Intangible assets are a major problem in international taxation. They are the basis of much of the base erosion and profit shifting (BEPS) that is the focus of concern at the G8 and G20 which has given rise to the discussion I am taking part in at the OECD.
It's my argument, and that of the BEPS Monitoring Group of major NGOs that I am representing here, that intangibles are real. No one can pretend that logos are not real, the copyright in a book is artificial and that patents can protect innovators to ensure that they can earn a return on their investment in R&D can be protected for a reasonable period before it becomes public property. All these things are intangible assets (or IP - for intellectual property).
However, intangible as they are they rarely, if ever, create value by themselves. Take a simple example: this blog has a large traffic for a web site of its type but there is no cash flow that I can attribute to it. None of my funders ask me to write it. No one will penalise me if I do not. No one pays to read what is posted here. I choose not to carry advertising. The intangible asset that this blog represents is very real but has no obvious value attributed to it.
And that is also the problem when it comes to intangibles when it comes to tax. Clearly there is a legal issue of significance when it comes to intangible assets. They have to be created and protected. There is a cost to creation that may have a monetary cost on which a risk adjusted interest reward may be due. That seems fair. But what is also fair is that it be recognised that the creation and protection of intangible property is not what creates the value within it but that is all IP owning companies usually do.
What does instead create the value within IP is the activity of the user of the IP. That is, the marketing, selling and straightforward use of the IP that shows how it might develop in use it what creates the value in IP. When that IP is transferred to an asset owning enterprise ownership and use of the IP is separated, and when the asset owning company is located in a low tax state, which is now commonplace within many multinational corporations, the tax treatment of the IP owner and the company within a group that actually exploits that IP and makes the value that results from that use are also separated.
This is when the problem with IP arrives. How, when the ownership of IP is separated from the activity that creates the current value of the IP which gives rise to taxable income, can profit be apportioned between companies and states and what is the profit that should be apportioned?
The second question may in some ways be the easier to answer. The capital cost of creating the IP may appropriately be paid a return - effectively a form of interest on the cost of creation of the asset - as a first allocation of profit. But the reality is that if the IP has real value the group that owns it will create value overall and it will be almost impossible to attribute that to the ownership of any one asset, whether it's tangible or intangible. Arguing that the return to an intangible can be determined is about as meaningless as arguing that the profit due to the company's investment in IT can be determined - which will not be the case. It's an almost absurd question to ask.
So what should instead be done is to ask how this excess profit over the risk adjusted interest return for the period can be allocated for the period when it arises - which is what taxation is about. The answer to this question is, in my opinion, to go back to what drives profit. Ownership definitely does not. But the process of selling does. And the people who work within an entity do create value (hopefully). And they need real, tangible assets to support their work - which indicate whee they are. Purchases also indicate value creation - because there is value in what is bought in, of course, but given that this value is taxable in the hands of the suppliers of those goods this is not a great indicator of where taxable profit should be allocated within a company. In that case the allocation formula to indicate where value (after risk based returns) is generated in a period is, I think, fairly based on a formula based on where these real activities undertaking by human beings take place, but what is very clear is that the formula cannot take IP into account.
There is good reason for that suggestion that IP is not in any formula. Ip cannot generate profit. It is undoubtedly true that it can protect or defend such a stream but it cannot create one. In that case the ownership of IP is not a profit driver, wherever it is located and so profit cannot be allocated to it beyond an adjusted rate of return on capital , which once the IP is in use will be relatively modest as the risk related component of that return will usually by then be relatively small.
To put it another way, for profit allocation purposes IP can effectively be ignored. Doing so would undermine tax abuse models used by many multinational corporations. As importantly, the whole transfer pricing area will be simplified, considerably. You can see why the former is why many large companies are reluctant to see change in this area and the latter is a reason why tax authorities may want change. I am neither such body; I simply want fair taxation and to allocate profit to an intangible asset makes no sense in that context. To use an idea not wholly unrelated in tax, such an asset can have no incidence relationship with tax generation. In that case it's time to ignore such assets for tax purposes.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
I don’t follow how this can possibly be right. Say I sell the exact same coffee as Starbucks in a very similar looking shop – does that mean a Starbucks customer will automatically be as likely to come to my shop as they are to go to Starbucks? Of course it doesn’t. So the brand itself must have value separate from the physical activities. Intangible assets do have value. The question you should be asking is what is the best way to determine where an intangible is based and whether a redomiciliation of a brand has any economic function or is purely motivated by tax avoidance, surely?
