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Valuing Intellectual Capital: Multinationals and TaxhavensGio Wiederhold (auth.)
Valuing Intellectual Capital provides readers with prescriptive strategies and practical insights for estimating the value of intellectual property (IP) and the people who create that IP within multinational companies. This book addresses the crucial topic of taxation from a rigorous and quantitative perspective, backed by experience and original research that illustrates how large corporations need to measure the worth of their intangible assets. Each method in the text is applied through the lens of a model corporation, in order for readers to understand and quantify the operation of a real-world multinational enterprise and pinpoint how companies easily misvalue their intellectual capital when transferring IP rights to offshore tax havens. The effect contributes to the issues that can lead to budgetary crises, such as the so-called "fiscal cliff" that was partially averted by passage of the American Taxpayer Relief Act on New Year's day 2013. This book also features a chapter containing recommendations for a fair and balanced corporate tax structure free of misvaluation and questionable mechanisms.
CFOs, corporate auditors, corporate financial analysts, corporate financial planners, economists, and journalists working with issues of taxation will benefit from the concepts and background presented in the book. The material clearly indicates how a trustworthy valuation of intellectual capital allows a realistic assessment of a company's income, earnings, and obligations. Because of the intense interest in the topic of corporate tax avoidance the material is organized to be accessible to a broad audience.
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Management for Professionals Gio Wiederhold Valuing Intellectual Capital Multinationals and Taxhavens Management for Professionals For further volumes: http://www.springer.com/series/10101 Gio Wiederhold Valuing Intellectual Capital Multinationals and Taxhavens Gio Wiederhold Stanford University Stanford, CA, USA ISSN 2192-8096 ISSN 2192-810X (electronic) ISBN 978-1-4614-6610-9 ISBN 978-1-4614-6611-6 (eBook) DOI 10.1007/978-1-4614-6611-6 Springer New York Heidelberg Dordrecht London Library of Congress Control Number: 2013936744 © Springer Science+Business Media New York 2014 This work is subject to copyright. 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Violations are liable to prosecution under the respective Copyright Law. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. While the advice and information in this book are believed to be true and accurate at the date of publication, neither the authors nor the editors nor the publisher can accept any legal responsibility for any errors or omissions that may be made. The publisher makes no warranty, express or implied, with respect to the material contained herein. Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com) This work is dedicated to the many individuals who have to make sense out of laws, rules, regulations, and conventions covering taxation, and try to generate outcomes that are fair to the enterprises that pay taxes and to the governments that rely on tax revenues. Preface Intellectual capital covers the capability of talented employees in modern and innovative enterprises and the intellectual property they generate. Exploitation of these intellectual assets generates the income that businesses need to function and grow. Today, intellectual capital contributes more to modern industry than financial capital does, but its influence on the national economy and global economy is not well understood, and not at all quantified. Rather than discussing intellectual capital in a broad and philosophical way, this book focuses narrowly on its use in multinational corporations. Valuing intellectual capital properly is a prerequisite for formulating industrial policies, considering how and where jobs may be created, and dealing with issues that are caused when companies shift valuable intangible assets overseas. The invisibility of intellectual capital makes it easy to ignore the driver of modern growth and focus narrowly on financial factors. Once rights to intellectual assets are part of corporate globalization, they are no longer subject to national laws and regulations. Taxhavens have been willing collaborators, enabling multinational corporations to reduce their worldwide taxes greatly, while benefiting from educational and transportation infrastructures paid for by citizens at their home locations. Many offshore countries also provide incentives to grow and create jobs, but are not able to collect taxes subsequently because the earnings wind up in other remote taxhavens. Tax avoidance is perfectly legal and beneficial for corporations, but when taken to extremes, it has serious consequences for society—both in the USA and in the foreign countries where the companies operate [Johnston:03]. This book explains in clear, understandable terms how legal means for minimizing corporate taxes greatly reduce the government revenue needed for education and public services while they increase the global wealth of corporations and their owners. vii viii Preface Intellectual Capital and Jobs The public, in the USA and abroad, is affected by the perilous state of the worldwide economy. One concern is the shift of jobs to remote locations [AsprayVM:06]. Politicians take advantage of those concerns by proposing new systems for taxation, which are in turn attacked by their colleagues as hurting the poor, or the middle class, or the rich, or small businesses, or the corporations that are supposed to create jobs. Hosts on TV shows comment on the benefits or faults of the schemes being proposed, but convey little understanding. They invite wise commentators to explain complex alternatives in 5 minute sound bites. The connection between corporate growth and jobs is a common theme. Helping corporations is supposed to create more jobs. Reducing corporate taxes is supposed to create more jobs. Those workers will buy more goods, causing businesses to prosper. Once these relationship issues are put on a global platform a disconnect becomes clear. Multinationals already enjoy low taxes by using taxhavens. They will create jobs where it is most profitable. Reducing taxes in one locality will help the corporation but not the public in that location. Prices of goods will be low if they are allocated to locations where taxes are low. Corporate Tax Avoidance Corporate profits are greatly reduced by paying taxes on their earnings. For multinational corporations taxation is an international issue [Doernberg:08]. Conflicts are created when taxation differs in domestic and global contexts [Sullivan:11]. There will always be some large and small countries that can distort an acceptable economic balance by offering freedom or exemption from taxation as inducements to powerful companies. Waiting for global agreements to be signed and faithfully executed by all parties is not a viable option [JollyK:12]. Tax avoidance by corporations affects nations much more than tax avoidance by rich individuals and celebrities. Multinationals employ more than 14 % of the total US workforce, most in well-paying jobs. Corporate accounts represent the majority of capital sheltered in offshore taxhavens. That capital is not just financial; it includes rights to intellectual capital, the basis for profits and growth in modern technological industries [Sveiby:97]. Although methods used by multinational corporations to avoid taxes are made visible in this book, I offer no recipes for corporate tax avoidance. Plenty of consulting firms provide comprehensive advice and support to corporations wanting to reduce their taxes. Their advice is not broadcast to the general public, and the corporations that follow their consultants' advice are not motivated to inform their shareholders or their employees of any specifics. Preface ix Audience This work is intended to be the source for informed discussions on issues of offshoring, international competitiveness, job creation, and changes to tax policies in the global economy. I will show how offshore investments are distorted by US and international taxation policies. A solid understanding can provide a balance of what is rational and achievable. My intent is not to make the reader mad about what is happening. Instead my focus is on the effects of corporate decisions on governmental tax revenues. Whether those governments spend their income wisely or not is not assessed. This book contains the background information needed by professionals who want to understand the processes of creating value in modern enterprises and the attendant problems. The focus is on multinational corporations and their intellectual capital because of their importance in the global economy. The flexibility of intellectual capital assignments is poorly understood and ignored by experts using outdated concepts from the past when assets and companies had known locations. Without being able to assign a value to intellectual capital, reformers have little leverage. Today, intellectual capital generates most corporate profits. Businesses depend on creative workers and smart tools. An emphasis on improving education shows awareness of the need to have a capable workforce that can create and maintain attractive and competitive products. The path from creativity to profits and wealth has not been elucidated. Corporations and their owners manage most of the flows, and their objectives may differ from what the workers and their friends expect. Paying little tax by moving intellectual and financial assets offshore increases the value of corporations, but leaves governments and the services the public expects with inadequate resources. Today, politicians and the public are subjected to piecemeal discussions of the existing tax code and proposed improvements, interwoven with promises of goodies that taxes will pay for and growth that will follow tax reductions. Articles covering globalization and tax issues in newspapers and business magazines are rarely comprehensive and at times naïve. Presentation To describe the process, I have created a model multinational company; I call it MNC. MNC represents structures and features found in actual businesses, but having a model avoids dealing with the excruciating detail and confidential facts of specific cases. MNC, like many of its high-tech peers, resides in California and moves a basket of operations and financial functions offshore. As it grows, it establishes subsidiary operations in Malaysia and India. Two shell companies, one in Palm Island and the other in The Netherlands, manage and hold rights to financial capital and intellectual capital. x Preface MNC does nothing illegal or explicitly immoral. Still, over a period of a dozen years MNC manages to greatly reduce its taxes and accumulate a trove of capital that is best invested in offshore growth. Because MNC is a US-based company, my computations follow US laws and regulations. Substantially identical methods are used by most US high-technology companies, although their structures will be much more complex than those of MNC [GOA:09]. A few public reports that document specific instances of questionable corporate tax payments are cited. Although I present interactions with other countries, I leave implications for non-US situations to other authors. The in-depth presentation of MNC's growth over 25 years documents the interplay of opportunities enabled by well-intentioned policies that enable extreme corporate tax avoidance. In Chap. 9 I can show that MNC is a valid model for the US corporate economy in general and US multinationals specifically. Although the modeled MNC is realistic, its processes are much easier to follow than the convoluted actions of its real-world peers. The contents, layout, and style chosen for this book are designed for a broad variety of readers. The essence of the material is presented in ten chapters without distracting detail. The technical alternatives of IP valuation are concentrated in Chap. 5. Throughout, references to material in the appendices allow readers who wish to dig deeper to identify specific items of controversy and assess their relative significance in tax avoidance. If readers feel that changes in policy are needed, the factors and choices that appear throughout this book can help determine what is fair, reasonable, and simple enough to apply in practice. My final recommendation may be surprising, but should make sense by the time the reader has reached that final chapter. That drastic recommendation, R20, supports recent calls to: Abolish Corporate Taxation This recommendation will engender interesting discussions among readers. My support for this change has no ideological basis. It surfaced only as I was writing this book, sorting through the many paths to tax avoidance I have encountered. In the end, tax authorities anywhere are unable to deal effectively with the problems presented. As I dissected the global situation and subsequent problems, it became clear that incremental repairs to the US tax system, by enforcing US laws and regulations globally and patching specific loopholes, will not work. Preface xi Chapter Organization This book covers comprehensively the conditions and methods that multinational corporations employ to avoid taxation. The initial eight chapters provide the foundation to discuss their effect on national economies here and abroad. Chapter 1 is a brief introduction of the corporate cycle of investing in intellectual capital, creating products, earning income, and using the profits for growth. Chapter 2 provides a detailed example of how intellectual capital is created and exploited; the specific issues will be dealt with one after another. Chapter 3 defines precisely the categories of intellectual capital. Chapter 4 deals with international transfers of corporate assets, as rights to IP. Chapter 5 details the methods used to assign a monetary value to IP. Chapter 6 presents the capabilities of a variety of taxhavens. Chapter 7 applies the technical material of Chaps. 