Testing the TCJA

Back in 2019, for Law360 I wrote that while companies had been slow to respond to the incentives to onshore valuable intellectual property in the Tax Cuts and Jobs Act, the true test of this regime could be whether companies choose to shift the patents and copyrights of a new generation of technology offshore.

“The law generally hasn't provoked most American companies to haul their prize intellectual property back home–but it may make startups think twice about setting up overseas tax structures in the first place,” I wrote.

Five years have passed, but the situation hasn’t changed a great deal. The pace of repatriations has picked up, and anecdotally you hear practitioners say that the opportunities for lucrative profit-shifting have dwindled to a trickle. But at the same time, offshore structures remain, and companies are still waiting for the international tax structure to settle for a bit before making any dramatic decisions.

But the march of technology moves on, and Silicon Valley wizards are continuing to experiment with extraordinary new algorithms and products. Sooner or later there will be surely be a Next Big Thing in tech, and companies will face a choice about whether to keep it onshore or perhaps use cost-sharing arrangements or other methods to shift its intangibles offshore.

One thing to note: by a “new generation of technology,” I’m not talking about the iPhone 20 or whatever. New versions of existing products do contain new patents and IP, but they tend to be closely linked with the existing tech. If those techs are held offshore, the company has most likely set up a cost-sharing arrangement with foreign subsidiaries that will generate the next version’s IP offshore as well. That’s actually what we mean by “IP held offshore”–just using generics, chances are the IP for Big Hit Computer Game was developed and held domestically, but the company used a cost-sharing agreement to generate foreign-use IP for Big Hit Computer Game 2 and 3 and so on offshore.

In shorthand this is often called “shifting” the IP, but in reality U.S. laws make it very difficult to shift an existing intangible asset abroad outright through transfer pricing. That’s where these agreements come in.

In theory offshore related parties in the agreement are assuming some of the risk in the project, although one can question how much risk there really is for products that are just the latest in an extremely successful franchise.

The contracts in the agreement are supposed to be based on the arm's-length standard, the global benchmark that related-party transactions are priced at what independent parties would have paid. But intangibles tend to be very unique, and they're difficult and subjective to price. The TCJA dealt with this by enacting the 10.5% tax on global intangible low-taxed income, which targets income held in low-tax jurisdictions when the company does not have much economic substance there–what these cost-sharing arrangements often produce. It also includes the deduction for foreign-derived intangible income, an incentive on profits from domestic IP.

But, as I discussed, GILTI and FDII may not be able to bring existing platform technologies home, in all cases. But what about something totally new, with technology that is essentially disconnected from those other products? When that comes along, whatever it is, it will be a major test for the TCJA as well as other recent new tax reforms. Will companies still use aggressive arrangements to shift the profits from that tech offshore, or will its intangibles be, in a sense, trapped in the jurisdiction where they were made?

If you’ve been following trends in the past year or so, this may raise the question–is artificial intelligence the test?

Since OpenAI released ChatGPT in 2022, many observers have claimed, with both fascination and fear, that the era of transformative AI may have arrived. These simple, intuitive programs seem capable of answering difficult and complex questions with nuance, grasping fine distinctions in human language and making HAL 9000 look like a grunting Neanderthal.

The implications and possibilities raised by this are mind-blowing, to the extent they can be conceived at all. The programs have already become routine for many in the legal profession, and it has become a force in tax compliance as well. (Disclosure: Exactera, this newsletter’s sponsor, is an AI-based tax compliance firm). Busy work may well become a thing of the past. AI has become such a common part of household tasks, some are helpless without their digital assistants. And that’s just the public-facing part of it–AI will also become incorporated into business decision-making and operations in ways that customers may never appreciate.

So is this the tech that companies may be tempted to deposit offshore, unless they find the TCJA to be too high a fence?

To give a short answer: No. At least, not yet.

The very fluidity and uncertain possibilities of this technology are exactly what make it a bad candidate for these kinds of tax structures. While everyone thinks these programs are likely to be very profitable, they’re not quite certain how they’ll be, or which particular part will be the moneymaker. (We tend to talk about patents and IP like they’re just a handful, but a single product can have hundreds.)