I am not saying IP cannot be separated and stored separately. It can be. I am just saying the tax treatment for this intra-group transaction should be the same as the accounting one: it should be ignored, as it is in consolidated accounts. Accounts ignore such deals to reflect reality. Why should we tax a legal fiction?
That fiction bears no comparison with a genuine third party transaction. In the highly implausible scenario you suggest there is a genuine trade. It should be taxed. But to pretend an intra-group trade is in any way similar is to play an absurd game of self deception. That game has cost society a fortune: it is time to end it, now.
In ghat case I think you are agreeing with me
I don’t agree. You can’t just ignore something because it’s not easy to tax, you have to deal with the reality (because it is a reality) otherwise you open opportunities for avoidance the other way. The problem in intra-group transactions is lack of HMRC enforcement resources to tackle weak comparables, in my view. HMRC should challenge and enforce the rules more aggressively.
I’m not ignoring it!
If it is a third party payment tax the recipient
Preferably deduct tax at source from the payment too
If it is an intra-group payment it’s artificial. Tax the real profits where they’re made.
Read my new blog on the issue
To take an example of a UK company that creates a successful brand identity (which I think you accept is IP), and then sets up a French subsidiary to use that brand in France, would you argue that for tax purposes the UK should not recognise any form of income relating to the French use of the IP? That is, all profits made by the French company should be taxed only in France, with any royalties paid to the UK for the use of the IP being ignored in both France (hence not deductible) and the UK (not taxable)?
That would seem to be ignoring a significant commercial issue. You may consider your own blog to be worthless (if you excuse the phrasing!), but many people consider other forms of IP to be worth paying considerable sums for, to third parties as well as related ones.
The upshot would be, for example, that subsidiaries using group branding would be taxed more harshly than third-party franchisees using the same branding. And in the example above, the UK parent would have expended considerable tax-deductible costs to generate non-taxable royalty income, which again would seem odd.
I’d agree that it is hard to get IP valuations right, and there’s a lot of subjectivity there, but simply washing one’s hands of a tricky question seems to me to cause more problems than it hopes to solve.
Your claim is based on a number of assumptions that you have probably never chosen to question because few do. They are nonetheless just assumptions; they are not facts.
The first of these assumptions is that the entities in France and the UK are separate entities but this is quite untrue: whilst under common control they actually form parts of a single entity. There is no reason why they are separate: a branch could also be used. It is choice but not necessity that a separate legal entity is used but to suggest that because this legal form is adopted the two entities are distinct and separate. You explicitly state that one controls the other. They are therefore not just under common control, they are an integrated whole.
That then is how they should be taxed, as a single entity. Any other approach is taxation on the basis of a fiction that does not really exist. In this case the tax base for the two companies is their combined profit. That is what they make and can return to their owners; a legal fact that the availability of group consolidated accounts recognises. The duplicity of tax and accounting approaches here is absurd: accounting seeks to reflect the reality of the integrated whole, the tax part of what is in effect the same profession seeks to deny that reality when the group profit does, in practice, provide the appropriate tax base (subject to adjustments) for the entity as a whole.
In that case the question to be asked is how the group profit is allocated between the states in which the combined company operates. That has, again, to reflect economic reality. And if a payment was made from France to the UK for the use of intellectual property that was the supposed property of the UK group that would, of course, be eliminated from consideration in the group accounts as being irrelevant to the overall profit made. All it represents is an allocation of profit — which is of course subject to challenge by both tax authorities on the basis of its artificiality under transfer pricing rules.
So what I am suggesting is that arbitrary payment that is open to challenge be ignored for tax and instead the combined profit be allocated on the basis of facts to the two states in which the combined operation trades. The basis suggested is a formula based on rational, ascertainable and pretty much indisputable data.
The question then is why would you prefer to be taxed on the basis of a fiction — which is what happens in the separate entity, arm’s length pricing approach instead of on the basis of economic and accounting reality with profits apportioned on the basis of fact and by ignored wholly artificial assets that have no real intra-group significance, like intellectual property? The only answer I can come up with is that the artificial approach — fairy tale taxation as I think of it — helps the tax profession abuse profit allocation for its own advantage (there are lots of fees to be earned in this process which is little understood by the businesses concerned, who are therefore stuck over a barrel when the demand for payment from the profession is presented) and which allows it to claim its own intellectual property when candidly not many of the tax profession can otherwise claim a unique competitive advnatge of equivalent value.
So what I propose offers certainty, simplicity, economic reality and reduced documentation, all with the result that reduced accountancy fees are paid.
