Chapter 4
Intellectual Property Rights: Current Developments

Possible Changes in the Us Patent Regime

Thomas Jefferson, drafter of the American Declaration of Independence, examined his nation's first patent in 1790. Today the US has patented some 6.5 million inventions. At any one point in time there are currently some seven million applications underway, reflecting today's knowledge explosion. Proposals aimed at liberalizing US patent law have proved controversial: US law presently allows an inventor to keep a patent application secret for as long as it takes the Patent and Trade Mark Office to issue or deny a patent. This period is supposed to average two years but in practice it averages four years and, for a very complex technology, five to ten years is common. (The first patent on laser technology took 20 years to process.) Until 1995 a US patent was effective for 17 years from issue but that was amended to 20 years from filing of patent application, following a US/Japan trade deal. Current proposals on patent reform are aimed at:

• making the Patent and Trade Mark Office a quasi-private corporation
• widening the basis on which patents may be challenged
• requiring patent applications to be published 18 months after filing.

Quasi-privatization is aimed at speeding the patent process by reducing bureaucracy, but critics claim that a less deliberative patent grant will lead to less effective patent coverage and may also favour big corporations over smaller ones or individual inventors. Why? They will have more clout with the private patent agency because, of necessity, they will be its main paymasters.

The second proposal (widening challenge bases) is aimed at quicker and better diffusion of technology – particularly important where product life cycles are shortening. Opponents claim, however, that this will scare off individual inventors and small corporations/venture capitalists by making the process less certain and thereby damaging inventiveness.

The third proposal (early publication) is aimed at reducing 'submarine patents' from surfacing years after a technology has been widely adopted, thus allowing patent owners to extract potentially ruinous royalties from others who have innocently been using the technology in the interim. But this again has been criticized: as one US commentator, Dana Rohrabacher, a Republican from California and one-time speech writer for Ronald Reagan has said, likening the proposals to a David (small inventors) versus Goliath (big corporations) battle, the proposed changes will 'gut our patent system and put our economy in jeopardy' because 'every international thief and gangster corporation is just waiting ... for us to disclose all our information before patents are issued'.

The Twenty-First Century Patent Coalition, a group of large corporations that support reform proposals, claim that reform will help US inventors bring ideas to market more quickly with less uncertainty over patent challenges. Industry needs ever more inventions to survive in the global market: IBM, for example, earns more than 50% of its revenues from products that have been marketed for less than 12 months. It seems there is a majority of large US corporations in favour of change.

Problems with Existing Patent Arrangements

Intellectual property rights are the foundation of the information revolution and the technological edifice it has built. Skills and knowledge have become, arguably, the only source of sustainable long-term competitive advantage and therefore knowledge is at the centre of the modern organization's success – or failure. What has changed from the commercial and industrial world that has dominated in the last 100 years?

• raw materials can be traded globally and their long-term price trends are downwards
• capital is now a global commodity
• truly unique technical equipment which once provided competitive advantage is now virtually unknown.

If materials, capital and productive capacity are now unlikely to be the primary foundation of economic success, then they have been replaced by knowledge and knowledge workers. Microsoft owns little of value except knowledge, and its founder, Bill Gates, the archetypal knowledge worker, is now one of the world's richest men. The industrially developed nations' fastest growth industries are:

• microelectronics
• biotechnology
• energy conversion
• speciality materials
• telecommunications.

All of these are knowledge-based industries. If their IPRs can be easily stolen and copied then fortunes can be made and lost. More importantly, the economies that depend on them may be irreversibly damaged.

IP is increasingly important as a source of licence revenues. For US electronics giant Texas Instruments the income derived from aggressive licensing has in some years exceeded that from operations. Other corporations are expected to increase their efforts to derive income from licensing. IP is increasingly important in corporate strategic planning; companies like Intel have large legal budgets to defend their own IPRs, and have been accused of harrying competitors on IPRs with a strategy of creating uncertainty, higher start-up costs and slower market penetration for rivals. The world's most successful companies today are those with a lock on some form of knowledge.

