February 2012 Archives

Will patent auctions open up bank IP lending?

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Over at the IAM Magazine Blog, Joff Wild has an interesting posting on a new patent auction based on Article 9 of the Uniform Commercial Code (UCC). Article 9 of the UCC deals with default of a loan and the recovery of collateral. The case in question deals with the auction of 12 registered patents and patent applications the defunct company SemiQuest Inc. on behalf of 3M Innovative Properties -- the only secured creditor of SemiQuest's debt (see press release).

One question about this auction is why this mechanism hasn't been used before. In a comment to Joff's posting by Patrick Anderson notes, there have been lots of cases where patents have been directly or indirectly assigned as collateral. And as the press release states "Bank lenders typically use Article 9 all the time to enforce their rights as creditors, but this case is groundbreaking because a nonbank lender [3M] is credit-bidding its debt in the form of a competitive auction."

I think what is interesting here is the increased trend to breaking out the IP from the rest of the business. While banks use Article 9 as a mechanism to recover losses from defaults, it has never been clear to me that banks think there is a way to use Article 9 for IP. They know how to liquidate tangible assets (real estate and equipment). They don't know how to liquidate intangible assets. Therefore, while intangibles such as patents may be included in the collateral package, they are not valued very highly. Use of Article 9 might be a step towards making banks more comfortable in lending based specifically on IP (rather than treating IP as a side thought).

There is a new report out from the National Science Foundation (NSF) on "Business Use of Intellectual Property Protection Documented in NSF Survey". This InfoBrief looks at data collected in the NSF/Census 2009 Business R&D and Innovation Survey (BRDIS). Taken at an aggregate level, the report is somewhat surprising. Only 5% of businesses say that utility patents are either very or somewhat important. Only 12% said copyrights were very or somewhat important. Only 14% said trade secrets and only 15% said trademarks were very or somewhat important. In other works, 85% of U.S. businesses don't think trade secrets are important and 96% don't think patents are important.

But, once you start getting into the details, at least some of this begins to make sense. Certain industries believe certain types of intellectual property rights (IPR) are of importance. Copyright in the publishing industry is an obvious example. A not-so-obvious examples is that, according to the report, "98% of businesses in the semiconductor machinery industry (NAICS 333295) reported trade secrets as important--no other NAICS industry reported a higher share of any type of IPR as important." One would think patents rather than trade secrets would be of key importance.

The difference is also stark when it comes to business who conduct R&D and those who do not (self-defined). Not surprising, those who say they do not undertake R&D overwhelming rate IPR as not important. On the other side, however, only about half of those businesses that do have R&D activities rate some form of IPR as very or somewhat important.

A couple of questions jump out at me from the survey. First is the most obvious. Do companies really understand intellectual property?

But thinking about it more, another question emerges. In the text is this note: "Only about 3% of the estimated 1.9 million for-profit companies represented in the survey performed and/or funded R&D in 2008." So the issue is not necessarily IPR. Regardless of whether they utilize IPR or not, do companies understand that they are selling knowledge? They may very well understand this point and we have failed to capture that understanding. The long standing problem here is that many companies are creating and selling knowledge that is outside of the traditional definition of R&D.

So, maybe some of these companies get it -- that their intellectual capital/intangible assets are more important than their formal IP. Maybe IPR is not as important as we think. Or maybe the companies are just clueless.

Obviously, more needs to be done before we can understand what is going on here.

Are non-compete agreements bad for innovation?

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Non-compete agreements are a standard mechanism that companies use to try to protect what they see as their intellectual property. They are so standard that they are recognized by the accountants as an intangible asset. Yet, the question remains whether they are effective and enforceable. As I noted in Intangible Asset Monetization, non-compete agreements are considered illegal under California's Business and Professions Code Section 16600 as a restraint of commerce. A number of other states also tend not to enforce non-compete agreements or limit their scope. For example, last November the Virginia Supreme Court once again ruled that an overly broad non-compete agreement could not be enforced (see earlier posting).

But the real question is whether such restrictions can harm innovation. The standard counter-argument to non-compete agreement is Silicon Valley. Many have argued that the lack of such restrictions on the free flow of information and people is a hallmark of the Valley's innovative culture.

Recent work by Matt Max of MIT and his colleagues describe a different problem: the impact on human capital. In one study, they found that enforcement of non-compete agreements drives away inventors to locations that do not enforce these agreements (see "Regional Disadvantage? Non-compete Agreements and Brain Drain". Another study shows that non-compete agreements waste human capitol by forcing knowledge workers to switch fields, thereby losing the ability to utilize their existing skills and knowledge base (see "Non-compete agreements create 'career detours".)

The issue is beginning to get more attention in policy circles. For example, the Kauffman Foundation's new report StartUp Act for the States specifically mentions the problem of non-compete agreements restricting labor mobility and cites the work done by Professor Marx and others. While not calling for the elimination of non-compete agreements, the report lays the case for why a state might want to relax enforcement:

What we recommend is that each state look hard at its legislative policy and judicial doctrine on the matter and make a calculated decision as to whether lax or vigorous enforcement will better serve its objectives. If a state seeks to promote higher entry by new businesses and help them hire and grow, then perhaps more relaxed enforcement is called for. If a state seeks to bolster the economic health of its existing businesses--perhaps because the state's economy relies heavily on sectors with larger and older companies--then non-compete enforcement might remain appropriate policy.
This was elaborated on in response to a question I asked during panel discussion at the Kauffman State of Entrepreneurship event - see video at 38:00 minute. In that answer Bob Litan of Kauffman made it very clear that there are other ways to protect intellectual property - specifically through trade secrets.