No wonder tax advisers do not like my suggestion. But that does not mean it’s wrong. Indeed, it may well mean it is right.
But If the UK company spends a lot of money building up the brand/IP prior to the French company coming to existence (and in some industries – e.g. Pharma where huge amounts are spent on R&D over long periods – this may be particularly prnounced) then the UK has lowered profits up until France is incorporated.
Post France being incorporated, the profits of the whole increase and France gets a relatively larger share of the ‘whole’ under your model than it would under a model where France pays the UK for use of the IP – And of course teh UK gets a relatively lower share.
I am not sure in my mind that creates a fair split of the profits post incorporation of France – just becasue sales are happening in France.
That is possible: there is no panacea
It will also be rare
We have to live with what is overall fair
What we have is undoubtedly broken
So you agree that IP exists and has value but that it should not be allowed to be separated from the main company and stored in its own tax haven subsidiary.
The use of a logo or name (such as Apple) must have value and can be invoiced separate from conventional income. Even if you get your way, what if the main company sells the IP to a completely separate company with no group connection or ownership?
Then it could be placed in its own location no matter where that would be….If you can sell the IP and separate it, then that fatally undermines your argument that it can not be accounted for independently.
I am not saying IP cannot be separated and stored separately. it can be. I am just saying the tax treatment for this intra-group transaction should be the same as the accounting one: it should be ignored, as it is in consolidated accounts. Accounts ignore such deals to reflect reality. Why should we tax a legal fiction?
That fiction bears no comparison with a genuine third party transaction. In the highly implausible scenario you suggest there is a genuine trade. It should be taxed. But to pretend an intra-group trade is in any way similar is to play an absurd game of self deception. That game has cost society a fortune: it is time to end it, now.
Tax abuse through IP is one facet of the unhealthy control multi nationals are exerting over IP.
“….patents can protect innovators to ensure that they can earn a return on their investment in R&D can be protected for a reasonable period before it becomes public property.”
Unfortunately, multi nationals are hijacking IP and trying to do their level best to ensure it does not become public property and stifling innovation and future competition.
This makes interesting reading:-
https://wikileaks.org/tpp/pressrelease.html
The problem with IP rights is that they can be artificially transferred between companies and states, thereby becoming divorced from the activities which gave rise to them. Starbucks is a classic example. I first visited Starbucks in Manchester in 2000 when I thought it was just a local chain (and wasn’t very impressed with the coffee, but that’s another matter). The IP which had been generated in the US didn’t really transfer over here. However, Starbucks could grow quickly because they had the capital to open branches in many locations quickly (and the ‘cluster-bombing’ to drive out independent competition is a separate matter) and launch big advertising campaigns. A payment for this is reasonable, but you are paying for the use of capital and services provided by the US parent. What appears incontestable to me is that any payment should be taxed in the US, because that is where the Starbucks brand and business was built up. It certainly had no real connection with Luxembourg, or even the Netherlands, which is where I think the payments were taxed, and the IP was only located there due to an artificial legal transfer of IP.
Hi, as you deleted my comment, I’ve reposted the main points on my own (somewhat nelected) blog: http://andrewjjackson.wordpress.com/
I’d be interested in any comments you may have.
I have not deleted any comment you have made
I have just not moderated it yet
That’s different
Apologies – normally I can see the comment as pending until you clear it, but it had disappeared. This is what has happened when you have deleted comments, so I assumed that you had deleted this one too. Presumably there was a glitch with my browser or something.
I waited as I was too busy / travelling to respond to what I thought a fair comment
Richard,
I agree that intangibles such as IP should be ignored, mainly on the basis that vast amounts of tax relief is given up to the point the IP becomes an asset
If real money is spent on creating the IP I have no problem in allowing that for tax
agreed!
Much of the misunderstanding about this issue results I think from the reification in the very concept of intellectual property. This makes people think of something like a brand name in terms of a specific discrete asset, created by an act of invention. In fact, global brands are built up as a continuous process of interaction of the firm with its customers. The value of a global brand such as Starbucks is not just due to the inherent magic of the name, which I personally thought very off-putting when it first appeared in Europe. It results from the combination of universal recognition and local acceptance which the company behind it builds up over time, by interacting with its consumers. This is even clearer today now that the value of internet companies such as Facebook and Twitter depends on active contributions from their users. The value is generated globally, pretty much in proportion to the number of consumers or users the company has. So apportionment of profits based on a balance between production factors (employees, by number and payroll) and consumption factors (sales) is appropriate. In that sense intangible property is a fiction.
Thanks Sol