Intellectual Property Transfer Pricing and Taxation

Multinational companies with distributed operations and geographic centers of specialized activities tend to transfer intangibles including intellectual property assets among their various affiliates. These transfers between entities are priced at levels that approximate fair market value and are simultaneously consistent with every company's duty to maximize shareholder value. Tax authorities have long complained that multinationals are setting international transfer prices to avoid taxes by lowering income in high tax jurisdictions and raising income in low tax jurisdictions. In theory, a multinational should not suffer prejudice in such a case (beyond the payment of appropriate penalties) because international tax treaties contemplate adjustments; the underpayment would be collected and the overpayment refunded in each respective jurisdiction. As a practical matter however, there is a real risk of double taxation since sovereign tax authorities may come to disagree on transfer pricing levels.

Sensitized by recent high-profile tax disputes, multinational companies are now specifically seeking strategies to minimize transfer pricing conflicts with the Internal Revenue Service and other international taxing bodies. This article introduces one practical solution.

IP Transfer, Pricing and Conflict

Tax Consequences of IP Transfer

Multinational companies often transfer qualified intellectual property among their various affiliates. For purposes of this article, and in accordance with 170(e)(1)(B)(iii) of the Code, the term, “qualified intellectual property” means patents, trademarks, trade names, trade secrets, and know-how; and transfers include such transactions as the licensing of IP, sale of IP, sale of goods with embedded IP, and IP-associated services. Such transfers of qualified intellectual property create taxable revenues in certain tax jurisdictions and simultaneously create payment obligations and tax deductions in others.

Transfer Pricing

Current IRS regulations, and the broad global trend among various international tax authorities, require multinational entities to peg transfer pricing levels to the amount a third party should be willing to pay under like circumstances. This is the so-called Fair Market Value or Arm's Length Standard, and it assumes that unrelated buyers and sellers are each seeking to maximize their own profits. As the transfers within a multinational take place among parties that may be related or may be acting to maximize the profits of the parent entity, the emergence of apparent deviations from the standard is inevitable.

Tax Disputes

While the IRS publicly declares that it is indifferent to pricing method and seeks only a reasonable result, in the absence of private sector market makers, pricing established through a hypothetical arm's length price is open to dispute. And what are the key features of the disputes? First is that the tax deduction (or income) is based on the value of the IP asset. Second is that the value is determined by the taxpayer.

Highly Visible Disputes

GSK and Zantac

GlaxoSmithKline, plc [GBX: GSK] is a UK-domiciled multinational pharmaceutical company. The Group's principal activities are the creation, discovery, development, manufacture and marketing of pharmaceutical products and consumer health-related products. The Group's geographic operations are located in such countries as the United Kingdom, the United States, Austria, Belgium, Channel Islands, Denmark, Finland, France, Germany, Greece, Hungary, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Spain, Republic of Ireland, Sweden, Switzerland, Bermuda, Canada, Australia, China, India, Malaysia and New Zealand. It reported 2004 global sales of $38B.

Zantac' (ranitidine HCl) is a widely prescribed drug for the treatment of duodenal ulceration, gastric ulceration and oesophageal reflux disease. It was first introduced by Glaxo Holdings in the United States in the early 1980s and laid the groundwork for Glaxo's growth by overrunning the market previously dominated by Smith Kline's Tagamet'.

Last year, GSK was hit with a $5 billion assessment by the IRS related to purported royalty overpayments (from the United States to the United Kingdom) and marketing service underpayments (from the United Kingdom to the United States) arising out of the sale of Zantac from the years 1989 through 1996. GSK disputes the IRS assessment and is litigating its position vigorously in the U.S. tax courts. Although the Zantac case has perhaps increased GSK's visibility in connection with this issue, and although smaller but significant tax cases involving GSK have proceeded in Canada and Japan, transfer pricing disagreements plague all global corporations.

What is particularly ominous about the Zantac dispute from the perspective of other multinationals has been the impasse between the IRS and the British tax authority, Inland Revenue, that creates a very real risk of double taxation for GSK. Logic suggests that any underpayment of tax in the United States should be offset (excluding penalties which are substantial) by an overpayment in the United Kingdom that should be refunded. However, the IRS and Inland Revenue simply disagree on the correct level of transfer pricing. It would be difficult to identify two governments, legal systems, or taxing authorities more likely to operate cooperatively than those of the United States and United Kingdom. The failure to come to an agreement in this case does not bode well for the smooth functioning of the Competent Authority system (that is, the governing protocols for arbitrating disputes among/between tax authorities) at least in connection with transfer pricing issues.

A Global Witch Hunt?

