1. 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

2. 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

3. 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

4. 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).

5. 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 (May 30, 2008) (emphasis added).

6. 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

7. 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 ; IRB 1, 2008 TNT (Mar. 27, 2008).
Raw materials businesses may be different, but I suspect Exxon would agree.

8. 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.

9. 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.

10. 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.

11. 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