies, no royalties could be paid.
Clearly it is not just in the US and Europe that tax authorities are pressing for increased recognition of income for IP. In its annual report on taxation, released in June 2004, the Japanese National Tax Authority notes: “The growing importance of transactions related to non-tangible assets and services provisions corresponding to the increase of Japanese corporations’ manufacturing bases to overseas locations.”
The exploitation or transfer of IP will remain on the radar screen, particularly in those countries facing capacity relocation to low cost countries.
Conclusion
It is clear that IP is becoming an increasingly important area of enquiry put into the limelight by investors and revenue services alike.
The challenge, however, is appropriately to capture and record the assets and income in a reporting environment which still finds it hard to recognise the values in question. The tax authorities, meanwhile, are beginning to demand increasing amounts of information and to take an increasingly hard line when that information is not available.