Even though the cost-sharing arrangement ostensibly involves risk, tax planners aren’t supposed to be gamblers. They need sure things, or as sure as they can be.

This is one reason why, at least according to folks within the industry, that you don’t see auto companies engaging in similar types of transactions. Even though cars have become heavily computerized, the industry is too unpredictable to make tax planning worth it. You could end up shifting losses to a low-tax jurisdiction, costing the company millions.

So it may take a while for the TCJA to be tested by AI, specifically. Something else may come along, if it hasn’t already.

In fact, I’m very curious about how these new weight-loss drugs will be priced for taxes. Pharmaceuticals are their own sphere of complex tax challenges, combining the valuable IP of tech with intricate manufacturing processes and supply chains. And these weight-loss prescriptions which can, at long last, effectively manage hunger have turned companies like Novo Nordisk into behemoths overnight.

What’s especially interesting about this is that many of these drugs were originally developed for diabetes. I don’t know anything about the specifics, but it’s likely that some are priced based on this initial purpose, not taking into account this lucrative new use. These kinds of situations can be especially vexing for tax authorities, and are one of the reasons why the U.S. adopted rules like the commensurate with income standard, that go beyond pricing under the arm’s-length standard. (While some transfer pricing methods do take later profits into account, as a principle ex post evaluations aren’t necessarily required. If you buy an old bureau from a flea market and find a treasure map inside, you’re not obligated to go back and reimburse the seller. Legally, at least–what you’re obligated to do by ethics is another question.)

This may be the acid test that the TCJA has been waiting for, as well as Pillar Two and the new tax regime. How it fares could be a huge factor in how Congress and other policymakers decide to continue the system in 2025.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• The U.S. Treasury Department on Tuesday released a long-awaited follow-up to last year’s proposed rules implementing the Inflation Reduction Act’s 1% tax on stock buybacks. Back in July I wrote about how the rules could affect some other legitimate transactions, including the acquisition of stock in a foreign parent, and how the “principal purpose” test used to identify abusive transactions inserts a degree of subjectivity into the rules’ application. The new rules scale back this part, and a controversial “per se” rule mandating that the principal purpose test has been satisfied would be replaced by a “rebuttable presumption” that applies in some situations. This may not satisfy critics who claim that the rules will create a lot of compliance headaches for multinational companies who are not engaged in traditional stock buybacks.
• A new rule requiring that entities report who ultimately can access their funds–the “beneficial owner”–is currently under threat of being rule unconstitutional, and a prominent group of accountants is asking that it be suspended during the judicial proceedings. The American Institute of Certified Public Accountants and state CPA societies are asking that Treasury and Financial Crimes Enforcement Network suspend the rule, which went into effect at the beginning of the year. The constitutional challenge is considered a long shot, but AICPA argued that both the legal uncertainty and compliance burden on small businesses require more time for evaluation. In its request, the organizations also ask that there be no retroactive enforcement of the rules for the suspended time period.
• The Congressional Research Service is like Congress’ own semi-secret think tank, which issues reports and evaluations of important issues facing legislators. Unlike the Joint Committee on Taxation and Congressional Budget Office, its work isn’t automatically public, although most eventually get published. A report from April 1 compares the OECD’s Pillar One with digital services taxes, the national levies on certain types of online revenues which the OECD policy is meant to replace. Pillar One appears stalled and faces long odds of being implemented, but aspects of it could live on regardless. In the meantime, countries seem likely to keep their DSTs despite U.S. opposition. One difference between the two that the CRS report notes–companies that pay Pillar One taxes would receive foreign tax credits, so the cost would ultimately fall on the U.S. Treasury. But the cost for DSTs would, in most cases, be passed on to consumers. Definitely worth a read.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

John Hunter of the Marsmen, appearing first in Man O' Mars #1 in 1953. A man of Earth raised and trained by Good Martians, to lead an army of humans to defeat the Bad Martians. In just one appearance he saves Earth from destruction. (Name and overall story seem suspiciously similar to John Carter of Mars.)

Contact the author at amparkerdc@gmail.com.