IP Transfer and Pricing Considerations for Financial Service Firms

Financial service companies make their money primarily through two core intellectual assets. The first is their expert knowledge of ways to create, expose, tranche and protect asset value. The second is their ability to project their expertise as embodied in their brand. Aside from the specialized intellectual asset merchant banks, financial service companies do not know how to value their knowledge nor their brand. Furthermore, historically they have not paid much attention to which of their global affiliates created the intellectual asset nor which of their affiliates deployed the asset ' an activity that creates the accounting and financing phenomenon of “transfer pricing.” The importance, more specifically the urgency, in rectifying this informational vacuum arises from recent changes in international tax law pertaining to the pricing of intangible assets that are transferred among Multinational Entity (“MNE”) affiliates. This article, targeting the financial service industry, briefly summarizes the fears of the industry concerning transfer pricing and intellectual property (“IP”); cites an example of a recent innovation that has led to a revolution in the way bonds are priced identifying possible IP transfer pricing red flags; and concludes with suggestions for process improvements.

Introduction

The American Express Company, a well-known financial service company, is valued on the New York Stock Exchange at about $62 billion. The company's book value is only $12 billion. American Express has codified its expert knowledge in at least 173 issued and pending U.S. patents and has built an iconic brand that Interbrand estimates is worth today $18.5 billion. Goldman Sachs Group, Inc., another well-known financial service company, is valued on the Exchange at about $55 billion. The company's book value is only $16 billion. Goldman Sachs has codified its knowledge in at least 14 issued and pending U.S. patents and has built an iconic brand that Interbrand estimates is worth today $8.5 billion.

These two iconic multinational entities deploy their intellectual assets to create staggering amounts of wealth. They reach the marketplace with their patents and know-how almost overnight and generate trillions of dollars in notional transactions ' and billions in commissions and fees. Such fabulous wealth flows to traders, bankers, and increasingly product structuring experts throughout their global network in a process that is not transparent. It may be suggested by certain tax authorities that the global allocation ' international transfer pricing ' may not be entirely free of internal political maneuver, and these authorities are increasingly demanding better accounting for asset value creation and disposition. For the financial service industry, the very rapidity of wealth generation makes the value-tracking proposition challenging. For these companies, international transfer pricing of intellectual assets is a major, unaddressed, financial challenge.

Financial Service CFOs Are Worried About Their Transfer Pricing

In a recent E&Y survey, 60% of surveyed companies expect the “high probability” of a tax challenge within 2 years; 37% saw it as a “virtual certainty.” In a surprising blow to IRS brand value, more companies (68%) expected to be challenged by the UK's Inland Revenue than by the IRS (49%).

The concerns reflected in the E&Y survey are sensible. The IRS, Inland Revenue and other international tax authorities are seeking to recoup billions in (allegedly) lost revenue by focusing their attention on jurisdictions where value is created. The question the tax authorities are asking is what an independent investor would charge (or pay) for the specific value created.

It is the view of such authorities that core value is rarely created in tax havens such as Bermuda and the Caymans. Indeed, fears identified in the E&Y survey of challenges by UK and U.S. tax authorities accurately reflect the leadership positions of London and New York respectively in being the seats of financial service innovation and revenue.

Because the asset value of financial services MNEs will be inevitably weighted toward the intangible, driven by relationships, reputation and innovation, it follows that tax authorities will seek to attribute income to the transfer of intangibles, generally from high-tax transferor jurisdictions (ie, London and New York). They will want to see royalties or other appropriate compensation flowing to those innovative high tax value-originating jurisdictions.

Indeed, between 1980 and 2001 approximately 1500 new types of securities were invented, including mortgage-backed securities, asset-backed securities and equity-linked debt (each of these three examples drove trillions of dollars in transactions). Six investment banks were responsible for some 75% of this innovation wave and reaped commensurate rewards in deal flow dominance.

Ironically, there is a historic disconnect between intellectual property and financial industry expertise. Until State Street Bank v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998), business methods were thought to be non-patentable. This belief resulted in a patent bar under-trained in business and financial service methodologies (the PTO specifically had to address limitations of its examiner staff in the aftermath of State Street) and an industry that until recently was generally inclined to discount the value of idea creation in relation to deal execution. Of course the existence, value and tax implication of underlying intellectual property exists independently of any decision to utilize patent protection.

