EXECUTIVE SUMMARY

MULTINATIONAL COMPANIES NEED TO PLAN for issues involving identification, use, reporting and valuation of their intellectual property (IP) in order to avoid misdirecting internal investments or depriving their international business units of the use of such intangible assets. CPAs CAN ASSIST BUSINESSES in planning IP strategies by using a four-step process: Identify IP and demonstrate how effectively managing it can help a company achieve strategic business objectives, develop alternatives for structuring business functions and risks, develop a strategy for aligning risks and functions with ownership of IP within the company, and implement and monitor the strategy to ensure the company gets maximum return on its IP. FINANCIAL MANAGERS NEED TO IDENTIFY IP issues that could lead to international business problems and help uncover opportunities for improvement, such as undocumented IP ownership, gaps in legal protection, an inefficient entity structure, low return on investment in IP development, high transaction costs and customs duties and unpredictable profitability in multiple jurisdictions. CPAs SHOULD WORK CLOSELY WITH OPERATIONS and treasury personnel to continuously monitor the IP plan and validate the strategy by examining monthly management reports, reviewing quarterly financial data and periodically assessing the tax and financial statement impact of business transactions. COMPANIES CONTINUOUSLY FACE LIFE-CYCLE EVENTS that reshape plans to develop and maximize the value of specific assets. When a company begins an R&D project, CPAs should perform a cost-sharing analysis to decide whether multiple business units should fund the costs of development and, as a result, own rights to use the ensuing IP.

MICHAEL W. HARDGROVE, CPA, JD, is a partner at PricewaterhouseCoopers. Based in Boston, he is the firm’s national leader for global structure alignment, which deals with international business transition and intangible asset strategies. His e-mail address is michael.w.hardgrove@us.pwcglobal.com. ALEX VOLOSHKO, CPA, is a manager in the global structuring practice also at PricewaterhouseCoopers in Boston. His e-mail address is alex.voloshko@us.pwcglobal.com.

s companies seek earnings growth and sources of investment capital, it becomes critical for them to manage resources more productively. In today’s global economy, many enterprises rely extensively on developing and effectively exploiting their intellectual property (IP) to enhance the bottom line. For companies with customers, suppliers or business activities in multiple countries, managing such intangible assets can be extremely complicated. CPAs, as financial managers or advisers, can help their employers or clients develop a strategy that tackles many complex international business issues, including cash management, resource allocation, administrative simplification and cost containment. This article discusses how CPAs can help their clients treat IP as the economic cornerstone of a sound business strategy while avoiding some all-too-common pitfalls along the way.

WATCH OUT FOR PITFALLS
CPAs can identify IP activities that create financial value as well as develop strategies to use, value and report on intangibles. Companies that do not have such strategies run the risk of either mismanaging their IP investments or not fully capitalizing on them. For example, a company might be legally or contractually prohibited from transferring an important technology to a foreign business unit that could otherwise benefit from it. Furthermore, if management does not identify internally developed or enhanced IP, such as processes, unpatented know-how or marketing intangibles, it could jeopardize the legal protection of such assets. This can be especially true in foreign countries where local laws may not protect unregistered rights as they do in the United States. As a result, operating expenses, taxes, cash flows and profits of a company’s global business units could be adversely affected.

For example, AB-Tech established a subsidiary for technology development and marketing in France. The French operation not only generated enhancements to the technology but also created a substantial customer base throughout Europe. In focusing on rapid market expansion in the United States, company management had little time for strategic planning for its European operations, let alone the potential growth in IP value.

CAs a result AB-Tech managers treated U.S. R&D as the company’s only source of IP and did not consider that the contracts and activities of the French subsidiary also contributed to the corporate IP portfolio. This misunderstanding caused several problems. First, AB-Tech did not register the technology enhancements it had developed in France, nor did it take measures to protect the subsidiary’s marketing rights and customer lists. Consequently these assets were at risk of “theft” from competitors or its own enterprising employees. Second, U.S. operations managers did not internalize any of the French unit’s processes (for example, systems improvements and marketing knowledge) that could have benefited the entire organization. Because AB-Tech’s U.S. managers didn’t know about or use these intangible assets, the company couldn’t effectively leverage them or report their value to banks, investors or customers. The company’s poor handling of its IP created problems that could have been avoided—such as lost efficiencies resulting in a higher cost of products delivered to customers and the replication of certain R&D activities by the parent, as well as exposure to French income taxes on profits attributable to the IP the subsidiary developed.