The number of transfer pricing cases filed in U.S. federal courts for the first half of 2004 was twice the number filed during the same period in 2003. Meanwhile, the amounts in controversy increased eightfold. Late Feb. 2005, an IRS spokesman was quoted in the financial press as reporting that an international task force, consisting of tax officials from the United States, United Kingdom, Canada, and Australia, was “scrutinizing tax arbitrage by multinationals.”

Weakness of Third-Party Opinions

Fairness Opinions

Since multinationals necessarily lack information on arm's length pricing, the best that GSK and others can do currently is to conscientiously reproduce or reconstruct negotiations with imperfect knowledge. Expert intellectual property valuation firms have risen to the challenge, and many have established a lucrative business in valuation and fairness opinions.

Legacy of the IP Donations

Unfortunately, many of these same valuation experts are undergoing scrutiny consequent to the excesses associated with the valuation of donated IP. That practice, which provided many companies with significant tax deductions, has been severely curtailed by changes to Section 170 of the Code that went into effect June 3, 2004. The going forward tax benefits potentially extractable are significantly diminished and a host of anti-abuse rules has been added as a response to what both the executive and legislative branches of the U.S. government perceived to be overly aggressive tax minimization strategies. Furthermore, legacy transactions are still being reviewed carefully by the IRS for evidence of abuse, and penalties are being pursued.

Strength of the Third-Party Market Makers

What we are proposing is an incremental modification of the market-tested whole company securitization vehicle blended with the asset-independence of swaps ' an exchange of cash flows without an exchange of assets.

Whole Company Securitization

For several years, our affiliate UCC Capital has injected market pricing mechanisms into IP transfers through a financial structure known as Whole Company Securitization. This product has worked well for middle market companies, and while the principles are sound, the capital demands to offer the same to a multinational company would be overwhelming. Moreover, it is exceedingly unlikely that a multinational company would be either capable or willing to place its core intellectual assets in a special purpose vehicle.

Swaps

The current global swaps market carries some $50 trillion in notional value, and accurately prices risk and value in connection with credit, equities, currencies, interest rates, and commodities without requiring the transfer of underlying assets. We think it is possible to capture the objectivity, precision, and rigor of arm's length pricing with respect to an underlying asset through an exchange of pure cash flows. Indeed, the universal acceptance of swaps and their demonstrable efficiency in allocating risk and identifying value would bolster any argument to taxing authorities as they would be necessarily familiar with the form, as are certainly the treasury professionals of any multinational.

IP Swap

We have therefore designed a modified “market-making” mechanism with a well-capitalized, credible, financially sophisticated counterparty that provides a transparent risk/reward trade-off that in turn meets the services ideal for an arm's length transaction. A well-designed transaction may have some or all of the following features:

1) A swap transactional form. (In trades involving early stage research, it may be preferable to utilize a swaption structure. In a swaption structure, the financial counterparty pays a premium for the right to exercise a European style call option on the swap transaction.) The market-maker would agree to exchange some predetermined financial benchmark returns (ie, LIBOR + X) for a position in the relevant flows (reflecting a participation in value appreciation which may be straightforwardly engineered). The transaction requires no special purpose vehicle, and no exchange of title to the assets in question, nor is control of underlying assets compromised.

2) The market-maker's position would be large enough to be material, but no larger. The market-maker would take real risk pegged to value.

3) A swap may be designed to test IP value (and royalty levels) in which case the financial counterparty would exchange the financial benchmark returns for returns reflecting IP royalties or asset appreciation. But it is also possible to engineer a total return swap reflecting change in the value of multiple assets. Such a total return swap may address, for example, the particularly difficult issue of value added by marketing (the brand) vs. value contributed by R&D (the patent).

A Fair Market Value Transaction

Benefits to the Multinational Company

The benefits to a multinational company would include: 1) time values associated with any premium payment; 2) a cash hedge against significant R&D underperformance; and 3) price discovery resulting from the commitment of risk capital after arm's length negotiations validating transfer pricing (and implicit valuation) assumptions. This in turn would powerfully support certainty in tax planning assumptions.

Benefits to the Counterparty

Benefits to the market-maker would obviously include the chance to participate in attractive returns from the appreciation in value of intellectual property (including R&D) assets, appropriately adjusted for risk.

Summary

International transfer pricing tax disputes, arising from inconsistent or unpredictable positions taken by international tax authorities, can be avoided by letting market transactions set market pricing. A multinational's transfer pricing tax risk, particularly involving intangibles such as intellectual property, may be significantly reduced by adapting well-understood financial tools to confer price discovery in this area.

Naturally, the details of structure and timing would require the concentrated attention of the parties, and not all parties will have transactions that will fit the investment appetite of a suitable counterparty. However, while there is obviously a great deal of challenging work to be done, we believe we have arrived at a flexible and practical transactional vehicle and identified willing, responsible, and well-capitalized counterparties that attest to the reasonableness of this solution.