It seems to me that the trade secret route could be a much more effective mechanism. It would be interesting to see work on the application of trade secrets in places like California and Colorado where non-compete agreements are not allowed. The problem is that maintaining trade secrets is more difficult and takes more work on the part of the company. I wonder if companies simply default to the easier action of using non-compete agreements. If that is the case, then the restriction or elimination of non-compete agreements might force greater attention to trade secrets.

Given this new attention - and the availability of alternatives, I would not be surprised to see at least some states begin to take a hard look at their position on non-compete agreements.

Manufacturing/service fusion explained

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Here is a great description of the fusion of manufacturing and services by Henry Chesbrough. This is taken from an interview of Chesbrough -- "At the Court of King Henry." Of course, most the interview is about open innovation (and worth reading for that discussion). But Chesbrough is interested in the broader question of value creation and he said about manufacturing and services was especially interesting:

"Xerox now gets more than 25 percent of its revenue from services. IBM is another classic case. A lot of its revenue is generated from services. Company after company is getting more and more of their business from services. In some cases what's really happening is the business model is shifting. So for example, a GE aircraft engine can be sold for tens of millions of dollars to an airframe manufacturer. That same engine can also be leased on a so-called "power by the hour" program to that airframe manufacturer. In the first case it's a product transaction. In the second case it becomes a service. And with the latter what benefits GE is all the aftermarket sales and service, spare parts, etc., that accrue during the 30-year life of the engine and operations. So now all that comes back to GE, whereas with the first case, when GE sold the engine, they were in competition in the aftermarket with all the former GE technicians that spent 10 years at GE and then decided to go out on their own. They've got all the tools. They've got all the manuals. They've got all the equipment, the training, but they don't have GE's overhead. So they're undercutting GE, 20, 30 percent on price, and it's the same people. So this is the way to kind of bring that 30-year aftermarket back into the fold of GE."
Its all about selling off of your knowledge base -- as a product, a service or both.

Brookings manufacturing event

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Those of you who follow me on twitter know that I was at the Brooking Institute's event on manufacturing yesterday -- you can see the twitter traffic at #usmfg. It was a great event which is now online (click here). Below is the link to the video:

Some of the major restaurant chains have figured out that they run a business based on intangible assets -- including their wait staff. This was made clear in a recent "living" section piece in the Wall Street Journal -- "How Waiters Read Your Table". While meant to be a guide for diners, it explains the companies' strategy:

"We asked what can we do that will set us apart from the scrum," besides discounting and coupons, says Wayne Vandewater, vice president of learning and development for Applebee's, owned by DineEquity Inc. "Food is easy to copy, a building is easy to copy, but it's not easy to copy our people."
. . .
"We changed 'suggestive selling' to 'situational selling,' " says Rene Zimmerman, senior director of training and development for Bob Evans Farms Inc., a family-style restaurant and food maker. Instead of offering every breakfast guest one additional item, say biscuits and gravy, waiters are taught to adjust their offer depending upon the guest. For a diner who places a lighter order, like a bagel and fruit, the waiter might suggest a cup of coffee or tea.
. . .
Reading a table happens within seconds of a waiter coming to a table. By asking for a cocktail menu or smiling and making strong eye contact, "they are saying 'hey, I want to engage with you and I want you to make me feel really important,' " says Mark Maynard-Parisi, managing partner of Blue Smoke, a pair of barbecue restaurants in New York, owned by Union Square Hospitality Group. If people seem shy, "you want to put them at ease, say, 'take your time, look at the menu.' "
Blue Smoke does seven days of training with new waiters, five days of trailing an experienced waiter and two days of being trailed by the experienced waiter. Each day includes a quiz and a focus such as greeting guests.
I love the fact that Applebee's has a "vice president of learning and development." I know that McDonald's has its own training facility (often referred to as "Hamburger U"). But, as I understand it, their emphasis is still on uniformity and efficiency - based on their well-known factory type methodology. These other chains seem to be moving away from the mass production model to emphasizing the customized model. But then again, the customized model was the dominant model in the restaurant business forever before McDonald's industrialized it. As any trip to your favorite local diner will confirm.

Obama proposal for corporate tax reform

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Today, the White House and the Treasury Department released The President's Framework for Business Tax Reform. The main focus of attention is on the proposed reduction of the corporate tax rate to be paid for by eliminating many tax incentives (aka loopholes). This follows the "cut and broaden" strategy advocated by a number of sources.

However, the President's proposal does not eliminate all incentives. In fact, it has an entire section on strengthening incentives for manufacturing and innovation, including expanding the R&E tax credit. But nothing about a "patent box" or a "knowledge tax credit" for on-the-job worker training.

It also refers to the previous proposals on transfer pricing of intangibles being shifted to low tax jurisdictions (see earlier posting).

Interestingly, Appendix II of the document lists the effective marginal tax rates on new investments. According to this analysis, the effective marginal tax rate for a new investment in intangibles is 6.2% for a corporation and -3.1% for noncoporate businesses. This seem to poster the claim by the Treasury Department of some years ago that intangibles are already favored under the tax code (see earlier postings). However, since the analysis specifically notes that intangibles include R&D, I assume that most of this low effective tax rate is due to the R&E credit. It would be interesting to see the full analysis on all forms of intangibles. And the economic impact of those rate on investment decisions!