Source: Intellectual property survey of U.K. companies, PricewaterhouseCoopers, March 2002.

A BETTER STRATEGY
CPAs have many of the skills and expertise needed to advise clients on how to create a business structure that optimizes IP. “CPAs, in their capacity as financial and business advisers, are the logical choice to assist companies in identifying and developing long-term, value-creating IP strategies,” says CPA Michelle Fugawa, an attorney and senior director of worldwide tax at Ingram Micro Inc. in Santa Ana, California. “They are familiar with accounting systems, technical rules and expectations of capital markets.”

Step 1: Identify IP and demonstrate how managing it effectively can help a company achieve its strategic business objectives. By addressing IP management issues, CPAs and financial managers can help companies avoid limitations to international business growth while uncovering opportunities for improvement. For example, an IP review can identify undocumented IP ownership, gaps in legal protection, an inefficient entity structure, low return on investment in IP development, high transaction costs, value-added taxes or customs duties and unpredictable profitability in multiple jurisdictions. (For a cost/benefit breakout of IP planning, see exhibit 1, above.)

CPAs can begin the planning process by determining which intangible value drivers, or operational resources, account for the success of a particular product or service. By interviewing company employees (for example, R&D engineers, supply chain managers and marketing and distribution personnel), CPAs can analyze each business function in order to understand how it contributes to generating intangible assets. Gathering such information is often referred to as a “functional analysis.”

In such an analysis CPAs can not only identify registered IP but also ask managers which of their business unit activities result in value-creating expenditures, such as R&D, marketing and customer service. In public remarks, Joseph Ripp, CPA, vice-chairman of America Online Inc., recommended that financial managers break down IP by line of business and perform frequent updates via feedback from the company’s operating units. This process can be instrumental in creating an IP inventory. For each significant intangible asset, companies should determine the metrics, such as revenue per customer or annual cost savings, that measure its success in maximizing its value. Financial managers should use these metrics to make business decisions—for example, how best to expand the customer base or whether to develop IP internally or acquire it.

By performing a functional analysis, AB-Tech’s accountants would have learned that both the successful product design and the company’s growing trade reputation in France had created valuable marketing IP. With this knowledge and an IP inventory, management then could have decided how to use it effectively throughout the entire organization.

Step 2: Develop alternatives for structuring business functions and risks. Armed with the results of a “functional analysis,” CPAs should evaluate the company’s business units in the context of “profit centers” and “cost centers.” Cost centers typically do not own value-creating assets; they bear limited commercial risk and can act as group service providers. Economists often refer to such services as “routine” because these services do not, by themselves, create value. A cost center with limited IP or risk, and performing administrative, distribution or procurement functions, is often referred to as a shared services center. Such centers allow the company to reduce transaction costs and respond to financial and operational challenges faster and more efficiently.

Financial managers can use shared services centers not only to reduce redundant costs by pooling resources and standardizing processes such as invoicing, data processing and cash collection, but also to design transaction flows with customers and between business units that will support the global IP strategy. In those cases earnings are attributable to factors such as assuming business risks, owning technology and funding expenditures and may be considered “premium” or value-creating. Therefore, if the shared services center enters into the transaction flows and retains the economic rights to developing IP, it can become a profit center. In international business, such operations (especially when housed in a separate subsidiary) are often referred to as a “principal company.”

Step 3: Develop a strategy for aligning risks and functions with ownership of IP within the company. CPAs can recommend spreading development expenses among business units as a strategy for sharing risk. If a multinational organization expects significant economic benefits from its IP, sharing development costs can ensure that all business units that are parties to the arrangement will benefit from and have rights to the resulting IP. At a 2002 conference, David Roth, CPA and international tax manager at General Motors Corp., said his company began using global cost-sharing agreements many years ago as a worldwide IP management tool to help strike a balance between the need for centralized control over emerging automobile technology developed and used in multiple locations and the company’s move to decentralized management. In addition cost sharing gave GM business units access to the entire IP portfolio while helping them reduce and maintain centralized IP funding and legal ownership.

In the hypothetical example, AB-Tech’s CPA advisers could have encouraged the company management to establish a profit center (or principal company) with sufficient financial and managerial resources to develop, own and use IP of value in a geographic region or market segment. AB-Tech’s global units could have used the principal company, along with cost sharing, to codevelop and co-own European IP rights to reduce the risk of a dispute between the IRS and French tax authorities over IP ownership. For example, U.S.-based AB-Tech and a European principal company could have proportionately funded global R&D and marketing costs, and both entities would have co-owned a global intellectual property.

