Offshoring* and IP
Discussion points
not an argument pro or con offshoring
*offshore outsourcing
Gio Wiederhold
Emeritus, i.e. no responsibility
Stanford University & MITRE Corp.
and they are even less responsible for what I bring up
March 2004, updated June 2004
www-db.stanford.edu/people/gio.html
No answers, but perhaps some understanding
Based on seminar given at MIT Sloan school’s Outsourcing Seminar, 14 April 2004
Hypothesis
• Current offshoring of jobs is effective because
of concurrent Intellectual Property (IP) transfer
• Some of that IP is corporate property
• Transfer of corporate IP is poorly understood
– IP as property is not well measured
– There are many components, coming from
• open source, R&D, marketing, reputation
as
• Patents, copyright, trade secret (covered by NDAs)
• The IP transfer is a valuable, significant export
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Link
To be effective a worker has to know what has to be done
• call center employees
• That knowledge consists of
• technicians
• engineers
– The technology
• managers
•
–
The business methods
•
•
•
Documentation, prior versions, quality control
How technology in the product is marketed
The flow from buyers to improved products and methods
Companies distinguish themselves by proprietary IP
1. Patents, sometimes copyrights
2. Confidential Documents
3. Knowledge within its people - protected by NDAs
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Trade
secrets
3
To illustrate: a sequence of Hx cases
• Moving from sales to Transfer of property
– Country-based vs. Global companies
• Moving from tangible to Intangible
– Visible & measurable, barely so, or not at all
• Intangible knowledge to Intangible property
– Services versus Patents and Trade Secrets
• Outsourcing
– Work and its enablers: human and intellectual capital
Definitions emerge as we proceed through 10 cases
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Case 1: Tangible export only
U.S. Machine tools * producer
* To simplify: tools are not innovative, could be be built anywhere
• Exports its products to foreign countries
– Receives payments for those exports
– Pays taxes on resulting profit
IP Note: the producer does supply documents for use of
the machines. Those documents may be copyrighted.
But copyright does not protect the intellectual contents,
only protects outright copying.
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Case 2: Tangible transfer
Global Machine tools producer G
• Exports machines to foreign factory F owned by G,
to be used in production of other products at F
– G receives transfer payments T from F for those exports
– Must show that the transfer price T is reasonable
• Should match prices of external sales by G, or by other Co’s
• Unreasonably low transfer prices imply U.S. tax avoidance
and hiding profits at a foreign base.
– Pays taxes on resulting profit
It's hard though to be profitable without distinguishing abilities/IP
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Case 3: Tangible + market value transfer
Renowned r Global Machine tools producer R
Reputation r is due to investment in quality and advertising
• Exports machines to its owned foreign factory Q
– Gets higher prices T+ for external sales because of r
– R receives transfer payments for the internal exports
• Transfer price includes r when based on its T+ export prices
• Harder to assess when there are no exports, and other
companies in the business have different reputations
• Reputation r is IP generated by marketing & product quality
fast effect - long-term effect .
– Pays taxes on resulting profit
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Case 4: Intangible export
U.S. Software tools creator and producer
• Exports software to foreign countries
– Receives payments for those exports
– Pays taxes on resulting profit
• Problem: software is easily copied
– Protection desired, achieved by combination of
•
•
•
•
Only issuing licenses -- avoids property rights issues
Copyright laws and patents -- requires govmnt cooperation
Making copying hard -- technology game
Restricting maintenance -- works for critical packages
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Case 5: Intangible transfer
U.S. Software creator and producer
with foreign distribution
• Exports software products to foreign subsidiary,
to be marketed and sold there
• Receives transfer payments for those exports
– Must show that the transfer price is reasonable
• By comparison with other sales by self, or by other co’s
– More difficult than tangibles.