3–6 to MNC's taxes. Chapter 8 shows why it is difficult for the IRS to deal with the issues raised. Chapter 9 matches MNC to US corporations and multinationals and allows projection of corporate initiatives in the future. Chapter 10 lists a score of recommendations, from the obvious to the radical, all intended to make taxation fair and supportive of economic growth. The recommendations I make have been expressed by others, but rarely considered in the setting that modern and global industry presents. Even Recommendation 20, to abolish both corporate taxation and the concessions in the tax code to compensate for double taxation, is still relatively simple. • Appendix A shows MNC's financial statements. • Appendix B presents some relevant sections of the tax code. Entries are cited as [B.section.subsection.legal-parapgraphs]. • Appendix C covers payment for intellectual capital by royalties. • The Glossary, Appendix D, presents extensive definitions to aid readers with diverse backgrounds. • Appendix E deals with tax expenditures, the credits, exemptions, and deductions that reduce corporate taxes significantly. • Appendix F presents all substantiating formulas and their justifications. The separation keeps the text easy to read. The formulas are referred to as [F chapter. formula number]. The 14 % fraction of US employment by US multinationals shown in this preface is computed per [F0.1]. An extensive Reference section allows the reader to verify issues and follow-up. The references cover a wide range of related topics, such as corporate economics, technology, globalization, taxation and tax avoidance, and the effects of national laws and regulations on all of those issues. Stanford, CA, USA Gio Wiederhold Acknowledgment I have to thank the dozens of professionals who have interacted with me while consulting and unwittingly contributed to the insights presented in this work. A course directed by Jeremy Dent at the London Business School helped me understand valuation issues in general. Discussions with colleagues and students at Stanford University and the University of Arizona Eller School of Business provided focus. I received constructive feedback from George Bachmann, Avron Barr, Nello Biglegue, Ron Burback, Seamus Grimes, Amar Gupta, Jan Heeramaneck, Bob Herriott, Steve Hoffer, Richard Karpinski, Bipin Lekshmanan, Happy Lust, Kathleen Much, Claudia Newbold, Bill Nowicki, Stanley Peters, John Sauter, Hiner Sierras, Marianne Siroker, Crown Spark, David Waxman, Shirley Wardenclyffe, John Wiederhold, Voy Wiederhold, May Wong, many unnamed experts, reviewers of earlier papers on the topic, and, of course, my students. Kathleen Much, the BookDoctor, edited the writing and May Wong, formerly a technology reporter in Silicon Valley for the Associated Press, added thoroughness and clarity. Voy Wiederhold used her experience in teaching and writing user manuals at Stanford to contribute to the book's final presentation. Marianne Siroker helped in locating the many hundreds of references I perused during the writing process. Any errors and questionable opinions in this book are, of course, solely my responsibility, but I cannot assume the responsibility for business decisions made based on the use of the presented material. xiii Contents 1 International Corporations and Taxes .................................................. 1.1 Intellectual Capital ........................................................................... 1.2 Routine and Nonroutine Earnings.................................................... 1.3 Tax Avoidance .................................................................................. 1.4 Summary .......................................................................................... 1 3 5 6 7 2 Growth of a Multinational Corporation ............................................... 2.1 MNC, A US-Based Start-Up Company ........................................... 2.2 MNC Establishes Foreign Sales Divisions ...................................... 2.2.1 Dealing with Double Taxation and Tax Treaties .................. 2.2.2 Offshoring of Manufacturing ............................................... 2.3 MNC's Controlled Holding Company: CONCH ............................. 2.3.1 Buy-In .................................................................................. 2.3.2 Cost-Sharing of Ongoing Development ............................... 2.3.3 Ownership of Rights to Intellectual Capital ......................... 2.3.4 The Financial Intermediary, CAAS...................................... 2.4 Growth of MNC ............................................................................... 2.4.1 Organic Growth .................................................................... 2.4.2 External Growth by Mergers and Acquisitions .................... 2.4.3 Repatriation and Acquisitions .............................................. 2.4.4 Combined Growth ................................................................ 2.5 MNC's Tax Arrangement ................................................................. 2.5.1 Taxes Paid by MNC's Operating Offshore CFCs ................ 2.5.2 Companies Related to MNC ................................................ 2.6 Moving All Income-Generating IP to a Taxhaven ........................... 2.6.1 An Example Where All IP Rights Reside in a Taxhaven ......... 2.7 Inversions ......................................................................................... 2.8 Associated Tax Advisers .................................................................. 2.8.1 Capabilities........................................................................... 2.8.2 Sharing Information Within ATA ......................................... 2.9 Summary .......................................................................................... 9 9 10 11 13 14 15 16 17 17 18 18 18 20 21 23 25 25 26 26 28 30 31 31 32 xv xvi Contents 3 The Value of Intellectual Capital ........................................................... 3.1 Intellectual Capital and Intellectual Property .................................. 3.1.1 Establishing Property Rights to Intellectual Assets ............. 3.1.2 The Value of the Workforce ................................................. 3.1.3 Integration of Workforce and Intellectual Property ............. 3.2 Creation of Intangibles..................................................................... 3.2.1 Process ................................................................................. 3.2.2 Lag ....................................................................................... 3.2.3 Sales Life and Lag................................................................ 3.3 Types of Intangible Assets ............................................................... 3.3.1 A Listing of Candidate Intangible Assets ............................ 3.3.2 Categorization of Types of Intellectual Assets ..................... 3.3.3 Results of Research .............................................................. 3.3.4 Reimbursement for Services ................................................ 3.3.5 Trademark ............................................................................ 3.3.6 Goodwill............................................................................... 3.3.7 Unrecognized Intangibles .................................................... 3.3.8 Aggregating Intellectual Asset Values.................................. 3.4 Life of Intangibles ............................................................................ 3.5 Misvaluation .................................................................................... 3.6 Summary .......................................................................................... 3.6.1 Concepts Needed to Understand the Role of IP ................... 35 36 36 39 40 42 43 46 49 51 52 53 53 55 56 57 58 59 59 60 61 62 4 Transfer Pricing and Rights Transfers ................................................. 4.1 Transfer Pricing................................................................................ 4.1.1 MNC's Pricing of Transferred IP ......................................... 4.1.2 Governmental Concerns and Constraints ............................. 4.2 Transfers of Rights ........................................................................... 4.2.1 Rights to Tangible Assets ..................................................... 4.2.2 Rights to Intangible Assets ................................................... 4.2.3 Allocation by "Reasonably Anticipated Benefits" ............... 4.3 Cost Sharing of Asset Maintenance ................................................. 4.3.1 Taxation and Cost-Sharing ................................................... 4.3.2 Asset Maintenance and Life ................................................. 4.3.3 Offshoring Alternatives ........................................................ 4.4 Sharing the Cost of Acquisitions ..................................................... 4.4.1 Valuing the Offshore Tranche of Acquisitions ..................... 4.4.2 Scope of Acquired Intellectual Assets .................................. 4.4.3 Reimbursing the Cost of IP Transfers .................................. 4.5 Summary of Transfer Pricing ........................................................... 63 63 64 65 66 67 69 70 72 72 73 74 76 76 78 80 81 5 Valuation Methods for IP ....................................................................... 5.1 Assets to be Valued .......................................................................... 5.1.1 Tangibles Are Simple to Value ............................................. 5.1.2 Intangibles Are Not So Simple to Value............................... 5.1.3 Maniac Has Both Tangible and Intangible Components...... 5.1.4 Rights to Anything Are Intangible ....................................... 85 86 86 86 87 87 Contents 5.2 5.3 5.4 5.5 5.6 xvii Financial Value of Intellectual Capital ............................................. 5.2.1 Approach .............................................................................. Eight Methods to Value Intellectual Capital .................................... 5.3.1 M1: MC-VM, Market Capitalization-Based Valuation Method ................................................................. 5.3.2 M2: Inc-VM, Income-Based Valuation Method .................. 5.3.3 M3: IIP-VM, Identified IP Valuation Method ...................... 5.3.4 M4: CUT-VM, Comparable Uncontrolled Transaction Valuation Method ................................................................. 5.3.5 M5: CP-VM, Comparable Profits Valuation Method ........... 5.3.6 M6: PS-M, Profit-Split Methods .......................................... 5.3.7 M7: RO-VM, Roll-Over Valuation Method ......................... 5.3.8 M8: PP-VM, Purchase Price Valuation Method................... Choosing and Combining Valuation Methods ................................. Valuation of Cost-Shared Acquisitions ............................................ Summary of Valuation Methods ...................................................... 