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There's something in the water

Category Technical Articles
AuthorTechnical Department
Article by Andrew Casley and Jonathan Spalter published in the May 2002 issue of Tax Adviser.

The authors are a partner and consultant respectively in the Business Transformation group of PwC’s tax practice in London. The views expressed in this article are those of the authors and not necessarily those of the firm.

What is it that the Water Bar has managed to do in order to create a successful business and is it sustainable? and as far as tax is concerned, does it even matter? KEY POINTS


  • Identifying what the IP actually consists of is key to being able to value it for both tax and accounting purposes
  • Within three years, it is likely that business acquisitions by EU listed companies will involve separate disclosure of the value of the different intangible assets acquired
  • Transfer pricing implications indicate that tax professionals may have to get more involved in how a group’s IP is actually being used in the business
  • Constitutional differences between the UK and Europe have led to different outlooks towards tax-planning
  • Company and contract law within the UK are very laissez faire
  • Separation of steps in a transaction is an important tool of tax planning.

The Water Bar opens on a sunny day in June. Its product? Water. Still, fizzy, flavoured, laced, ice cold, steamed, pints, shots, Australian or French. The décor is minimalist, glass and fountains, dark wood and steel, that kind of thing. It’s a hit. The City types love it, the clubbers go wild for it and the treadmill thousands lap it up. The summer is long and the Water Bar has entered the scene at just the right time. The venture capital providers are talking to the owner about expansion, franchising and initial public offerings (IPOs).

But where is the value? You could walk into the kitchen now and run yourself a satisfying cup of chilled water straight from the tap for close to zero cost. What is it that the Water Bar has managed to do in order to create a successful business and is it sustainable? And as far as tax is concerned, does it even matter?

We all know that a new legislative framework is now in place in the United Kingdom (UK) for the taxation of intellectual property (IP). However, it is not only the tax changes that will drive the tax professionals’ interest in what makes, as an example, the Water Bar successful. The accounting rules are changing significantly, the law is changing and a recent survey has provided a revealing and surprising insight into the approach taken by companies in relation to IP*.

The environment

On 1 April 2002 the UK tax rules for IP underwent a radical overhaul, driven by the
government’s competitiveness agenda. The changes make available additional tax
reliefs for the cost of purchased intangibles. They also make the tax treatment
of intangible assets more complex than ever. Readers will already have recognised the need to review the way in which companies acquire, own and exploit intangible assets to ensure that they maximise the benefits and minimise the exposures caused by the new tax regime.

But that is not all. This is a time of significant change in relation to the financial environment surrounding IP, largely as a result of the rules affecting accounting (most immediately in the United States (US) and for non-US companies using US generally accepted accounting principles (GAAP)); the law on IP; and the UK and international environment for transfer pricing.

In the area of financial reporting, the US accounting standard-setters now require business combinations to be accounted for using acquisition accounting. The new regime applies for business combinations initiated after 30 June 2001. One effect of the change is that businesses reporting under US GAAP must recognise and disclose the fair market value of the particular classes of intangible assets acquired in their accounts. Previously, most business combinations could apply an accounting treatment which allowed them to pool
the acquired interests with existing business interests and disclose most of the IP as ‘goodwill’. Additionally, the value at which these assets are shown in the accounts must be reviewed at each balance sheet date using a special framework of rules to ascertain whether value has been impaired; impairments may lead to a charge to the profit and loss account.

This now directly affects nearly all businesses which have securities listed on a capital market in the US. However, similar rules are likely to affect businesses in the UK and Europe as international accounting standards (IAS) are implemented. IAS are expected to drive the introduction of national accounting standards similar to the US model. Currently, 2005 is the proposed deadline announced by the European Union (EU) for IAS adoption for listed companies in the EU; the impact of this is that, within three years, it is likely that business acquisitions by EU listed companies will involve separate disclosure of the value of the different intangible assets acquired, using an accounting framework which draws on the new US model.

The current UK accounting standards, which philosophically view the majority of
intangible assets as part of business goodwill, are a very long way from this. The forthcoming change reflects the views of valuers and economists – the following example is drawn from a fairly standard text book:

‘Goodwill value rises from failures to properly value intangible assets and intellectual property. All of the positive attributes and characteristics cited as evidence of a goodwill asset are really attributes and characteristics of specific intangible assets and intellectual property.’**

The book’s authors go a long way down this road, for example dealing separately with the value of an experienced labour force. It is debatable whether tax professionals will ever need to go this far in formal terms, but it is a good example of how much more of an understanding we all might need of where the value in a company arises. If and to the extent that the value is in the labour force, then it is not in the trademarks, the patents or the property leases.

Pursuing the Water Bar example, trademarks and property (location) are easy to see, but what about patents? Another area of movement in the IP arena is with regard to business method patents; these are available in the US. An EU Draft Directive has now been issued to address this specific topic and it is proposed a similar form of patent protection will be introduced to the EU. Interestingly under a quarter of respondents to our survey felt that these were needed or wanted which may indicate that our US counterparts are more alert to the protection available to them and to the need to protect both business methods and software.

Similarly, the EU Copyright Directive was approved last year, yet 68 per cent of respondents to the survey (who had identified themselves as the person most knowledgeable about IP in their organisation) knew little more than that it existed.

The findings in the survey suggest that a major change in information flows and in skills required in commercial management (the protection available), in accounts preparation (recognising value) and, thereby, tax must necessarily take place over the next two or three years.