Financial Service Patent Portfolios: Some Assembly Required

The industry has tried to play catch-up in recent years. For example Citibank, filed 367 applications for business method patents in 2003, clustering in financial methods. More broadly, financial method patents have grown as a fraction of the total number of business method patents. Goldman Sachs, with only 14 publicly disclosed U.S. patents or applications as of Oct. 1, 2005, famously warned in its SEC filings of 2003 that intellectual property risk, including the risk of patent infringement, could be material to earnings.

Predictably, a good deal of the energy invested by financial service professionals in IP issues has centered on tactics to repel so-called patent “trolls.” There is, accordingly, a prominent ' if not dominant ' view in the financial services industry that patents primarily represent a liability risk issue.

The industry as a whole has not focused on the tax planning implications of its own highly valuable IP and has failed to adopt the structures and protocols necessary to track and allocate value consistent with the required independent investor standard. It seems inconsistent to focus energy on avoiding the $100 million verdict that is the patent troll's Holy Grail while ignoring the multibillion dollar liability Inland Revenue will impose for failing to allocate income to value creation.

London Takes the Lead

A credit default swap (“CDS”) is a credit derivative that provides a buyer (often the owner of underlying bonds) protection against specific risks. Common risks include bankruptcy, failure to pay, debt restructuring, acceleration or repudiation. Building blocks of the product include complex risk pooling techniques and risk correlation calculations. The cornerstone insight is said to be the application of the Gaussian Copula to correlation calculations, but each major player in the market refines this method with its own proprietary systems.

In 1997 the CDS market presented a lonely brackish backwater of global financial services. By the third quarter of 2005, some $12 trillion in notional contracts were outstanding ' an increase of 48% in deal volume just since January. Much of this growth was triggered by the effectiveness and stability of the market in the aftermath of the Enron default.

At least as interestingly, specialists now believe that CDS markets process new market information more efficiently than bond markets and thus set superior pricing signals. Impending credit downgrades will be reflected in CDS price movements before they are reflected in the underlying assets.

It is the industry consensus that innovation leadership in CDS products and proprietary modeling is squarely centered in London. How might Inland Revenue begin to think about framing the broadest value creation argument?

The Financial Service sector is very good at allocating rewards for direct deals. CDS product developers and product structuring experts are seeing seven figure bonuses ' paid in Sterling. However, Inland Revenue might ask about the London allocation of New York bond trading profits. CDS techniques have made corporate bonds more liquid; have led to more sales of both distressed and exotic bonds; and have fueled arbitrage strategies reliant on CDS market signals. The hypothetical independent investor setting value would surely demand compensation for increases in New York volume and profits attributable to IP created in London. Inland Revenue may certainly advance the argument and can be relied on to do so when the right opportunity arises.

The intellectual property/financial services disconnect is at issue here. IBM (as reinforced by the trolls) taught the IP licensing world about the value of aggressive out-licensing. Intellectual capital value creation is not linear; relevant transfer pricing value allocations must reflect that fact.

Having identified the strategic challenge and offered exemplary tactical issues it remains for us to recommend remedial action.

Capturing and Allocating Value

The first process challenge is to document and track relative intangible contributions among subsidiaries and to engage in the most rigorous possible formal valuation exercise. Many financial service MNEs will not be ready for the first process challenge because they are not equipped to accurately identify (much less value) core intangible contributions. Thus, the first (pre-process) step will more likely be to engage a dedicated, interdisciplinary Patent Analytics team. This team will consist of IP experts possessing financial expertise and specialist counsel. The Analytics team approach will be mission critical to identifying assets for many financial service companies.

Having identified assets and engaged in rigorous valuation, the client will, wherever possible, utilize transactions to test assumptions. Transactional examples may include cross-licenses among competitors or cash flow swaps with third-party investors. Swaps allow third parties to invest in cash flows benchmarked to internal valuations without clouding title to the underlying assets. By risking capital based on valuation assumptions, the investor could satisfy the arms-length pricing required by regulators. This will provide a critical diligence step and confer a measure of transparency and objectivity on a process otherwise open to charges of manipulation.

In summary, financial service MNEs have seen fantastic returns on their intellectual capital but have not developed processes and models to track and allocate related value among affiliates. It is highly unlikely that internal jockeying will reproduce the results of arms-length counter-party pricing, which is the standard required by international tax authorities. The financial services industry can only meet tax authority requirements with the assistance of interdisciplinary expertise and, where possible, the injection of risk capital by third parties in swaps or licensing transactions.

The challenge is formidable. Time is short. But the stakes are worth the effort required.

