A new set of proposed regulations from the Internal Revenue Service aims to change the way companies use accounting methods to switch profits from countries with high corporate tax to countries where corporate taxes are low.The regs - all 85 pages of them - create an ambitious regime with a number of nebulous new concepts, including an "investor model," to insure that businesses value intangibles, such as marketing, research and development, and patents, in a way that will maximize exposure to U.S. tax.
"The main drivers of economic value creation and economic growth in American multinational companies are intangible assets, which contribute significantly to an enterprise's competitive advantage. They often have the potential to yield above-average profits, while physical and financial assets are rapidly becoming commoditized," said Selva Ozelli, a CPA and international tax expert.
"U.S. multinational companies are critically dependent on their intangible assets to enter new markets and sell their products competitively," she continued. "They are induced to avoid U.S. taxation of sales to foreign customers by migrating the intangibles offshore, especially to low-tax jurisdictions or to jurisdictions that have a tax treaty with the U.S. that imposes minimal or no withholding tax on royalties."
"The proposed regs provide further ammunition to the existing transfer pricing regulations to help deter offshore migration of intangibles," she said. "They give guidance on methods for determining taxable income from cost-sharing arrangements where participants agree to share the costs and risks of intangible development."
Cost sharing is based on an arms'-length standard, according to Martin Tittle, a Detroit-based international tax attorney. "The challenge is, how do you create an arm's-length standard when there is no third party that sells anything like what you're buying from your own subsidiary? If you want to buy six-penny nails, that's not hard. But with a cutting-edge product, it's hard to construct a fair price."
The proposed regulations replace the current regs on cost sharing with a completely new set of requirements.
"Twenty years ago, it was a common technique for U.S.-based multinationals to develop, say, a patent for a valuable drug in the U.S.," explained John Warner, an attorney and shareholder in the Washington office of Buchanan Ingersoll.
"After they made the judgment that this would be a worldwide winner, they would transfer the patent to an offshore affiliate. Then the affiliate would use the patent to manufacture the drug itself or the bulk form of the drug, and then sell the bulk form back to a distribution affiliate and then distribute directly to regular customers," he said. "The advantage to that was that the offshore affiliate which got the patent could charge an amount that would yield 80 to 90 percent of overall profit on the transaction overseas, outside the U.S. taxing jurisdiction, even though the patent was developed by a U.S. company."
The IRS tried and failed to challenge this, said Warner, so they prevailed on Congress to tighten up the law so patents can't be transferred tax-free within the group.
"The offshore affiliate pays an amount commensurate with the income that the intangible property is likely to generate, so a substantial part of the income comes back. That's where the law is today, with one exception - cost sharing," he said. "When a multinational is thinking of developing a product, it can enter an agreement with various affiliates around the world. All the research may be conducted in the U.S., but the foreign affiliate has an obligation to contribute to the endeavor a share of the cost of development that mirrors the likely benefit it will get from owning the developed intangible."
There also needs to be a "buy-in" payment to reflect the likely value of pre-existing intangibles, according to Warner.
"The problem is that a lot of amorphous intangibles are escaping, and multinationals have been undervaluing pre-existing intangibles," he said. "They typically say a Generation One technique is not of much value because it's at the end of its life cycle. The IRS fought this in audit situations, but it was hard for them because most taxpayers have some kind of microeconomic evidence that the buy-in is reasonable."
"It's an expensive fight, and becomes a battle of economists," he said. "As a result, they became concerned over time that cost sharing could be a way of draining U.S. tax coffers, so they came up with these years-in-the-making proposed regulations. They're an attempt to isolate pre-existing intangibles and other contributions."
The investor model
The proposed regulations introduce the new concept of an investor model, to address the relationship of contributions of controlled participants, according to Warner. "Even though knowledge embedded in Generation One has played out its course, the technology may have a much higher value to the next generation. If Generation Two is a blockbuster, the IRS now can say it is because Generation One knowledge was so valuable, and you should have paid more for it."
"The essence of the investor model is to bulk up or enhance these buy-in payments, and make sure they're valued based on a tighter view of pre-existing technology contributed to the next generation. The present regs don't give the IRS a lot of punch in trying to make sure that the buy-in payments will reflect relevant value."
The logic behind the investor model is that it follows the natural flow of business, according to Dr. Ali Gure, M.D., a medical researcher with the Ludwig Institute. "For example, when a research institute comes up with an idea that can be commercially developed, a commercial company and private investors will fund further research and development based on their own projections of return," he said. "It's the way industry financing occurs. It could contribute to the research and development aspect of engineering new technology."
However, the investor model concept adopted in the proposed regs may pose its own set of valuation and application problems for a multinational's high-profit intangibles, according to Ozelli. "These may have historically been undervalued and not accounted for on a company's balance sheet."
"Under the investor model concept, each controlled participant would make an aggregate investment attributable to the intangible development costs consisting of an ongoing share of intangible development costs - 'cost contributions' - and pre-existing advantages which the participants bring into the arrangement - 'external contributions.' The aim is to achieve an anticipated rate of investment return appropriate to the risks of the cost of the sharing arrangement over the term of the development and exploitation of the intangible," she said.
"The new regs' approach assumes that valuations would be appropriate only if an investor would undertake to invest in the arrangement because its total anticipated return is more than the total return that could have been achieved through an alternative investment that is realistically available to it. But since patents and copyrights confer on their owners the exclusive right to exploitation of the protected ideas, there rarely would be alternative investments in the marketplace that could serve as a meaningful guide to value," Ozelli added.
