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It's time to wring tax savings out of E-business outlays. In one survey, 68 percent of CFOs said taxes played little or no role in their decision-making on E-business initiatives.
Ian Springsteel, CFO Magazine
May 1, 2001
If taxes aren't the first thing that come to mind when you think of spending on information technology, you aren't alone. For example, according to a survey last fall by KPMG LLP and eCFO (the technology- focused cousin of this magazine), 68 percent of CFOs said taxes played little or no role in their decision-making on E-business initiatives.
That spending was certainly lavish. A study published during the first quarter of 2001 by the high-tech research firm Forrester Research found that companies spent an average 3.6 percent of revenue on E- business initiatives last year.
What a difference a few months make. As profits tighten, companies are now looking harder than ever for cash flow from these investments, and, consultants report, that includes maximizing whatever tax benefits apply. After all, for a company taxed at the top corporate rate of 40 percent (federal and state), a $180 million expenditure could translate into a tax benefit of $72 million, all of it perhaps available in the year of outlay.
The same thinking applies to new spending. Although Forrester says some preliminary indicators suggest new spending will fall this year, the experts note that companies just getting around to implementing big IT transformation projects are integrating tax accounting and planning into their plans, boosting the likely aftertax returns from the outset. That, naturally enough, will put those who have already finished new initiatives under even more pressure to find tax savings.
"Applying good tax-planning ideas to E-business initiatives can often produce some significant cost savings and cash-flow benefits, sometimes enough to pay for the entire cost of the initiative itself," says Michael Burke, a partner at KPMG and leader of the firm's E-tax- solutions practice. However, he contends there's plenty of upside for those just getting around to focusing on tax efficiency, though it may require better communication between the IT and finance departments. "Within many companies," he says, "there's often a big disconnect between E-business initiatives and the rest of the organization, including the tax department."
Companies are finding tax savings via two avenues. First, there's the possibility of accelerating deductions by carefully reviewing and documenting expenses related to any major E-business initiative. Properly categorized, deductions could come from spending on E-commerce development, but also networked business-to-business technologies--such as procurement and accounts-receivable portals--as well as customer relationship management (CRM) projects and some aspects of enterprise resource planning (ERP) implementation. The goal, as with the tax accounting for most technology expenditure programs, is to justify the immediate write-off of as much of the costs as possible.
The second avenue uses E-business as a foil for tax planning, typically by helping shift income from high-tax jurisdictions to those that are relatively low-tax through appropriately structuring expenses and transfer-pricing mechanisms. Although the techniques are based on long-standing tactics involving intellectual property, tax specialists report a surge in interest in applying them to E-business, and claim substantial savings are in the works.
DIVIDE AND CONQUER
While the first route--expensing rather than capitalizing expenditures--is more straightforward, the savings it can produce aren't always obvious or easy to defend. The Internal Revenue Service is usually bent on spreading those expenses over at least three years, sometimes more. This is particularly the case with any expenses related to new technology that is used only internally, including business- process improvements, notes Jim Hunter, head of the E-business cost- analysis practice at PricewaterhouseCoopers.
Too often, Hunter explains, the pieces of a large project are lumped together, with development costs for internal-and external-use software aggregated along with costs for contractors, packaged software, and hardware. "Carefully analyzing and separating all those expenses into distinct categories can usually identify many items that can be immediately expensed," he says. For instance, much of the strategic planning and training work that takes place in the switch to a Web- based procurement process might be classified as a "normal and ordinary" business expense, and thus separated from other implementation costs, which would be capitalized.
In addition, much can be gained from the careful transfer pricing of such costs to business units nationally and internationally, assuming they have a legitimate interest in the project. "There are very fact- specific questions that have to be answered about what costs need to be shared with subsidiaries, or when a taxpayer might instead charge the subsidiary for use of the technology on an ongoing basis," says Hunter.
Granted, companies would have fewer hoops to jump through should Congress enact a proposal by Rep. Jerry Weller (RIll.). The proposal would make a wide variety of expenses for computer-based and other digitally based hardware and software deductible immediately instead of over the three years or more generally required by the IRS. "It has been over 20 years since Congress reformed the depreciation section of the tax code," says Weller. "In these two decades, we have seen a dramatic growth in the IT industry and an increasing reliance by business on technology that was never imagined by those writing the code."
At least some Democrats support his plan. But companies aren't holding their breath. Consider Kimberly-Clark Corp., the $1.8 billion consumer paper products company. Now in the early stages of implementing its ERP system, it is wasting no time in taking care of the tax issues the effort raises.
"We want to expense what we can," admits David Bernard, vice president of tax at Kimberly-Clark. "But more important is to come up with the correct tax result, so the IRS doesn't come back to us years from now with a problem [with] how we accounted for the project."
