"But everyone else does it": the Corporate edition

Last week, fellow Kat Neil delighted us with a brilliant post on one of the biggest nightmares of IP lawyers, who are so often confronted with the wisdom of the crowd. “But everyone else does it” is not only the client’s dreaded response to an advice he dislikes. It works equally well (or bad) to explain corporate practices that raise doubts or concerns. A couple of days ago, representatives of Apple appeared before the Permanent Subcommittee on Investigations of the US Senate, at a hearing dedicated to ‘Offshore Profit Shifting and the US Tax Code’, to testify about the Cupertino-based company’s fiscal practices (video here). This post is not a comment on these practices, but a collection of IP-centred thoughts, triggered by the arguments and issues discussed at the hearing.

A familiar sight welcomed this Kat
during a trip to Austria

The members of the Subcommittee, whose positions concerning Apple’s fiscal practices varied from appreciation to severe criticism, appeared particularly concerned by the discrepancy between the share of research and development conducted in the US, some 95%, and the allocation of the majority of its worldwide income, consisting in the profits made through the sale of products on several non-US markets, to subsidiaries in Ireland, where a very low tax rate is applied (a process characterised, by the Chairman, as intellectual property ‘shifting’ from Apple to its subsidiaries, for the purpose of minimising the company's tax burden). Apple clarified that all the profits generated by sales in the US (35% of worldwide income) were taxed in that country. The Chairman Senator Levin, however, argued that the company benefits from the favourable environment and services offered by the US. Senator McCain added

'[a] company that found remarkable success by harnessing American ingenuity and the opportunities afforded by the U.S. economy should not be shifting its profits overseas to avoid the payment of U.S. tax, purposefully depriving the American people of revenue' (statement here). 

These remarks trigger an interesting question: what is the relationship between corporate taxes and IP?

Answering this question requires a level of abstraction. If taxes paid by individuals are generally seen both as a compensation for services rendered by the public administration and as a contribution to their financing, proportional to the citizen’s income, the situation is different in relation to corporations. Many of the services they benefit from are either financed through non-income based taxes (e.g. property taxes in relation to local services), or are indirect and non-exclusive. As far as IP, in a broad sense, is concerned, these services include the establishment of an intellectual property law system (through relevant national legislation and international cooperation efforts), the creation of judicial bodies and procedures that ensure the enforcement of IP law, the creation and maintenance of a high-quality educational system (from which future innovators come from), and the development of research-centred policies (including public research financing, incentives for research and development, grants and international exchange programmes, etc.).

Assuming that a relevant part of corporate taxes is indeed devoted to this aim, it would be interesting to measure the efficiency and costs of these services, comparing these data with corporate tax contributions. In this hypothesis, the interdependence between the IP system, the companies that use it, and the (future) inventors that fuel it would necessary imply that, when companies attempt to minimize their fiscal burden, the overall development of the intellectual property system, and its beneficial effects, could be reduced, to the detriment of companies themselves. In other words, low-taxed profits may generate happy share holders in the short term, but may also take a long term hit on the overall efficiency of the IP environment from which the companies benefit. Several arguments could dispute this reasoning.  For example, we could argue that a very small amount of corporate taxes is used to improve the IP system, or that its efficiency does not justify the current tax rates - Apple's CEO expressed its disappointment about the length of IP trials in the US, in contrast to the fast productive cycles of the same products which are the matter of the underlying disputes. Most of these counter-arguments, however, share a common concern: it is in the companies' interest that their taxes are invested in the development of a working and efficient environment for the protection of IP. Perhaps the Subcommittee should have focused on this perspective as well, since it may actively influence the companies' fiscal strategies.

Tim Cook, Apple's CEO

There is more to the story, though. Most of Apple's hearing revolved around its tax practices, the interests of shareholders versus those of the American people, and the enormous amount of cash owned by Apple oversea (more than US$ 100 billion). Although intellectual property was originally meant to protect 'the labours of the mind, productions and interests as much a man's own, and as much the fruit of his honest industry, as the wheat he cultivates, or the flocks he rears' (Davoll v Brown, 1845), its use has recently shifted, from a primary force in company growth to a strategic asset frequently asserted for defensive purposes. This shift has been accompanied by an increase in patent transfers, F/RAND litigation, hold-up and other defensive or anti-competitive practices, and a corresponding decline in patent quality (noted by the OECD here), and slowdown of investments in the research and development of innovative technologies (exacerbated by the economic crisis and by investments in incremental innovation and other areas of IP). Fast productive cycles, which represent one of Apple's strengths, and incremental innovation are capable of generating fast upgrade rates and a corresponding high income, reinforced by the usually generous gross margins enjoyed by companies in the ITC sector. However, the long term sustainability of a business remains strongly rooted in its ability to bring real innovation to the market. From this point of view, although incremental innovation has many positive effects, as it allows companies continuously to bring improved products to the market, it also generates a slow but continuous deceleration in medium term sales, which is usually offset by a new generation of products, based on a more innovative technology.

These dynamics suggest that investments in research and development could provide important long term benefits. A low fiscal burden, coupled with high cash deposits and generous policies for rewarding share holders, may improve a company's financial stability in the short term. By contrast, a higher participation to public spending in the IP sector, through a fair tax contribution, and the use of cash reserves to improve the company's potential to generate innovation, may result in lower short term income, and meet the share holder's criticism, but should secure the long-term business sustainability which essentially gives innovative companies a competitive advantage independent from the market's trends, and the stability that comes from the reduced reliance on it. Even if market dynamics, consumers' preferences and strategic use of cash and IP assets appear to drive competitors' moves, the "everyone else does it" mantra may prove, once again, to be a weak argument.