Acquiring and sublicensing film rights not a "trade"

Still on the subject of UK tax and its impact on the creative industries, the Court of Appeal (Sir Terence Etherton (Chancellor) and Lords Justices Christopher Clarke and Vos) gave a ruling yesterday in Eclipse Film Partners No 35 LLP v HM Revenue and Customs [2015] EWCA Civ 95. In July 2012 the First-Tier Tribunal held, on the facts before it, that a partnership's activities in acquiring film rights and then sublicensing them to a distributor did not amount to carrying on a trade [see earlier IP Finance blogpost here]. This being so, the partnership's members were unable to obtain tax relief on interest paid on the borrowings which they had made in order to finance the partnership's activities under the Income and Corporation Taxes Act 1988 sections 353 and 362.

Low Valuations at the Heart of Tax Avoidance IP Schemes – An IP Solution?

Professor Andrew Blair-Stanek of the University of Marlyand, Francis King Carey School of Law, has published an article on SSRN titled, “Intellectual Property Law Solutions to Tax Avoidance” (forthcoming 62 U.C.L.A. Law Rev. __).  The article helpfully explains how transferring IP can result in substantial tax savings for IP owners and why initial low valuations of IP are at the heart of tax avoidance schemes.  He focuses his proposal on addressing tax avoidance schemes by using substantive IP law, as well as procedural rules involving IP cases, to incentivize IP owners to make initial valuations of IP closer to their “actual value.”  He provides a hypothetical example of the problem involving Google and licensing:

When Google’s California-based engineers develop a promising invention, Google owns the rights to all patents that can be obtained on the invention. Corporate ownership of employee-created IP is common practice.

Google then quickly licenses all the patent rights to a subsidiary in a tax haven like Ireland. Licensing allows the future profits from the patents to accrue to the Irish subsidiary, while the legal ownership remains with Google itself in the U.S., with its robust protection for IP owners.  This license is respected, since Google and its Irish subsidiary are separate corporate entities, and IP can be freely licensed.

U.S. tax law requires that Google receive “arm’s-length” royalties from its Irish subsidiary for the patent license.  The “arm’s-length” price is defined as the price that would have been charged if Google had instead been dealing with an unrelated party under the same circumstances.  The “arm’s-length” principle for cross-border transactions is deeply enmeshed in not only U.S. tax law, but also the numerous bilateral tax treaties that the U.S. has signed with its trading partners, including Ireland.  Google must pay U.S. corporate tax of 35% of these “arm’s-length” royalties.  

Herein lies the mischief. Google does not transfer its promising IP to unrelated parties, so there is no observable “arm’s-length” price. Valuing IP – particularly brand-new IP – is difficult and subjective. Unlike a mass-produced machine or a ton of aluminum, each piece of IP is unique and its economic potential is difficult to predict. Treasury regulations provide detailed econometric methods to estimate IP values, but these are extremely imprecise, often leading to a wide possible range of acceptable prices.

Google must hire appraisers (oftentimes economists) to ascertain an “arm’s-length” price for the transfer to Ireland, and to support that price with extensive contemporaneous documentation.  But Google chooses and pays these appraisers, who are inclined to err towards lower valuations. As a leading tax practitioner recently observed, “appraisers tend to agree with their paymasters on [valuation] questions.”

After the transfer to Google’s Irish subsidiary, the patented technology is incorporated into a new Google device.  The Irish subsidiary oversees a Chinese contract manufacturer’s building of the new devices.  The Irish subsidiary then sells the devices for a full markup that includes the value of the IP to Google distribution subsidiaries worldwide, who then sell them to consumers. The substantial profits from the IP remain in Ireland, typically not subject to Irish tax, and not subject to U.S. tax as long as the cash is not returned to the U.S.

He also discusses why meaningful change in tax laws is unlikely to happen which leads to his IP focused proposals.  Why is the solution unlikely to be based in tax law?  He provides, at least two reasons: nearly impossible coordination of tax law between many countries; and information asymmetries between multinationals and government tax authorities.  In describing the information asymmetry problem, he states that:

First, information asymmetry refers to the fact that the taxpayer inherently knows far more about the characteristics, potential, and value of its IP than does the IRS [U.S. Internal Revenue Service] (or any appraiser). For example, Google understands how its new invention could fit profitably into a new smartphone in a way that neither a team of IRS experts, nor a team of private appraisers, ever could. When the IRS challenges a low transfer price in court, the taxpayer has a depth of understanding of its own IP that gives it a large advantage in refuting the IRS challenge.

Largely as a result of this information asymmetry, the IRS has lost both high-profile IP transfer-pricing cases litigated in the past decade. A quote from one of those opinions encapsulates the problem: “Taxpayers are merely required to be compliant, not prescient.” Taxpayers can fully comply with the law by disclosing all facts to their appraisers who must determine the “arm’s-length” transfer price. Any outsider (including judges) will not be able to discern its profit potential. But the multinational can determine its profit potential, which materializes after the IP is safely in Ireland.