87 88 89 90 95 102 117 124 129 133 139 146 148 149 6 Taxhavens................................................................................................. 6.1 Functions of Taxhavens.................................................................... 6.1.1 Categories............................................................................. 6.2 Primary Taxhavens ........................................................................... 6.2.1 IP in Taxhavens .................................................................... 6.2.2 MNC's Taxhavens ................................................................ 6.3 Conduit Taxhavens ........................................................................... 6.3.1 Reporting Requirements in Conduit Taxhavens ................... 6.3.2 Functions of Operations in Conduit Taxhavens ................... 6.3.3 Identifying Conduit Taxhavens ............................................ 6.4 Semi-taxhavens ................................................................................ 6.4.1 Incentives ............................................................................. 6.4.2 Trade-offs ............................................................................. 6.5 Nearshore Taxhavens ....................................................................... 6.6 Prominent Taxhavens ....................................................................... 6.7 Formal Definitions of Taxhavens ..................................................... 6.8 Shifting Ownership of Assets Held in a Taxhaven........................... 6.9 MNC's Use of Taxhavens ................................................................ 6.9.1 Selection of a Jurisdiction for Growth ................................. 6.10 Trends Enabled by Taxhavens.......................................................... 6.11 Summary .......................................................................................... 151 152 152 154 159 160 161 161 162 164 167 167 170 171 172 173 173 175 176 177 178 7 Taxation of MNC ..................................................................................... 7.1 Misvaluation..................................................................................... 7.1.1 Acceptance of Tax Avoidance Approaches .......................... 7.2 Range of Valuations ......................................................................... 7.2.1 The "Best" Method Rule ...................................................... 7.2.2 The Valuation of the Buy-in for CONCH ............................ 7.2.3 Correcting a Misvaluation .................................................... 181 181 182 183 184 185 186 xviii Contents 7.3 7.4 A Corrected Valuation Cannot Be Accommodated.......................... Subsequent Growth of MNC and CONCH ...................................... 7.4.1 Acquisitions ......................................................................... 7.4.2 The ATA Acquisition Valuations .......................................... 7.4.3 MNC's Motivation for Acquisitions..................................... Further Financial Capital Accumulation Offshore ........................... Intellectual Capital Rights Accumulation Offshore ......................... Summary .......................................................................................... 188 190 191 193 195 196 198 199 8 US Taxation.............................................................................................. 8.1 Authority and Means to Collect Tax ................................................ 8.1.1 History .................................................................................. 8.1.2 Organization of the IRS ....................................................... 8.2 Current Corporate Taxation ............................................................. 8.2.1 Dealing with Large Enterprises............................................ 8.2.2 Corporate Costs of Taxation................................................. 8.2.3 Corporate Privacy ................................................................. 8.3 Worldwide and Territorial Taxation ................................................. 8.3.1 Worldwide Taxation ............................................................. 8.3.2 Territorial Taxation ............................................................... 8.3.3 Worldwide Versus Territorial Taxation................................. 8.4 The Taxpayer Chooses the Methods for Its Business ...................... 8.5 Controversies ................................................................................... 8.5.1 Controversial Valuations ...................................................... 8.5.2 Penalties ............................................................................... 8.5.3 Rollback and Settlements ..................................................... 8.6 Double Taxation ............................................................................... 8.6.1 Flavors of Double Taxation .................................................. 8.6.2 Double Taxation of Corporate Payouts ................................ 8.6.3 Tax Treaties .......................................................................... 8.7 The IRS ............................................................................................ 8.7.1 Documentation ..................................................................... 8.7.2 Adapting to Modern Business Processes ............................. 8.7.3 Resources at the IRS ............................................................ 8.7.4 Imbalance of Resources ....................................................... 8.7.5 Fixing Imbalances in Taxation ............................................. 8.7.6 Governmental Resources ..................................................... 8.8 Other Taxes ...................................................................................... 8.9 Summary .......................................................................................... 203 203 204 206 206 207 208 208 209 209 210 213 214 215 215 216 217 217 218 220 222 223 223 224 225 225 226 227 227 229 9 Effect on the National Economy ............................................................ 9.1 MNC as a Model .............................................................................. 9.2 MNC Versus Other US Businesses .................................................. 9.2.1 Similarities of MNC and Other US Corporations ................ 9.2.2 Differences Between MNC and Other US Corporations ..... 9.2.3 MNC Versus Other Multinationals ....................................... 9.2.4 Summarizing the Match ....................................................... 231 231 232 233 233 234 235 7.5 7.6 7.7 Contents 9.3 National and Multinational Trends .................................................. 9.3.1 Offshore Finances ................................................................ 9.3.2 Trends in Corporate Taxation ............................................... Trustworthiness ................................................................................ 9.4.1 Distortion Due to Taxes........................................................ 9.4.2 Bias....................................................................................... 9.4.3 Effective Tax Rates............................................................... 9.4.4 A Better Basis to Compare Tax Rates .................................. 9.4.5 A Choice of Effective Tax Rates .......................................... 9.4.6 International Effective Tax Rates ......................................... Growth of US Offshore Activities.................................................... 9.5.1 Operating a Taxhaven ........................................................... 9.5.2 Use of Assets Held in Foreign Taxhavens ............................ 9.5.3 The Missing Piece: Where Goes the IP? .............................. Allocation of Jobs ............................................................................ 9.6.1 Outsourcing Services ........................................................... 9.6.2 Outsourcing Core Competencies ......................................... 9.6.3 A Global Disconnect: Growth and Job Creation.................. 9.6.4 Incentives Offered by Foreign Countries ............................. Tax Avoidance or Tax Evasion? ....................................................... 9.7.1 Tax Avoidance Is Legal ........................................................ 9.7.2 Extreme Tax Avoidance Versus Tax Evasion ....................... Summary .......................................................................................... 9.8.1 Who Should Care About Intellectual Capital Held in Taxhavens? ....................................................................... 236 236 238 242 242 243 243 245 245 246 248 249 251 254 255 255 256 257 258 258 259 260 261 Recommendations ................................................................................... 10.1 Scope of the Recommendations ..................................................... 10.1.1 The Complexity of Change .............................................. 10.2 New Laws and Regulations: R1–R4 .............................................. 10.2.1 Implementation Costs of Changing Tax Laws ................. 10.2.2 Overloaded Bills .............................................................. 10.2.3 Global Consistency .......................................................... 10.2.4 Overly Specific Regulations............................................. 10.3 Transparency: R5–R14 .................................................................. 10.3.1 Visibility into Offshore Operations .................................. 10.3.2 Reporting of Intellectual Capital ...................................... 10.3.3 Capitalization of IP Creation ........................................... 10.3.4 Settlements ....................................................................... 10.4 Tax Collection: R15–R17 .............................................................. 10.4.1 Realistic Treatment of Anticipated Benefits .................... 10.4.2 Avoid Inappropriate Use of Royalties .............................. 10.4.3 Repatriation of Assets From Taxhavens ........................... 10.5 Role of Tax Expenditures: R18–R19 ............................................. 10.5.1 Supporting Research ........................................................ 263 264 264 267 267 268 269 270 271 271 274 276 277 278 278 280 281 283 283 9.4 9.5 9.6 9.7 9.8 10 xix 262 xx Contents 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 Abolish Corporate Taxation: R20 ................................................ Financial Effects of Abolishing Corporate Income Taxes ........... 10.7.1 Change in Corporate Activity and Payments ............... 10.7.2 Effect on Small Businesses .......................................... 10.7.3 Effects on Individual Incomes ..................................... 10.7.4 The Effects on US Government Tax Revenues ............ Operational, Administrative, and Social Effects of R20 .............. 10.8.1 Corporate Business Operations .................................... 10.8.2 Administrative Effects on Individuals and Small Businesses ................................................... 10.8.3 Governmental Changes Without Corporate Taxes ....... Objections to Abolishing Corporate Taxation.............................. 10.9.1 Twenty Likely Gripes and Rejoinders ......................... 10.9.2 Misuse of Taxation to Compensate for Corporate Costs ...................................................... International Effects and Responses to a US Abolition of Corporate Taxation .................................................................. 10.10.1 International Capital Flows .......................................... 10.10.2 Effect on Taxation in Other Countries ......................... 10.10.3 International Trade ....................................................... 10.10.4 International Responses ............................................... Employment by Multinationals.................................................... Summary: Ending Unbalanced Taxation ..................................... 10.12.1 Origin of the Lack of Balance...................................... 10.12.2 Exploitation of Opportunities ...................................... 10.12.3 Repairing the Damage ................................................. 10.12.4 The Future .................................................................... 10.12.5 Initial Recommendations ............................................. 