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Johnson & Johnson hatches plan for marketing intangibles

As the OECD tries to settle the dilemma of digital tax, the pharmaceutical industry is looking for a way to make marketing intangibles the core of a global solution.

The OECD consultation document has no shortage of critics in the business community. Not only do multinational companies (MNEs) fear that the attempts to tax the digital economy will undermine traditional transfer (TP) pricing arrangements, businesses are concerned that the solutions will come at their expense.

One head of TP at a FTSE 100 company told TP Week: “The BEPS project really came out of a veryreal need to modernise global tax rules. There was a lot of public frustration with businesses who were perceived as not paying their fair share.”

Some MNEs are even seeking out practical solutions rather than wait for governments to define the policy debate. Louise Weingrod, vice president of global tax at Johnson & Johnson, and her colleague Katherine Amos, vice president of global TP, laid out the case for a three-pronged approach.

“The most basic version of a simplified method would be to take a fixed amount of global operating profits and allocate it to the local market companies,” Amos said.

“We thought there should be some measures around the differences in local country markets and types of businesses,” she explained. “We were uncertain if all countries would accept a splitting of losses when a company generates an overall loss that could be related to product development, or manufacturing problems unrelated to the local market distributor [LMD].”

If this is fixed at say 20% return on sales (ROS) the profits generated could be allocated to the local market, taking local revenue and the number of employees as a key for apportioning income. This is where many discussions about the future of the arm’s-length principle (ALP) and unitary taxation lead to.

Amos and Weingrod recommend a base return of 3% ROS for LMDs. When it comes to tech companies with no revenue booked where they have users, the two tax directors suggested “total revenues may be required to calculate the base return”.

This solution aims to adjust profit targets for particular business operations and achieve a simple approach to taxing digital activities. However, simplicity has long been elusive in tax policymaking. If anything, the global system is getting more and more complex every year.

Almost all companies would rather keep the ALP, but a growing number of businesses seem to be entertaining the possibility of a new global standard. “The OECD guidelines were a step forward in many ways, but they were not as helpful as they could have been,” the head of TP said. “Finally the OECD has realised that there is a lot more work to be done.”

“The OECD realised that the arm’s-length principle is actually quite crude,” the head of TP said. “It’s basically ‘do what third parties do, go!’

Three levers

Any MNE with a vast amount of intellectual property (IP) will be vulnerable to taking a hit from the digital tax debate. This is why it’s surprising to find Johnson & Johnson has laid out practical ways that the tax authorities could take to approach the marketing of intangibles.

The Johnson & Johnson solution uses a formulaic method that starts with setting a base rate and uses three levers:

  • assessing group profitability and profit allocation in local markets;
  • analysing business marketing expenditure on a country-by-country basis;
  • setting profitability targets for local market activities to limit the impact from other parts of the supply chain.

Lever One

The first lever is intended to bridge the gaps in industry profitability. “Companies with high operating margins would add to the 3% base rate using a formula,” Amos said. “In companies where overall enterprise operating margins exceed a fixed amount, 12% ROS in our example, the LMD target profit would increase from the base amount by 20% of the increase.”

This would mean an MNE group with overall profitability of 17% ROS would see the LMD target ROS increase from 3% to 4%. The group ROS would be 5% higher than the 12% base and the LMD would receive 20% of the difference. This would be another way to approaching sharing out residual profits.

“Conversely, in cases of lower group profitability, the base return would decrease,” Weingrod said. “Take a company with an overall 7% operating margin, where the 3% ROS base target provides the LMD with a share of the group profitability…Here, the 7% actual ROS result is 5% below the 12% ROS comparison rate established, and we propose the impact again be 20% of the difference.” She concluded “This would result in a 1% impact to the base target and a reduction of the target to 2% ROS.”

Lever Two

While the first lever provides the basis for profit allocation to LMDs, the second lever involves breaking down the marketing spend country-by-country, taking into account national differences.

“We propose that a basic calculation of LMD marketing spend as a percentage of LMD sales be compared to a target, with the LMD ROS target being increased where heavy marketing expenses are incurred and reduced where marketing expenses are lower,” Amos said.

“This would account for differences in margins, required for brand focused B2C markets, versus less marketing-intensive B2B markets,” Weingrod said.

An important part of this process is how to define marketing expenses. It could include everything from coupons and free samples to the registration costs of trademarks. Johnson & Johnson recommended that marketing costs should be included.

“We would recommend more discussion around whether [or not] this category should be expanded to include both sales and marketing costs,” Amos said. “This might be a very practical consideration for companies and tax authorities.”

Lever three

The third lever is meant to set limits on profit targets for LMDs. These distributors are typically engaged in low-risk activities and belong to an extensive supply chain, whereas other parts of the business take care of the high-risk activities.

This means it would be wrong to allocate such risks to the LMDs. So Johnson & Johnson argued that there should be “a floor and a ceiling” to avoid the LMD facing the brunt of decisions made elsewhere in the supply chain.

“Our straw-man proposal would be to limit the LMD to break even on distribution, even if the application of the other two levers would result in the LMD targeting a negative ROS,” Amos said.

“We think a ceiling is necessary to allow other entities in the supply chain to earn returns for risks and intangibles developed,” Weingrod said. “Our proposal is to cap LMD returns at no more than 40% of group operating profits.”

This 40% might be best calculated on an aggregate basis. The company stressed it does not endorse the proposals in the OECD consultation paper and all of the numbers in its proposal are laid out for illustrative purposes only.

“While we are proposing a formulaic method for the LMD, we believe that the arm’s-length standard is the only viable solution to deal with the complexities ranging from high-risk product development to multi-location high-value manufacturing,” Amos said.

“If we adopt this type of approach, our data will be easier to use in the more complex calculations once we can carve out the returns for the LMDs,” Weingrod said. “It may also be appropriate to consider using a three-year average calculation.”

Is there an alternative?

The debate over how to tax the digital economy is increasingly fraught and the marketing intangibles proposal is not the only option on the table. By contrast, Procter & Gamble favours an anti-abuse rule that would set a minimum tax rate on controlled foreign companies (CFCs).

“We are of the view that an ‘anti-abuse’ approach as an overlay to the existing transfer pricing guidelines, applicable to all businesses, may be the most appropriate solution,” said Timothy McDonald, vice president of finance at P&G.

“This could take the form of a well-designed CFC foreign minimum tax, e.g. reasonable tax rate computed on an aggregate basis, primary taxation rights attributable to the parent country jurisdiction,” McDonald said.

It could even take the form of a corresponding minimum tax in destination markets, where the company sells its products and services. Nevertheless, the vice president makes several caveats about the anti-abuse proposal.

“We disagree with the principles behind the global anti-base erosion proposal as it seeks to extend the right to tax beyond where economic substance is located,” McDonald said. “The proposal is not in line with the arm’s-length principle and is looking to assigning taxing rights based on the level of tax attributed to the transaction rather than economic functions, assets and risks.”

The company made it clear that it would not support a minimum tax that denies deductions and treaty benefits where “income is not sufficiently taxed” in another jurisdiction. It should be possible to deal with the problem of base erosion and profit shifting to low-tax jurisdictions without imposing a rule on all MNEs.

It’s obvious why a ‘flexible’ approach to anti-abuse measures would appeal to taxpayers. The bad news may be that the world has changed and international institutions like the OECD and the EU are all too eager to take a hard line.

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