US Treasury Department Issues White Paper Critiquing EU State Aid Investigations of Transfer Pricing Rulings

On August 24, 2016, the U.S. Department of Treasury issued a White Paper titled, “The European Union’s Recent State Aid Investigations of Transfer Pricing Rulings,” explaining United States transfer pricing concerns with the EU Commission.  The state aid investigations of note, include Apple, Starbucks, Fiat/Chrysler and Amazon.  There are indications that there may be more investigations launched.  Notably, the EU Commission’s positions, apparently, mostly involve transfer pricing concerning intellectual property. 

In February of 2016, Treasury Secretary Lew authored an open letter to the President of the Commission, Jean-Claude Juncker, stating:

that the Commission’s “sweeping interpretation” of State aid doctrine “threatens to undermine” the progress made by the international community “to curtail the erosion of our respective corporate tax bases” and described four principal concerns.  First, the Commission has “sought to impose penalties retroactively based on a new and expansive interpretation of state aid rules.”  Second, the investigations appear “to be targeting U.S. companies disproportionately.”  Third, the new enforcement theory “appears to target, in at least several of its investigations, income that Member States have no right to tax under well established international tax standards.”  Fourth, the Commission’s investigations “could undermine U.S. tax treaties with EU Member States."

The White Paper further explains the concerns and in the Executive Summary states:

The Commission’s Approach Is New and Departs from Prior EU Case Law and Commission Decisions.  The Commission has advanced several previously unarticulated theories as to why its Member States’ generally available tax rulings may constitute impermissible State aid in particular cases.  Such a change in course, which has required the Commission to second-guess Member State income tax determinations, was an unforeseeable departure from the status quo.

The Commission Should Not Seek Retroactive Recoveries Under Its New Approach.  The Commission is seeking to recover amounts related to tax years prior to the announcement of this new approach—in effect seeking retroactive recoveries.  Because the Commission’s approach departs from prior practice, it should not be applied retroactively.  Indeed, it would be inconsistent with EU legal principles to do so.  Moreover, imposing retroactive recoveries would undermine the G20’s efforts to improve tax certainty and set an undesirable precedent for tax authorities in other countries. 

The Commission’s New Approach Is Inconsistent with International Norms and Undermines the International Tax System.  The OECD Transfer Pricing Guidelines (“OECD TP Guidelines”) are widely used by tax authorities to ensure consistent application of the “arm’s length principle,” which generally governs transfer pricing determinations.  Rather than adhere to the OECD TP Guidelines, the Commission asserts it is employing a different arm’s length principle that is derived from EU treaty law.  The Commission’s actions undermine the international consensus on transfer pricing standards, call into question the ability of Member States to honor their bilateral tax treaties, and undermine the progress made under the OECD/G20 Base Erosion and Profit Shifting (“BEPS”) project.

[Hat tip to Pepperdine University School of Law Professor Paul Caron's TaxProfBlog]

Low Valuations at the Heart of Tax Avoidance IP Schemes – An IP Solution?

Professor Andrew Blair-Stanek of the University of Marlyand, Francis King Carey School of Law, has published an article on SSRN titled, “Intellectual Property Law Solutions to Tax Avoidance” (forthcoming 62 U.C.L.A. Law Rev. __).  The article helpfully explains how transferring IP can result in substantial tax savings for IP owners and why initial low valuations of IP are at the heart of tax avoidance schemes.  He focuses his proposal on addressing tax avoidance schemes by using substantive IP law, as well as procedural rules involving IP cases, to incentivize IP owners to make initial valuations of IP closer to their “actual value.”  He provides a hypothetical example of the problem involving Google and licensing:

When Google’s California-based engineers develop a promising invention, Google owns the rights to all patents that can be obtained on the invention. Corporate ownership of employee-created IP is common practice.