Innovation in construction - an example

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We tend to think of construction as not very innovative. But, as this story from today's Washington Post ("Why National Gallery's East Building shed its pink marble skin") illustrates, construction can face some daunting technical challenges:

In 2005, the pink marble panels that envelop I.M. Pei's stunning museum [National Gallery's East Building] started to show worrying symptoms. Excess mortar and lead shims had inadvertently tied the stones together. Instead of each being able to float freely over the brick and concrete wall behind, they were locked to one another. As temperatures rose and fell over 30 years, the fastening system failed. Stones started to pull away from the building.

It is a bad thing to have stones pulling away from a building. Flatten a single tourist with a 450-pound slab of falling marble and people talk. And so a challenge was issued: Who can fix this?

The response came from people such as Lenny Pagliaro, a mason and one of a team of contractors who have come together to take off all 17,000 stones, refinish them and put them back in exactly the same places. It's an $85 million project that won't be finished until 2014.

. . .

Then there's the little matter of making sure what happened once doesn't happen again. The marble cladding is attached with various anchors, and each panel is supposed to be free to move independently. Engineers came up with a sophisticated set of components to replace the old method, along with a soft silicone gasket that won't stress the stones. Then they built a training facility in Bowie just to test the technique and teach workers how to use it.

Necessity really is the mother of invention/innovation. The next question is whether this technique will be used elsewhere or whether it is a one-off. This is where invention becomes innovation.

Economic Report of the President - includes intangibles

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The Economic Report of the President was released last Friday. Understandably much of the focus by the press/pundits/blogsphere is about the macro economy outlook (for example, see "How the Economy Looks From the White House"). But within the document there are a number of interesting references to intangibles and innovation.

First of all, let me draw your attention to the document's specific discussion of investments in intangibles (on page 56). This discussion not only talks about current BEA efforts to include intangibles, such as R&D, as investments in the GDP calculations. It also argues for a broader view of intangibles, such as human capital:

Some researchers have argued that investment in intangibles should be defined even more broadly (Corrado, Hulten, and Sichel 2009; Corrado and Hulten 2010). In addition to research and development that builds on a scientific base of knowledge, for example, there is an argument for treating as investment the money firms spend on other sorts of new product development, such as the development of new motion pictures or new financial services products. Businesses also spend money on strategic planning, the implementation of new business processes, and employee training, all of which may add significantly to future productivity and thus arguably should be treated as investment as well. Taking an even broader perspective, time and money devoted to formal education add to the human capital of the American workforce and thus to its future productivity. While accounting accurately for the value of these investments poses some difficult measurement challenges (Abraham 2010), their importance to future economic growth should not be overlooked. According to some research (Krueger 1999), returns on human capital generate the lion's share of national income.
I welcome this attention -- and hope it might be the groundwork for the creation of a crosscutting look at investments in intangibles assets in the Federal government's budget (see earlier postings).

I should note that the Report raises a number of data questions, such as the discussion on pages 52 and 53 about measures of the service economy. See also a WSJ piece on "White House Highlights Need For New Data Based on Changing Economy."

The Report also includes a discussion of trade in services -- highlighting the importance of royalties & license fees and business services. To its credit, the Report talks about the contribution of trade in intangibles without falling into the all too common trap of "services will save us." In addition, in a footnote the Report references the issue of companies locating their intellectual property "in low-tax jurisdictions, minimizing their global tax liability as well as measured U.S. royalties and license fees."

Interestingly, the discussion of innovation is tucked in the section on "Improving the Quality of Life" (Chapter 8). Here the discussion is, predictably, on technology-focused issue: measuring technological innovation; IP; funding of R&D; commercialization of university research; wireless and spectrum. Unfortunately, we still can't seem to get beyond our narrow policy thinking on innovation.

BTW - the Report also has a section on modernizing unemployment insurance, including an endorsement of work sharing programs (see earlier posting) and use of UI funds to support entrepreneurship.

In an earlier posting I noted that the sale of broadcast spectrum (an intangible asset) is being used to fund the extension of unemployment insurance (UI) benefits in the Middle Class Tax Relief and Job Creation Act of 2012 (H.R. 3630). But also tucked inside the bill is a modification to the UI program to create a "work sharing" program -- including a training portion as I have advocated in the past. Subtitle D of Title II of the bill authorizes the use of UI funds for "short-term compensation programs" for workers who have had their hours cut back. Since UI is a State-run program, the States will have to create job sharing programs within their specific UI program.

This is a major step forward in re-orienting our UI system. As a story in the Wall Street Journal ("Tax Bill Passed by Congress Broadens Jobless Program") notes:

The bill will expand a program known as "work sharing" that uses unemployment-insurance funds to supplement the paychecks of employees whose hours have been reduced as part of a company's cost-cutting. Supporters credit the program, used in Rhode Island and several other states, with encouraging companies to keep workers in part-time jobs rather than resort to layoffs.
"Right now, we have a UI system that is biased toward laying people off rather than cutting hours," said Betsey Stevenson, a former chief economist in the Obama Labor Department and currently a visiting professor at Princeton University. With the changes, she said, "you're not only spreading out the pain but you're actually minimizing the pain, because we know that when people go through a spell of unemployment, there are actually long-term consequences."

