Transfer Pricing and IP Location: Research Reveals the Real MotivatorsPublished: September 04, 2012 in Knowledge@Australian School of Business
In 1912, among the world's 10 largest companies were the likes of US Steel, Jersey Standard, Pullman and American Tobacco. Their success rested with their physical assets: oil fields, railroads and factories. A century on, oil companies still dominate the top 10, but there have been some new entrants: IBM, Microsoft and Apple, with Apple vying for the top spot.
Unlike the old industrial giants, these three tech companies rely not on physical assets for their prosperity, but on ideas and innovation – in short, their intellectual property (IP). Indeed, far from owning its factories, Apple outsources the production of its ubiquitous iPhones and iPads to Chinese manufacturers.
The change illustrates the increasing importance in the global economy of intangible assets, such as IP. As manufacturing and manufactured goods have become commoditised, ideas are driving wealth creation. "Modern business is based increasingly on the potential, rather than the piecemeal value of assets," observe Michael Walpole, a professor of taxation at the Australian School of Business, and Nadine Riedel of Oxford University's Centre for Business Taxation. "As the costs of many tangible assets have declined through mass production and technological innovation, the value of intangible assets has increased and these assets often constitute a significant, if not majority portion of a business's value," write the researchers in their paper, The Role of Tax in Choice of Location of Intellectual Property.
Indeed, in 1984, the book value of the top 150 US public companies – what their physical assets could be sold for on the open market – made up about 75% of their stock market value, according to a paper by US private sector economists Robert J. Shapiro and Nam D. Pham. By 2005, the book value of the top 150 companies had dropped to just 36% of their market value. The remaining two-thirds of value lay in their intangible assets, in particular IP.
IP is defined as an intangible asset because it has no physical form. According to the World Intellectual Property Organisation, IP refers to creations of the mind: inventions, literary and artistic works, and symbols, names, images and designs used in commerce.
Walpole and Riedel set out the problems – and the opportunity – that intangible assets pose for government. The intangible nature of the assets means they are "mobile and able to be relocated, reconstructed and even manipulated by business to optimise the benefits (or minimise the disadvantages) of the application of legal and tax rules".
"Multinational companies are better able than most to exercise choice regarding the location of such assets. As one of the intangibles that is more readily defined, valued and protected through the legal system, IP is prime amongst this group of assets," they write.
The mobile nature of IP means that tax authorities can distrust companies' motivations for locating IP where they do. Authorities often suspect that companies move IP to low tax jurisdictions and shuffle profits across borders to minimise their tax obligations.
Revelations that tech giant Google paid just A$74,000 in Australian taxes in 2011, despite generating around A$1.1 billion from local customers, have put the taxation of multinationals on the political agenda. Separately, the federal government has updated its 30-year-old rules on the way it taxes multinationals that shift profits between subsidiaries in different countries, known as transfer pricing. The new legislation, passed in August, is causing concern in the business community because it backdates the changes to 2004.
Although IP is an intangible asset, it is still located by companies in a physical place, which often determines which country's tax regime it falls under. The location can be determined by the place of registration of the company or subsidiary that owns the IP, or by the country in which the IP is registered.
Walpole and Riedel's paper investigates factors in corporations' decisions about where to locate their IP, and how much of a role tax has played in this decision. The pair interviewed tax directors or senior tax managers of 20 IP-rich multinational companies listed on the London Stock Exchange in industries including pharmaceuticals, medical supplies, information technology, media, energy and manufacturing.
They discovered that while a country's tax laws and tax administration was taken into account by corporations, it was not the primary factor in the location of IP. Walpole says the findings suggest that tax authorities can be overly suspicious that companies are making business decisions with the primary motivation of minimising their tax. "Tax authorities really need to understand that there are business dynamics at play and few of them have anything to do with tax," he says.
The researchers found that only a minority of the companies they interviewed said they held valuable IP in countries where tax rates were low. "It would be difficult to say there was a trend to location of IP in low tax jurisdictions specifically for the purpose of transfer pricing to reduce the group's tax liability," the authors write. "Specifics of the businesses involved tended to override any opportunity for this on a widespread basis."
Almost all of the 20 companies interviewed acknowledged that tax was a factor they considered when determining where to locate IP, but several said it was less important than other factors. Some said a commercial decision was made before tax had even been considered. "In such cases the tax department of the company is left to 'catch up' and perhaps to salvage a tax-effective outcome from the situation," write Walpole and Riedel.
The researchers also examined transfer pricing – the price one company of a group of companies charges for use of products and services (including IP) that it provides to another part of the same group in order to calculate each division's profits and tax obligations separately. Multinational companies also use transfer pricing to calculate how much tax they have to pay in the different jurisdictions in which they operate.
As with the consideration of tax rates, companies used transfer pricing for legitimate business reasons. "What I'm really trying to advocate here is that you should not have a knee-jerk reaction to a transfer-pricing arrangement, because it could be absolutely necessary and perfectly above board," says Walpole.
