IBSA members were treated at their bi-monthly discussion group meeting on 2nd March to an analysis of how to identify, protect, value and exploit intellectual property. Based on two case studies, one an independent boys’ school established in 1701 licensing its name to a Chinese group, and the second a newly created premium gin distillery, IBSA’s panel of experts spoke for just over an hour on the issues described in this month’s newsletter article.
Although the article interestingly describes mainly non-tax issues relating to IP, the international tax ramifications of profit allocation across borders is likely to give rise to lengthy and costly tax disputes. The ‘modified nexus approach’ referred to at the end of the article is just one example of how tax administrations are going to make assessments based not on legal ownership nor established understanding, but on arbitrary profit allocation. The Google example in last month’s IFS newsletter is a good example of how the concept of permanent establishment is being extended beyond existing law, undoubtedly leading to more disputes in the future.
I have arranged a workshop for the IBSA on 12th April [click here] to study the ramifications of such arbitrary assessments in the absence of definitive and conclusive mutual agreement procedures between multinational tax administrations. We are fortunate to have HMRC’s head of transfer pricing participating in the workshop who is responsible for the mutual agreement procedures in the UK. Also participating will be Philip Baker QC, a leading and influential international tax barrister, Keith Brockman, tax director at Mars Ltd, and Philippe de Saint-Bauzel, French lawyer with Squire Patton Boggs who are the hosts for the workshop.
There is no doubt that we are tumbling into unchartered waters if the Action points of the BEPS initiative are adopted in part or in entirety. But regardless of tax implications, understanding that 80% of global corporate wealth is in their intellectual property demands a thorough awareness of the need to fully understand such a valuable asset.
Identification
Using the two case studies to illustrate the range of intellectual property identified, we started with the school entering into a licence or joint venture agreement with the Chinese group, giving it an exclusive right to use the name and brand in China. The school would also provide its know-how, curricula, course materials and consultancy services in consideration of an up-front payment and an annual royalty based on fee income. The school is aware that although it has registered its trade name, the unregistered rights relating to the longevity of its brand and the goodwill attached to it, and the copyright in its course materials and know-how, are unprotected.
The gin distillery business has registered its name as a trade mark, and has also attempted to register the particular taste of the gin it distils. It has a website which provides online distillery tutorials which is growing internationally, as well as a social media following of over 500,000 individuals. It wants to broaden its merchandising and brand possibilities to other products such as clothing and sports equipment. As with the school, its intellectual property is partly protected through local trade mark registration of its name, but the copyright in its logo and packaging, and the very significant database of its followers are incapable of protection.
In both cases, the companies need to consider what they can protect, where they should seek protection and critically how much they need to spend on such protection.
Protection
The discussion group recommended that the school should search the trade mark register in China to see if there are competitors with earlier rights in identical or similar names. It may be that individuals have registered speculative trade marks in the hope of ransoming legitimate owners who want to create such licence agreements, and although there is a code of conduct for lawyers in most countries preventing spurious applications, this code may not be universally applicable.
When registering a trade mark, the school may simply require registration under the category of education services. But the gin distillery may wish for a much broader range of protection with a view to licensing and merchandising, although the broader the range of services/products, the more likelihood there is that other registrations may already exist under conflicting trade marks.
There is no global trade mark registration, so the next issue is in which countries registration should be made. Local registration in one EU country may be made, but this can be extended to all 28 EU countries through a Community Trademark costing just €900 for 10 years! Then the Madrid Protocol is a bundle of national trade mark rights which may protect companies when licencing their names in countries such as the US, China and Japan, which is also cost effective.
Whether registration is worthwhile depends on whether a company can use such registration for protection within a particular country. However, there may be a need for registration to satisfy the due diligence requirements of investors and bankers who may be more impressed with documents of registration than the relevant company merely having traded profitably for many years.
Valuation
We then addressed the issue of valuation and royalty rates. Maybe the school has no intention of selling its IPRs and merely wishes to licence the rights, but perhaps it wishes to open its own schools in other Asian countries once it has experienced the problems and opportunities in China, for which it needs to raise finance. The banks or investors will require a valuation which will take into account not only the registered trade mark but the other identified IPRs. The valuation will also depend on the licensing agreement entered into, with issues such as exclusivity, term and jurisdiction dictating whether a premium or otherwise on valuation is required.