10.12.6 The Final Recommendation ......................................... Call to Action: What's Next? ....................................................... 285 287 288 291 291 294 299 299 300 303 304 304 314 314 314 315 317 318 318 319 320 320 320 320 321 321 322 Appendix A: MNC's Annual Report ............................................................. 323 Appendix B: Tax Laws and Regulations ....................................................... 327 Appendix C: Royalties .................................................................................... 345 Appendix D: Definitions and Glossary .......................................................... 359 Appendix E: Tax Expenditures ...................................................................... 407 Appendix F: Formulas .................................................................................... 419 References ........................................................................................................ 485 Author and Book Background ....................................................................... 519 Index ................................................................................................................. 521 Chapter 1 International Corporations and Taxes International trade has more than doubled over the last 25 years and continues to grow [HinesS:09]. More than 70 % of US international trade is now in the hands of multinational corporations, companies that have operations and legal residences in more than one country [Clausing:06]. More than half of the trade of those multinational corporations, and about half of all US international trade, is shipped among their international divisions [Economist:11M]. Intra-firm trading is not as visible as external sales. Trading among corporate divisions has given multinational companies ample opportunities to minimize taxes by adjusting prices for transfers of their goods [Kopits:76]. What's more, establishing fair transfer prices is especially difficult when dealing with intangible goods and assets [Harrison:03]. Those intangible assets are the principal component of today's knowledge-based industries [Nakamura:99]. Tax avoidance is beneficial to a company competing in world markets. In fact, Wall Street investors applaud companies whenever they achieve a lower tax rate. In the USA and other developed nations, paying taxes at the prescribed rates could reduce the profits of a company by more than one third. The more a firm spends on taxes, the less money it has available for shareholder dividends and investments for future growth. Companies that manage to pay little or no tax by using tax avoidance methods become more competitive than companies that pay higher taxes. Many of the tax avoidance methods described in this book are based on laws and regulations that are intended to make US companies more competitive abroad [GuptaWS:09]. Once those methods are in place, companies can easily exploit them to cover more than what US legislators originally foresaw. Poor valuation of offshored corporate intellectual capital enables a high share of tax avoidance by modern industry. As multinationals have become quite competent in avoiding taxes where they operate, companies that remain local—and local citizens—have to bear heavier tax burdens for public services. Raising tax rates is politically unpopular, so balancing national budgets with less tax income means curtailing government services to all residents. Yet the services that governments provide from their tax income do not G. Wiederhold, Valuing Intellectual Capital: Multinationals and Taxhavens, Management for Professionals 23, DOI 10.1007/978-1-4614-6611-6_1, © Springer Science+Business Media New York 2014 1 1 2 International Corporations and Taxes differentiate among their residents, so that companies engaging in substantial tax avoidance still enjoy the same level of benefits of government investments in infrastructure, national defense, and education. Our model California-based multinational corporation, MNC, illustrates actual tax avoidance methods. It has a much simpler structure than we find in actual situations, but is not too simple. MNC has just five divisions in five countries, whereas having 50 divisions in a dozen locations is typical for a mature multinational corporation. The offshore operational companies set up by MNC are considered to be Controlled Foreign Corporations (CFCs). MNC, a typical High-technology manufacturing company, has two offshore operating CFCs, one in Malaysia and one in India. MNC's CFC in Johor Baru, Malaysia, called MNC JB, focuses on manufacturing an electronic gadget, the Maniac, designed by MNC in California. The CFC in India, MNC MY in Mysore, helps develop the software embedded in MNC's Maniacs. In most multinational companies, product creation and manufacturing are split among local and offshore divisions according to local competencies [WGN:10]. There will also be offshore divisions established primarily for tax avoidance. MNC has two of those, CONCH in Palm Island and CAAS in The Netherlands. (None of these names refer to an actual company.) Just like most large US corporations, MNC employs a Controlled Foreign Holding company (CFH), where it can park assets and shelter them for the long term. Such holdings are typically located in "taxhavens" [Economist:13]. Section 6.2 describes CFH operations. Our MNC has only one CFH, CONCH. MNC also has established a Controlled Financial Intermediary company (CFI), CAAS, a conduit to move financial assets rapidly and undetected among MNC's locales. Financial advice and services to MNC are provided by an external consulting firm, Associated Tax Advisers (ATA). "Taxhaven" is a concept in this exposition IP $ $ The development of those divisions of MNC is covered in Chap. 2, but their relationships are already sketched in Fig. 1.1. 1.1 Intellectual Capital 3 Fig. 1.1 Business divisions of MNC MNC MNC JB MNC MY CONCH CAAS ATA IRS The parent company in the USA, designs and improves Maniacs The manufacturer of Maniacs in Malaysia according to MNC's specifications The software division in India The taxhaven entity that holds financial and intellectual capital and formally controls all offshore sales The conduit company that shuffles funds among MNC's offshore divisions The consulting firm that provides advice and services to MNC The tax authorities that have to understand what's going on It is clear that most of the corporate complexity is due to the financial arrangements of MNC. 1.1 Intellectual Capital High-tech companies depend on intellectual efforts for making valuable products [Sveiby:97]. A business generates income and profits through exploitation of its capital assets by its workforce. Assets can be tangible or intangible. Intangible assets (formally, items we cannot touch) are products of the mind, ranging from inventions to customer lists and trademarks. Intangible assets complement and can dominate a company's tangible assets, such as machines, tools, buildings, and cash [Hulten:06]. Owned assets become property. When ownership can be asserted over intangible assets, they become "intangible property"; an alternate term focusing on the origin of the assets owned is "intellectual property." Both terms are abbreviated as IP, and often the distinction can be ignored. In Chap. 3 the terms and the components of IP are defined in detail. 4 1 International Corporations and Taxes Table 1.1 Industry sectors that depend on IP Industry category Electronic consumer products OEMs making electronic parts and assemblies Software product producers Pharmaceutical companies Financial institutions Service organizations Consulting firms Automobile manufacturers Specific issues in international trade Manufacturing is mainly assembling parts from Original Equipment Manufacturers (OEMs), often offshore Substantial manufacturing is offshore; output is shipped to offshore product manufacturers Research and Development is done at multiple sites. R&D is intense, but 80 % of R&D is for improved versions; the manufacturing cost is negligible Research and Development costs are very high compared to manufacturing costs Services depend on internal software, employed at worldwide sites, but the contribution of that shared software is ignored in most analyses Product is not formally protected The assets are hard to quantify and localize. Know-how is of value Internal R&D contribution is low per unit sold. OEM suppliers do their own IP characteristic Assembly know-how is also moving offshore Product and IP moves unseen among sites outside the USA Product valuation is arduous, but essential for export as all profits are due to IP There is a long delay before IP generates profits Profits are generated by interaction of people and software Profit is generated indirectly Internal IP is not marketable Costs are visible The workforce and the IP together make up the "intellectual capital" of a business. In modern businesses they dominate the generation of income. MNC requires little equipment. Rights to intellectual capital can be traded among partners for mutual benefit. The business scenarios within this book are applicable to industries in any high-tech sector. Whether they specialize in biotechnology or consumer electronics, companies in the real-world benefit from tax avoidance measures. Firms in a wide range of industry sectors practice offshoring. Tax avoidance is easier when the value of their products is based largely on intellectual capital. Consumer product manufacturing companies tend to rely on other companies for components that embody much technical IP, adding valuable integration and marketing competence. In service-oriented companies, the human intellectual capital is crucial. The final entry in Table 1.1, an industry relying much less on IP, provides a contrast. The common term "IP" is used broadly in this introductory chapter. The focus is on technical IP, but trademarks have valuable IP as well. Chapter 3 categorizes IP into a dozen major types. 1.2 Routine and Nonroutine Earnings 1.2 5 Routine and Nonroutine Earnings Selling commodity products earns a company what economists refer to as "routine profits." An analysis of nearly 13,000 companies from 1994 to 2000 showed that routine earnings' margins before taxes ranged from 2 to 10 % of sales [HandL:03]. That result comes from formula [F1.1]. Earnings due to IP are referred to as "nonroutine profits." Most earnings in seven of the eight industries shown in Table 1.1 are due to their IP. A company with much IP, a knowledge-based company—if well run—can be very profitable. The average total earnings margin was 25 % of sales for companies that had invested in R&D and advertising [HandL:03]. The earnings margins for successful high-tech firms are much higher than 25 %, but are hard to validate because of poor accounting for expenses associated with generating IP [F1.2]. Nonroutine earnings sustain modern economies through a cycle of public investment in infrastructure and education, and private investment in corporate innovation. MNC's spending on its intellectual capital, namely its staff, R&D, marketing, and their integration, produces the unique product, the Maniac, with a functionality that is highly valued by MNC's customers. Investing corporate earnings in R&D and advertising creates IP and fosters future corporate growth. The annual growth of companies that can exploit IP averaged 3.4 % versus 0.4 % for the median of S&P companies [Kao:07]. Corporations can grow locally or offshore. Where in the world corporate growth will occur in the future is affected by national and international tax policies. Those issues are addressed in the final chapters of this book. MNC is an innovative corporation. It is able to earn a high margin on sales of its products because of the intellectual assets it possesses. The two main types of MNC's intellectual assets are the specific competencies of MNC's workforce and its intellectual property (IP), as sketched in Fig. 1.2. The workforce includes MNC's managers, designers, engineers, and marketing staff. MNC's IP are assets that it has legally protected by patents, copyrights, trademark registrations, and by keeping trade secrets. Without specialized competence, a manufacturing company would be able to produce only commodity products. MNC's high-value products earn significantly higher margins, due to nonroutine earnings from its revenues, than commodity products would earn. MNC is characteristic of many successful businesses in the modern world [USCoC:11]. Already in 1998—the dawn of the Information Age— the intangible assets of the S&P 500 made up 85 % of the companies' value [Daum:01]. 