Google then quickly licenses all the patent rights to a subsidiary in a tax haven like Ireland. Licensing allows the future profits from the patents to accrue to the Irish subsidiary, while the legal ownership remains with Google itself in the U.S., with its robust protection for IP owners.  This license is respected, since Google and its Irish subsidiary are separate corporate entities, and IP can be freely licensed.

U.S. tax law requires that Google receive “arm’s-length” royalties from its Irish subsidiary for the patent license.  The “arm’s-length” price is defined as the price that would have been charged if Google had instead been dealing with an unrelated party under the same circumstances.  The “arm’s-length” principle for cross-border transactions is deeply enmeshed in not only U.S. tax law, but also the numerous bilateral tax treaties that the U.S. has signed with its trading partners, including Ireland.  Google must pay U.S. corporate tax of 35% of these “arm’s-length” royalties.  

Herein lies the mischief. Google does not transfer its promising IP to unrelated parties, so there is no observable “arm’s-length” price. Valuing IP – particularly brand-new IP – is difficult and subjective. Unlike a mass-produced machine or a ton of aluminum, each piece of IP is unique and its economic potential is difficult to predict. Treasury regulations provide detailed econometric methods to estimate IP values, but these are extremely imprecise, often leading to a wide possible range of acceptable prices.

Google must hire appraisers (oftentimes economists) to ascertain an “arm’s-length” price for the transfer to Ireland, and to support that price with extensive contemporaneous documentation.  But Google chooses and pays these appraisers, who are inclined to err towards lower valuations. As a leading tax practitioner recently observed, “appraisers tend to agree with their paymasters on [valuation] questions.”

After the transfer to Google’s Irish subsidiary, the patented technology is incorporated into a new Google device.  The Irish subsidiary oversees a Chinese contract manufacturer’s building of the new devices.  The Irish subsidiary then sells the devices for a full markup that includes the value of the IP to Google distribution subsidiaries worldwide, who then sell them to consumers. The substantial profits from the IP remain in Ireland, typically not subject to Irish tax, and not subject to U.S. tax as long as the cash is not returned to the U.S.

He also discusses why meaningful change in tax laws is unlikely to happen which leads to his IP focused proposals.  Why is the solution unlikely to be based in tax law?  He provides, at least two reasons: nearly impossible coordination of tax law between many countries; and information asymmetries between multinationals and government tax authorities.  In describing the information asymmetry problem, he states that:

First, information asymmetry refers to the fact that the taxpayer inherently knows far more about the characteristics, potential, and value of its IP than does the IRS [U.S. Internal Revenue Service] (or any appraiser). For example, Google understands how its new invention could fit profitably into a new smartphone in a way that neither a team of IRS experts, nor a team of private appraisers, ever could. When the IRS challenges a low transfer price in court, the taxpayer has a depth of understanding of its own IP that gives it a large advantage in refuting the IRS challenge.

Largely as a result of this information asymmetry, the IRS has lost both high-profile IP transfer-pricing cases litigated in the past decade. A quote from one of those opinions encapsulates the problem: “Taxpayers are merely required to be compliant, not prescient.” Taxpayers can fully comply with the law by disclosing all facts to their appraisers who must determine the “arm’s-length” transfer price. Any outsider (including judges) will not be able to discern its profit potential. But the multinational can determine its profit potential, which materializes after the IP is safely in Ireland.

His proposals for change (or perhaps, in some cases, suggestions for interesting arguments) essentially focus on using the initial low valuation position taken by the IP owner against it later in litigation (when the relevant information is likely discoverable) and licensing.  For example, he states:

First, the defendant should argue that the artificially low price is evidence that the patent was obvious at the time of invention, and hence is invalid.  Patent law recognizes that non-technical “secondary considerations” such as commercial success and licensing success are evidence for or against the validity of a patent. The artificially low price fits nicely into this rubric, because it demonstrates with a hard figure that, immediately after the invention, Google did not see the patent as being a substantial innovation. Additionally, the expert documentation justifying the low price may include damaging language downplaying the patent’s innovativeness.