But more than spreading the pain, the program specifically includes training as part of the package. The bill (in Sec. 2161) states that "(6) eligible employees may participate, as appropriate, in training (including employer-sponsored training or worker training funded under the Workforce Investment Act of 1998) to enhance job skills if such program has been approved by the State agency". This allows those receiving the fund to be treated the same as anyone else receiving UI benefits. I would have liked to have seen the words "shall participate" instead of "may participate." Better to pay workers to sit in a classroom than sit at home. But this is still a step forward.

As I have argued before, the UI system needs an overhaul. The need for a UI overhaul and the shift from simply job search to training is illustrated by a recent story in the Washington Post ("U.S. manufacturing sees shortage of skilled factory workers"). That piece describes the problem perfectly:

Much of the demand for skilled workers arises because the automated factories demand workers who can operate, program and maintain the new computerized equipment. Many of those who have been laid off can operate only the old-fashioned manual machines.
As skills are constantly changing, workers need help in keeping up. Rather than laying those workers off, a work sharing program tied to training would give those workers the skills they need be more productive and keep their jobs in the first place. And if they do get laid-off, to quickly find a new job.

When we had this debate last summer, I called the UI extension bill a wasted opportunity. I'm glad to see that Congress has seized on this opportunity in the form of creating the work sharing program. I hope the States also seize the opportunity and move forward quickly with its implementation.

Manufacturing workers are knowledge workers

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Richard Florida -- "A Blueprint for a 21st Century Workforce":

The manufacturing jobs that pay best today look a lot more like knowledge work than traditional factory work. In fact, high-paid manufacturing work - guiding and maintaining advanced machinery, engaging in problem solving, and continuous improvement with other workers and engineers - increasingly is knowledge work.
Exactly! And that is one of the reasons why manufacturing matters. Our knowledge workers are in every sectors. Therefore, every sector is a component part of a prosperous knowledge-based economy.

Talking manufacturing

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Manufacturing is getting hot. As part the recent spate of op-ed's and rebuttals on whether manufacturing matters, I've seen a lot of announcements/articles about manufacturing related postings and events. Here are a few. Note some of these are events that were planned long before the latest flare up of interest.

Don't Mock the Artisanal-Pickle Makers -- a great story on the potential return of the craft-manufacturing (in the information age).

Manufacturers Providing Boost To U.S. Economy -- an update on what is happening to manufacturing growth.

Do Manufacturers Need Special Treatment? -- Romer's NYT op-ed
Not understanding manufacturing? -- my response
The Outsized Benefits of U.S. Manufacturing -- a Brookings piece in response.
Why don't economists get it on manufacturing? -- Clyde Prestowitz's response in Foreign Affairs
Our Manufacturers Need a U.S. Competitiveness Strategy, Not Special Treatment -- ITIF's response

Why--and Which--Manufacturing Matters: Innovation and Production in the United States -- a upcoming Brookings event.

American Competitiveness: What Works -- a recent summit sponsored by GE and others including a day on manufacturing.

The future of the manufacturing industry -- a description of the World Economic Forum's project.

Production in the Innovation Economy (PIE) -- MIT's new project (see also my earlier posting on their comments on the fusion of manufacturing and services).

and the list could go on . . .

UI deal relies on selling government intangible assets

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Part of the economic package that Congress will soon vote on (a $150 billion measure) includes not only an extension of the payroll tax cut but also an extension of unemployment insurance (UI) benefits. (For more info, see the Conference Report for entire package.) The UI portion of that deal will be paid for using revenues from sale of a government intangible asset, specifically the auctioning of broadcast spectrum. According to the write up by the Democratic staff of the House Energy and Commerce Committee:

The legislation gives the Federal Communications Commission (FCC) the authority to pay TV broadcasters for underutilized broadcast spectrum and resell it at higher prices to wireless companies to meet the growing spectrum demands of smartphones and tablets. This provision is expected to make a large band of prime spectrum available for auction, raising over $25 billion. The bill provides $7 billion in auction proceeds and spectrum worth $2.75 billion (called the "D Block") to a new "First Responder Network Authority" to build a broadband network for police, firefighters, emergency medical service professionals, and other public safety officials. A key provision in the legislation authorizes the FCC to create guard bands in the broadcast spectrum auctioned to wireless carriers that can be used for innovative unlicensed uses like Super WiFi.
What to do about this underutilized spectrum has been a controversial issue for some time. Broadcasters wanted to make sure they didn't have to give up spectrum they were using (and were adequately compensated). Wireless companies want to be able to buy most of that freed-up spectrum. Tech companies want to make sure it would be available as unlicensed spectrum for Wi-Fi usage. Public safety officials wanted to make sure they had access to spectrum for emergency communications systems. (For a quick over view, see the stories in The Hill, the New York Times, the Wall Street Journal, and GigaOM; for more in-depth, see the ongoing coverage in the Benton Foundations newsletter.).

The fight over selling over all of the spectrum and preserving some of it as unlicensed "white space" for Wi-Fi type applications is of special interest. It highlighted the conflicting roles of government assets: maximize revenues to the government or utilize those assets as essentially a subsidy to promote innovation. It also raised a question about how we think about and manage government intangible assets. Technically, this part of the broadband spectrum is not a government asset, as it was already allocated to the TV broadcast companies. The government will have to buy back the spectrum first in order to re-allocate it. Had the issue been approached as a issue of the long term management of an important intangible asset, the original allocation process might have been structure differently.