6 1 International Corporations and Taxes Fig. 1.2 The investment and product cycle of MNC 1.3 Tax Avoidance Larger companies in the categories shown in Table 1.1 are by nature global and must deal with many taxing jurisdictions. How and where multinationals choose to set up their divisions directly affects their tax rates. IP and the rights to IP are easily moved across international borders, making differences of taxation a consideration. Operating in multiple countries makes tax avoidance harder to understand and detect. Individuals are expected to have one domicile, but businesses can have a legal presence in multiple locales and are more difficult to scrutinize [UScensus:10]. The complexity of international IP transfers makes it easy to move from tax avoidance into tax evasion [Browning:10]. Unless MNC takes advantage of tax-avoidance strategies, it faces taxes on all earnings, both routine and nonroutine. The funds remaining after taxes are paid are available to improve and develop further high-tech products. The taxes collected allow the governments to provide services to the general public and to MNC. A well-functioning public infrastructure keeps MNC effective and operating in a stable environment. A good education system provides the common knowledge MNC's employees need. All of these public contributions help MNC to prosper and grow. 1.4 Summary 1.4 7 Summary Companies that operate internationally can derive many benefits from having distinct, controlled subsidiaries in multiple countries. Such multinational corporations take advantage of differing resources, laws, tax regulations, and enforcement practices in the countries where their divisions establish domicile. Shifting funds and intangible assets among their divisions is nearly invisible. Most tax avoidance by multinational corporations involves transfers of rights to IP among corporate divisions to benefit from differences in the laws, regulations, and standards of behavior set by a variety of jurisdictions. With ATA's advice, MNC manages to reduce its taxes on its US income from the statutory rate of 35 % to less than 22 % within 10 years, while paying negligible taxes on income from its exports to other countries. The overall tax rate on MNC's worldwide income becomes 11.1 % [F1.3]. Beyond that, MNC can take advantage of tax incentives provided by the US government. Our MNC is still less aggressive than most real-world multinational companies; the average tax rate in 2004 for US multinationals was 2.3 % and is likely much less in 2012, 8 years later [Gibbs:09]. The differences in taxation of US domestic and multinational corporations have a broad impact. Paying 35 % federal tax rather than 2.3 % reduces profits by a third [F1.4]. Companies that remain bound to the USA show lower profits and will pay more for investment capital. US-based companies also accumulate more obligations to their employees. Let's move on to Chap. 2 to see how our model multinational company, MNC, grew and how it moved into tax avoidance. Observing MNC's history provides the understanding we need to deal with specific issues that enable tax avoidance. The issues that will be encountered—the scope of intellectual capital, transfer pricing, valuation of IP, the advantages offered by taxhavens, and the governmental inability to deal with taxhavens—need their own chapter. Only then can a responsible summary and recommendations be made. Chapter 2 Growth of a Multinational Corporation This chapter covers the life of our model multinational company. It is documented using 25 years of typical corporate records. Although it is simpler than an actual multinational, there is enough detail to support the analyses in the chapters that follow. 2.1 MNC, A US-Based Start-Up Company MNC is a typical modern company. It produces products and associated services based on its intellectual capital. It was established about a dozen years ago by a combination of developers who had gained experience in their field, had novel ideas, but found that their current employer was no longer willing to take risks. Some recent university graduates ready to work in an exciting setting joined MNC, even though the future of the start-up was not assured. An early prototype showed enough promise to attract funding by a venture capitalist. Within a few years, an initial product, the Maniac 1000, was ready for marketing and sale. Sales of the Maniac grew steadily, and MNC invested its profits in product improvement, new Maniac releases, and marketing to a broader base of consumers. Within 5 years MNC went public, so that its shares were available for trading on the stock exchange. Initially, sales outside of the USA were handled by distributors, who got Maniacs at a 40 % discount and did their own marketing. The distributors used MNC's trademark, so that MNC became globally recognized. On the basis of feedback from its distributors, MNC's staff in California internationalized its product interfaces so that future Maniacs could be easily adapted to worldwide user habits and communication standards. The Maniac 2000, shown in Fig. 2.1, gained wide acceptance. G. Wiederhold, Valuing Intellectual Capital: Multinationals and Taxhavens, Management for Professionals 23, DOI 10.1007/978-1-4614-6611-6_2, © Springer Science+Business Media New York 2014 9 10 2 Growth of a Multinational Corporation Fig. 2.1 MNC's current product and trademark; both contain MNC's IP MNC's annual report showed a successful American company poised for further growth based on its valuable intellectual property, as documented in Appendix A. 2.2 MNC Establishes Foreign Sales Divisions To gain control of sales outside the USA, MNC bought its most effective European distributor, located in Graz, Austria. MNC's management renamed the new division MNC EMEA and transferred all European, Middle East, and Africa distribution of its Maniacs to MNC EMEA, thus establishing MNC's first Controlled Foreign Corporation (CFC). Soon the EMEA division took on the actual adaptation of Maniacs to standards appropriate to each country in Europe. The costs for those adaptations were charged to MNC in the USA and accounted for about 5 % of the product's prices. Subsequently MNC established two more CFCs for selling Maniacs offshore. The first CFC was MNC PFE, based in Yokohama, Japan. It sells Maniacs in the Pacific region and the Far East. The PFE division made a special effort to introduce the MNC trademark into Asia. A year later, MNC LSA was set up in Belize to serve Latinlanguage speakers in Central and South America. After that time, the MNC parent company sold products directly only in the USA and Canada. Figure 2.2 shows the international scope of MNC: a parent MNC US with three distribution divisions, MNC EMEA for Europe, MNC PFE for Asia, and MNC LSA for Latin America. Design and manufacturing of its Maniacs remained in California. An internal "transfer price" was established for Maniacs shipped from the USA to the three CFC sales divisions. Based on experience with the prior distributors, the transfer price was set at 55 % of the sales price, as computed in Appendix F, formula [F2.1]. That meant that 55 % of the sales revenue from Maniac sales is transmitted from the three "offshore" distributing divisions to the USA as revenue to be booked at MNC US. After deducting the actual cost of manufacturing the Maniacs, MNC books the remainder as gross income. After deducting the expenses MNC incurred for management and financing, MNC paid taxes on the aggregated US earnings, as shown in Table A.1. 2.2 MNC Establishes Foreign Sales Divisions 11 Fig. 2.2 The world of MNC before ATA's proposals: three sales CFCs Earnings of the three CFC distributing divisions, calculated on their 45 % share minus their costs for sales and distribution of Maniacs, were booked at the CFCs. Those earnings were taxed by the authorities in Austria, Japan, and Belize. Corporate tax rates in those countries are roughly similar to those in the USA, although there are some concessions for products exported to other countries in the region. The after-tax profits were transmitted to MNC in the USA. Although MNC sold its Maniacs worldwide, it still behaved like a US-based company. MNC's management and its innovators expect continued growth. It will continue to invest in research, but those expenses should not grow as fast as the expected revenues. Figure 2.3 documents those expectations. To achieve that expected growth, MNC will restructure its operations. 2.2.1 Dealing with Double Taxation and Tax Treaties The USA does not have a tax treaty with Belize, so profits of MNC's LSA division are subject to actual "double taxation." Double taxation means that Belize will first collect its 25 % corporate tax on earnings of LSA, and the remaining 75 % of those earnings, when transferred to MNC in the USA, will be subject to the US 35 % tax rate, making the total effective tax rate 51.25 % [F2.2]. Belize is an exception. The US Treasury has tax treaties with 68 other large and small countries [IRS-901:11]. 12 2 Growth of a Multinational Corporation Fig. 2.3 Expected income growth of MNC Belize, however, does not charge taxes on income from exports to members of the Caribbean Single Market, and the country provides an export allowance for other substantial exports into Latin America. As income attributable to actual sales within Belize was relatively small, MNC ignored the problem of double taxation there, especially because MNC's consulting firm, the Associated Tax Advisors (ATA), was preparing to propose a more comprehensive tax plan to MNC's board of directors. Double taxation was not a problem for MNC's EMEA and PFE divisions. The US federal government has tax treaties with the two countries, Austria and Japan, where MNC's other foreign divisions are located. Having a tax treaty generally means that taxes that have been paid in those countries will be credited in the USA, reducing US taxes by those amounts. Taxable earnings at MNC's independent distributor in Austria are based on the revenues it receives from its sales in the EMEA area minus the transfer price for the imported Maniacs and its local expenses. Corporate taxes in Austria are only 25 %. For the Maniacs sold by EMEA, after their import and all expenses in Austria have been accounted for, 9.6 % of their sales price is taxed in Austria, and only the difference between that and the US statutory rate of 35 % is due to the USA [F2.3]. The Austrian government gets $3.2M per year, but the changes being proposed by ATA will reduce foreign taxes as well. The profit that MNC in the USA makes on those exports of Maniacs to the CFCs is taxed in the USA and in California. Taxes to be paid to the state of California could be reduced by incorporating MNC in a low-tax state in the USA, such as Delaware, but I intend to remain focused on federal tax avoidance. 2.2 MNC Establishes Foreign Sales Divisions 13 Table 2.1 Divisions of MNC after offshoring selected sales and manufacturing efforts Division MNC US Location Role California, USA Management, R&D, prototyping, and sales MNC EMEA Graz, Austria Interaction with clients, adaptation, and sales MNC PFE Tokyo, Japan Adaptation and sales MNC LSA MNC JB Belize Johor, Malaysia MNC MY Mysore, India 2.2.2 Source of IP growth All aspects, main development site Business intelligence, local adaptation Only trademark and local adaptation Adaptation and sales Local adaptation only Copy manufacturing No local IP, Copy prototype exactly Product test and improvement Joint software development Offshoring of Manufacturing In a second phase, MNC moved some of its manufacturing operations offshore. Because MNC realized that the IP within its products was crucial, its management decided not to use contractors for offshore manufacturing, but instead established new, subsidiary corporations. The existing CFC locations were not deemed suitable for substantial new manufacturing operations. New CFCs were created in jurisdictions that offered both capable labor and inducements to establish operations there: the MNC JB division in Malaysia for its electronic products, and the MNC MY division in India for the associated software development. Both countries offered relatively low-cost, educated personnel and incentives to locate operating divisions there. Malaysia had established a free-trade zone (FTZ) in Johor Bahru, close to Singapore, providing excellent access and communications. To gain easy access to Indian professional personnel, MNC MY was located in Mysore, an area where many offshore operations from other companies were based, but costs were still modest. Because of its effective interaction with the developments in the growing European Union (EU), the role of the MNC EMEA division in Austria was increased to ensure compatibility with changing European standards. The IP situation differs in the various CFCs now established by MNC. Table 2.1 lists the parent and its five offshore divisions. For the MNC JB operations, MNC adopted the "Copy Exactly" technique promulgated by the US chipmaker Intel, to make sure its process and products completely matched those manufactured on prototyping lines in the USA [McDonald:98]. Potential clients for quantity purchases are located mainly in the USA and at MNC EMEA. They are shown current Maniac prototypes and can trust that products delivered from MNC JB will fulfill precisely the same specifications and be reliable and consistent. For the division in India, MNC MY, product incompatibilities are of less concern, as software and software improvements are shipped rapidly over the Internet and loaded into the Maniac hardware just before distribution or sale. The next step is to establish a foreign holding company, CONCH (Controlled Offshore Nominal Capital Holding), located in the Bermuda triangle, where income, transferred via CAAS, disappears from sight, as sketched in Fig. 2.4. 