The Rise of Global Innovation by US Multinationals

Lee G. Branstetter, Britta Glennon, and J. Bradford Jensen of the Peterson Institute for International Economics provide an interesting discussion of the risks and opportunities from the following:

Total US R&D spending as a share of GDP increased slightly from 2.5 percent in 1999 to 2.7 percent in 2016.2 Multinationals are an important driver of aggregate R&D spending in the United States.3 Their share of total US R&D spending was 57 percent in 2015.4 US MNCs play a disproportionately important role in driving innovation within the United States. At the same time, US MNCs have dramatically increased their overseas R&D expenditures. Figure 1 shows that US MNCs’ foreign R&D expenditures increased from nearly $15 billion in 1997 to over $55 billion in 2015. In some industries, the growth of overseas R&D has been especially striking. R&D expenditures by overseas affiliates in professional, scientific, and technical services increased by more than a factor of 18 between 1999 and 2014, and the ratio of overseas R&D to domestic R&D by multinationals in this industry has increased from under 10 percent in 1999 to over 40 percent in 2015. While US MNCs’ foreign R&D expenditures have increased dramatically, they still conducted about 83 percent of their R&D in the United States in 2015 (down from 92 percent in 1989).

I wish to add one more wrinkle – that being the transfer pricing implications from these observations and the latest from the IRS:

Captive Services Provider Campaign … The section 482 regulations and the OECD Transfer Pricing Guidelines provide rules for determining arm’s length pricing for transactions between controlled entities, including transactions in which a foreign captive subsidiary performs services exclusively for the parent or other members of the multinational group. The arm’s length price is determined by taking into consideration data available on companies performing functions, employing assets, and assuming risks that are comparable to those of the captive subsidiary. Excessive pricing for these services would inappropriately shift taxable income to these foreign entities and erode the U.S. tax base. The goal of this campaign is to ensure that U.S. multinational companies are paying their captive service providers no more than arm’s length prices.

So where are the foreign R&D affiliates located? The Peterson Institute Policy Brief also notes:

In 1989, US MNCs were conducting 74 percent of all foreign R&D in just five countries—the United Kingdom, Germany, Japan, France, and Canada. They were prominent R&D locations because of their historical importance as global centers of scientific research (and as lucrative consumer markets for US MNC products). By 2014, however, only 43 percent of all foreign R&D was being conducted in these five countries. Figure 2b shows the growing importance of new locations and the corresponding decline in the relative importance of traditional R&D hubs. Many of these new hubs have only recently graduated from the ranks of developing countries, and two of the most important new destinations for US MNC R&D, China and India, still have relatively low per capita incomes.

Let’s take as an example an Indian contract R&D affiliate that incurs $100 million per year in expenses. While the Indian tax authority would likely expect a 25% markup ($25 million per year in profits), the IRS is likely to argue for cost plus 5%. Of course, I have seen situations where a European parent has engaged a U.S. based affiliate to perform contract R&D at cost plus 5% whereas the IRS has insisted on much higher markups. So much for consistency I guess. How to resolve this potential double taxation? Quick call the Big Four accounting firms or some law firm like this:

Eide Bailly’s recommended approach in a captive subsidiary transfer pricing analysis is to benchmark the profitability of the entity with the less complex functions and fewer risks.

Now you might think these guys are about to charge the multinational big bucks for this kind of gibberish – and you would be right. But I should not pick on this firm as what their competitors are peddling is even more gibberish. Of course, a multinational could migrate any successful R&D to a tax haven and pay these firms even bigger bucks to essentially lie in order to make Base Erosion and Profit Shifting “perfectly legal”. But that topic will have to wait for another day as I put my thoughts together on something called the Altera litigation.