His proposals for change (or perhaps, in some cases, suggestions for interesting arguments) essentially focus on using the initial low valuation position taken by the IP owner against it later in litigation (when the relevant information is likely discoverable) and licensing.  For example, he states:

First, the defendant should argue that the artificially low price is evidence that the patent was obvious at the time of invention, and hence is invalid.  Patent law recognizes that non-technical “secondary considerations” such as commercial success and licensing success are evidence for or against the validity of a patent. The artificially low price fits nicely into this rubric, because it demonstrates with a hard figure that, immediately after the invention, Google did not see the patent as being a substantial innovation. Additionally, the expert documentation justifying the low price may include damaging language downplaying the patent’s innovativeness.

Second, the defendant should argue that, even if the patent is valid, it has a narrow scope. Courts give innovative patents a broad scope that allows finding infringement whenever the infringer uses a close equivalent to the claimed invention. By contrast, less-innovative patents are given a narrower scope. The low transfer price is evidence that Google did not perceive the patent as particularly innovative, and thus should receive a narrower scope. Again, the expert documentation justifying the low price will often include damaging language downplaying the innovation.

Third, even if the court finds the patent valid and infringed, the defendant should be able to point to the low transfer price as evidence that damages should be correspondingly low. After all, a patent’s price reflects its potential to generate profits and royalties, and patent damages replace the patentholder’s lost profits and royalties.

Fourth, patent plaintiffs typically request a preliminary injunction against infringement and, if they prevail on the merits, then request a permanent injunction. But a low price for the patent suggests that infringement is unlikely to cause Google “irreparable harm,” which is required for injunctions. The low price also suggests Google does not come out ahead on the “balance of hardships,” another requirement for injunctions. Additionally, as discussed earlier, the low transfer price is evidence of invalidity and narrower scope, both of which suggest Google has a lower “likelihood of success on the ultimate merits,” a requirement for a preliminary injunction.

Finally, even if the court finds Google’s patent valid and infringed, the defendant should be able to argue that Google’s tax avoidance was “patent misuse.” When a court finds that a patentholder used the patent in a way that violates public policy, it will refuse to award damages or injunctive relief, at least until the misuse has been remedied. Misuse does not require that the patentholder harmed the defendant, only that the patentholder used the IP in a way that violated public policy. If the court finds Google’s tax avoidance sufficiently egregious, it could refuse relief to Google until it has repaid the U.S. Treasury the taxes it improperly avoided.  

Professor Stanek also discusses how copyright and trademark law have similar doctrines, such as copyright fair use, strength of the mark and secondary meaning, and damages that could be used to incentivize valuations closer to “actual valuation” and how the theories underlying IP protection support his proposals.  Notably, he states that usage of the initial transfer valuation could be used to undermine the IP holders royalty negotiation position if his proposals are adopted.  Do readers know of situations where the initial transfer valuation has been used in negotiating royalties, arguing damages, or in arguments concerning the scope or validity of IP?  (Hat tip to Professor Paul L. Caron’s (Pepperdine University) Taxprof blog for a lead to the article). 

CIPA defends UK patent box

From Treasury to Treasure? Tax-
efficiency from the Patent Box*

The United Kingdom's Chartered Institute of Patent Attorneys has been quick to defend the increasingly-repeated assertion that the British "patent box" tax scheme [frequently discussed on IP Finance since it was originally proposed: see pieces listed here] is simply a tax avoidance device, rather than a mechanism for encouraging investment.  In to a media release last week, CIPA's President Chris Mercer nails the myth firmly.  The media release reads as follows:

‘Patent box’ designed  to encourage innovation, not avoid tax, says patent attorneys’ president 

“Headlines in today’s media linking the ‘patent box’ to tax avoidance measures are missing the point,” says Chris Mercer, President of the Chartered Institute of Patent Attorneys. 

“Fiscal measures are one of the few tools government can use to influence corporate behaviour,” he says. “The Patent Box has only just come into effect, but there are already signs that it is having a positive effect. Companies – especially mid-size, technology-based enterprises – are starting to incorporate IP into their strategic plans. Patent attorneys are being invited to talk to main boards, not just to the R&D department [Both of these are 'attitude-changers' rather than anything else, but attitude-changing is vital if we expect there to be a change in investment behaviour too]. This is good example of how a government initiative is actually achieving the desired effect – encouraging businesses to innovate and add value by protecting their IP. 

“The idea that anyone would start inventing things and patenting them as a way of avoiding tax is nonsensical,” he added. 

There has also been an increase in patent applications at the Intellectual Property Office. ”This increase is a welcome and much-needed,” said the CIPA President. “UK companies have been falling behind their foreign competitors in terms of patent filings. The Patent Box and other government  measures to encourage innovation may have helped reverse the trend.