– Pays taxes on resulting profit
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Case 6: Intangible manufacturing
U.S. Software producer with foreign distribution
• Exports software master to its subsidiary,
to be copied*, marketed, and sold there
• Receives transfer payments for single export
– Must show that the transfer price is reasonable
• One instance allows thousands of sales, generates ongoing
income over its lifetime
• Valuation requires projection of income over life
– When is income realized? What is the life of the software?.
– Pays taxes on resulting profit
* equivalent to manufacturing;
writing software is considered R&D
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Case 7: Intangible transfer, joint creation
Software producer with foreign specialists
• Exports software master to its subsidiary,
to be adapted, copied, marketed, and maintained there
– Source of foreign part of knowledge is remote
– Assume cost of all R&D centrally accounted
• Receives transfer payments for those exports
–
–
–
–
Must show again that the transfer price is reasonable
Share R&D cost according to locale of revenue
Credit foreign R&D against foreign revenue
Pays taxes on U.S. assignable profit of foreign sales
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Case 8: Shared intangible creation
Global Software producer
• Develops globally, perhaps 24/7
– Shares all knowledge globally at initiation
– Assume cost of all R&D centrally accounted
• Transfer payments should move both ways
– Must show that the transfer prices are reasonable
• Use of prior IP
• Allocation? cost, hours?
– Pays taxes on any resulting profit in U.S.
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Case 9: Shared IP creation costs
Truly global Software creator and producer
• Develops globally, perhaps 24/7
– IP creation cost distribution matches U.S./foreign
income distribution ( excellent prediction and accounting)
• No transfer payments needed
– Implies balanced offshoring - no IP export/import
– Must show that the balance is reasonable
• No use of prior IP, or has been paid for as `buy-in'
– Pays taxes on U.S. sales profit only
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Doonesbury 1/2
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Doonsbury 2/2
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Case 10: Extreme offshoring
Company offshores everything
R&D, Production, distribution, service, feedback
• All IP has been exported
– Value of export is value of entire company, except
for tangibles (HQ building, cash, option income)
– All income is offshore
– Only profits needed for dividends are repatriated
– No U.S. taxable income on continuing operations
– Initial export of IP should be (have been) taxed?
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Market value effect due to outsourcing
Market value of a company =
Stock price  number of shares outstanding
(complication: stock options dilute market value)
1. Not directly effected by outsourcing
2. Indirect effects, hard to predict, manage
•
•
•
•
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Lower personnel costs increase profits
If IP transfer is not recognized then imbalance of
income location versus IP location
If foreign profits are large -- and not taxed, then
excessive cash is accumulated outside of the U.S.
Motivates further investments outside of the U.S.
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Valuing IP, Absolute
•
Absolute metrics
Note: IP not on books in U.S. accounting, unless purchased
1. Expected income / profit attributable to the IP
Requires estimating life, mix %tage of multiple IP sources,
market projection, discounting
2. Market cap of company minus tangibles
Represents expected future profits seen as by stockholders
3. Purchased value of a company (`goodwill’)
Depreciation based on irrelevant historical rules
4. R&D + advertising effort  leverages
Leverage is poorly understood, long latencies
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Valuing IP, Relative
•
Relative metrics
1. Amount spent on R&D
•
•
Note that all SW is considered R&D spending and not
capitalized under U.S. accounting rules
Quality of work has a long-range reputation impact
2. Amount spent on marketing
•
•
•
Distinguish product and corporate name marketing
Different effectiveness in U.S. versus foreign
Pure sales efforts are outbound; good marketing
provides feedback to corporate R&D directions
Balance of those two - and any others
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Mis-measurement
There is a lack of trustworthy data
1. US commerce department, 2003:
“Imports of services from unaffiliated companies
from India = $209M”
– Includes tourism services etc.
2. Business week, in 2003
“Income from North America by the Indian Big 5= $2,400M”
(Tata, Infosys, Wipro, Sayam, HCL)
– Includes Mexico, Canada
• Not covered here are transfers from affiliates,
– as Dell, Microsoft, Intel, ...
