International Tax Policy Forum Business Income in a Global Economy Ronald A. Pearlman Georgetown University Law Center Washington International Tax Policy Forum October 3, 2008 © Copyright 2008 Ronald A. Pearlman

Cross-border taxation of income attributable to intangible property. Overview Cross-border taxation of income attributable to intangible property. Two big questions: (1) The really big question -- Is the race to the bottom inevitable? (2) The moderately big question -- Is the arm’s-length method doomed? Intellectual property Race to the bottom – taxation of income from capital

Back then, life seemed so simple. A machine was a machine – it had a cost, and it had a selling price. In business acquisitions, all too often premiums were capitalized as non-amortizable goodwill. 1969, after 4 years with the CC

But, the world has changed. As businesses, aided by more detailed economic analyses, recognized the importance of intellectual property in all of their operations. Mortgage servicing and bank core deposits (circa 1969). Growth of allocation disputes (largest category of coordinated exam issues). Section 197 (1993).

As a result, in the integrated development, manufacture, and distribution of tangible products by multinational businesses, there is much more focus on the intangible components of the enterprise. “The APA program has seen an increasing number of cases involving transfers of intangibles . . ., [Craig] Sharon [Director, Advance Pricing Agreement Program] noted. Overall, he said, he expects these trends to continue as the information age matures globally. In general, ‘transfer pricing provides a window into what's happening in the world,’ he said. With multinational companies becoming more mobile and more dispersed and as intellectual property increases in relative value, Sharon said, he expects to see "an increase in the volume, variety, and complexity of transfer pricing transactions generally." Lisa M. Nadal, “New Director Shares Goals and Expectations for APA Program,” 2008 TNT 105-4 (May 30, 2008) (emphasis added).

Businesses Identify and Attach Value to their Intangibles Research and development Product design and engineering Process engineering Manufacturing Technical training Purchasing and materials management Product testing and quality control Product assembly and/or packaging Distribution Transportation and warehousing  Marketing Technical support for sales staff, including those of independent distributors Product service Managerial, legal, accounting, finance, personnel, and other support services And more

The 2007 APA Annual Report “The majority of APAs have Covered Transactions that involve numerous business functions . . . . For instance, . . . multinational groups that manufacture products typically conduct research and development, engage in product design and engineering, manufacture the product, market and distribute the product, and perform support functions such as legal, finance, and human resources services.” (Announcement and Report Concerning Advance Pricing Agreements, IRS Announcement 2008-27; 2008-15 IRB 1, 2008 TNT 61-15 (Mar. 27, 2008). Raw materials businesses may be different, but I suspect Exxon would agree.

Each function has value. Frequently resulting in the identification of intangible assets that account for the lion’s share of the value of a business. Leaving relatively little value in hard assets -- machinery, equipment, and other tangible and real property.

With What Results? 1. The source rules, which give primacy to geographical location of the ownership of intangibles, are defective. Attaching value to an intangible asset at the place of ownership even though it is exploited elsewhere facilitates the misallocation of business profits across borders. Intangibles can be “located” anywhere, subject to local law intellectual property constraints. Thus, the attraction of tax haven jurisdictions. Transfer of ownership of intellectual property from one country to another: Implicit cross-border transfers in connection with cost-sharing arrangements. Explicit transfers of intangibles is just too easy, indeed, often unintentional and not tax-motivated. Fail to recognize the multi-jurisdictional relevance of the intangible.

With What Results?, cont’d. 2. The permanent establishment concept is outdated. In a world where intangible property can be exploited without the owner, i.e., a software developer, being physically present, the requirement of a permanent establishment for the taxation of business profits attributable to the intangible cheats the market/destination jurisdiction.

Concluding Observations Unless the source rules are changed and the current permanent establishment concept rejected -- 1. The relative ease with which large portions of business profits may be converted into compensation for the use of intangible property, and the ability to locate intangibles in zero- or low-tax jurisdictions, makes the race to the bottom with respect to the taxation of income from capital inevitable. 2. Given the ability to manipulate the place where business income ultimately is taxed (or not) through deductible royalty payments, developed and developing countries that seek to preserve their business tax base will abandon the arm’s-length method? We know than