The Intangible Economy

The President's FY2011 budget announced last week includes two proposals to change tax law as it relates to the transfer of intangible assets (from the Treasury Departments' General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals aka The Green Book). The proposals go to the issue of companies transferring their intellectual property to subsidiaries located in countries where the royalty income is tax at a low rate or not taxed at all. The parent company "sells" the IP to the subsidiary and then pays royalties to that subsidiary for the use of the IP. The key question is the fair market value of that transfer. US law requires that the transfer be valued at the same level as if it was an arms-length transaction between two independent entities. The parent would then pay US taxes on that income. There is concern that companies are low balling the value of the IP, "selling" it cheaply so as to minimize the amount of US taxes they have to pay on the income from those sales. The US loses in two ways, the tax on the income from the sale and the tax on the income from the royalties.

The specific proposals from the Green Book are:

TAX CURRENTLY EXCESS RETURNS ASSOCIATED WITH TRANSFERS OF INTANGIBLES OFFSHORE

Current Law
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." The regulations under Section 482 provide that the standard to be applied is that of unrelated persons dealing at arm's length. In the case of transfers of intangible assets, section 482 further provides that the income with respect to the transaction must be commensurate with the income attributable to the intangible assets transferred.

Reasons for Change
The potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules. There is evidence indicating that income shifting through transfers of intangibles to low-taxed affiliates has resulted in a significant erosion of the U.S. tax base.

Proposal
Under the proposal, if a U.S. person transfers an intangible from the United States to a related controlled foreign corporation that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting, then an amount equal to the excessive return would be treated as subpart F income in a separate foreign tax credit limitation basket.
The proposal would be effective for taxable years beginning after December 31, 2010.

- - -
LIMIT SHIFTING OF INCOME THROUGH INTANGIBLE PROPERTY TRANSFERS

Current Law
Section 482 permits the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." Section 482 also provides that in the case of any transfer of intangible assets, the income with respect to the transaction must be commensurate with the income attributable to the intangible assets transferred. Further, under section 367(d), if a U.S. person transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the property that are commensurate with the transferee's income from the property. The payments generally continue annually over the useful life of the property.

Reasons for Change
Controversy often arises concerning the value of intangible property transferred between related persons and the scope of the intangible property subject to sections 482 and 367(d). This lack of clarity may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.

Proposal
To prevent inappropriate shifting of income outside the United States, the proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal also would clarify that where multiple intangible properties are transferred, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. In addition, the proposal would clarify that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
The proposal would be effective for taxable years beginning after December 31, 2010.

The first proposal seems to be an attempt to strengthen the enforcement capabilities. The second is similar to a proposal made last year (see earlier posting). However, last year's proposal called for the valuation of the intangible "at its highest and best use, as it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." In other words, a market transaction. The new proposal is to value the intangibles "taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative." I'm not sure that what really means, but I think it might be a movement from a market transaction based valuation method to to an income-based method.

As I noted back then, this proposal contain three components: an expansion of the definition of intangibles; dealing with the issue of transfer of multiple intangible properties; and, a valuation issue. The valuation issues I just mentioned -- market based versus income based.

The second component goes to the power of the IRS Commissioner under Section 482 to place his/her own value on a transfer whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." The proposal would allow the Commissioner to value the intangible on an aggregate basis. This appears to go after the well-know issue that portfolios on intangibles are more valuable than the individual items taken separately. This issue is also tied to the market valuation issue -- as the current rules of using income appear to require tying the income to each specific intangible.

The third component would expand the definition of intangibles include workforce in place, goodwill and going concern value. It is also, at least to me, attacking a very different issue than the other two. Those three intangibles are essentially "whole-enterprise" assets. They can not be split off from the enterprise. As such, they are generally not transferred from entity to another as individual components like a patent or a trademark could be.

Thus, the issue of international transfer pricing is different in this case. It is about transferring control of the enterprise to a foreign owner. This is a slightly different "loophole" the IRS has been going after. Beginning 2007, the IRS has defined workforce in place as an intangible asset for purposes of what is called Section 936 Exit Strategies (see Industry Director Directive on Section 936 Exit Strategies # 1 and Industry Director Directive on Section 936 Exit Strategies # 2). These are specific transactions having to do with the restructuring of companies who had gained tax credits for operating in Puerto Rico as those credits have been phased out. The classification of workforce in place as an intangible asset made such a transfer a taxable event. Not surprisingly, this is view as a very controversial move. (For more information see the KPMG write up The Transfer of Workforce in Place to a Foreign Corporation.) It appears that this latest proposal is an extension of that same principle -- that all asset transfers should be subject to taxation -- to all transactions.