14 2 Growth of a Multinational Corporation Fig. 2.4 The split world of MNC after the buy-in 2.3 MNC's Controlled Holding Company: CONCH When MNC started earning more than 40 % of its revenue from foreign sales by its CFCs, the MNC board of directors agreed to set up a controlled foreign holding company (CFH) in a primary taxhaven, following the suggestion of its Associated Tax Advisers (ATA). MNC named that new subsidiary division CONCH. Having a CFH allows income from sales to be sheltered and held there without paying US taxes. The CONCH division was established by ATA in Palm Island, a small Caribbean country, using ATA's existing experience and facilities. CONCH issued restricted shares, and MNC US purchased those shares, providing an initial $6M capital for CONCH. The directors of CONCH were selected from staff at MNC and ATA. Palm Island does not levy taxes on income, and once CONCH was established, the annual cost is nominal; only a $3,000 fee is due to the island's registration authorities [Devasabai:09]. ATA's ongoing support charges billed to MNC are low as well, because CONCH shares facilities in Palm Island with many other offshore holding companies. ATA's costs there are mainly keeping some files and ensuring that any mail, e-mail, and faxes sent to CONCH are forwarded to MNC in the USA, where actual control is exercised. 2.3 MNC's Controlled Holding Company: CONCH MNC Controls all, design & US sales 15 MNC JB, MY, & EMEA Offshore manufacturing License and exploit the IP $ Salaries for R&D costs Integration CONCH purchased the rights to hold and license the IP to others. CAAS Distribution IP documents $ Buy-in: for initial 5 IP rights years purchase MNC EMEA, LSA, & PFE Rest-of-the-World sales Consolidated enterprise Fig. 2.5 Divisions of MNC and their interaction CONCH purchased rights to MNC's IP, a fraction or "tranche" sufficient to gain the rights to access all of MNC's intellectual capital, the platform that is the base of MNC's income. It can now collect all of MNC's foreign revenue and hold the derived earnings. MNC in the USA does not pay taxes on any offshore earnings that are not needed to support operations in the USA and are held at CONCH. Figure 2.5 shows the new interplay of the divisions of MNC. The new CAAS division in The Netherlands is set up by ATA to handle the financial transfers. The fraction of revenue transferred to MNC in the USA was not based on actual cost data but on prior agreements with an independent distributor. When, a few years later, the business relationship changes, these assignments are no longer realistic and should be reevaluated. But the effort to justify new transfer prices and reset existing financial contracts is substantial. MNC had little motivation to change, so it kept the existing rates throughout subsequent events, even though its operations changed greatly. 2.3.1 Buy-In In order to make CONCH eligible to receive the nonroutine profits, a tranche of ownership rights to the IP was transferred from its current owners, MNC in the USA, to CONCH. In return, CONCH had to make a buy-in payment to reimburse MNC US for the right to use that IP. ATA determined that a fair transfer price for the IP was $50M, using the percentage of expected sales from distributors outside of North America, which was 42 % [F2.4]. In return, CONCH received the right to 16 2 Growth of a Multinational Corporation collect 42 %, or $105M, of MNC's income. By the end of its first year, CONCH actually could keep $44M of MNC's earnings that year in its local accounts [F2.5]. The loan by MNC for the buy-in payment that enabled CONCH to purchase the IP rights from MNC was to be paid back in installments in equal amounts over 5 years. The low 8 % interest rate for the $50M loan was based on MNC's cost of money. CONCH accounts could easily transfer to MNC the $12.231M repayments due annually from the earnings booked there [F2.6]. Any income received in the USA is subject to income tax, after expenses are deducted. The interest payments for the loan are added to the installment payments for the buy-in and will be taxed. Few new expenses were incurred. 184.108.40.206 Income Shift, Short Range and Long Range MNC in the USA received the installment income from the buy-in and recorded it on its accounting ledgers as earnings from exports. MNC had to pay taxes on that $3.1M income every quarter for the 5-year term [F2.6]. MNC no longer received the earnings from its foreign operations. The change in the amount of earnings received was initially modest. No shareholder or revenue agent noticed the difference in the type of income. Only in later years does that difference become significant. The independent auditing division of ATA engaged by MNC did not question the transaction and said so in notes attached to MNC's annual reports [Vause:09]. After 5 years, CONCH had paid a total of $61.2M and no longer had to pay quarterly installments. Now MNC no longer received the installment income or any share of the foreign earnings. All net foreign earnings were sheltered at CONCH, free of taxes. The price to earnings (p/e) multiple of 1.25 for the buy-in, given that CONCH paid $50M to receive $44M that first year and increasing amounts each year thereafter, seems like an over-friendly deal [BodieKM:08]. An IRS analyst checking that p/e multiple against common investment multiples may suspect that the buy-in was not valued fairly. Nevertheless, the risk of any scrutiny is low. MNC's tax returns are convoluted with the interest payments and cost-sharing payments for R&D at MNC, as sketched in Fig. 2.5. The IRS audits only about 25 % of major corporate tax returns [Zerbe:10]. Because MNC delivered all its documentation, including the ATA study justifying the $50M valuation of the CONCH tranche of MNC's IP, the financial reporting was valid. No IRS audit was initiated by the IRS examiner. IP valuations are difficult and require the expertise of economists and other specialists. In fact, detractors will say that fair IP valuations are impossible, but Chap. 5 will show how to reasonably estimate the value of MNC's IP and the buy-in. 2.3.2 Cost-Sharing of Ongoing Development The buy-in is actually part of a broader cost-sharing agreement between MNC in the USA and CONCH. After the buy-in, research and development continued at MNC 2.3 MNC's Controlled Holding Company: CONCH 17 in California. Very little changed in the work setting for creative MNC employees. The software group now receives assistance in testing Maniac software from MNC MY in India and gradually turns over the maintenance of prior versions of the software to MNC MY staff. The IP generated by ongoing development in the USA and software testing at MNC MY will benefit foreign sales of Maniacs as much as the US sales of Maniacs. To reimburse the creators for that benefit, the foreign divisions of MNC contribute to the costs of all such efforts. Through the initial buy-in and the ongoing costsharing payments, CONCH shares the ongoing rights to the resulting IP. Only costs incurred for strictly local adaptations will not be shared. To simplify accounting, all R&D costs incurred by MNC in California and by MNC MY are aggregated in a single account. Because all earnings from foreign selling divisions in MNC's corporate structure flow to CONCH, it pays for its share of the R&D costs. Taxes have to be paid on the funds that CONCH transfers to the USA, so CONCH will actually pay about 135 % of its share of the total R&D cost, or $34M [F2.7]. R&D costs average about 12 % of MNC's revenues; the remaining foreign earnings accumulate at CONCH [F2.8]. 2.3.3 Ownership of Rights to Intellectual Capital CONCH derives an important benefit from the R&D cost-sharing payments; it continues to own a share of the intellectual property generated by those R&D efforts. As the fraction of foreign sales of Maniacs increases, the income at CONCH increases as well, so that it obtains a greater portion of the nonroutine profits from MNC's foreign sales. In recent times MNC's foreign sales have increased by 23 % of the original offshore ratio. CONCH now gets 54 % of MNC's total profits, even though the initial buy-in transfer payment was based on a 44 % share [F2.9]. MNC's portion of taxable earnings shrinks as more income winds up at CONCH. Because the ongoing development of Maniacs and its successor products takes place in California, CONCH implicitly has access to the workforce and the knowhow at MNC US as well. The IP rights hence convey rights to all of MNC's intellectual capital. Chapter 3 defines those rights. 2.3.4 The Financial Intermediary, CAAS ATA also established a Controlled Financial Intermediary (CFI) for MNC and gave it the name Confidential Asset Accounting Services (CAAS). CAAS collects all foreign income, distributes it to cover all offshore costs, and then transmits what is left to CONCH, MNC's taxhaven subsidiary. The actual services are provided by a division of ATA in Hilversum, close to Amsterdam's airport in The Netherlands. ATA also submitted the required registration to the Dutch authorities and maintains its books. No actual MNC staff is required. 18 2 Growth of a Multinational Corporation Although the flow of funds through CAAS is substantial, CAAS gets little actual revenue from The Netherlands. As a mere conduit, it has minimal reporting requirements in The Netherlands [Kroon:00]. Because The Netherlands is subject to European Union rules, the assumption is that all receipts and payments follow International Accounting Standards (IAS) promulgated by the IAS Board (IASB) in London. The operations at CAAS are invisible to MNC's shareholders. In 2002, the US Securities and Exchange Commission (SEC) relaxed reporting regulations, so that since then the existence of CAAS no longer needs to be reported in MNC's annual reports. We will encounter CAAS again in Chap. 6, where we deal in more detail with taxhavens. 2.4 Growth of MNC A company can grow in two ways: 1. "Organic growth" is due to internal technical and marketing innovations created from resources within the company. Technical growth requires spending on R&D. 2. "External growth" is due to mergers and acquisitions. Acquisitions can be supported from excess income, by issuing shares or bonds to investors or by borrowing money. MNC used both types of growth. The IP growth due to those two approaches overlaps and becomes indistinguishable in the long run. Recognizing the origin of the IP and the nonroutine earnings they generate helps in understanding corporate growth. Quantifying the relative share of the two contributions to growth is impossible. 2.4.1 Organic Growth Organic growth tends to be steady. Consistent high quality and low prices can keep the rate of growth high for a long time [Sveiby:97]. Once a company is well established in its market sector, it is hard to grow much faster than the general growth of the economy. A company growing only organically also risks being sideswiped by alternative products or technologies. 