I have two pet peeves starting with a free lunch claim from Bruce Bartlett:
The wealthy pay more in taxes when tax rates fall … the share of total income taxes paid by the wealthy has risen even as statutory tax rates have fallen sharply.
Bruce’s op-ed notes that the share of Federal taxes that comes from the top 1% of income earners has actually increased – but that mainly reflects the fact that the top 1% is getting a larger share of overall income. This observation does not prove any alleged increase in their income was caused by lower tax rates.
But my main pet peeve of the day goes back to the David Cay Johnson argument in Perfectly Legal that certain tax planners are enabling the rich to avoid taxes. Chapter 18, which is entitled Letters to Switzerland, was attacked by this tax attorney who did let us know about section 367(d) and section 482 of the U.S. tax code. As we noted here, effective enforcement of these two sections requires that the IRS have at its disposal economists who understand the concepts of “arm’s-length pricing” and “fair market value” as they apply to the valuation of intangible assets.
Which brings me to crediting the Bush Administration and the Treasury Department for what they call the “investor model” approach to enforcing these rules. But it seems the Tax Executive Institute (TEI) is attaching this investor model, which simply put is an application of discounted cash flow (DCF) principles. A recent publication notes:
TEI said the “investor model” concept in the proposed rules “goes beyond ensuring that buy-in payments are based on an arm’s-length analysis.” The model requires that two separate transactions – the buy-in payment and the cost sharing contribution – be analyzed as if they were a single investment decision based on an expectation of a given overall return, the group said. At best, this linking of the buy-in and cost sharing contribution is unnecessary to address the IRS’s concerns, and at worst, “it deprives a cost sharing participant a fair economic return once that participant has committed to making arm’s-length buy-in payments,” TEI wrote. The institute said the investor model could increase controversy with other nations because it substantially departs from the transfer pricing principles set forth in the existing Section 482 regulations.
When TEI says the IRS approach deprives a participant with a “fair economic return”, I have to scratch my head as the proposed regulations specifically note that participants should receive:
an anticipated return appropriate to the risks of the cost sharing arrangement over the term of the development and exploitation of the intangibles resulting from the arrangement.
The same attorney who criticized Mr. Johnson recently argued:
There is great danger that the discount rate is too small, which causes the external contribution to be overvalued.
Other critics of the proposed regulations explained:
Although the proposed regulations may not have intended that the default discount rate to be used should be WACC, specifically stating it as an example of one such appropriate rate may lead to the unintended consequence of an IRS examiner applying the WACC as the rate” in applying the investor model, the business group said. TEI said using WACC could undervalue the cost of capital for discrete projects because the WACC for an entire company “blends together all the projects a company may undertake,” while the cost of capital for any specific research effort may be considerably higher than a WACC based on the activities of a diversified company as a whole.
Higher maybe – but considerably higher? Let me explain what this controversy is all about in terms of a simple example. Let’s suppose you have been paying your U.S. R&D team to develop what you hope to be a hot new technology – writing off their expenses on your U.S. tax return for several years – and today you learn that they have succeeded such that you expect to receive enormous intangible returns for the next 25 years. In fact, your intangible returns to be earned in the European part of your operations alone are expected to be $1 billion per year from 2006 to 2030. A tax planner advises you to park the European rights in a Swiss subsidiary so these intangible profits will be taxed at a low rate.
But your tax attorney advises you to address section 367(d) and commission a valuation of the intangible assets with a wink and a nod that his economic guru will place a value equal to something between $2 billion and $3 billion. Sound a tad low? Ah come on – isn’t the appropriate discount rate between 30% and 50%?
An IRS economist might object claiming that the discount rate should only be 10% so the valuation should have been in excess of $9 billion. But suppose we have very good evidence that your company’s weighted average cost of capital (WACC) is 12% not 10%. And suppose half of the value of your company is due to routine activities (or if you prefer tangible assets) and the other half is due to intangible value and profits. Couldn’t the appropriate discount rate be as high as the economic guru for the tax attorney? Well no, since the weighted average of this discount rate and the discount rate for your routine activities must be 12%. So if the latter is 9%, then the appropriate discount rate is closer to 15% – not 30%. Which means that the payment back to the U.S. entity for the transferred intangible asset would be around $6.46 billion not $3 billion.
Now you might argue that estimating discount rates is hard, which is one reason why financial economists such as Aswath Damadaron use the market value of equity to derive implied equity risk premium. Damadaron’s approach requires certain assumptions as to expected future dividends (or cash flows depending on the nature of the valuation issue) as well as the assumption known as the Efficient Markets Hypothesis. The economists at the IRS have been pushing something called the Market Capitalization approach, which is heavily criticized by tax attorneys. But excuse me – when did the Journal of Finance tells us that the Efficient Markets Hypothesis was junk science. These same tax attorneys should read the Tax Court opinions in the DHL and Nestle litigations that involved the valuation of intangible assets – as the Court seems to accept the Efficient Markets Hypothesis.
Anyone familiar with the nonsense that passes for valuation work found during litigations involving Gifts & Estates cases might recognize this controversy over discount rates. Perhaps the funniest version of this comes from the Estate of Josephine T. Thompson who owned shares of Thomas Publishing Co., Inc. Both “experts” used a DCF approach but they differed on what the appropriate cost of capital should be. The expert for the government used a reasonable application of the Capital Asset Pricing Model to suggest a discount rate near 12%, but the “expert” for the taxpayer claimed (with no real basis) that the discount rate should be 30%. The funny part relates to the credentials of the taxpayer’s expert – he is an attorney who the estate trustee learned about by going on a fishing trip in Alaska.
I also suspect many taxpayers might find compliance less costly if we economists could get their attorney types to do their jobs and not ours. Of course, one AB reader who knows a thing or two about these issues might remind me that some economists are too willing to give their clients advocacy answers in order to get their work.
The article I noted from Robert Cole was supposed to be advice for John Kerry as he ran for President. For him to note to Senator Kerry this:
Thus, the Code now requires that a U.S. taxpayer take into account the full value of U.S. intangible property transferred overseas
and then for him to join TEI when the Treasury Department gets around to enforcing sections 367(d) and 482 is just plain hypocrisy. I’m glad the current Administration ignores Mr. Cole and I hope the next President does so too.