To get that answer, the company will be turning over much of the cost-analysis and transfer-pricing work to an outside service provider. "For a small tax shop like ours, with any expensive project like this with lots of transfer pricing involved, we don't have the ability to do all the work in-house," says Bernard. "It's best to get the experts with the most exposure to these issues."
Some companies are seeking research- and-experimentation tax credits for developing E-business activities, particularly new sales channels. But they could be asking for trouble, as the IRS has repeatedly played tough on such credits.
Companies choosing the second avenue to E-tax-savings are, for the most part, engaged in savvy multijurisdiction planning. The most common approach involves income-shifting; that is, finding a way to shift income to a subsidiary or special-purpose entity in a lower-tax jurisdiction by locating an asset there, usually some type of technology or other form of intellectual property. Other subsidiaries using that asset, often by license or service contract, are charged based on a justifiable transfer price. The fee reduces income subject to U.S. tax. While this technique is old hat for a number of industries, such as pharmaceuticals and software, in which the intangible qualities of a product make up most of its value, it is being applied further and further outside those arenas.
At the moment, the most common way to shift income is to capture customer information through applications running on servers based in lower-tax jurisdictions, the use of which is charged to operating divisions. As Burke of KPMG puts it, "This is where the real juice is in these E-business initiatives."
But these arrangements aren't a sure thing. The information subsidiary must meet certain conditions for the parent to avoid having the IRS tax the fees as income. Basically, a company must operate part of its business there, and that means more than plunking down a server in a tax haven. It will help, for instance, to locate employees at the site to analyze the data instead of merely collecting it.
Experts also warn that the IRS could impose a separate levy on companies that move established information centers from relatively high-tax to lower-tax locales. "Moving intangibles offshore may create a toll charge by the IRS, defeating the cost savings," says Burke.
Yet this kind of planning can be effective for new ventures, and is likely to draw more interest as U.S. companies go global. That's especially true of such expansion through acquisitions, since the acquired company's information systems may already be in a lower-tax locale, avoiding the problem of toll charges for operations that are moved.
"We've employed [international income-shifting] ideas with contract manufacturing and various special-purpose entities for intangibles since 1998," says the director of tax planning for a financial technology firm that recently expanded overseas through a purchase. "Now that we are far more international in our operations, and considering various E-business initiatives, applying that same technique to intellectual property generated from E-business activity is something we'll consider," he says. "E-business tax planning seems like a logical next step."
Ian Springsteel is a freelance writer based in Boston.
CRM AS A TAX SHELTER?
Locating a customer relationship management (CRM) center outside the United States can produce big tax benefits if done correctly.
Consider the example of a $2 billion industrial company that established a CRM center last year in Bermuda, which does not tax corporate income. The company's operating divisions collect the sales and customer data, but send such information directly to the center to be collected and analyzed. The center, which is actually staffed by marketing analysts employed by the company, sifts the data for useful sales patterns. That knowledge is then sent back to the operating divisions to help increase sales.
The operating divisions then pay service fees to the center, based on a predetermined transfer price. That lowers the divisions' income, and thus the taxes they pay. After paying the center's operating costs, the remaining profits are used to help fund international operations, though care must be taken to avoid repatriation and tax under U.S. tax rules.
For at least the first few years, the company expects its operating divisions to pay between $20 million and $40 million a year in fees to the CRM center, which would reduce taxes paid in the United States by $7 million to $14 million a year. And if the fees rise more than that, so would the tax savings.
The bottom line? Say the firm earns a pretax profit of $100 million. Based on that, its current fee arrangement would produce tax savings of roughly $10 million a year, or an ongoing boost to net earnings of 13 percent. --I.S.
CLEARING THE R&E HURDLES
Can software development qualify for the research-and- experimentation (R&E) tax credit? To do so, the Internal Revenue Service requires that the development aim to eliminate technical uncertainties, introduce new functionality, relate to a scientific experimentation process, and rely on computer-science principles. Moreover, if the software is deemed to be for internal use, it must meet three additional criteria. The software must be commercially unavailable, "innovative," and entail a significant economic risk to the company. Even then, the credit is limited to only 20 percent of the amount above a level based on past R&E expenses.
Claiming all this is one thing, but getting it past the IRS is quite another. Consider the stamina of an information services firm based in the Northeast, which spent five years fighting the IRS over such credits. The expenses, in excess of $300 million, involved the development during the mid-1990s of various computer distribution methods, including CD-ROMs, dial-up services, and the early stages of Internet use and E-commerce. Of those expenses, the company claimed more than $20 million in R&E credits. It finally settled for roughly two-thirds of that amount last year, but received more than $20 million after interest.
"The company made it clear they were willing to litigate," says Jim Hunter, head of the E-business cost-analysis practice at PricewaterhouseCoopers, who helped defend its claim. But it was also on relatively firm ground. "The key was that the technologies were not for internal use," he says, "but really were part of the company's product and its delivery channel." --I.S.