The gin distillery company may wish to expand its horizons and may contemplate developing a group structure where a foreign entity is to own and exploit the brand. In this case, the valuation will take into account the desire of the local tax administration to ensure a fair market value is attributed to the IPRs as a package. Or perhaps the IPRs are to be charged to pension fund trustees to secure an advance from an existing pension trust for business development.
For the gin distillery, creating a strong brand in a very competitive field may dictate a lower valuation. Moreover, value can be enhanced through licensees, and it must be established who has the rights to the enhanced value of the IPRs going forward.
Unfortunately, where bank finance is concerned, valuation of IPRs in a going concern may not be acceptable to the banks, whose Domesday approach to business also may require a valuation based on a forced sale basis pursuant to a liquidation of the going concern.
It is unfortunate that accounting standards do not enable companies to reflect the value of their IPRs on their balance sheet, other than merely the cost of their development. Otherwise, a company could revalue its IPRs to current valuation with a corresponding Reserve account in Shareholders’ funds. This would clearly demonstrate to banks, investors and customers that the company has a valuation in excess of merely share capital and retained earnings. This is especially relevant since 80% of global corporate wealth is in undervalued intellectual property. However, it was explained that only in circumstances of a merger or acquisition do current Accounting Standards, lamentable as they are, allow for the recognition of intangibles in Accounts; in-house developed IP cannot be shown at fair value.
The meeting then considered whether an inter-group sale could achieve this objective whilst allowing for tax efficient exploitation of the IPRs. This has tax implications which I explain below. Another technique may be to illustrate the value of in-house IP, its management and exploitation by say licensing, in an accompanying Operational Review document, a technique used by some of the major IP rich companies. There is no reason why SMEs cannot adopt the same strategy.
Exploitation
As regards the tax implications of an inter-group transfer of IPRs to a more favourable tax jurisdiction, this will result in a taxable disposal which will be calculated by the excess of valuation over acquisition and development costs. However, this would enable the acquiring group entity to reflect the full value on its balance sheet. The tax cost may be worthwhile if the IPRs are likely to increase substantially in value, and if royalty income from the exploitation of the IPRs is to be receivable in a low tax jurisdiction.
In the case of the school, being a registered charity, such a transfer of rights is unlikely and would be carefully monitored by the Commissioners. The gin distillery may however think this is a suitable strategy, subject to reputational issues should these affect the brand’s value. The valuer of the IPRs may also be requested to determine the royalty rate applicable to licensing arrangements so that transfer pricing adjustments can be countered with such independent documentation.
Many countries such as Malta, Cyprus, Luxembourg and Ireland have had advantageous tax regimes applicable to certain types of intellectual property, although the European Commission have determined that some of these regimes provide unacceptable State Aid. These jurisdictions have therefore adapted or even repealed their regimes to fall within accepted EC wisdom.
But another problem has raised its head, being the OECD BEPS initiative where countries are required to adopt the ‘modified nexus approach’ in relation to intangible assets, meaning that income from intellectual property rights should be where the initial risks and development work have been undertaken. Thus legal ownership (through acquisition) may not be sufficient to allow profits to be allocated for tax purposes to the relevant legal entity, and not to those entities where the risks and development work occurred.
With just one minute to go before the discussion group dispersed to a cocktail party of wine and nibbles courtesy of Farrer & Co, we fielded the question of the consequences of ‘Brexit’ on the Community Trademark and other aspects of European co-operation in the field of intellectual property (for example the Trade Secrets Directive or the protection of consumers from database infringements). Unsurprisingly, we agreed to leave this question for another occasion as this Molotov cocktail should not spoil our enjoyment of a more welcome cocktail.
For those readers who have not been to IBSA discussion groups which are held for IBSA members four or five times a year in London and in various other venues globally (Hong Kong, New York and many European capitals), the IBSA stands for the International Business Structuring Association (click here for the website). It is the only global association which is both multi-disciplinary as well as multi-jurisdictional, operating through four regional branches (Dubai to be added in October this year), and providing both knowledge in areas of expertise outside of members’ own area of knowledge, as well as informing members who to ask for advice in such areas should that be necessary. Having been established for just 2 years now, we are now pursuing a membership drive; if you would like further information, please email me or Joanna Bott.
With kind regards
Roy Saunders