The IRS has accepted cost sharing as a global business technique provided the taxpayer follows the regulations governing qualified cost-sharing arrangements. Outside the United States, the Organisation for Economic Co-operation and Development (a group of 30 countries that interprets emerging economic and social issues and identifies common policies, www.oecd.org) also has approved the cost-sharing concept and established its own cost-contribution-arrangement guidelines.

A caveat. The IRS has recognized the importance of IP to international business, and the use of common techniques such as cost sharing, in IRC section 482. However, many provisions of the current tax law preclude companies from entering into tax-motivated transactions, and recent IRS initiatives are aimed at further tightening the rules on disclosure and compliance.

For example, in her testimony before the House Ways and Means Committee on June 6, 2002, Pamela Olson, as acting assistant secretary for tax policy of the U.S. Treasury, pointed out the potential for abuse where IP or other assets are transferred between related parties at less than arm’s length. Olson announced that the Treasury would undertake a comprehensive study focusing on the tools needed to ensure that cross-border transfers and other related-party transactions, particularly transfers of IP, could not be used to shift income outside the United States. This could include a review and possibly revisions of the documentation and penalty rules and of the substantive rules relating to IP transfers and the use of cost-sharing arrangements in order to ensure that current transfer pricing rules could not be used to facilitate the transfer of IP outside the United States for less than arm’s-length consideration.

Step 4: Implement and monitor the business’s global IP strategy. CPAs should design business structures to be flexible enough to help managers deal effectively with changes in circumstances. In AB-Tech’s case, the CPAs can guide management through financial, accounting and tax issues to transfer European distribution and cash management functions to the principal company. When CPAs draft such a global plan, they should carefully document the international strategy in a report, discuss alternative scenarios with operations management and review and coordinate issues with legal counsel and other experts in foreign jurisdictions.

Management and CPAs together should undertake the implementation steps of the international IP planning process. Included in this phase would be the preparation of income statements and balance sheets and monitoring the effects of any changes in operations. Traditional annual assessments might not be sufficient, particularly in volatile areas of the world. Instead, the CPAs should work closely with operations and treasury personnel to continuously monitor the strategy by examining monthly management reports, reviewing quarterly financial data and periodically assessing the tax and financial statement impact of business transactions.

Such analyses enable financial advisers to examine how a company complies with local accounting rules, manages costs of intercompany transactions, evaluates foreign exchange exposures and reviews tax-return-filing positions. In addition, when CPAs help management create and implement an efficient structure for a business, planning opportunities may follow. For instance, when an organization establishes an international principal company, it can change transaction flows or structure the ownership of subsidiaries to benefit from treaties between countries and reduce its cost of cash flow.

ALIGN PROCESS WITH LIFE CYCLE
Strategic objectives alone do not drive the IP planning process—companies continuously face events that reshape their plans for developing and maximizing the value of specific assets. As a company grows and matures, it must make decisions about R&D efforts, obtaining financing, enlarging the revenue base for new products and services or geographic expansion. As a business matures, the costs and complexity of implementing many of its decisions often grow exponentially. But a company can find it relatively inexpensive to achieve financial and international tax benefits if it proactively structures IP rights and business functions and risks in conjunction with the major events in its life cycle. (For an example of a company’s life cycle, see exhibit 2.)

Exhibit 2: Company Life Cycle

IP planning is essential in another life-cycle event—a merger or acquisition. Provisions of FASB Statement no. 142, Goodwill and Other Intangible Assets, encourage companies to inventory their IP rights during an acquisition and treat them as “strategic assets.” (For more information see “FASB Changes Accounting for IP,” and “A New Scorecard for Intellectual Property,” JofA, Apr.02, page 75.)

Efficient corporate planning and cost sharing can ensure that IP creation enhances the business’s objectives and helps it avoid having to relocate or restructure its IP-generating functions (R&D, marketing, customer service and procurement). For example, if AB-Tech had had a better IP plan, it could have facilitated sharing of global IP by its American and French operations and invested in technology more effectively.

TAKE A BEST-IN-CLASS APPROACH
As more American companies venture into the global marketplace and establish business units in various foreign countries, CPA advisers can help them develop IP strategies that deal with international business issues and avoid pitfalls. It is essential for companies relying on intangible assets to have business structures that protect them among their global units while minimizing the risks and costs of doing business internationally. With an appropriate plan in place, organizations can arrange transactions to reduce the costs and risks, better manage their aftertax cash flows, facilitate joint ventures and acquisitions and monitor their processes to maximize profits.