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June 24, 2013
Economic Analysis: The 3-Way Tug of War for Intangible Profits
by Martin A. Sullivan

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by Martin A. Sullivan

Let's keep it simple. There are basically three approaches to taxing intangible profits. They can be taxed where intangibles are developed, where products are sold, or where the costs of intangible development are funded.

Under the first approach, a U.S. multinational that does all of its research in the United States would include all of its profits from its U.S.-developed technology and patents in its U.S.-source income. Income from marketing intangibles like trade names and trademarks would be divvied up among U.S. and foreign locations in proportion to the amount of marketing activity that takes place in each jurisdiction.

Under the second approach, profits from intangibles would be booked where sales to unrelated parties occur. For marketing intangibles, there may be a lot of overlap between this and the first approach because marketing activity will often occur in the same location as sales. But for production intangibles like patents, there is a world of difference. For your typical U.S. multinational (for example, Apple), a much smaller share of profits would be taxed in the United States under this approach than if intangible profits were booked where research takes place.

Under the third approach, profits from intangibles are assigned to the location of the entity that pays for the development of intangible assets. This approach is embodied in a typical cost-sharing agreement. In these arrangements, a U.S. parent company is assigned the U.S. rights to an intangible asset and a foreign subsidiary in a tax haven is assigned the foreign rights. The U.S. parent books the income and pays its share of development costs (usually in proportion to the U.S. share of worldwide sales). And in return for paying the foreign share of development costs, the foreign subsidiary books all the foreign intangible income.

Because the three approaches have widely different implications for the distribution of corporate tax revenue among governments and for the worldwide effective tax rates paid by corporations, international tax reform cannot really proceed until tough choices are made. At the House Ways and Means Committee hearing on June 13, all three approaches received a lot of attention. Unfortunately for those who like to be optimistic about the prospects for tax reform, the hearing clarified that sharp differences of opinion remain on the critical issue of where intangible income should be subject to tax. (Prior coverage: Tax Notes, June 17, 2013, p. 1373.)

'Value-Creating Activities'

In his opening statement, Ways and Means Committee Chair Dave Camp, R-Mich., remarked that concerns about base erosion were warranted because multinationals book income for tax purposes in locations separate from "the jurisdiction in which the economic activity takes place." The use of the word "activity" (here and elsewhere in his statement) would seem to imply that Camp is leaning toward more closely tying intangible income to the location where development or sales occur. However, it could also be interpreted -- certainly by business advocates -- as meaning that some intangible income may be allocated to affiliates in tax havens that fund development as long as they perform some yet-to-be-determined business activity. It would also seem to imply that intangible income may not be allocated to pure shell corporations that have no employees and do not physically perform activities (even if they outsource those activities).

The first witness at the hearing was Pascal Saint-Amans, director of the OECD Centre for Tax Policy Administration. On the topic of where to assign intangible income, the remarks of Saint-Amans were generally in line with those of Camp. Base erosion and profit shifting take place because multinationals are "often able to artificially separate their taxable income from jurisdictions in which their income-producing activities occur," Saint-Amans said. Multinationals have advantages over domestic firms because some reduce their taxes by separating their income from the jurisdictions in which they operate, he said, adding that to address base erosion and profit shifting, countries will need "to better align taxation and the substance of taxpayers' value-creating activities." And transfer pricing rules should be improved to address "the use of intangibles and the shifting of risk to separate taxable income and value creation," he said.

As with Camp's remarks, Saint-Amans's statement would seem to be leaning in the direction of allocating intangible profits to where research is done or where sales are made. But some could interpret it as allowing funding to be a factor if sufficient activity takes place in the entity doing the funding.

However, it is important to note that Saint-Amans was significantly less adamant about the role of physical activity than the OECD June 2012 discussion draft on transfer pricing for intangibles. That document stated that "the entity claiming entitlement to intangible related returns will physically perform, through its own employees." The statement was blasted by the business community in comments submitted to the OECD. Based on Saint-Amans's testimony and other public statements made by OECD officials, it seems likely that the OECD will respond to the withering criticism and recommend that a subsidiary that funds intangibles be entitled to some share of intangible profit as a return for that funding. (Public comments on the discussion draft are available at For a discussion on why the funding entity is entitled to a return but may still be taxable outside its jurisdiction, see Tax Notes, May 27, 2013, p. 973.)

'Knock-Down, Drag-Out Fight'

Edward Kleinbard, a professor of law at the University of Southern California Gould School of Law, was clearer than either Camp or Saint-Amans about where intangible income should be taxed. Kleinbard, a former chief of staff of the Joint Committee on Taxation, considered allocation by reference to where development activity takes place and allocation by reference to where sales occur to both be legitimate approaches. He said he would let politicians defending their nations' interests decide between the two. In response to a question, Kleinbard told the committee: "In my worldview, we ought to end up with a knock-down, drag-out fight all the time between the country of residence and the country of what I call source or the market country, where things are actually sold."