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2  Greenspan: Protecting ideas is key to economy + No protectionism
“As America's economy shifts from emphasizing the production of
material goods to the creation of ideas, intellectual property rights
have assumed increasing importance, Federal Reserve Chairman Alan
Greenspan said Feb. 27 at the inaugural economic summit hosted by
the Stanford Institute for Economic Policy Research.”
http://news-service.stanford.edu/news/2004/march3/greenspan-33.html
A week later
"As history clearly shows, our economy is best served by full and
vigorous engagement in the global economy," Greenspan said a
day after Bush inveighed against any effort to restrict access to
U.S. markets by saying it might hurt U.S. exporters.
http://money.cnn.com/2004/03/11/news/economy/fed_protection.reut/index.htm
• Isn’t that a conflict?
 Isn’t IP part of the economy?
 Isn’t the shift to IP world-wide?
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Gartner et al. estimates quoted
Six years from now, one quarter of traditional U.S. IT jobs will be done
offshore, in countries like India and China, according to new predictions
from researchers at one of the top industry analyst firms.
Today, an estimated 5 percent or fewer of U.S. IT jobs have been
offshored, according to Diane Morello, vice president in research at
Gartner, Inc. By 2010, 25 percent will be situated in emerging countries.
Forrester Research, a Massachusetts-based analyst firm, recently
predicted that $136 billion in wages, or 3.3 million jobs, will move
offshore in the next 15 years.
And this week, Deloitte Research announced predictions that by 2008,
275,000 jobs in the telecom industry will be offshored. That number
accounts for five percent of the industry's 5.5 million member labor force.
The Deloitte report also states that of the telecom companies already
offshoring or planning on offshoring, they cite a 20% to 30% reduction in
IT costs within four years, higher quality tech support and accelerated
time-to-market for advanced data services and applications. (26Mar2004)
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
Symmetry 
Exports and Transfers go both ways
• There is innovation everywhere
• If the U.S. imports IP, the receiver should pay
– Basic and fundamental research in the U.S. is declining
• Growth was motivated by WW II experience [Vannevar Bush]
• Many countries now fund basic research
– The ratio of applied to basic research is increasing
• Industrial research is mainly applied
• Technological research is rarely basic
– Development requires more resources
• Industrial and management infrastructure
Good in the U.S
• Demonstration and Beta sites - early adopters
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Convoluting non-owned IP issues
• Education: Services that transmit valuable,
but non-proprietary knowledge to others.
– If receiver pays, can take it anywhere
– If the state pays, can it / should it be reimbursed?
• Publication:
– Who benefits?
• The reader gets knowledge / The writer gets fame
• Society becomes more egalitarian, effective
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Business Tax effects?
Is uncaptured IP export one of the reasons why
today corporate taxes are about 17% of the total federal tax,
while corporate taxes were to about 35% fifteen years ago?
How significant is the IP effect?
-- there are many other ways to avoid taxes.
Individuals, Employees, and Subchapter S corporations now pay
the higher remaining share.
Income due to services performed in foreign countries, as
training, can be taxed, but I think it will be very hard to
capture a significant fraction of the lost IP via that path.
If the value of IP exports could be captured, then taxes should be
paid on the value of those exports. The income from such
taxes could offset some of the national costs incurred.
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Summary: Outsourcing and IP export
Understanding and accounting for IP exports
(making them visible)
• would increase corporate profits in the U.S.
• should reduce cash held in foreign accounts
• provide taxes that could be used to compensate
• for R&D support provided by the government
• for educational costs
• for unfunded retirement benefits of workers
whose jobs were outsourced
• Is unlikely to stop offshoring altogether
• Amounts would be large in a number of cases
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Global philosophical question
Happiness or contentment
• Personal
– More cheap stuff --- a benefit of offshoring
– More employment --- a cost of offshoring
• Global benefits of offshoring -- long term
– Greater income equality among countries
– Similar working conditions within countries
• NAFTA
• Friendly countries
• World-wide
• Can a corporation or government be happy?
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