Multinational companies with distributed operations and geographic centers of specialized activities tend to transfer intangibles including intellectual property assets among their various affiliates. These transfers between entities are priced at levels that approximate fair market value and are simultaneously consistent with every company's duty to maximize shareholder value. Tax authorities have long complained that multinationals are setting international transfer prices to avoid taxes by lowering income in high tax jurisdictions and raising income in low tax jurisdictions. In theory, a multinational should not suffer prejudice in such a case (beyond the payment of appropriate penalties) because international tax treaties contemplate adjustments; the underpayment would be collected and the overpayment refunded in each respective jurisdiction. As a practical matter however, there is a real risk of double taxation since sovereign tax authorities may come to disagree on transfer pricing levels.

Sensitized by recent high-profile tax disputes, multinational companies are now specifically seeking strategies to minimize transfer pricing conflicts with the Internal Revenue Service and other international taxing bodies. This article introduces one practical solution.

IP Transfer, Pricing and Conflict

Tax Consequences of IP Transfer

Multinational companies often transfer qualified intellectual property among their various affiliates. For purposes of this article, and in accordance with 170(e)(1)(B)(iii) of the Code, the term, “qualified intellectual property” means patents, trademarks, trade names, trade secrets, and know-how; and transfers include such transactions as the licensing of IP, sale of IP, sale of goods with embedded IP, and IP-associated services. Such transfers of qualified intellectual property create taxable revenues in certain tax jurisdictions and simultaneously create payment obligations and tax deductions in others.

Transfer Pricing

Current IRS regulations, and the broad global trend among various international tax authorities, require multinational entities to peg transfer pricing levels to the amount a third party should be willing to pay under like circumstances. This is the so-called Fair Market Value or Arm's Length Standard, and it assumes that unrelated buyers and sellers are each seeking to maximize their own profits. As the transfers within a multinational take place among parties that may be related or may be acting to maximize the profits of the parent entity, the emergence of apparent deviations from the standard is inevitable.

Tax Disputes

While the IRS publicly declares that it is indifferent to pricing method and seeks only a reasonable result, in the absence of private sector market makers, pricing established through a hypothetical arm's length price is open to dispute. And what are the key features of the disputes? First is that the tax deduction (or income) is based on the value of the IP asset. Second is that the value is determined by the taxpayer.

Highly Visible Disputes

GSK and Zantac

GlaxoSmithKline, plc [GBX: GSK] is a UK-domiciled multinational pharmaceutical company. The Group's principal activities are the creation, discovery, development, manufacture and marketing of pharmaceutical products and consumer health-related products. The Group's geographic operations are located in such countries as the United Kingdom, the United States, Austria, Belgium, Channel Islands, Denmark, Finland, France, Germany, Greece, Hungary, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Spain, Republic of Ireland, Sweden, Switzerland, Bermuda, Canada, Australia, China, India, Malaysia and New Zealand. It reported 2004 global sales of $38B.

Zantac' (ranitidine HCl) is a widely prescribed drug for the treatment of duodenal ulceration, gastric ulceration and oesophageal reflux disease. It was first introduced by Glaxo Holdings in the United States in the early 1980s and laid the groundwork for Glaxo's growth by overrunning the market previously dominated by Smith Kline's Tagamet'.

Last year, GSK was hit with a $5 billion assessment by the IRS related to purported royalty overpayments (from the United States to the United Kingdom) and marketing service underpayments (from the United Kingdom to the United States) arising out of the sale of Zantac from the years 1989 through 1996. GSK disputes the IRS assessment and is litigating its position vigorously in the U.S. tax courts. Although the Zantac case has perhaps increased GSK's visibility in connection with this issue, and although smaller but significant tax cases involving GSK have proceeded in Canada and Japan, transfer pricing disagreements plague all global corporations.

What is particularly ominous about the Zantac dispute from the perspective of other multinationals has been the impasse between the IRS and the British tax authority, Inland Revenue, that creates a very real risk of double taxation for GSK. Logic suggests that any underpayment of tax in the United States should be offset (excluding penalties which are substantial) by an overpayment in the United Kingdom that should be refunded. However, the IRS and Inland Revenue simply disagree on the correct level of transfer pricing. It would be difficult to identify two governments, legal systems, or taxing authorities more likely to operate cooperatively than those of the United States and United Kingdom. The failure to come to an agreement in this case does not bode well for the smooth functioning of the Competent Authority system (that is, the governing protocols for arbitrating disputes among/between tax authorities) at least in connection with transfer pricing issues.

A Global Witch Hunt?