Financial service companies make their money primarily through two core intellectual assets. The first is their expert knowledge of ways to create, expose, tranche and protect asset value. The second is their ability to project their expertise as embodied in their brand. Aside from the specialized intellectual asset merchant banks, financial service companies do not know how to value their knowledge nor their brand. Furthermore, historically they have not paid much attention to which of their global affiliates created the intellectual asset nor which of their affiliates deployed the asset ' an activity that creates the accounting and financing phenomenon of “transfer pricing.” The importance, more specifically the urgency, in rectifying this informational vacuum arises from recent changes in international tax law pertaining to the pricing of intangible assets that are transferred among Multinational Entity (“MNE”) affiliates. This article, targeting the financial service industry, briefly summarizes the fears of the industry concerning transfer pricing and intellectual property (“IP”); cites an example of a recent innovation that has led to a revolution in the way bonds are priced identifying possible IP transfer pricing red flags; and concludes with suggestions for process improvements.

Introduction

The American Express Company, a well-known financial service company, is valued on the New York Stock Exchange at about $62 billion. The company's book value is only $12 billion. American Express has codified its expert knowledge in at least 173 issued and pending U.S. patents and has built an iconic brand that Interbrand estimates is worth today $18.5 billion. Goldman Sachs Group, Inc., another well-known financial service company, is valued on the Exchange at about $55 billion. The company's book value is only $16 billion. Goldman Sachs has codified its knowledge in at least 14 issued and pending U.S. patents and has built an iconic brand that Interbrand estimates is worth today $8.5 billion.

These two iconic multinational entities deploy their intellectual assets to create staggering amounts of wealth. They reach the marketplace with their patents and know-how almost overnight and generate trillions of dollars in notional transactions ' and billions in commissions and fees. Such fabulous wealth flows to traders, bankers, and increasingly product structuring experts throughout their global network in a process that is not transparent. It may be suggested by certain tax authorities that the global allocation ' international transfer pricing ' may not be entirely free of internal political maneuver, and these authorities are increasingly demanding better accounting for asset value creation and disposition. For the financial service industry, the very rapidity of wealth generation makes the value-tracking proposition challenging. For these companies, international transfer pricing of intellectual assets is a major, unaddressed, financial challenge.

Financial Service CFOs Are Worried About Their Transfer Pricing

In a recent E&Y survey, 60% of surveyed companies expect the “high probability” of a tax challenge within 2 years; 37% saw it as a “virtual certainty.” In a surprising blow to IRS brand value, more companies (68%) expected to be challenged by the UK's Inland Revenue than by the IRS (49%).

The concerns reflected in the E&Y survey are sensible. The IRS, Inland Revenue and other international tax authorities are seeking to recoup billions in (allegedly) lost revenue by focusing their attention on jurisdictions where value is created. The question the tax authorities are asking is what an independent investor would charge (or pay) for the specific value created.

It is the view of such authorities that core value is rarely created in tax havens such as Bermuda and the Caymans. Indeed, fears identified in the E&Y survey of challenges by UK and U.S. tax authorities accurately reflect the leadership positions of London and New York respectively in being the seats of financial service innovation and revenue.

Because the asset value of financial services MNEs will be inevitably weighted toward the intangible, driven by relationships, reputation and innovation, it follows that tax authorities will seek to attribute income to the transfer of intangibles, generally from high-tax transferor jurisdictions (ie, London and New York). They will want to see royalties or other appropriate compensation flowing to those innovative high tax value-originating jurisdictions.

Indeed, between 1980 and 2001 approximately 1500 new types of securities were invented, including mortgage-backed securities, asset-backed securities and equity-linked debt (each of these three examples drove trillions of dollars in transactions). Six investment banks were responsible for some 75% of this innovation wave and reaped commensurate rewards in deal flow dominance.

Ironically, there is a historic disconnect between intellectual property and financial industry expertise. Until State Street Bank v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998), business methods were thought to be non-patentable. This belief resulted in a patent bar under-trained in business and financial service methodologies (the PTO specifically had to address limitations of its examiner staff in the aftermath of State Street) and an industry that until recently was generally inclined to discount the value of idea creation in relation to deal execution. Of course the existence, value and tax implication of underlying intellectual property exists independently of any decision to utilize patent protection.

