When cutting your tax bill hurts innovation

Picture: Catherine Magelssen, Assistant Professor of Strategy and Entrepreneurship

Credit: Kate Stanworth/LBS

Imagine a scenario, you are the CEO of a profitable subsidiary in a diverse multinational business.

Your subsidiary is in a field that is ripe for technological disruption and your staff of talented engineers often spot opportunities to innovate. They are committed to the company and keen to invest their time and energy developing these opportunities.

In the region where you are based there are many technology-intensive businesses – large and small – to collaborate with and enter into IP license agreements with. 

And, keen to promote the ‘creative cluster’, the regional government, has just introduced substantial tax breaks for research and development (R&D) activity. 

All the stars seem to be aligning: great people, great ideas, and sources of complementary assets and subsidies.

Time to select a few of those great ideas and set your engineers free to experiment. This is the fertile ground for investing in innovation we would all hope for.

However, there’s a complication. A few years ago, the Group Board, on the advice of their crafty auditors, introduced a new tax-avoidance policy. This involved transferring all subsidiary-generated IP within another subsidiary in the Cayman Islands, a low-tax jurisdiction. In order for the scheme to work that IP-owning subsidiary also needed to approve and pay for the R&D projects that resulted in IP generation in return for royalties for use of the IP.

Group subsidiaries like yours – which are typically in high-tax territories - pay the Cayman entity royalties for the IP they use to reduce their taxable profits.

The Cayman company pays for the R&D in exchange for the IP rights. This Cayman company makes a nice big profit but that’s fine because it pays hardly any tax.

None of this should affect innovation within the subsidiary. If it needs money for R&D, it can ask for it and if it wants to use the resulting IP, it simply asks for a license and pays royalties. It is all still inside the group.

And yet poised to innovate, you hesitate. Will you – as a business or individual – be rewarded for generating a return from the new products that result from the IP you generate? 

You might reasonably ask yourself, if any formal IP is generated, is it worth exploiting it to the full, knowing that profits will disappear from your top line with limited contribution to your bottom line KPIs? 

Wouldn’t it have been easier if you paid for your own R&D and exploited resulting IP locally? You wish you could just back your own judgement and be accountable for the return.

How much truth is there in this scenario?

Much has been written about the tax advantages of transferring ownership of multinational company assets – including IP (patents, trademarks, copyright etc.) to ‘special purpose vehicles’ in low-tax regimes to which other group companies pay royalties. 

However, there has been little consideration given to the, unintended, consequences of such structures. The conventional wisdom is that these consequences are minor. After all, the subsidiaries are 100% group-owned and therefore part of one family.

So, why should there be any impact on R&D?  Do subsidiary heads really think and act in the way of our imagined CEO?

This is the question that Catherine Magelssen, Assistant Professor of Strategy and Entrepreneurship, sought to answer by connecting the innovation performance of multinational company subsidiaries to the company policy on ownership of IP. 

She reviewed written company policies from a dataset on subsidiaries between 1997 and 2011 and correlated them with the number of high-impact patents generated by the subsidiary. The period covered 78 multinationals each with an average of 10 R&D subsidiaries.

She separated out those businesses that operated in high technology regions, hypothesising that IP ownership policy might have a greater effect on those subsidiaries in such regions.

Professor Magelssen also separated out subsidiaries operating in territories that had recently introduced tax incentives for R&D. This allowed her to assess causality – whether policy affects performance or vice versa.

The research found that, particularly for subsidiaries operating in technology-cluster regions, the innovation performance on companies that paid for R&D and owned resulting IP locally were twice as likely to create impactful patents.

And furthermore – it is the policy that drives performance, not vice versa.

There is a real, but as yet unrecognised, cost when firms distance the creators of IP from the owners of that IP – even when both are under the same corporate umbrella. 

The thought processes of our fictional CEO mirrors what happens in practice. Elaborate IP tax avoidance policies may seem like a good idea on paper but they do impact creativity within a business and as a consequence, its long-term value.

‘Allocation of property rights and technological innovation within firms’ by Catherine Magelssen was published in the Strategic Management Journal, September 2019.

Jeff Skinner is Executive Director of the Institute of Innovation and Entrepreneurship.