As I've argued before, we need to do a better job of understand our government intangible assets. With the deal now cut, maybe an after-action analysis is in order. Such an analysis might help us learn from of this experience as to how to better manage these assets.

Entrepreneurial training in President's budget

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Here is a little gem hidden in the President's budget proposal (from the Fact Sheet):

The Community College to Career Fund will support pathways to entrepreneurship for 5 million small business owners over three years through the nation's workforce system and its partners, including: a six-week online training course on entrepreneurship that could reach up to 500,000 new entrepreneurs and an intensive six-month entrepreneurship training program resulting in entrepreneurship certification for 100,000 small business owners.
I really like this idea -- especially the online training part. While I'm not sure that an "entrepreneurship certification" is all that useful, the intensive certainly will be. Maybe they can tie the certification to some form of loan or equity financing program.

More importantly, the training courses needs to include intangible asset management. As Mary Adams and I noted in our paper Intellectual Capital Management and Entrepreneurial Mentoring and Education: entrepreneurship mentoring and training needs to move beyond technical assistance:

Many such technical assistance resources already exist: legal, accounting, financial etc. In fact, an important part of the mentoring process is connecting the struggling entrepreneur with the appropriate technical resources. However, there is one set of technical assistance resources that are yet to be fully developed and deployed to help entrepreneurs: intellectual or intangible capital (IC) management. Economy-wide, IC comprises a large part of corporate value. In some high-growth companies this percentage can often approach 100% and successful management of IC is often the key to their success.
. . .
While large companies can afford the consulting expertise required to undertake IC management, such assistance is not available in an accessible, cost-effective form to high-growth start-ups. Intangible assets are basically all most start-ups have. It is critical therefore that entrepreneurs are able to visualize and articulate what are the start-up's intangible assets and how they work as a system. This is especially important for investors but also for recruitment and strategy. Start-ups need to thinking carefully about their business models: how to get paid for what they know-including navigating between free and paid aspects of a value proposition. Keeping track of intangible investments is an important way of backing up the story of the company's development. Finally, entrepreneurs need to understand that the ultimate reputation of their organization will be earned as a result of good intangibles management.
Adding an intangibles management module to the course would be a huge step forward.

BTW - the Community College to Career Fund is a much larger program to boost worker training. In and of itself, that is a step forward in strengthening America's intangible asset base.

It is "budget Monday" when the Obama Administration is releasing its FY 2013 budget. A lot of ink will be spilled and bandwidth wasted analyzing the minute details -- and the mega question of whether the Administration's budget request matters at all. Over the next week or so, I will highlight a couple of areas of interest. But right now, I want to draw you attention to the accompanying document from the Department of the Treasury: the FY2013 Greenbook (aka the General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals). As in the two previous budgets, the Administration is proposing two changes to how offshore transfers of intangibles are handled. This year's proposal (below) is almost identical to last year's proposal. The only difference is that a phase in (or phase out, depending on your point of view) of the excess returns tax for effective tax rates of 10 to 15 percent.


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 transferred intangible assets.

In general, the subpart F rules (sections 951-964) require U.S. shareholders with a 10- percent or greater interest in a controlled foreign corporation (CFC) to include currently in income for U.S. tax purposes their pro rata share of certain income of the CFC (referred to as "subpart F income"), without regard to whether the income is actually distributed to the shareholders. A CFC generally is defined as any foreign corporation if U.S. persons own (directly, indirectly, or constructively) more than 50 percent of the corporation's stock (measured by vote or value), taking into account only those U.S. persons that own at least 10 percent of the corporation's voting stock.

Subpart F income consists of foreign base company income, insurance income, and certain income relating to international boycotts and other proscribed activities. Foreign base company income consists of foreign personal holding company income (which includes passive income such as dividends, interest, rents, royalties, and annuities) and other categories of income from business operations, including foreign base company sales income, foreign base company services income, and foreign base company oil-related income.

A foreign tax credit is generally available for foreign income taxes paid by a CFC to the extent that the CFC's income is taxed to a U.S. shareholder under subpart F, subject to the limitations set forth in section 904.

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. Expanding subpart F to include excess income from intangibles transferred to low-taxed affiliates will reduce the incentive for taxpayers to engage in these transactions.


The proposal would provide that if a U.S. person transfers (directly or indirectly) an intangible from the United States to a related CFC (a "covered intangible"), then certain excess income from transactions connected with or benefitting from the covered intangible would be treated as subpart F income if the income is subject to a low foreign effective tax rate. In the case of an effective tax rate of 10 percent or less, the proposal would treat all excess income as subpart F income, and would then phase out ratably for effective tax rates of 10 to 15 percent. For this purpose, excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from such covered intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. For purposes of this proposal, the transfer of an intangible includes by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement)). This subpart F income will be a separate category of income for purposes of determining the taxpayer's foreign tax credit limitation under section 904.

The proposal would be effective for transactions in taxable years beginning after December 31, 2012.

- - -


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." Section 482 also provides that in the case of transfers of intangible assets, the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets. 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.


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, 2012.

