Book review by Elisabeth Walliser (GRM)
Rubrique Trends and comments
VALUING INTELLECTUAL CAPITAL. MULTINATIONALS AND TAX HAVENS
Wiederhold Gio (2014), Valuing Intellectual Capital. Multinationals and Tax Havens, Springer, 543 pages.
Book review – Elisabeth Walliser
In the foreword to his work Gio Wiederhold warns us that intellectual capital will not be discussed in a broad and philosophical way; it is rather a question of focusing on its use in multinational corporations. According to the author, it is indeed the exploitation of this intellectual capital which allows these companies to generate the income that is essential for their functioning and their growth. The possibility of valuing intellectual capital properly is also required in order to formulate adequate economic policies. The objective is thus as follows: to make understandable the fact that, using legal means, multinationals succeed in minimising corporate taxes, therefore reducing the income of a State that is needed, amongst other things, for education and public services. At the same time, these legal means increase the wealth of corporations and their owners. The author, an emeritus professor at Stanford University, draws support from American regulations and illustrates his remarks with a fictitious Californian multinational (MNC) that is growing in the advanced technology sector, which succeeds in gradually decreasing the tax burden via the valuation of its intellectual capital and the use of transfer prices.
How is this work structured? In 10 different chapters.
The first chapter explains the way that a 21st century multinational functions. The various functions of a company are fragmented in various countries, according to the skills of each division, with the knowledge that design and development remain the responsibility of the parent company in the United States. As with most American companies, MNC employs a controlled foreign holding (CFH) company in which it can park intellectual assets and shelter these. This holding company is situated in a tax haven. MNC is an innovative company that obtains a high value-added product thanks to expenses relating to intellectual capital: R&D expenses, marketing etc. The product thus generates a significant margin. According to the author, “workforce and intellectual property (IP) rights make up the intellectual capital of a business” (p. 4). The workforce includes managers, designers, engineers and marketing staff. IP are assets legally protected by patents, copyrights, registered trademarks or trade secrets. An intellectual capital-intensive product thus allows “non-routine earnings” to be generated, in other words a difference of income compared with commodity products.
The second chapter supplies a detailed example of the way in which intellectual capital is created and exploited. If some subsidiaries manufacture and distribute products, other subsidiaries are motivated solely by tax avoidance. This is the case when a multinational uses a subsidiary domiciled in a tax haven, to which it transfers a tranche of ownership rights to IP, generating important earnings. In return this subsidiary has to make a buy-in payment to reimburse MNC US for the right to use that IP on the basis of a transfer price determined by tax advisers. Sheltering US-sourced earnings offshore allows MNC to avoid US tax on such earnings.
The third chapter reviews the various elements that comprise the intellectual capital of a company, while the fifth chapter sets out the available valuation methods. As these elements are usually dealt with in articles and works dedicated to intellectual capital, we recommend that the reader should instead spend more time on the fourth chapter, which approaches the valuable notion of transfer pricing in a more precise way. “Paying for the exchange of property among divisions of a company is called transfer pricing”. In a multinational transfer prices are, indeed, at the heart of the tax avoidance plan because they valorise the internal sale of IP rights between subsidiaries that are part of the same group (p. 63). The difficulty lies in fixing the transfer price that is supposed to reflect a “true arm’s length” business situation. The transfer price of IP requires an estimate of the income it will earn in the future. In fact, because subsidiaries are linked to each other, other parameters, in particular fiscal ones, are taken into account in order to avoid taxation. Transfer prices are therefore not submitted to the simple game of the market.
The sixth chapter deals with tax havens. There are various tax havens (p 152), some (primary tax havens) host shell corporations that hold financial capital and IP rights. Others (conduit tax havens) facilitate the opaque transfer of funds. Finally, the last ones (semi-tax havens) encourage business to establish manufacturing.
The seventh chapter clarifies in more detail the leading role played by tax advisers in underestimating the transferred IP rights. Yet, according to the author, “once a business model is based on exploiting a misevaluation, it cannot be reversed (p. 200).”
Whereas the eighth chapter is dedicated to the American tax system, the ninth chapter looks in detail at the effects of tax avoidance on the national economy and underlines the responsibility of multinationals in the seizure (confiscation) of the wealth which should return to the workforce.
The tenth and final chapter concludes with lengthy recommendations to reduce tax avoidance that the author considers to be harmful (p 263). He sets out the changes to fiscal rules and measures that are possible to enable transparency and fairness in the way taxes are collected. Finally, the author even recommends the abolition of corporate income taxes (p. 321).
In this book, the reader emerges with a clear vision on a complex problem: tax avoidance via the use of transfer pricing dealing with IP rights. The demonstration of this, via a fictitious example, is very educational. We can thus recommend this book to those who wish to approach the complexity of financial plans (montages financiers) that involve intellectual capital.
Nevertheless, we would have liked to find more explicit references to current events in the book. We remember the Bloomberg investigation which, in 2010, revealed the actions of Google, who applied transfer pricing via Ireland and Bermuda. Indeed, whereas the European activities of the multinational were managed by Google Ireland Limited, IP rights were controlled by Bermuda-based Google Ireland Holdings (GIH). The Irish company thus had to return royalties to GIH. Now it turns out that these royalties corresponded approximately to the profits that Google realised in Europe. In addition, profits also passed via transit through the Netherlands, with the country exempting profits that exited its borders to go to Bermuda. In the end, this trick allowed Google to pay only 2.4% of taxes on profits outside the United States. (http://www.bloomberg.com/news/articles/2010-10-21/google-2-4-rate-shows-how-60-billion-u-s-revenue-lost-to-tax-loopholes)