Tax Analysts Blog

Taxation of Intangibles: Still Hazy After All These Years

Posted on Feb 15, 2013

This week a lot of very smart people gathered at the Ritz-Carlton in Washington DC for a two-day conference on tax issues related to the taxation of patents, trademarks, know-how and all other types of intellectual property ("intangibles" in tax speak). If you think this an obscure topic let me put this into context for you. The driving force behind tax reform is corporate tax reform. The driving force behind corporate tax reform is international tax reform. The central issue in international tax reform is the taxation of intangibles. It is the number one money issue for the IRS. And for many multinationals it is by far the biggest issue in their tax planning.

As the conferees made clear, although governments want to provide incentives for the development of intangibles through research credits and preferential tax rates (called "patent boxes"), they also want to crack down on aggressive (but perfectly legal) tax avoidance whereby multinationals shift intangible assets into holding companies located in tax havens. The IRS could devote more resources to this problem and it could write tougher regulations. But it has been doing this for decades and the problem has only gotten worse. The fundamental problem is that the U.S. is wedded to the arm's-length standard. Under the arm's length standard the IRS and multinationals have to a set a price for transfers of intangibles to tax havens. The IRS says the price should be high. The multinationals--with an army of transfer pricing consultants advising them--say the price should be low. Invariably the multinationals win the fight.

An approach used in other countries to provide a backstop to the beleaguered transfer pricing rules is the expansion of anti-abuse rules ("CFC rules" or "Subpart F rules" in tax lingo). Much of this week's conference was devoted to discussion of the pros and cons of Ways and Means Committee Chairman Dave Camp's draft proposals to establish new rules--some similar to those proposed by President Obama (see p. 88 of the "Green Book")--that would immediately subject foreign income to U.S. tax if that income was booked in a tax haven or was generated from an intangible asset (or both). These rules would be very complicated and if not carefully drafted could leave a lot of opportunities for tax planners to shift income.

There are other ways to limit transfer pricing abuse. For example, President Obama has also proposed a minimum tax on foreign profits.

The approach that is not getting enough attention is what is called formulary apportionment. U.S. states use formulary methods, and The European Union is considering formulary apportionment. Under this approach U.S. taxable profits would be a fraction of worldwide income where the fraction is the share of sales (and/or payroll) that is in the United States. With their long-tradition of promoting the arm's-length standard, the U.S. Treasury and the OECD are dead set against what (to them) would be such a radical change. There are no silver bullets in taxation and some of their concerns are legitimate, like the possibilities for avoidance (for example, by shifting where sales are booked to low-tax locations) and how formulary apportionment might require renegotiated U.S. tax treaties. But these problems are not unsurmountable, especially when compared to the problems encountered under current law, which has been an abject failure, despite decades of attempts to repair it.

Read Comments (4)

Falstaff @ the Boar's HeadFeb 14, 2013

It's often said the European Union is moving to a formulary apportionment
system. That conclusion strikes me as premature. Most of the important EU
nations for crossborder tax planning (U.K., Ireland, Netherlands, Luxembourg)
all seem to be opting out of CCCTB. So what good will F.A. be if its scope is
limited to transfers between high-tax jurisdictions like Germany and France? I
suspect that arm's length will out-live all of us, for better or worse.

Rusty SteeleFeb 15, 2013

The arms length standard features in all our tax treaties. But it's not unheard
of for Congress to enact laws that function as treaty overrides. Couldn't we
adopt formulary apportionment legislation and let the chips fall as they may?
Double taxation cases could get kicked to competent authority, which happens
any under our current transfer pricing rules.

niclas virinFeb 15, 2013

The best - if not the only - solution would be to scrap corporate taxation.

bill parksFeb 26, 2013

Bill Parks
Sales based formulary apportionment is simple, elegant, and much less prone to
gaming than our present system. Obviously, it will be fought to the bitter end
by the tax avoidance industry because, as Upton Sinclair said, “It is difficult
to get a man to understand something, when his salary depends upon his not
understanding it!" It therefore makes sense that tax practitioners will
manufacture objections no matter that Europe is poised to enact a financial
transactions tax that would reach much further than any apportionment tax.

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