Like much of the budget and tax recommendations, I am doubtful that these two provisions will be enacted as is. They may, however, constitute part of a "patent box" proposal (as I have advocated in the past) or as part of a larger switch to a territorial tax system as some in the GOP have advocated (see earlier posting).

December trade in intangibles - and 2011

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The not so good news on trade continued in December, according to data released today by BEA. The deficit once again rose to $48.8 billion, up $1.7 billion from the November revised deficit of $47.1 billion. Imports were up by $3 billion while exports rose by only $1.2 billion. Unlike last month, the increased deficit was all non-petroleum goods, as the December petroleum goods deficit actual shrunk slightly. Some of the biggest contributors to the deficit were imports of capital goods and autos & auto parts.

Conversely, our deficit in Advanced Technology Products improve markedly in December, dropping by over $2.7 billion. Much of this was due to a drop in information and communications technology imports. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

Our trade surplus in intangibles grew ever so slightly in December. This was due to a growth in the balance of trade in royalties -- where exports (incoming payments) grew faster than imports (outgoing payments). The surplus in business services decreased slightly as imports grew faster than exports.

On an annual basis, our intangibles trade was basically unchanged in 2011 after a spurt in 2010. Our intangible surplus remains small compared with the increasing trade deficits in goods.

Intangibles trade-Dec11.gif

Intangibles and goods-Dec11.gif

Oil good intangibles-Dec11.gif

Intangibles trade-2011.gif

Annual - intangibles v goods 2011.gif

Note: we define trade in intangibles as the sum of "royalties and license fees" and "other private services". The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees - Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term "royalties" generally refers to payments for the utilization of copyrights or trademarks, and the term "license fees" generally refers to payments for the use of patents or industrial processes.

Other Private Services - Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term "affiliated" refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise's voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

Manufacturing jobs stabilize

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The BLS employment projections to 2020 are now out (in the January edition of the Monthly Labor Review). And there is a rush to judgment to proclaim that manufacturing is continuing its decline. What the report really says is that the number of jobs in "manufacturing" as an industry category will decline by 0.1% between 2010 and 2020 after declining by 4% in the previous decade. A drop of 0.1% sounds well within any margin of error to me -- meaning that manufacturing employment will be essentially unchanged. Interestingly, it also shows "production" occupations as growing by 4.2%.

A closer look at the data shows a more interesting story. For example, the data shows some of the fastest growing manufacturing industries as those related to construction. The most rapidly declining is apparel knitting mills. So it depends on what manufacturing industry you are talking about. Then there is the question of output versus employment. The fasting growing industry in terms of output is projected to be computer and peripheral equipment manufacturing. One most rapidly declining in terms of employment is computer and peripheral equipment manufacturing.

Thus, the real picture is a lot more complicated.

NAE forum on 21st Century Manufacturing and Design

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Back in October 2010, the 2011 National Academy of Engineering meeting hosted a forum on manufacturing. The summary of that forum -- Making Things: 21st Century Manufacturing and Design -- is now available.

A couple of points from the forum jumped out at me. First, Rodney Brooks of Heartland Robotics stressed the changing nature of the high-tech production of "low-tech" goods. Part of the competitive edge of these products is not necessarily their technological sophistication but their responsiveness to customer demand. That responsiveness is driven by the ability to do short-run production at a nearby facility. As Brooks is quoted saying:

"If you [manufacture low technology products] close to where they are sold, they become fast moving, and you get a lot more innovation happening here in the United States.

The second point was that manufacturing is an integrated system. As the report notes:

Manufacturing is a lot more than what goes on in factories. It includes designing, engineering, sourcing, producing, distributing, marketing, and selling products.
This point was made by Lawrence Burns, former vice president for research and development (R&D) and strategic planning at General Motors, who is quoted saying "We must teach the next generation about manufacturing in this broad context."

The third point is one I have raised before: the link between design and manufacturing and the importance of design thinking. But design thinking is not about making object look nice -- it is about creative solutions. This point was stressed by David Kelley of IDEO and the Stanford design school. Creativity requires what Kelley calls "radical collaboration. As the report states:

"I'm a mechanical engineering professor," said Kelley. "Five mechanical engineers as a team do not come up with the same ideas as a team with a business person, an anthropologist, a social scientist, an educator, and a mechanical engineer. . . . Putting that diversity to work is a great thing."

A next point built upon the earlier point of low-tech products and addressed what I call the high-value fixation. The report summarizes:

To keep value in the United States, the know-how responsible for creating that value needs to exist here. This know-how is not always in high technologies. As Ursula Burns, chairman and CEO, Xerox Corporation, observed, Xerox wants to build things in the United States but is having trouble in the Northeast finding manufacturing engineers. The United States has "lost the low end--the building of the physical gear boxes and things like that." Once those capabilities are lost to other countries, they can be very hard to get back.

I wish I could say that the forum broke new ground on ideas as to how to confront the policy challenges. They did not - falling back on more R&D (especially for DARPA like activities) and fixing education. But they did raise important points about the future of manufacturing -- points we which we need to take to heart and follow up on in crafting our manufacturing strategy.