Our previous report, Intangible Asset Monetization: The Promise and the Reality, pointed out that taxation is an important policy tool that has not yet fully come to grips with the rise of importance of intangibles assets. For example, we have long advocated the expansion of the R&D tax credit into a knowledge tax credit by incorporating tax incentives for investments human capital as well as research. As part of a review of the intangibles and taxation, we suggest that it might be time to "explore lowering the tax rate on intangible asset royalties, in conjunction with stricter regulations on international transfer-pricing mechanisms and cost-sharing arrangements and on passive investment companies." The report goes on to say:

Providing a more direct tax incentive to the licensing of intangibles by lowering the rate on intangible asset royalties, such as to the capital gains rate, is a more controversial proposal. This lower rate could be crafted to apply only to royalties for new licenses for a limited time, such as a sliding scale for three years. In crafting such an incentive, safeguards would need to be established to prevent the incentive from being used for simply transferring existing licenses to SPEs [special purpose entities] and to ensure that the incentive went to new licensing activities only.

We didn't have that discussion last year when the Administration made its proposals. Maybe we can this time around.

January's employment data released this morning from BLS showed a welcome trend: the unemployment rate dropped to 9.7%. Not great but going in the right direction -- contrary to economist's expectations. On the other hand, job losses continued (with employment down by 20,000). There had been hope that the economy would begin to create jobs. And revisions to the 2009 data showed a greater job loss than previously reported.

The good news is that the number of involuntary underemployed (part time for economic reasons) and those part time because of slack work both declined dramatically in January. Not to read too much into this, but the trend (as the chart below shows) is in the right direction. Involuntary underemployment essentially peaked in March. As I said last month, this confirms that the fall is over. But the overall numbers point to a slow recovery.

Late last year, I posted a short comment on the Obama Administration's A Framework for Revitalizing American Manufacturing. As I noted then, the Framework recognizes the importance of intellectual capital limits itself to R&D and intellectual property--although the section on worker skills is part of a larger intellectual capital structure. Today, Athena Alliance is releasing a Policy Brief--Intellectual Capital and Revitalizing Manufacturing--which expands the Framework to explicitly incorporate intellectual capital. The following are the paper's recommendations:

Expand the Manufacturing Extension Partnership (MEP) to Boost Intellectual Capital. The Framework appropriately calls for doubling the MEP budget, but the scope of this assistance to manufacturers needs to be expanded to include innovation, new product development, and utilization of intellectual capital. Manufacturing companies have a wealth of intellectual capital that they often do not recognize or manage well. MEP services must include intellectual resource management that covers a broad array of assets, beyond help with intellectual property. The program's budget increase should be used to expand services and staffing in areas such as marketing, finance, and business model development, in addition to new product development and process adoption.

Help Entrepreneurs Manage Intellectual Capital. The Framework specifically cites efforts by the U.S. Small Business Administration (SBA) to provide entrepreneurship training and to foster partnerships with community colleges, universities, and others. It also mentions the U.S. Economic Development Administration (EDA) program of supporting business incubators. But most of these training programs do not explicitly recognize the importance of managing intangible assets and intellectual capital. Programs that support entrepreneurs need to incorporate these topics as part of their activities and impart these essential skills to would-be innovators.

Transform the Baldrige National Quality Program into the Baldrige Quality, Productivity, and Innovation Award. The Framework calls for "facilitating the diffusion of business practice innovations." One way to do this is through the Baldrige program, whose criteria have shifted and broadened over time to focus more on productivity and innovation. This shift, however, has largely gone unheralded. Changing the name--in essence, rebranding the program--would ensure that it rewards not just quality, but also productivity and innovation. The change might also prompt a review of the selection criteria to reflect this broader view.

Increase Worker Training. The Framework rightly calls for increasing federal funding for job training. However, the current system is geared toward assisting workers who have lost their jobs. Just as vital is support for on-the-job training so that workers are able to bolster their current skills, which enhances the competitive edge of employers and improves workers' viability in the marketplace. The important of on-the-job training is heightened in an economic downturn, when companies can easily lose their built-up supply of intellectual capital by laying off workers who may eventually find employment elsewhere.

Funding for on-the-job training could take a number of forms:
•   Direct government funding of training programs, possibly run through the community colleges (as also mentioned in the Framework).
•   A knowledge tax credit to cover employer costs. We already give tax incentives for investments in research and development (R&D) and in machinery. We should also give tax incentives for investments in workers.
•   In a "job-sharing" program. Proposals have been made for a national job-sharing program, where workers would reduce the number of hours worked from full time to part time; for example, from 40 hours to 35 hours a week. The wages saved by the employer would be use to hire additional workers and unemployment insurance funds would be used to pay workers for hours not worked as part of the program. On-the-job training could be included in such programs by requiring workers to spend that time in a training program.