This blogger doubts that there is any correlation between the availability of patent box tax breaks and the number of patents filed.  In his view, given the cost and the sheer effort that attends the filing of most patents, and the negative return that most of them can realistically expected to deliver, anything that encourages investors to commit to new products and processes rather than concentrate on old, tried-and-tested ones, should be warmly welcomed.

* The illustration is of a Merck family Treasure Chest Christmas Ornament, available here for US$ 18.99.

Dutch sandwich in danger, but most of the pie remains untaxed

From Mary-Ellen Field (Chairman, Brand Finance), via Mark Colvin, comes news of "No more “Dutch Sandwich”? The Netherlands reviews its role in tax avoidance" by Cyrus Farivar, posted on Ars Technica last week (here). According to this post, in relevant part:

"In recent years, governments have become increasingly aware of the fact that lots of major corporations -- notably tech companies including Apple, Google, Yahoo, Dell, and many others -- are using shady, albeit legal, techniques to shift income in ways that drastically minimize a company's tax burden. A trick known as the “Dutch Sandwich,” in which companies move money through the Netherlands, has become one of the preferred ways of reducing a firm's financial liability. ...

Here’s how it works: as Bloomberg also reported in 2010, a company sells or licenses its foreign rights to intellectual property developed in the United States to a subsidiary in a country with lower tax rates. That means that in many cases, companies will license their own IP to one of their own foreign subsidiaries (often based in Ireland), whose profits then stop over in the Netherlands. In turn, those profits finally settle in Bermuda, a British overseas territory in the North Atlantic, and a notorious tax haven. ...".

Last Wednesday, however, a Dutch parliamentary committee met to consider the fairness of its own tax system and to re-evaluate its role as part of a legal financial chain that allows companies to reduce the amount of tax they pay. Other European countries, including the United Kingdom, Ireland and France, are also looking more closely at the tax arrangements of international IT and online businesses, which either pay little tax of any description or, when they do pay tax, they tend not to pay it in European countries in which they have been profitably trading.

 It seems to this blogger that European countries will have to sort out their priorities before they can individually get to grips with the problem of international companies which earn megabucks and pay little or no tax in the EU.  This is because real and meaningful taxation is only going to be raised when all 27 (soon to be 28) Member States have identical tax rules, while each EU Member State would like to be seen to be that bit more attractive in tax terms than its neighbours, in order to attract foreign businesses to base themselves and their IP portfolios locally.  The businesses themselves will naturally wish to exploit any tax differentials and pay where tax is at the lowest rate, thus encouraging a race to the bottom.

Double Irish Dutch Sandwich explained here

Film finance not "trade", rules FTT

Decisions of the UK's First-Tier Tax Tribunal don't often get a mention on this blog, but Eclipse Film Partners No 35 LLP v Revenue & Customs [2012] UKFTT 270 (TC)  looked quite interesting, this being a lengthy decision of Judges Edward Sadler and John Walters QC of 20 April.


Eclipse, an investment partnership, was incorporated in October 2006 and comprised 289 members. According to its partnership deed, its business was the production, distribution, financing and exploitation of films. Eclipse struck a complex licensing agreement with Disney under which each member made substantial contributions of capital to pay the licence fee, stumping up some £50 million of their own cash and borrowing another £790 million under a 20-year facility. At the same time, the film rights were sub-licensed to a distributor, which agreed to pay annual specified sums over a 20-year period. Eclipse then entered into a marketing services agreement as a means of supervising the implementation of the distributor's release plans for the films, as well as a consultancy agreement relating to the future selection, acquisition and exploitation of films and film rights. 


In its first partnership return, Eclipse said it was carrying on a commercial trade of acquiring and exploiting film rights, although no profits had yet accrued. In reliance on the Income and Corporation Taxes Act 1988 sections 353 and 362, its members claimed tax relief in respect of the interest paid on their borrowings. 


The Commissioners for Customs and Revenue considered that there was no entitlement to tax relief because Eclipse was basically just a vehicle for speculative investment rather than a trade. Were they right?.

Dismissing Eclipse's appeal, the FTT explained that the burden was on Eclipse to establish that it was carrying on a trade, not for the Commissioners to disprove it.  The transactions and arrangements entered into by Eclipse were not a sham; indeed, they had legal effect according to their terms, and the fact that they were set up as a tax avoidance scheme did not automatically mean that they could not be trade.  The killer punch here, though, was that the way Eclipse's members financed their capital contributions and the extent to which they did so was extraneous to Eclipse's actual activities.


On these facts, said the FTT, the interdependent and coterminous licensing and distribution transactions entered into by Eclipse did not have the speculative aspect that could be expected of trading transactions. True, the sub-licence produced profit -- but the bulk of that profit was predetermined and could not be regarded as the speculative profit of a trading venture. Any additional profits which might materialise were clearly viewed as a bonus rather than a profit reasonably to be expected. In commercial terms, Eclipse did not have a "customer" but had merely been given the opportunity by Disney of participating in its licensing arrangements.