Portfolio strategy for managing R&D, royalties and transnational taxes

• DOI: http://doi.org/10.1002/jcaf.22443
• Published date: 01 July 2020
• Author: William V. Rapp
• Date: 01 July 2020

BLIND PEER REVIEW

Portfolio strategy for managing R&D, royalties and

transnational taxes

William V. Rapp

Martin Tuchman School of Management,

New Jersey Institute of Technology,

Newark, New Jersey

Correspondence

William V. Rapp, Martin Tuchman School

of Management, New Jersey Institute of

Technology, Newark, NJ 07102.

Email: william.v.rapp@njit.edu

Abstract

This article is based on a successful consulting project for a large Fortune

100 technology-based US MNE facing various tax and royalty issues related to

the use of its technology by its subsidiaries and affiliates and its licensing

agreements with other companies in different countries.

KEYWORDS

R&D, royalties, taxes

1|INTRODUCTION

Large US MNEs face a complex tax environment when

accounting for nonarms-length royalty arrangements

with foreign subsidiaries and affiliates. Other countries

wish to minimize royalty and other transfer payments to

a US parent that are deductible to a subsidiary or affiliate

and therefore reduce taxes in that country. The UN has

published an extensive study addressing this issue for

Developing Countries entitled Protecting the Tax Base of

Developing Countries against Base-eroding Payments Rent

and Royalties (2017). This study warns countries about

the risks of trying to use low taxes to attract technology

companies. The OECD (2014, 2015) has also developed a

model tax convention designed to avoid double taxation

among its members. Article 12 specifically covers rent

and royalty payments related to intellectual property.

At the same time, the IRS wants royalty payments

higher since they are US taxable income. The IRS has

thus argued some royalty payments to a US MNE do not

properly reflect the value of the technology licensed given

the greater profitability of foreign subsidiaries and affili-

ates compared to local firms in those countries. IRS

believes in such cases royalties are intentionally under-

valued by some US licensors and higher US taxes are

owed. This is a significant issue given the IRS has wide

discretion under §482

1

and §861

2

to compel a firm to jus-

tify their treatment of royalties if the IRS feels the current

treatment is an abusive attempt to avoid taxes. This can

include “Patent Boxes”that are located in low tax or tax

haven countries where patents have been transferred

from the actual development location. The NY Times has

reported Apple as being particularly aggressive in this

respect (Duhigg & Kocieniewski, 2012a, 2012b).

While all transfer payments are subject to this kind of

scrutiny, the technology explosion and its worldwide

reach along with the global pervasiveness and large reve-

nue streams of Big Tech has dramatically elevated the

royalty and related tax issues. For some firms, if the IRS

view prevailed, it would mean double taxation when

their foreign royalties are basically fixed due to prior

negotiations with various governments. This article

explains a successful strategy by one US MNE that trans-

parently addresses these tax and revenue issues and has

thus drawn less tax authority scrutiny while simplifying

management of the firm's global technology and licens-

ing portfolio.

3

2|ECONOMICS OF

TECHNOLOGY'S GREATER

PROFITABILITY IN FOREIGN

MARKETS

Large technology firms that develop, license, and use

technology worldwide to strategically support their goods

and services have a multiplicity of intellectual property

relationships. Rights can include patents, copyrighted

Received: 5 October 2019 Revised: 14 January 2020 Accepted: 10 February 2020

DOI: 10.1002/jcaf.22443

48 © 2020 Wiley Periodicals, Inc. J Corp Acct Fin. 2020;31:48–56.wileyonlinelibrary.com/journal/jcaf