Second, the defendant should argue that, even if the patent is valid, it has a narrow scope. Courts give innovative patents a broad scope that allows finding infringement whenever the infringer uses a close equivalent to the claimed invention. By contrast, less-innovative patents are given a narrower scope. The low transfer price is evidence that Google did not perceive the patent as particularly innovative, and thus should receive a narrower scope. Again, the expert documentation justifying the low price will often include damaging language downplaying the innovation.

Third, even if the court finds the patent valid and infringed, the defendant should be able to point to the low transfer price as evidence that damages should be correspondingly low. After all, a patent’s price reflects its potential to generate profits and royalties, and patent damages replace the patentholder’s lost profits and royalties.

Fourth, patent plaintiffs typically request a preliminary injunction against infringement and, if they prevail on the merits, then request a permanent injunction. But a low price for the patent suggests that infringement is unlikely to cause Google “irreparable harm,” which is required for injunctions. The low price also suggests Google does not come out ahead on the “balance of hardships,” another requirement for injunctions. Additionally, as discussed earlier, the low transfer price is evidence of invalidity and narrower scope, both of which suggest Google has a lower “likelihood of success on the ultimate merits,” a requirement for a preliminary injunction.

Finally, even if the court finds Google’s patent valid and infringed, the defendant should be able to argue that Google’s tax avoidance was “patent misuse.” When a court finds that a patentholder used the patent in a way that violates public policy, it will refuse to award damages or injunctive relief, at least until the misuse has been remedied. Misuse does not require that the patentholder harmed the defendant, only that the patentholder used the IP in a way that violated public policy. If the court finds Google’s tax avoidance sufficiently egregious, it could refuse relief to Google until it has repaid the U.S. Treasury the taxes it improperly avoided.  

Professor Stanek also discusses how copyright and trademark law have similar doctrines, such as copyright fair use, strength of the mark and secondary meaning, and damages that could be used to incentivize valuations closer to “actual valuation” and how the theories underlying IP protection support his proposals.  Notably, he states that usage of the initial transfer valuation could be used to undermine the IP holders royalty negotiation position if his proposals are adopted.  Do readers know of situations where the initial transfer valuation has been used in negotiating royalties, arguing damages, or in arguments concerning the scope or validity of IP?  (Hat tip to Professor Paul L. Caron’s (Pepperdine University) Taxprof blog for a lead to the article). 

Denmark's new transfer pricing IP valuation guideline

Skat's (Denmark's tax authorities) have issued new guidelines on IP valuation entitled "Transfer Pricing, controlled transactions, valuation". Google's handy translation tool will translate the lengthy download in the link for interested readers. Deloitte's summary provides the once over:

"The new guidelines significantly change the generally accepted approaches to valuing individual intangible assets, as well as entire businesses, for Danish transfer pricing purposes. The guidelines focus on forward-looking valuation approaches, which are generally in line with the methodologies followed by most taxpayers. However, the documentation requirements included in the guidelines are broad and extensive and not well-defined. Accordingly, the guidelines should be considered in detail when contemplating IP or business reorganizations involving Danish groups or entities." Deloitte

Transfer Pricing Focus Study by E&Y: Africa

Transfer pricing is the most important international tax matter after valued-added tax and double taxation [affecting SA multinationals], according to a study released by Ernst & Young at the weekend and reported by Business Day here. SA, Namibia, Kenya, Mozambique, and Tanzania have introduced laws dealing with transfer pricing. Other countries tax multinational companies’ transactions under anti-avoidance sections of their domestic tax legislation. About 40% of multinational companies in Africa prepare documentation on a single country basis, modified to meet the needs of specific jurisdictions, rather than on the co- ordinated basis. More than 20% of companies acknowledged that they did not prepare transfer pricing documentation. The research was based on independent interviews with 40 participants in Anglophone Africa in August and September last year.