Thoughts on manufacturing

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In an earlier posting, I complained about economists not understanding manufacturing. Here are a couple of relatively recent articles that get it right. First, David Wessel gets it mostly right on the importance of manufacturing in his piece "Factory Floor Has Ceiling on Job Creation". It is not necessarily the factory floor jobs - but all the activity that surrounds the factory floor:

There are good reasons to cheer for domestic manufacturing. Expanding factories have beneficial side effects. "If you get an auto-assembly plant, Wal-Mart follows," says Ron Bloom, until recently President Barack Obama's manufacturing czar. "If you get a Wal-Mart, an auto-assembly plant doesn't follow."
Modern factory jobs, many of which require more brainpower and computer know-how than muscle, often pay well and are secure. Research and development--the key to maintaining the U.S. edge in innovation--sometimes migrate abroad when production does, a good reason to strive to keep production at home.
But he, and many others, are also right that manufacturing "isn't going to be the ticket to the middle class for unskilled workers who haven't gone beyond high school."

In fact, as Steve Denning points out in his piece in Forbes -- "The Future Is (Gasp) Manufacturing?", factories many not even be factories in the future. He is talking about something I have mentioned a number of times: 3D printing aka additive manufacturing:

Now the economics of large-scale production runs carried out overseas are being disrupted by the possibility of making, selling and delivering millions of manufactured items one unit at a time, right next to the customer.
There is a lot more going on right now under the rubric of "advanced manufacturing" beyond additive manufacturing that will forever change the processes by which we manipulate atoms (aka make things). I hope to be talking about some of these in the not too distant future. Bottom line is that manufacturing is far from a dead (or dying) activity. It just not going to look the way it did in your grandparent's time.

The intangible economy in rural areas

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Here is a great article on The Worth of the Rural 'Creative Economy'. The article talks about how the Mississippi Arts Commission is building a creative economy in rural areas. Years ago I did a piece on "Building on Local Information Assets" for Rural Matters on a similar theme. Back then I noted that:

It is often thought that rural areas are at a distinct disadvantage in this race to develop intangible assets. For example, it is difficult for rural areas to put together the scientific and research assets needed for technology-led economic development. Likewise, following the notion of Richard Florida's The Creative Class, more and more urban areas have latched on to the notion that "cool" is a defining intangible asset on which to build their economic base. These assets are commonly seen as an active nightlife, arts and entertainment centers that will attract young creative people. Rural areas generally don't have the agglomeration of such features.

But recent studies show that rural areas and smaller communities may be better suited to commercialization of new products (a specialized form of "innovation") rather than scientific and technical innovation. And small-town and rural life styles have their own appeal as "cool." What sells is a unique or distinct approach - that important intangible asset of "brand" that more and more communities are beginning to recognize.

There are numerous examples of rural communities or regions that have utilized local knowledge to spark development. The Appalachian Center for Economic Networks (ACEnet) in Athena, Ohio has created a local economic cluster centered on the specialty food products industry. Other examples include film making around Wilmington, NC; windsurfing-related sporting goods and apparel in Hood River, Oregon; fishing gear in Woodland, Washington; snowmobile manufacturing in northern Minnesota; and houseboat manufacturing in Kentucky. These areas, and many others, show that it can be economically "cool" to be rural.

I think that is still true today.

Not understanding manufacturing?

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In a recent article in the New York Times, Christina Romer (former head of the White House Council of Economic advisors) asks Do Manufacturers Need Special Treatment?. The article articulates the standard neoclassical argument: where is the market failure. Interestingly, her argument glosses over the major market failure as evidenced by the massive trade deficit. She notes that selling architectural drawings is as important as selling cars. I agree. But she ignores the magnitude of the difference between our intangibles trade surplus of not quite $14 billion per month and our goods deficit of over $63 billion per month. Clearly the overall market is not working when our international income is not even one quarter of our international expenses.

She also does not address the linkage between the various sectors of the economy. Over and over again, studies have shown that as manufacturing has moved offshore, services have followed.

At a deeper level, the tone of the articles raises a different question. She questions the need to "subsidize" manufacturing -- as opposed to, for example, investing in infrastructure. Why is an explicit programs of spending on infrastructure an "investment" while a specific policy to assist manufacturing make the transition called a "subsidy"?

The core of Romer's argument is that the type of industries we have is not important. Spoken like a true macroeconomist, the structure of the economy doesn't seem to matter. It is the old "computer chips, potato chips, what's the difference" argument. "Let the market decide!" Of course, this ignores that the market doesn't decide because almost every other nation has an active policy of economic development that is focused on the structure of their economy.

Romer is right on one major point (if this is the point she was trying to make): the issue is not helping manufacturing while not helping other sectors. Over and over again, she cites examples of policies that would help all sectors. That is true. But there are also specific issue and challenges that face manufacturing which need to be specifically addressed.

One of those challenges is the mistaken view that manufacturing doesn't matter. Under this view, manufacturing is a dying economic activity that is better left to low wage countries. Rather, so the thinking goes, we should concentrate in services and let others concentrate in manufacturing. Of course, as I've noted may times before, that analysis fails in to the all too common trap of thinking of "manufacturing" and "services" as separate and totally distinct activities. In fact, they are heavily intertwined and co-dependent. While she acknowledges that manufacturing has become more technologically sophisticated, it is unclear that she understands the implications of that shift -- which increases the interconnection.

As the article unwittingly illustrates, this misunderstanding of the shifting nature of the economic structure is often at the heart of the policy debate. And is one of the reason why we can't seem to break out of a set of 1950's type arguments. Unfortunately, Dr. Romer's comments only adds to that misunderstanding.