The Results

Tax advisers and in-house tax professionals will be expected to consult on the IP ramifications of the full range of queries from transfer pricing issues to current rule changes. Before anyone can really start understanding this area four fundamental questions are inescapable: What IP exists? Who owns it? Who uses it? What is it worth? Unfortunately, the survey demonstrates that quite apart from tax, companies are likely to have widely varying approaches to IP.

What is the IP?

‘As any fule kno’ (even Molesworth) the term Intellectual Property is distressingly broad. Sticking a pin in a book of tax treaties yielded the following (proxy) definition from a royalties article:

‘any copyright of literary, artistic or scientific work (including cinematograph films, and films or tapes for radio or television broadcasting), any patent, trade mark, design or model, plan, secret formula or process, or … the use of, or the right to use, industrial, commercial or scientific equipment, or … information concerning industrial, commercial or scientific experience.’***

The water business has long been used by economists (for example in oligopoly theory) because input costs can be assumed to be very low. The point of the Water Bar example, then, is the question of what the IP might actually be – because most of the value is elsewhere than in the product.

As a result, identifying those ‘specific intangible assets and intellectual property’ referred to by Smith & Parr has often been rapidly consigned to the ‘too difficult’ pile. Two things are true today: first you won’t get the tax right if you haven’t worked out what the valuable IP actually is, and second when the company does such an exercise for accounting purposes tax consequences will follow.

So who will identify the IP? Forty seven per cent of respondents to the survey answered that the legal department in their company holds responsibility for the legal, financial and tax management of IP, 24 per cent answered company secretariat and 12 per cent finance. Only ten per cent of all respondents have a dedicated IP specialist. Of the lawyers responding to the survey (which was conducted by telephone interview) precisely zero per cent claimed any familiarity with transfer pricing rules. A similar result may be expected for the new tax regime. Tax practitioners are likely to have to work much harder with the other IP specialists in an organisation if the tax implications of IP and current changes are to be properly addressed.

Who owns the IP?

The survey indicates that parent companies and special purpose IP companies within a group tend to own a group’s IP. Typically, then, the question of who will be the registered owner of IP has been determined by administrative efficiency and convenience. There is also evidence that attention is only really paid to the IP elements people are interested in, e.g. patents and trademarks. The ownership of other forms of IP may be more widely dispersed, there may be local legal and tax implications and these may all be quite difficult to pin down.

However, if some of these other forms of IP are going to start being recognised in balance sheets they are about to become highly visible. Tax professionals may need to be involved in any process of determining just what the IP is and which entity owns it, if only to ensure that the issues that are then thrown up can be addressed on a timely basis.

Who uses the IP?

Over half of all companies surveyed state that their IP is used by third parties. This is indicative of the wide potential uses of IP both within a group and elsewhere. Yet despite the potential for third party IP revenues, less than a third conduct any form of review of licencing income or IP management processes. What this means for the purposes of this article is that while licencing is in fact more common than many would suppose, the transactions are not particularly visible internally and data may be hard to find.

It is perhaps unsurprising then, that 61 per cent of those surveyed never charge other group companies for the use of IP, suggesting either that the IP is not being used or that the extent of its use is not being recognised or measured. The transfer pricing implications alone indicate that tax professionals might have to get involved far more in the question of how a group’s IP is actually being used in the business.

What is the IP worth?

Our survey indicates that an astonishing proportion of companies do not have any in-depth appreciation of the value of IP in their company. Three quarters of respondents to our survey were unable to estimate the value of their firm’s IP. This is a reflection of the inherent difficulty of performing reliable IP valuations as well as of identifying the IP involved. It seems likely therefore that companies are either undervaluing their IP or are only recognising the elements of their IP that are most easily identified.

Garbage in garbage out is a modern day maxim. Although that 68 per cent of companies state that their IP is used by third parties, two-thirds were unable to estimate the income generated for their organisations as a result of external companies’ use of their IP. The conclusion must be that financial reporting systems do not track and manage the value of certain streams of income. If IP is not appropriately distinguished in the first place then companies are going to find meaningful analysis very difficult.

An implication of undervaluing the assets is that IP management and protection will be under-resourced. This is another conclusion supported by the survey. Almost half of all respondents couldn’t estimate the amounts spent annually on litigation or other actions to defend and manage IP, while a further third estimated it at less than £20,000 on each.

The implication here is that tax professionals may find little resource available within a company to help them tackle the issues they face. Availability of data will be key, not just in valuing IP, but in identifying what it is and where it is to be found. The data may be thin on the ground.

Conclusion

The clear conclusion is that the tax profession faces an uphill struggle in coping with changes to the IP rules – both in tax and other areas. Overcoming this is going to require fairly close co-operation with all the specialist departments in a company (legal, finance, company secretariat, etc.) as well as operational units.

Tax professionals also need to find out what companies are proposing to do about the changing IP environment and, where possible, to make sure they have a place at the table.

These two conclusions are related but one thing they have in common is the extra work involved.

*PricewaterhouseCoopers and Landwell (the correspondent legal practice of PricewaterhouseCoopers) recently commissioned research in the UK, to explore Intellectual Property and in particular the legal, financial and tax issues relating to it. The findings were published in March 2002.

**From Smith & Parr: Valuation of Intellectual Property and Intangible Assets, Second edition 1994 p.182

***From Article 12(2), UK-Netherlands Tax Treaty 1980

Technical Department
020 7235 9381
May 2002 by Andrew Casley

 

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