Volume 5, Number 6 - October 2004
Managing IP Value at Risk (Part Two of a Two-Part Series)
Patent Strategy & Management
By Andrew W. Carter and Robert J. Block

In Part 1 of this article, we examined the risks to intellectual property (IP) value that would most preoccupy IP professionals, including: third-party risks for infringement liability, first-party risks to IP assets, and Directors & Officers (D&O) risks arising out of relevant valuation and disclosure. However, as IP specifically accounts for a higher ratio of market capitalization and shareholder value for publicly traded corporations, strategic choices relating to IP impact the firm's financial fortunes in more subtle ways, commensurate with that increased value. To cite one salient example: for IP-rich companies, tax planning is increasingly intertwined with Intellectual Asset Management (IAM) strategy.

One threshold challenge for IP-rich companies is that corporate tax professionals and IP experts do not usually speak the same professional language. This is unsurprising - tax professionals are not usually also IP experts, making it difficult for them to understand and take advantage of complex IP-related strategies. The practical solution is to ensure that the right IP experts and tax professionals communicate with each other meaningfully and regularly. Risk management can propose and facilitate such a solution.

Risk management's best argument for such an approach is that the IRS appears to be paying very serious attention to the IP valuation assumptions embedded in corporate tax planning and reporting. This part of our article will identify three strategic tax choke-points where risk management can identify and protect shareholder value by better understanding IP valuation issues.

IP Transfer Pricing
Global companies allocate costs and income to operations in different sovereign jurisdictions. When pencils or staplers are transferred between such entities, market guidelines are presumably not difficult to obtain. Where the transfer and allocation involves intangibles, such as IP, scrutiny and risk are heightened.

Recently one global pharmaceutical leader was presented with a $3.2 billion adjusted tax bill in the US for allegedly overpaying patent royalties to another operating division in the UK. While the competent authority system is designed to adjust such discrepancies, its infallibility in operation is being called into question. Political or technical obstacles could lead to effective double payment of already burdensome tax obligations, devastating shareholder value.

Loss control and preventative attention to valuation is, of course, important as a matter of policy. But insurance can offer tools in this area that confer unique value. For example, tax law suggests that where a policyholder planning error leads to payment of more than the lowest tax that could have been legitimately paid (on the non-tax facts of a case) indemnity or insurance proceeds are received tax-free. Thus, in a case where premium is deductible and claim proceeds are untaxed, risk-finance and risk-transfer may be combined in such a way as to offer "synthetic" deductibility for an otherwise nondeductible loss.

A closely related opportunity is to use patents as currency in connection with insurance transactions. Difficult-to-insure risks might be financed and transferred through the partial substitution of carefully selected (non-strategic) patent assets for cash premium. The transferred patents are then back-licensed by the insured from the insurer in exchange for a floating rate royalty, which is tied to a formula that tracks claims and out-licensing (IAM) revenues. If out-licensing exceeds claims, the license is royalty free (and the insured might participate in some split of such revenue). If claims exceed out-licensing, royalties "float" upward to cover some or all of the cost. The insurer obtains potential upside participation in valuable IP; the insured obtains low-cash insurance coverage for difficult risks, financed in part with fully deductible royalties. Indeed, the floating back-license is a tax-efficient, loss-sensitive mechanism that can be calibrated to fit a variety of risk appetites.

IP Holding Companies
One particular transfer-pricing strategy deserves extra attention. IP Holding companies ("IPHCs") are increasingly common, and preserving benefits (by reducing the risk of a successful tax authority challenge) should be a risk management objective.

In the typical IPHC, the corporate owner of IP transfers some or all of its IP assets to a newly formed, wholly owned entity in exchange for entity stock. Tax benefits may then be realized from royalty payments deducted in high tax jurisdictions and received in low tax jurisdictions. For companies with rich IP portfolios, positive NPV can reach the hundreds of millions, or in rare cases, billions of dollars. Of course, these benefits are an outgrowth of a general IPHC strategy of enhanced management and value creation. Concentrating the IAM function in one entity tasked with overall strategic coordination of IP policy is often obvious to the IP professional, but too many IPHC owners focus too heavily on the tax savings. Tax authorities may be expected to aggressively and successfully challenge skeletal or sham operations.