January employment

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Good news in this morning's employment data from the BLS: the unemployment rate dropped to 8.3% in January as 243,000 jobs were created. All of those jobs were in the private sector with government employment holding steady (after declining for the past few months). And, contrary to previous months, the civilian labor force increased. So more people were looking for work and more people found work. That is a good sign.

The number of involuntary underemployed was essentially unchanged (increased very slightly). The somewhat worrying part, however, is that slack work increased. This may be a reflection of slowing demand - or simply a statistical correction taking into account last month's large decrease.


UPDATE: This story ran in the morning edition of the Washington Post (before the data was released) "Modest gains forecast for Jan. jobs report":

With the government's monthly unemployment report expected Friday, economists predicted it will show that the United States added about 150,000 jobs last month, sustaining a modest momentum in the economy.
The emphasis might be on modest.
Why do they even bother -- and why are we still listening to them?

Kodak's epitaph

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From Knowledge@Wharton - "What's Wrong with This Picture: Kodak's 30-year Slide into Bankruptcy":

When new technologies change the world, some companies are caught off-guard. Others see change coming and are able to adapt in time. And then there are companies like Kodak -- which saw the future and simply couldn't figure out what to do. Kodak's Chapter 11 bankruptcy filing on January 19 culminates the company's 30-year slide from innovation giant to aging behemoth crippled by its own legacy. (emphasis added)
As the story points out, however, Kodak did more than just see the future. They helped invent it -- especially in digital photography. But then they could not change to take advantage of what they created.

So here is the epitaph for Kodak: created the future; couldn't adapt.

Yes, more STEM - but which STEM?

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In the Fall 2011 Issues in Science and Technology, former Presidential science advisor Neal Lane has a thoughtful article on "Science Policy Tools: Time for an Update". He takes on a number of policy issues in that piece. But there was one that especially jumped out at me, concerning STEM education:

The nation is producing more Ph.D.s in some fields than there are jobs, or at least jobs that graduates want and are being trained for, and the imbalance is likely to get worse. This may be especially true for biomedical research, but it is a problem for some other fields as well. The nation may need more scientists and engineers, even Ph.D.s, but not in all areas. There are policy options that could be employed, but they are not easy. Given the rapid pace of change in this age of technology, it is simply not possible to predict what the specific needs will be 20 years from now. The ability of the United States to continue to be a world leader in technological innovation will depend not only on having the necessary technical talent, homegrown and from abroad, but also being able to retrain and redirect that talent in response to new developments.
While we have given a lot of attention to the "original" STEM education activities (both K-12 and higher education), this issue of redeployment of scientific and technical personnel has not been raised. We seem to just assume that people with STEM skills won't be displaced or need to re-focus their activities. Or maybe we assume that they just do this automatically.

Those may be bad assumptions. It is time to take a close look at the issue of life-long learning in the STEM fields and the process of redeployment of STEM talent. Maybe we need a new set of policies for mid-career STEM professionals - to be able to move in new directions. Dr. Lane has done us a service by raising the issue. Now the scientific community needs to follow up.

More examples of the fusion of manufacturing and services

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R&D Magazine recently did a story on MIT's new research project on Production in the Innovation Economy (PIE). That project will look at how manufacturing can thrive in America. One of the aspects that they are apparently looking at is something that I have been talking about for some time: the fusion of manufacturing and services (see earlier postings). As the story notes:

On a recent visit to a company that makes equipment pipes and tanks for biotechnology companies, she [MIT professor Suzanne Berger] found that a quarter of the company's revenue comes from repairing and servicing the equipment. "What we're discovering is that this connection between manufacturing and services is an integral one," Berger says. "A set of capabilities is gained in making products that then get redeployed in the service part of a business."
Exactly! I can't wait to see the project's interim report due out this spring.

BTW -- the story opens with another vignette of a factory visit by Professor Berger:

As she saw on the factory floor, the company has developed an innovative automation system that has increased its business: Between 2004 and 2008, its revenues doubled, and its workforce did, too. (emphasis added).
Clearly, productivity increases in manufacturing can lead to increased employment -- not that oppose as some are claiming.

The high value of personal -- and social -- data

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Here is an eye catching story from today's New York Times -- "Personal Data's Value? Facebook Is Set to Find Out?":

Facebook, the vast online social network, is poised to file for a public stock offering on Wednesday that will ultimately value the company at $75 billion to $100 billion, cashing in on the fuel that powers the engine of Internet commerce: personal data.
But that punch line is only part of the story. The real value of Facebook isn't just in the personal data that fuels advertising. It is in the social connections. Facebook does more than track your interests. They turn you into a viral, "word-of-mouth" advertising platform through the "like" and "friends" features. As the story notes:

If Google's search engine cast the Internet as an instrument of solitary exploration, Facebook requires its users to share what they do with their Facebook "friends." In some ways, the Facebook offering is a test of how valuable the social model of the Internet could be.
. . .
While advertising is its bread and butter, Facebook has sought new sources of income by becoming a place where goods and services are bought and sold, whether it is virtual farm animals or real concert tickets.
Analysts expect Facebook to be the driver of more such transactions, using the persuasive power of Facebook "friends." Company officials use the word "frictionless" to signal that whatever you watch, read, listen to or buy on Facebook or its partner sites can be displayed automatically for the friends of your choosing.
That next step is what really makes Facebook worth so much.

    Note: the views expressed here are solely those of the author and do not necessarily represent those of Athena Alliance.

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