Use IP to Provide Capital. As noted in the Framework, the administration is taking steps to increase the flow of capital to small businesses. Currently, small businesses can raise money based on their physical and financial assets, which can be easily bought and sold, borrowed against, and used to back other financial instruments. But using intangible assets, such as IP, to borrow funds is difficult. Here are some ways the government can free up this type of capital to unleash small business creation, innovation, and growth:

•   Tap SBA loans to fund innovation. SBA underwriting rules should be changed to allow companies to use their IP as collateral on loans. SBA already allows its loan funds to be used to buy intangibles when a new owner wants to acquire a company. Allowing IP to be used as collateral will increase the amount of funds a company, such as one in the high-tech sector, would qualify for.

•   Create an IP-backed loan fund. Other nations have developed special programs to encourage IP-based finance. The U.S. should set up similar programs on a pilot basis, ideally run by the SBA to take advantage of its lending expertise. Technical support could be provided by the SBA's Office of Technology, which already coordinates the Small Business Innovation Research (SBIR) program. The SBA technology office also works with the U.S. Commerce Department's National Institute of Standards and Technology (NIST) on its Technology Innovation Program and has a hand in other federal science- and technology-related initiatives. Such a direct lending program would be a step beyond SBA's current loan guarantee programs--direct lending is needed to jumpstart the process. Once the process of utilizing IP as collateral is fully established, the program could be converted to a loan guarantee structure.

Include Intellectual Capital and Intangible Assets in the Financial Regulatory System. The Framework explicitly points out that financial regulatory reform is necessary to create an environment of stability to promote economic growth and innovation. Yet intellectual capital and intangible assets remain outside of the discussion on financial reform, even though they represent between one-half and two-thirds of aggregate company value. The following methods could be used to bring these assets into the financial regulatory system:

•   Increase disclosure of intangible assets. The U.S. Securities and Exchange Commission (SEC) should be directed to study the barriers to intangible asset disclosure on corporate financial statements; assess past disclosure requirements, such as the 2003 guidance on the Management's Discussion and Analysis (MD&A) section in financial statements; and analyze the merits of a safe harbor for limited disclosure of financial information on intangibles not currently allowed in financial statements. In addition, the relevant federal agencies--the SEC and the departments of Treasury and Commerce--should establish an advisory committee to recommend ways to provide investors with an improved method of assessing the impact intangibles have on the accuracy of a company's financial picture and for supporting industry trade associations' efforts to adopt intellectual asset management and intangible disclosure guidelines for particular industries.

•   Provide information on intellectual capital and bank lending practices. The U.S. Federal Reserve is seeking to strengthen bank supervision practices through the expansion of stress testing to assess the health of individual institutions. As bank regulators undertake these actions, they should be aware of the role and value of intangible assets. The failure to overtly include intangible assets may have the following consequences:

•   Underestimation in the amount of collateral a lending institution has to call on in case of default (and therefore the undervaluation of the underlying loan).
•   Miscalculation of a lending institution's ability to recapture collateral if the lending institution is dealing with an asset it does not understand.
•   Improperly priced loans due to a failure to assign the correct value to the intangible assets or a tendency to apply exceedingly low loan-to-value ratios that are less a reflection of risk than of the institution's lack of knowledge about the performance of intangible assets.
•   Higher capital costs for borrowers, especially those in businesses heavily reliant on knowledge and technology.

Regulatory agencies can take steps to study and collect information on the role of intangibles in the financial system--and to underscore the risks of ignoring them. As they build knowledge in this area, the Federal Reserve and other financial regulatory agencies might consider the following questions:

•   To what extent are lending institutions employing intangible asset as collateral, either explicitly or implicitly?
•   What provisions are there in bank reporting requirements for intangibles?
•   Given that intangible assets can be wrapped up in the catch-all category of a blanket lien on all assets, how can lending institutions determine the value of intangible assets for the purposes of assessing collateral?
•   If intangibles are used explicitly as collateral, what underwriting standards are used and what are the specific valuation standards and loan-to-value ratios?

Promote Better Understanding of Intellectual Capital and Intangible Assets. The Framework mentions intellectual capital using the example of patents and managerial know-how. Yet, as noted earlier, intellectual capital and intangible assets cover a much broader range of categories, including worker skills and knowledge, business methods, organizational structure, and customer relations. There is a need to broaden the understanding of policymakers, business leaders, and the general public on the full scope of intellectual capital and intangible assets and how they function in the marketplace. There are a few ways to widen the scope of knowledge around this subject:

Commission a National Academies' study on intangibles. This was proposed at a June 2008 conference sponsored by the Bureau of Economic Analysis and the National Academies. A broad study of intangibles could include the following components:

•   A survey of efforts in other countries to advance the understanding of intangibles and their role in corporate performance and economic growth, promote financial investments in intangible assets, and foster the utilization of intangibles.
•   An inventory of federally owned intangible assets and an exploration of how to exploit them for economic growth.
•   A list of policy recommendations to accelerate private investment in and management of the types of intangible assets most likely to contribute to growth.