Financial Service Patent Portfolios: Some Assembly Required

The industry has tried to play catch-up in recent years. For example Citibank, filed 367 applications for business method patents in 2003, clustering in financial methods. More broadly, financial method patents have grown as a fraction of the total number of business method patents. Goldman Sachs, with only 14 publicly disclosed U.S. patents or applications as of Oct. 1, 2005, famously warned in its SEC filings of 2003 that intellectual property risk, including the risk of patent infringement, could be material to earnings.

Predictably, a good deal of the energy invested by financial service professionals in IP issues has centered on tactics to repel so-called patent “trolls.” There is, accordingly, a prominent ' if not dominant ' view in the financial services industry that patents primarily represent a liability risk issue.

The industry as a whole has not focused on the tax planning implications of its own highly valuable IP and has failed to adopt the structures and protocols necessary to track and allocate value consistent with the required independent investor standard. It seems inconsistent to focus energy on avoiding the $100 million verdict that is the patent troll's Holy Grail while ignoring the multibillion dollar liability Inland Revenue will impose for failing to allocate income to value creation.

London Takes the Lead

A credit default swap (“CDS”) is a credit derivative that provides a buyer (often the owner of underlying bonds) protection against specific risks. Common risks include bankruptcy, failure to pay, debt restructuring, acceleration or repudiation. Building blocks of the product include complex risk pooling techniques and risk correlation calculations. The cornerstone insight is said to be the application of the Gaussian Copula to correlation calculations, but each major player in the market refines this method with its own proprietary systems.

In 1997 the CDS market presented a lonely brackish backwater of global financial services. By the third quarter of 2005, some $12 trillion in notional contracts were outstanding ' an increase of 48% in deal volume just since January. Much of this growth was triggered by the effectiveness and stability of the market in the aftermath of the Enron default.

At least as interestingly, specialists now believe that CDS markets process new market information more efficiently than bond markets and thus set superior pricing signals. Impending credit downgrades will be reflected in CDS price movements before they are reflected in the underlying assets.

It is the industry consensus that innovation leadership in CDS products and proprietary modeling is squarely centered in London. How might Inland Revenue begin to think about framing the broadest value creation argument?

The Financial Service sector is very good at allocating rewards for direct deals. CDS product developers and product structuring experts are seeing seven figure bonuses ' paid in Sterling. However, Inland Revenue might ask about the London allocation of New York bond trading profits. CDS techniques have made corporate bonds more liquid; have led to more sales of both distressed and exotic bonds; and have fueled arbitrage strategies reliant on CDS market signals. The hypothetical independent investor setting value would surely demand compensation for increases in New York volume and profits attributable to IP created in London. Inland Revenue may certainly advance the argument and can be relied on to do so when the right opportunity arises.

The intellectual property/financial services disconnect is at issue here. IBM (as reinforced by the trolls) taught the IP licensing world about the value of aggressive out-licensing. Intellectual capital value creation is not linear; relevant transfer pricing value allocations must reflect that fact.

Having identified the strategic challenge and offered exemplary tactical issues it remains for us to recommend remedial action.

Capturing and Allocating Value

The first process challenge is to document and track relative intangible contributions among subsidiaries and to engage in the most rigorous possible formal valuation exercise. Many financial service MNEs will not be ready for the first process challenge because they are not equipped to accurately identify (much less value) core intangible contributions. Thus, the first (pre-process) step will more likely be to engage a dedicated, interdisciplinary Patent Analytics team. This team will consist of IP experts possessing financial expertise and specialist counsel. The Analytics team approach will be mission critical to identifying assets for many financial service companies.

Having identified assets and engaged in rigorous valuation, the client will, wherever possible, utilize transactions to test assumptions. Transactional examples may include cross-licenses among competitors or cash flow swaps with third-party investors. Swaps allow third parties to invest in cash flows benchmarked to internal valuations without clouding title to the underlying assets. By risking capital based on valuation assumptions, the investor could satisfy the arms-length pricing required by regulators. This will provide a critical diligence step and confer a measure of transparency and objectivity on a process otherwise open to charges of manipulation.

In summary, financial service MNEs have seen fantastic returns on their intellectual capital but have not developed processes and models to track and allocate related value among affiliates. It is highly unlikely that internal jockeying will reproduce the results of arms-length counter-party pricing, which is the standard required by international tax authorities. The financial services industry can only meet tax authority requirements with the assistance of interdisciplinary expertise and, where possible, the injection of risk capital by third parties in swaps or licensing transactions.

The challenge is formidable. Time is short. But the stakes are worth the effort required.