But Kleinbard had nothing nice to say about the third approach, which would allow income to be allocated to subsidiaries in tax havens. "What cost-sharing agreements as currently practiced do is siphon money off between the two legitimate claimants -- between the home country and the market country -- to nowhere. That's why I call it stateless income," he said.

Kleinbard provided four arguments for not allowing U.S. multinationals to create stateless income. First, although much of the income that ends up in tax havens has been shifted from other foreign jurisdictions, some of it is income that has been shifted out of the United States. Second, U.S. firms should not be allowed to engage in tax arbitrage in which they capitalize subsidiaries with equity while they deduct their global interest costs against domestic taxable income. Third, the ability to create stateless income creates large, distortionary incentives for U.S. corporations to invest in high-tax foreign countries. And finally, if the United States promotes its own multinationals by tolerating stateless tax planning, other governments will surely do the same. This will lead to a trade war with a "beggar-the-neighbor race to the bottom, where multinational firms collectively will be the winners and taxing jurisdictions will be the losers," Kleinbard said.

Cost Sharing and Sales

Unlike Kleinbard, who remained essentially neutral between location of development activity and location of sales as the preferred reference for sourcing intangible income, Paul W. Oosterhuis of Skadden, Arps, Slate, Meagher & Flom LLP strongly endorsed allocation by sales. As noted previously in these pages, this is an approach that is favorably viewed by several academics. Oosterhuis argued -- as has Apple CEO Tim Cook -- that Apple should not be viewed as improperly shifting profits outside the United States, because profits should be allocated in proportion to sales. And, as Oosterhuis pointed out, when individuals and legislators in the United Kingdom complain about the lack of tax paid by Amazon, Starbucks, and Google, they are essentially taking the position that the location of sales should determine the location of taxable profits.

Oosterhuis provided good, practical reasons to favor location of sales over location of development activities. If the United States tried to source all intangible income according to the location of product development activity, it would face strong head winds from market countries like China and India. Perhaps more importantly, Oosterhuis said he believes that if income is taxed where activities are located, it would provide large incentives to migrate research and other high-value activities outside the United States.

Kleinbard countered that his own experience in practice has shown that it is difficult to get highly paid professionals to migrate for tax purposes. But Oosterhuis stressed that although there may be no highly visible outflow of activity in the short run, the revision of tax laws under consideration is likely to be in place for a long time, and that over the long run the United States runs serious risks. "If we proceed with an 'origin-based' allocation of profits to product development activities, I worry that 30 years from now we could observe a migration of such activities that parallels the migration of manufacturing activities over the past 30 years," he said.

The largest source of disagreement between Kleinbard and Oosterhuis was on the role that funding intangible development plays in the allocation of intangible income. Stressing the critical importance of the concept of matching income with expenses, Oosterhuis argued that under the arm's-length standard, entities that fund intangible development are entitled to at least some of the returns on the investment.

Overall, Oosterhuis seems to be adopting a two-step approach for the allocation of intangibles, similar to that of Cook. For the division of profit between U.S. and non-U.S. locations, sales should be the allocation factor. As for the allocation of income among non-U.S. locations, foreign income can be allocated to tax havens if those entities bear costs related to foreign sales and income. Oosterhuis argued that tax planning that lowers foreign taxes and improves the competitiveness of U.S. companies is in the U.S. national interest. And there is little doubt that Congress agrees. Oosterhuis cited Congress's opposition in the late 1990s to the IRS's attempts to withdraw the check-the-box regulations and its subsequent affirmation of foreign-to-foreign profit shifting with its enactment of look-through rules.

In summary, while Kleinbard sees cost-sharing arrangements as a major cause of the problem of base erosion and profit shifting, Oosterhuis sees cost-sharing arrangements, with some improvements, as being part of the solution to the problem. What improvements? Oosterhuis would like to see cost-sharing arrangements mandated for inbound as well as outbound product sales. So, for example, the United States would impose tax on income from German-developed intangibles embedded in products sold in the United States. Oosterhuis would expand the scope of shared costs beyond product development expenses to global marketing and administration expenses. And he would allow the service provider to receive a markup on the costs it incurs rather than a simple reimbursement.


Of all the different aspects of U.S. tax reform, probably the one that has gotten the most attention is the reform of international tax rules. But the wide divergence of views on display at the Ways and Means Committee hearing suggests it may be a long time before Congress can pass legislation on the topic. Nor is the OECD going to move quickly. Saint-Amans told the committee he expected it would generally take the OECD two years to finish its work on base erosion and profit shifting.

Kleinbard would keep profits out of tax havens and in the countries where most business activities take place. Business hates the idea, but if the OECD wants to win G-20 approval -- assuming those governments still want the revenue and still want to placate public concerns about corporations not paying their fair share -- that is the general direction the OECD will have to take.

Oosterhuis would allow profits to follow sales and funding out of the United States, and then once out of the country, he would allow some of it to go to tax haven subsidiaries as long as they properly bear the costs of the development. That is not likely to be a winner with the G-20, but if history is any indicator, it is an approach that Congress would have little trouble approving.

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