Manage the government's intangible assets more effectively. The federal government is a major investor in intangibles, but we don't have a clear picture of the size or nature of that investment across the agencies. The U.S. Office of Management and Budget (OMB) should build on the current federal budgeting process to engage in a cross-cutting analysis of federal investments in intangible assets. For some time the federal budget, as prepared by the Office of Management and Budget (OMB), has included a capital budget that includes physical capital, R&D, and education and training. The budget documents also include a separate analysis of statistical agencies' funding, which is not included in the investment budget. These and other budget studies already undertaken by OMB can serve as the starting point for a wide-ranging budgetary analysis of federal investments in intangible assets.

When the Obama Innovation Strategy came out last September, I noted the inclusion of a list of possible "Grand Challenges" at the end as setting some major priorities. Today's Federal Register has a the Office of Science and Technology Policy (OSTP) Request for Information on the Grand Challenges:

This Request for Information (RFI) is designed to collect input from the public regarding (1) The grand challenges that were identified in the strategy document; (2) other grand challenges that the Administration should consider, such as those identified by the National Academy of Engineering; (3) partners (e.g., companies, investors, foundations, social enterprises, non-profit organizations, philanthropists, research universities, consortia, etc.) that are interested in collaborating with each other and the Administration to achieve one or more of these goals, and (4) models for creating an ``architecture of participation'' that allows many individuals and organizations to contribute to these grand challenges.

Tom Kalil's posting on the OSTP blog today gives some further information, including links on the National Academy of Engineering's summits on their Grand Challenges for Engineering, university-based Grand Challenge Scholars Program and Expert Labs, a non-profit independent lab affiliated with the American Association for the Advancement of Science.

It will be interesting to see what people come up with in response to the RFI -- and if the solutions to the grand challenges move beyond just technological innovations.

President Obama is scheduled to announce today a program to use $30 billion of TARP funds to increase small business lending (a proposal that the Administration has been floating for some time). According to the Wall Street Journal:

In a briefing Monday, senior administration officials who helped draw up the proposal say that under the program, Treasury would provides capital investments in a swath of the nation's 8,000 banks with assets under $10 billion, which do more than half of U.S. small-business lending.
Banks that increase lending to small businesses beyond 2009 levels would qualify for reduced dividends owed to Treasury on the capital investment. White House economists hope that feature will spur interest in the program among community banks that shunned the original TARP program because of restrictions on the capital and worries that they would be tarred by their competitors as "troubled."

Here is another suggestion they might want to consider to help small business lending: unlock the lending potential of intangible assets. As we have pointed out in a couple of Athena Alliance reports (Intangible Asset Monetization: The Promise and the Realityand Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance), intangible asset backed lending is growing, but still nascent, means of financing innovation. Currently, companies can raise money based on their physical and financial assets. Such assets can be easily bought and sold, borrowed against, and used to back other financial instruments. But explicitly using intangible assets, such as IP, to borrow funds is difficult. While firms specializing in intangible-based financing are springing up, there are a couple of actions the Administration could take to foster this type of small business lending:

SBA loans to fund innovation. Explicitly change Small Business Administration (SBA) underwriting to allow companies to use their IP as collateral on loans. SBA already allows funds to be used to buy intangibles as part of the acquisition of a company by a new owner. Allowing IP to be used as collateral will increase the amount of funds a high-tech company would qualify for.

Create an IP-back loan fund. Other nations have developed special programs to encourage IP-based finance. A similar program in the U.S. should be set up on a pilot bases. The program could be run by the SBA, to take advantage of their lending expertise. Technical support could be provided by the SBA's Office of Technology, which coordinated the Small Business Innovation Research (SBIR) program and the Commerce Department's National Institute of Standards and Technology (NIST), which runs the Technology Innovation Program along with other science and technology related activities. Such a direct lending program would be a step beyond SBA's current loan guarantee programs. Direct lending is necessary, however, to jump start the process. Once the process of utilizing IP as collateral was fully established, the program could be converted to a loan guarantee program.

As I have noted before, the financial products discussed in this report are some of the most basic financing mechanisms in business, unlike some of the exotic financial vehicles. The innovation is in recognizing the value of intangible assets for corporate finance. Have the SBA enter the market would help regularize the market and set underwriting standards. That would go a long way to making intangible assets a regular and explicit part of the financial system.