2.4.2 External Growth by Mergers and Acquisitions Growth can be accelerated by investing in existing enterprises. Acquiring or merging with other companies provides stepwise growth. Mergers tend to be among equal-sized businesses and help build market share. Acquiring smaller companies 2.4 Growth of MNC 19 Fig. 2.6 Major income streams at MNC in the USA, and taxes due tends to complement and advance existing product lines, converting available capital to IP. MNC acquired several smaller companies around the time of the creation of CONCH, expecting to improve its products and to enter new but related markets. Acquisitions and mergers can be paid for with cash or shares or a mix of both. MNC's shares were valued highly, so half of its early acquisitions were paid for with newly issued shares. The acquisitions made sense to MNC's shareholders, and therefore MNC's share price was not greatly affected. The first round of acquisitions, made about the time that CONCH was established, incurred a cost of $300M. Sales of MNC shares and a loan paid for the acquisition. The acquisition included IP that also benefits CONCH, so CONCH had to reimburse MNC for its share and taxes on that amount. ATA determined that CONCH had to pay less than $29M for its share of the acquisitions that MNC purchased for $300M [F2.10]. The change in earnings and taxes at MNC in the USA are shown in Fig. 2.6. The documentation for the initial round of acquisitions and the cost sharing by CONCH was provided to the IRS and not challenged. MNC's management was smart. They invested in companies with technologies and products that match their existing operations. The acquired companies were relatively small, so staff and management could be easily integrated, and no harmful jockeying for senior positions resulted. Such issues crop up in many major mergers, and the resulting disruptions are costly. The companies acquired by MNC all had 20 2 Growth of a Multinational Corporation technology complementary to MNC's existing capabilities, so their integration was effective. MNC's market capitalization soon grew to more than $2,000M while CONCH continued to accumulate cash [F2.11]. 2.4.3 Repatriation and Acquisitions In 2004 the US Congress passed the American Jobs Creation Act (AJCA), giving US-based multinational corporations a one-time tax break. The legislation's objective was to encourage companies to repatriate funds from taxhavens and create jobs in the USA rather than in offshore CFCs [AJCA:04]. AJCA reduced the US tax rate on foreign earnings returned as dividends to the parent corporations in the USA from 35 to 5.25 % [F2.12]. Many US multinational companies participated and spent the funds in a variety of ways [DruckerRM:11]. When AJCA made repatriation of offshore funds attractive, MNC had four choices: 1. 2. 3. 4. Grow by hiring staff. But hiring creative staff for a short term is not feasible. Grow by acquiring companies, gaining instant staff and IP. Buy back stock to increase its value per share, increasing shareholder wealth. Pay dividends to its shareholders, providing shareholder income. Choices 3 and 4 are inappropriate. MNC is a young company, expected to grow and not to reduce its capital. MNC focused on the second approach and identified suitable acquisitions amounting to $475M. Following the prior strategy, CONCH would have cost shared those acquisitions as well, and spent $41.2M for the IP share it would obtain, plus the taxes at that low rate [F2.13]. Because MNC had so much capital accumulated offshore, it decided to take maximal advantage of the AJCA tax break and repatriated most of the cash MNC held in CONCH. CONCH paid for nearly $500M in acquisitions and related taxes [F2.13]. The wording of the AJCA specified only foreign income, but any income from MNC's sales of its products in the USA that were sheltered because of the IP rights held in CONCH, qualified as foreign income as well. AJCA-motivated acquisitions funded by CONCH cost $475M, and the taxes owed for transferring that amount into the USA amounted to only $25M. That kept the repatriated amount just under a $500M limit, so that MNC did not have to open its books at CONCH to the IRS [F2.14]. Without the AJCA tax break, $166M would have been paid in taxes, more than CONCH could afford [F2.15]. The portion of the acquisitions that was identified as IP enabled CONCH to own a larger share of the corporate IP. Figure 2.6 also shows the growth of MNC's US earnings and taxes paid after the second round of acquisitions. The regulations implementing AJCA could not ensure that the repatriated funds would be used only for job creation. In a traditional economy, planners foresee thousands of workers creating products and infrastructure. A business that relies on creative people to generate IP cannot hire staff rapidly to grow organically at a high rate. 2.4 Growth of MNC 21 Fig. 2.7 Long-term growth of MNC The repatriated funds, being fungible, were mainly used in other ways than choice 1, hiring staff [LevinEa:11]. MNC obtained new, valuable employees from those acquisitions, although the support personnel from the acquisitions were redundant and let go, reducing the amount of new staff to 57 % of the acquired personnel, leading to a net job loss in the USA [F2.16]. 2.4.4 Combined Growth By incorporating smaller competitors, MNC was able to grow substantially. It spent a total of $775M on acquisitions, a sum equal to nearly half its market value. Those acquisitions enhanced MNC's value considerably. The capital accumulated in MNC's taxhaven provided the resources. The sketch in Fig. 2.7 conveys a general impression of the growth paths. MNC's early value was determined by its initial investors, but after it went public, its value was set by the shareholders. Shareholders are concerned about future income of MNC as a whole, but have to depend mainly on MNC's consolidated statements that do not report the location of financial and intangible capital. The consolidated growth of MNC does not show the effect of CONCH directly. Capital keeps accumulating in CONCH. Unless there is motivation for another repatriation, the cash held in CONCH will be used for offshore production capabilities 22 2 Growth of a Multinational Corporation or for acquisition of foreign assets. Attractive are US companies that already have the majority of their value offshore. Such purchases become an untaxed extraterritorial transaction among foreign subsidiaries [Rahn:09]. 188.8.131.52 Allocation of IP Obtained from Acquisitions Rather than initiating new product lines, the two rounds of acquisitions brought new IP value to be integrated into MNC's Maniac products while ensuring that MNC remained at the forefront of innovation. That newly acquired IP is available to all of MNC's worldwide operations, so that it is also subject to the cost-sharing arrangement that was set up when CONCH was established. We briefly review the studies performed by ATA, MNC's trusted accountants, which allowed CONCH to increase its share of earnings beyond its expected share of foreign sales. Although the financial amounts paid for both sets of acquisitions are known, the appropriate payment for the IP rights conveyed to CONCH has to be estimated. The acquired companies did not yet have sales of their own, the prime basis for IP valuations. Some of the research at the acquired firms might never have a practical application. It was also unclear when and to what extent the acquired IP would contribute to MNC's future sales. ATA split the initial acquisition amount of $300M as follows: it found $30M of tangibles, considered another $28M to be a control premium that did not add value, wrote off $25M of research in process, assigned $15M as the value of the workforce being integrated into MNC, and valued the useful IP from all those acquisitions at $50M. Acquiring talent was an important motivation for several of the acquisitions, but ignored by ATA. The unaccounted $152M was assigned to goodwill, to be amortized over 15 years [see details in F2.10]. CONCH paid $28M for its share of the IP obtained and the taxes due on that amount. The ATA reports provided for each acquisition included the common term: "ATA believes that the valuation is fair and will not be challenged by the IRS." For the $475M in acquisitions following AJCA, ATA used a similar valuation process and pegged the total IP value at $106.7M [F 2.17]. Some of those were talent acquisitions as well. MNC had CONCH accounts pay the full acquisition cost and the taxes due at the low AJCA rate, a total just below $500M [F2.12]. Because CONCH funded the entire AJCA-motivated round of acquisitions, all of the additional IP rights and benefits to collect nonroutine earnings were allocated to CONCH. The total amount CONCH paid for the initial buy-in, both rounds of acquisitions, and the taxes for the funds transferred to the USA became $596M [F2.18]. The fraction of IP rights held at CONCH also grew. After the buy-in, CONCH paid for its proportionate share of IP during initial acquisitions, shared ongoing R&D costs, and then paid for all of the IP in the AJCA-motivated acquisitions; CONCH obtained 64 % of the IP-based rights to MNC's nonroutine income [F2.19]. Because of the growth of foreign sales, CONCH's income share grew as well, becoming 69 % [F2.20]. Figure 2.8 shows the effect: substantial US income can now be sheltered at CONCH. By Chap. 7 we will be able to assess to what extent ATA's methods were valid. 2.5 23 MNC's Tax Arrangement % 100 90 MNC U.S. earnings share 80 70 AJCA–motivated acquisitions Sales in U.S. 60 50 initial acquisitions US earnings held at CONCH 40 30 unadjusted R&D cost-sharing payment Foreign sales 20 CONCH earnings share Acquisitions paid mainly by MNC 10 0 Acquisitions paid by CONCH CONCH established Before Buy-in After Buy-in and cost-sharing Fig. 2.8 Allocation of non-routine earnings according to relative IP rights 2.5 MNC's Tax Arrangement With CONCH now controlling more than 2/3 of the IP rights, over 2/3 of MNC's nonroutine earnings will also be booked offshore. The sheltering of US-sourced earnings offshore allows MNC to avoid paying US tax on such earnings. This arrangement has a cumulative effect. As little as possible of the earnings derived from foreign operations is transferred back to the USA, letting US income pay for all routine costs. No US taxes were paid on earnings held at CONCH before AJCA was passed. Then, to pay for the second set of acquisitions, a large amount of capital was transferred at a very low, 5.25 %, tax rate. After that event, no further capital was transferred to the USA A year after the AJCA acquisitions, MNC in the USA owns only 33 % of the worldwide IP rights to its earnings. The remainder of the earnings from Maniac sales is allocated and held at CONCH. MNC thus pays US taxes only on the 33 % fraction of IP rights it now owns or $28M that year. If it were taxed at the full statutory tax rate, $89M in taxes would be due on its worldwide earnings, or at least $44M on its US-source earnings [F2.21]. Within 10 years after the initial buy-in, all but 26 % of MNC's nonroutine earnings will be sheltered from taxation. MNC's taxes become less than 9 % on its worldwide earnings and less than 14 % on its earnings from sales in the USA [F2.22]. Spending CONCH's untaxed capital on foreign projects and acquisitions will further reduce MNC's US taxable earnings. MNC's capital needs and costs in the USA remain low [F2.23]. Figure 2.9 shows the beginning of the trend. 2 24 Growth of a Multinational Corporation $M MNC U.S. only 220 Buy -in 200 180 MNC 160 2nd round 140 120 100 1st round US Profit 80 @5.25 % @ AJCA tax rate 60 40 40 20 Acquisitions paid mainly by MNC t bli h d CONCH established 0 Before buy-in q isitions Acquisitions Acqu paid p byy CONCH After buy-in and acquisitions, US earnings only Fig. 2.9 MNC's US earnings and tax effects of the buy-in and acquisitions MNC is but a small contributor to the sheltering of US corporate income from taxes. For all US corporations, such tax avoidance methods contribute substantially to the approximately $100B annual total of untaxed earnings from US sales, as shown later in Fig. 6.4 [F6.4]. Research Credits The USA, like many other countries, has adopted tax incentives to encourage innovation. In the USA such incentives are the Research and Experimentation (R&E) credits [B.2.8(4)]. Introduced in 1981, they have been regularly extended and often modified [NAM:04]. Because CONCH's cost-sharing payments overlap with the expenses eligible for the R&E credit, those credits apply to the cost-sharing payments MNC receives. The cost-sharing payments satisfy the prime R&E credit objective, supporting research jobs in the USA, but fail to satisfy the long-term objective of improving US competitiveness. The resulting IP will not generate taxable income for the USA, because the rights to any new IP created by cost sharing will be owned by CONCH, offshore. Optimizing the benefits from the taxation rules is a balancing act for MNC's accountants. A generous designation of corporate efforts to R&E costs would increase the tax credits earned. Such an allocation would also increase MNC's US income from CONCH and reduce the amount that MNC can shelter in the taxhaven. Because these amounts are documented on different forms submitted to the IRS, any inconsistencies may not be obvious. 