The number of transfer pricing cases filed in U.S. federal courts for the first half of 2004 was twice the number filed during the same period in 2003. Meanwhile, the amounts in controversy increased eightfold. Late Feb. 2005, an IRS spokesman was quoted in the financial press as reporting that an international task force, consisting of tax officials from the United States, United Kingdom, Canada, and Australia, was “scrutinizing tax arbitrage by multinationals.”

Weakness of Third-Party Opinions

Fairness Opinions

Since multinationals necessarily lack information on arm's length pricing, the best that GSK and others can do currently is to conscientiously reproduce or reconstruct negotiations with imperfect knowledge. Expert intellectual property valuation firms have risen to the challenge, and many have established a lucrative business in valuation and fairness opinions.

Legacy of the IP Donations

Unfortunately, many of these same valuation experts are undergoing scrutiny consequent to the excesses associated with the valuation of donated IP. That practice, which provided many companies with significant tax deductions, has been severely curtailed by changes to Section 170 of the Code that went into effect June 3, 2004. The going forward tax benefits potentially extractable are significantly diminished and a host of anti-abuse rules has been added as a response to what both the executive and legislative branches of the U.S. government perceived to be overly aggressive tax minimization strategies. Furthermore, legacy transactions are still being reviewed carefully by the IRS for evidence of abuse, and penalties are being pursued.

Strength of the Third-Party Market Makers

What we are proposing is an incremental modification of the market-tested whole company securitization vehicle blended with the asset-independence of swaps ' an exchange of cash flows without an exchange of assets.

Whole Company Securitization

For several years, our affiliate UCC Capital has injected market pricing mechanisms into IP transfers through a financial structure known as Whole Company Securitization. This product has worked well for middle market companies, and while the principles are sound, the capital demands to offer the same to a multinational company would be overwhelming. Moreover, it is exceedingly unlikely that a multinational company would be either capable or willing to place its core intellectual assets in a special purpose vehicle.

Swaps

The current global swaps market carries some $50 trillion in notional value, and accurately prices risk and value in connection with credit, equities, currencies, interest rates, and commodities without requiring the transfer of underlying assets. We think it is possible to capture the objectivity, precision, and rigor of arm's length pricing with respect to an underlying asset through an exchange of pure cash flows. Indeed, the universal acceptance of swaps and their demonstrable efficiency in allocating risk and identifying value would bolster any argument to taxing authorities as they would be necessarily familiar with the form, as are certainly the treasury professionals of any multinational.

IP Swap

We have therefore designed a modified “market-making” mechanism with a well-capitalized, credible, financially sophisticated counterparty that provides a transparent risk/reward trade-off that in turn meets the services ideal for an arm's length transaction. A well-designed transaction may have some or all of the following features:

1) A swap transactional form. (In trades involving early stage research, it may be preferable to utilize a swaption structure. In a swaption structure, the financial counterparty pays a premium for the right to exercise a European style call option on the swap transaction.) The market-maker would agree to exchange some predetermined financial benchmark returns (ie, LIBOR + X) for a position in the relevant flows (reflecting a participation in value appreciation which may be straightforwardly engineered). The transaction requires no special purpose vehicle, and no exchange of title to the assets in question, nor is control of underlying assets compromised.

2) The market-maker's position would be large enough to be material, but no larger. The market-maker would take real risk pegged to value.

3) A swap may be designed to test IP value (and royalty levels) in which case the financial counterparty would exchange the financial benchmark returns for returns reflecting IP royalties or asset appreciation. But it is also possible to engineer a total return swap reflecting change in the value of multiple assets. Such a total return swap may address, for example, the particularly difficult issue of value added by marketing (the brand) vs. value contributed by R&D (the patent).

A Fair Market Value Transaction

Benefits to the Multinational Company

The benefits to a multinational company would include: 1) time values associated with any premium payment; 2) a cash hedge against significant R&D underperformance; and 3) price discovery resulting from the commitment of risk capital after arm's length negotiations validating transfer pricing (and implicit valuation) assumptions. This in turn would powerfully support certainty in tax planning assumptions.

Benefits to the Counterparty

Benefits to the market-maker would obviously include the chance to participate in attractive returns from the appreciation in value of intellectual property (including R&D) assets, appropriately adjusted for risk.

Summary

International transfer pricing tax disputes, arising from inconsistent or unpredictable positions taken by international tax authorities, can be avoided by letting market transactions set market pricing. A multinational's transfer pricing tax risk, particularly involving intangibles such as intellectual property, may be significantly reduced by adapting well-understood financial tools to confer price discovery in this area.

Naturally, the details of structure and timing would require the concentrated attention of the parties, and not all parties will have transactions that will fit the investment appetite of a suitable counterparty. However, while there is obviously a great deal of challenging work to be done, we believe we have arrived at a flexible and practical transactional vehicle and identified willing, responsible, and well-capitalized counterparties that attest to the reasonableness of this solution.