Reasons for transfer pricing include the need for cost sharing in large, expensive, multi-party activities; sharing access within the company to valuable patents or important marketing intangibles; the sale of products throughout the group of products created in a single or few locations; and securing a return for the head office.
Last year the Australian Taxation Office (ATO) lost a transfer-pricing case it brought against French chemical multinational SNF. The ATO argued that SNF Australia was not paying an "arm's length price" to its parent, SNF France, for the supply of chemicals; that is, it was paying too much, thereby turning SNF Australia into a loss-making subsidiary without any local tax obligations.
As is usual in transfer-pricing cases, SNF had provided evidence of comparable prices paid elsewhere for chemicals to show that it was paying a market price. The ATO argued, however, that the circumstances surrounding these prices were different, so they were not truly comparable. But this argument was rejected by the Federal Court, which said accepting them would set too high a bar of proof for companies in transfer-pricing cases.
"I'm not sure that [the ATO] is always well placed to see into business decisions that people make," says Frank Drenth, executive director of the Corporate Tax Association. "With the SNF case, the Tax Office either failed to spot the facts or if they saw them they decided they weren't relevant."
Drenth says the ATO used the loss to argue to the federal government that tax revenue was under threat and to successfully lobby for a change in transfer-pricing laws: "They're always in a position where it's 'heads we win, tails you lose'; if they lose too many cases they just go to the government to change the law by making all sorts of threats by perhaps not being able to collect the right amount of tax."
Under current transfer-pricing rules, the ATO assesses whether a company has paid an arm's length price – in essence, a true commercial price – for goods or services to a related entity in another country.
The proposed new laws adopt the Organisation for Economic Co-operation and Development (OECD) transfer-pricing guidelines, which give more precedence to determining whether a local subsidiary has made a fair share of the global company's profits. Drenth says he is concerned that the ATO will take the OECD guidelines "as a licence to apply profits-based methods in every case if they think it will give them a better outcome, and that's not what the guidelines say".
In relation to the creation of IP, Walpole and Riedel found a general consensus that tax credits for research and development (R&D) were beneficial to business. But many companies felt that R&D tax credits missed the mark because they focused too much on innovation – or blue sky research – over the applied research that was most useful to business. There were concerns that the complexity of R&D tax credits had spawned a whole industry of consultants who would assist in collecting the credits in exchange for a contingency fee.
"Some respondents felt that on occasion the claiming of R&D tax credits involved describing what was being done already in such a way as to benefit from the credit," the researchers note.
Ian Ross-Gowan, a PhD student in tax at the Australian School of Business and an R&D consultant, takes a more positive view of R&D credits. Ross-Gowan agrees that tax credits do not necessarily create new R&D, but they encourage businesses to do more research within an existing project or to do more regular upgrades of their R&D.
"I've had personal experience of that with OneSteel," says Ross-Gowan, who is a former group taxation manager of the steel-maker. "Most projects are reviewed on a variety of measures, including discounted cash flow of payback period, and if you include the tax effect of that then that would raise a project's possibility of being accepted and being funded."
Ross-Gowan cites data showing that in 1985, the year before the tax concession was introduced in Australia, business expenditure on R&D was about 0.39% of GDP, but by 2008 that had risen to 1.35%, due in part to the tax credits.
IP-intensive companies rely heavily on technology and innovation for success and so a key consideration in where to locate IP is access to suitably trained and educated personnel. Walpole and Riedel cite one respondent who said that the UK education system and its training of scientists and engineers was more important to the company than the UK tax system. If the UK stopped producing qualified technicians, that company would leave the country. Another company located its IP in the US because the software developers that were key to its business success were available there and nowhere else.
But the survey indicated that Western nations might be losing this long-held advantage. Several respondents noted that China and India have started to offer an educated workforce that is cheaper to employ. China and India, however, lose out on another key factor in the location of IP: the protection that they offer companies for their valuable IP.
"The risk of loss of IP protection has meant that some respondents are prepared to use these jurisdictions in a limited way and arrangements are made to ensure only limited IP or low-value IP are exposed to risks in such jurisdictions," the authors write. "On the one hand it would appear that the attractions of low wages, costs and sound technical expertise was making jurisdictions such as China and India attractive – but it was clear that the risks inherent in operating in those jurisdictions still favour countries in which the means of protecting IP are strong and accessible."
Other factors that can influence where a company locates its IP are infrastructure that supports manufacturing and the markets where the IP is to be used. Nonetheless, this is not to say tax is not a factor at all, or that governments can't improve their tax administrations to help attract IP.
"The interviews also brought out that businesses do look around for where they are going to get a good tax deal, the very big ones do negotiate with tax authorities," says Walpole. "If they are interested in attracting the custom of the companies such as those we were interviewing, they need to be open to discussions with them and they need to respond."