The risk manager's objective in this scenario is to make the case that non-tax benefits are worth a prudent incremental investment. With such an investment in place, tax indemnity underwriters may transfer and protect a significant portion of NPV benefits. The IPHC should be actively managed, adequately staffed, and undertake real transactions. Examples can include: out-licensing of IP, IP collateralized debt obligations, and patent sales/license-back transactions. An IPHC can be used to preserve or lock-in the borrowing power of IP assets, thereby further mitigating the risk that the assets will be impaired (through, for example, a finding of invalidity).

Also, IPHC stock should be treated as precisely that: stock, meaning a claim on future licensing revenue and itself an important source of shareholder value. IPHC stock may, for example, be used to offer incentives to engineers and officers tasked with long-term value creation. With the right planning, targeted assets might even be spun off tax free, offering an attractive and non-dilutive alternative to conventional option awards.

Leading insurance markets can assist the risk manager in preserving shareholder value created by the IPHC if insurance is part of a holistic effort to drive down risk. If the value of corporate IP will not justify a reasonable investment in IPHC deals or resources, creation of the entity most likely represents a strategic mistake. Insurance can validate such policy choices.

Patent Donations
R&D operations often produce patents with commercial potential that simply do not fit with corporate marketing strategies. Some of these patents are sold or licensed to third parties. Remaining patents are often "put on the shelf" or abandoned. In either case, any value inherent within the patents is lost. However, within the last 10-12 years enterprising IAM departments have realized that patents, just like other assets, can be donated to qualified entities, with the attendant tax benefits that donations usually produce.

Numerous articles have been written on the benefits and mechanics of patent donations; we will not seek to recount them here. Instead, in consideration of the recent attacks by tax authorities, we consider the potential remedies.

The typical patent donation deduction is vulnerable to the extent that it lacks market validation of valuation assumptions, or price discovery. When IP is licensed or sold, the buyer exerts downward pressure on the seller's valuation, expressed as the royalty or purchase price. The result of arms-length bargaining is generally understood to represent the market price, a process the IRS understands and generally respects. In the donation context, the donor still has the same seller's incentive to maximize valuation (and the corresponding deduction) but the donee lacks the buyer's incentive to push back since the donee places no capital directly at risk. It is this lack of counter-party risk capital that calls the donation transaction into question.

Here risk management has an opportunity to confer unique value. Tax indemnity underwriters can insure a significant portion of the deduction claimed (after rigorous valuation audits) supplying the risk capital and downward valuation pressure otherwise missing from the transaction. The donor can, with the right methodologies, transfer risk and lock in tax benefits for a relatively modest investment in premium (typically 6-10% of the amount insured). Alternatively, if no underwriter will invest risk capital in the donor's valuation assumptions, the donor has received valuable information about the probability of an IRS challenge and may prefer to revise those assumptions. In short, the value of insurance can include signaling: communicating to regulators, or investors (as in the loss mitigation or litigation collaring example) or shareholders (as in the IP captive example) that an important assumption about value or risk has been respectively validated or contained.

Conclusion
Insurance is an invaluable tool for aligning and integrating tax and IAM strategies. The cost of misalignment can run into the billions as the IRS increasingly prioritizes the tax implications of IP valuation. The benefits of tax efficient IAM programs can, by way of contrast, generate hundreds of millions (or billions) in incremental NPV for companies with the richest IP portfolios. Risk management should represent a critical communication link between tax and IP in the development of a properly holistic value-at-risk analysis.

Andrew W. Carter (acarter@oceantomo.com ) is a Managing Director and co-founder of Ocean Tomo, an intellectual capital merchant banc. Robert J. Block (rblock@oceantomo.com ) is the Managing Director in charge of Ocean Tomo's IP Risk Management practice.

REPRINTED WITH PERMISSION FROM THE VOLUME 5, NUMBER 6 - OCTOBER 2004 EDITION OF THE PATENT STRATEGY & MANAGEMENT © 2004 ALM PROPERTIES, INC. ALL RIGHTS RESERVED. FURTHER DUPLICATION WITHOUT PERMISSION IS PROHIBITED.