2.5 MNC's Tax Arrangement 2.5.1 25 Taxes Paid by MNC's Operating Offshore CFCs When a company is profitable in the country of its residence, it should pay taxes to that country [dAroma:27]. But the nonroutine profits from MNC product sales in India, booked by MNC PFE, will flow via CAAS in The Netherlands to MNC's taxhaven subsidiary, CONCH. Only the profits that remain after paying royalties for the use of IP owned by CONCH will be taxed by India, which has a corporate tax rate of 30 %, similar to that of most industrial countries. Corporations and their advisors attempt to avoid taxes anywhere. To keep earnings from being taxed, ATA has instituted some further strategies. Most of the profitable activities of MNC's software division in India, MNC MY, require the use of IP owned by CONCH. By having MNC MY pay substantial royalties for the IP rights that CONCH holds, the earnings in India are greatly reduced, and little tax is paid there. Verifying fair rates for royalty rights is hard. Because the transfer is internal, the rates for the rights can be strategically set so that MNC MY has minimal or no profit in India, and hence pays little in taxes there. The software files and product designs that workers need at MNC MY are actually stored in India, but the rights to use them are owned by CONCH in the taxhaven. ATA has assigned only a file drawer to CONCH in its Palm Island office; there wouldn't be enough physical space to store any actual documents [Contractor:81]. Because MNC MY's software is shipped to the sales locations via the Internet, the value of its exports to the USA and offshore MNC distributors is not documented anywhere [BarlettS:00]. Avoiding taxation for MNC JB in Malaysia is even simpler. Even though the products are tangibles with intangible contents, being in a Free Trade Zone means MNC JB doesn't face import or export duties. No IP is generated at MNC JB. So even though neither India nor Malaysia is a primary taxhaven, their governments receive no significant tax revenues from MNC's business activities. Only the individual income of employees residing there is subject to national income and consumption taxes. Chapter 6 defines more precisely what roles various types of taxhavens play in corporate structures. MNC does not operate in isolation. It is part of a complex network of enterprises that together produce innovative products that sell well in the market. Many of those companies supply the parts and competence needed for consumer products and services worldwide. 2.5.2 Companies Related to MNC Maniacs use computer chips designed and supplied by a neighboring company in California, CCC. MNC and CCC worked closely together to make sure that those chips are effective and economical. Their design represents an integration of IP by MNC, CCC, and many other companies, including those that have developed the design software used by MNC and CCC. The actual chips are manufactured for CCC offshore by a chip foundry in Taiwan. CCC assumes only a flash title for its sales, as the foundry delivers the chips directly to MNC JB in Malaysia [GriffithS:09]. 26 2 Growth of a Multinational Corporation More than half of the chips made by CCC wind up back in the USA, as part of products such as Maniacs. It has used an offshore CFH for many years now, accumulating capital in a taxhaven. It now invests most of its earnings in growing its design and engineering capabilities offshore. CCC has acquired small companies in Eastern Europe and hired well-educated staff there. Many of these countries provide attractive incentives. Little growth in California is expected. 2.6 Moving All Income-Generating IP to a Taxhaven MNC has considered, but not adopted, a further suggestion made by ATA that would allow nearly all US profits to be sheltered from taxation. It would require that all of MNC's IP be transferred offshore to CONCH. Then only routine US earnings, computed as if the Maniac were a commodity product like a light switch, would be booked by MNC US. MNC's taxes would then shrink to <2 % of its earnings [F2.24]. The intent of the US government's cost-sharing regulations was to allow companies to shelter income generated outside of the USA and keep it available for active offshore activities, thus allowing US companies to reinvest foreign earnings to compete effectively with foreign competitors. The rules only require stating that the amounts are held for foreign reinvestment; repatriation of earnings can be indefinitely blocked. Because IP is well-nigh invisible and money is fungible, MNC's tax avoidance approach could be extended to all of its nonroutine profits. To avoid all US taxes would require another buy-in by CONCH, which would pay for all of MNC's remaining US IP rights. A valuation of that IP must then be made; ATA would take on that task. ATA could even recommend an "inversion," as described in Sect. 2.7. Our model MNC does not engage in any such questionable practices. 2.6.1 An Example Where All IP Rights Reside in a Taxhaven To assess more extreme strategies, let's look at a documented case of "Globetrotting Profits" [Drucker:10]. A pharmaceutical company, Forest Laboratories (NYSE symbol FRX), has its headquarters in New York and its primary research and testing laboratories (FLR) in St. Louis. The main product of FRX is Lexapro, a medication for anxiety disorders. All IP rights have been shifted to Bermuda, all manufacturing occurs in Ireland, and all sales are in the USA. As shown in Fig. 2.10, the FRX arrangement is simpler than the case of our MNC, as Forest Laboratories sells its products only in the USA To handle all the shifting of funds, Forest Laboratories uses a CFI in The Netherlands, FFBV. FFBV is registered as a "Besloten Venootschap" (BV) and serves as a conduit of external funds that is exempt from most reporting to the Dutch belastingsdienst (tax authority, NLbd) [deMooijN:08]. FFBV provides services in the Forest Laboratories structure in Amsterdam similar to those CAAS in Hilversum 2.6 Moving All Income-Generating IP to a Taxhaven 27 IT&C Dublin United States Ireland European Union Forest Labs. IE Ireland Dublin much less IE than $1 Forest Labs. headquarters New York, NY Forest Labs. Research St. Louis, FRX inc. FLI $64 pills NLbd den Haag NL FF Forest . BV Finance . Amsterdam . NL . MO IRS Washington FLR DC sales Forest Labs. Holdings FLH Bermuda pills drugstore Phoenix, AZ the Netherlands the $ amounts are presented as integers Based on Hermann Zschiegner in "Globe-trotting Profits" [Drucker:10] www.bloomberg.com/insight/lexapro.html Fig. 2.10 Example of funds and IP flow for Lexapro [F2.25] provides for MNC (see Fig. 6.6). Indeed, FFBV has no employees to enjoy the conviviality of Amsterdam. Nothing can be done until the IP is moved offshore, so that becomes the initial transaction: Transaction 0: At some time in the past, FRX transferred the rights to its IP (specifically the rights to patents that cover Lexapro) from FLR to FLH (Forest Laboratory Holdings), its offshore CFH in Bermuda. We do not know how much FLH paid FRX for the buy-in of those IP rights. If the transfer payment to FRX accounts in the USA occurred when the future sales of Lexapro were hard to estimate, the amount would have been modest. Following the money paid for a drug purchase, it takes eight transactions to get back to the taxes paid to the US IRS. Transaction 1: The customer pays $99 for a unit of Lexapro at a Phoenix drugstore. Transaction 2: The drug store pays $76 for that unit of Lexapro to FRX headquarters in NY. FRX collects $12 for marketing and administrative costs attributed to the sale. Transaction 3: The remaining $64 flows to Forest Finance BV in Amsterdam (FFBV) to pay for Forest Laboratories' offshore manufacturing operations. Transaction 4: The expenses incurred in Ireland, $18 in total, are transmitted by FFBV to FLI, the Irish manufacturing subsidiary of FRX. The actual cost of manufacturing a unit of Lexapro is $5. Because FLI has no nonroutine earnings in Ireland—the income is nearly equal to the expenses—the Irish taxes were negligible, only 11 US cents per unit. Transaction 5: The licensing fees of $12 for the IP used in Ireland are paid by FLI to FLH in Bermuda, the owners of the license. 28 2 Growth of a Multinational Corporation Transaction 6: Forest Labs's 10-K financial documents imply that all those transfers of funds consume about $2 per unit in administrative costs, leaving about $44 of the drug's sale in the FFBV account. FLH (Forest Laboratory Holdings), which owns all of Forest Labs's IP, has the right to all of that profit. Thus $44 untaxed profit is moved from the FFBV account to Forest Labs's holding company, FLH, in Bermuda, keeping the capital held at FFBV low. Transaction 7: FLH received $56. In order to maintain its rights to the IP, FLH pays the cost of the research and development employees at FLR in St. Louis, amounting to about 8 % of Forest Labs' net revenues. For that repatriation of earnings to the USA, FLH also pays the US taxes, transferring a total of $7 per unit of Lexapro. The remaining $49 is kept in Bermuda. Transaction 8: It appears that the IRS is owed about $2.50 in taxes from that payment to FLR, but after credits from a US research incentive and for taxes paid in Europe, only $1.09 is due. The final taxes are 2.4 % on Forest Labs's income, as reported by Business Week [Drucker:10]. After tax credits for Irish taxes and other typical credits and deductions for pharmaceutical companies, Forest Laboratories pays only $1.09 in US taxes, or 2.43 % US tax on its taxable earnings, well below the 35 % US corporate income statutory tax rate [F2.26]. The reduction in taxes paid is not achieved by manipulating the tax rate, but rather by hiding earnings offshore. The gross profit margin on Lexapro's sales revenue is 71 % [F2.27]. The high margin is possible because the company makes a product based on IP created or acquired in the US operation and pays negligible taxes in all places where Forest Labs operates. The remainder of the amount from a single sale, about $49, after all expenses at the other Forest Laboratories operations, is accumulated by FLH in Bermuda. It can collect interest there, but it is also available for new investments. If Forest Labs pays dividends to its shareholders, those will also have to be supported by FLH, because all capital is held in Bermuda. Amounts transferred to the USA for dividends will be taxed. Any US resident shareholder will be taxed on the dividend income as well, albeit at a lower rate. Large shareholders are thus motivated to declare their domicile in some taxhaven. By comparison, generic drug competitors—without the exclusivity afforded by the patents on Lexapro—would be selling an equivalent product for less, earning a 12.5 % routine margin. No taxhaven is needed. If all other costs and tax rates remain similar to Lexapro's, a unit of the generic drug would cost the consumer about $32 [F2.26]. Overall, generic medicines, being commodities, are indeed priced at about 1/3 of their protected predecessors [Levinson:08]. 2.7 Inversions A company willing to be even more drastic about avoiding taxes can elect to move the domicile of its formal headquarters offshore [Shaviro:11]. This arrangement is suitable for multinational corporations that have been adept at moving their IP rights to a taxhaven and sheltering earnings there. Once enough capital has been 2.7 29 Inversions Fig. 2.11 Inversion CHORD IP shift Nashville . time Buy-in CHORD6 Hamilton HQ shift 64 Memphis CHORD Hamilton Capital accumulated, the funds can be used to buy the parent and move its headquarters out of the USA [AviYonah:02]. Then it no longer has to report its consolidated income to the IRS. The process of moving the domicile of a company to a foreign jurisdiction is called an "inversion." To illustrate the process I define a fictional company, CHORD, which has its headquarters in Nashville, TN. CHORD's metamorphosis to CHORD offshore is sketched in Figure 2.11. CHORD is a multinational company and has already moved all of its IP to its CFH in a taxhaven, CHORD6. Over a period of about 6 years the IP rights owned by CHORD6 have allowed it to amass much capital offshore, but CHORD's management has not found any attractive investment opportunities [Misey:02]. They are worried that, because all that accumulated capital is not active, it may be taxed under the anti-deferral rules [B.1.2 §1375]. CHORD seeks advice from ATA and agrees to set up a second-level US subsidiary via CHORD6 in Memphis, identified as CHORD64. To capitalize CHORD64, CHORD6 r