Restrictions in the Flow of Knowledge

From 1945 until the mid-1980s technological knowledge flowed in a comparatively unrestricted way around the world, especially US knowledge. The American government funded most basic research in the US and, with the exception of military technology, encouraged worldwide dissemination. During the Cold War era, economic success of friendly countries was considered important to the US's own security interests. There was, in any case, a comfortable assumption pervading the US that since the rest of the world would be permanently behind the US's technological lead, unrestricted dissemination of today's IP to friendly nations was a sound policy. During the era of the 'brain drain' to the US, America's belief in the unassailability of its own technological superiority was probably well founded. At the end of the twentieth century, however, the US government was cutting its investment in R&D. Federal R&D investment fell a significant 14% by 2002 compared to 1997 levels. It may confidently be predicted that less new knowledge will be available in the public domain – and what there is will be more restricted.

As the US government slows R&D spending, there is a belief that US corporates will fill the void, though not necessarily in basic science. There is, however, a very real danger that, without stronger and more focused systems of IP protection, companies will opt for more secrecy as a means of protecting, and maximizing returns on, their R&D investment. It is well known that a rival's research programme that can identify what is already known by its main competitors can often leverage that knowledge. Without access to others' knowledge, a research programme may be forced to 'reinvent the wheel', thus slowing new product development and increasing costs. It has been estimated that in the US, 73% of private patents are based on knowledge obtained free of charge from public (mainly governmental) sources. This statistic alone suggests that widespread secrecy about new knowledge will hamper the development of the next generation of new knowledge.

Just What Can and Cannot Be Patented?

The development of new plant varieties, the isolation of genetic coding, animal cloning and the ability to download complete libraries of information via the Internet all challenge the traditional concept of IP protection. What can and what cannot be patented? And what does copyright really mean in the age of the 'world wide web'?

It has recently been argued (for example by Lester C. Thurow in 'Needed: A new system of intellectual property rights', Harvard Business Review, October 1997) that some differentiation is required between fundamental advances in knowledge and logical extensions to existing knowledge. Each of these deserves, he suggests, a different kind of patent. Thurow cites the case of a doctor of medicine who noted a relationship between a particular hormone and a congenital birth defect. He was granted a patent for this observation, although by itself his test had too many false positives to be useful. Later development demonstrated that if his test was used along with a brace of complementary tests, they would predict whether a baby would be born suffering from Down syndrome. The doctor is currently suing to obtain a $9 fee from every laboratory that uses 'his part' of the successful test. If he wins, Thurow notes, the cost of testing will more than double. Whilst acknowledging that the physician probably did deserve IP rights over his observation, Thurow suggests:

The Battle to Join the ‘Developed World’

The acquisition of knowledge is essential for industrially developing countries and undeveloped countries. At the beginning of the twenty-first century, a number of knowledge acquisition strategies are prevalent:

• Knowledge as a 'fee' for market access rights: nations acting as monopsonists (buyer controls the market) provide opportunities for investors/sellers in their ostensibly lucrative market. But before contracts are concluded, technology transfer is negotiated. For example in 1997 between Boeing and the Chinese government, where access to the Chinese aerospace market was granted only with significant technology transfer. Part of Boeing's strategy for allowing this was to pre-empt Europe's Airbus Industrie from doing the same thing. To operate in these markets, sellers must swap knowledge for access rights.
• Countertrade requirements: a more sophisticated version of the above, typically found in large-scale infrastructure or military projects, where a given percentage of a particular project's value must be spent by the seller in the host country. Know-how transfers are normally backed onto countertrade deals and are closely monitored to ensure terms are met by the seller.
• Copying: most rapidly developing countries are heavily involved in direct or indirect copying, either legally or illegally. In many of the cultures in which knowledge owners must operate, there is less regard for personal property rights – and especially intellectual property rights. This is a cultural issue and needs to be recognized as such.
• Universities: the establishment of, or increased investment in, institutes of higher education by industrially developing countries is often coupled with sending an elite cadre to study in 'first world' universities. In 1997 there were calls in the US Congress to debar foreign students from US universities in order to prevent a perceived threat of taxpayer-funded R&D and advanced technology know-how 'leaking' abroad.

All these developments, under the general banner of 'globalization', are putting strain on the patenting system. Patent costs tend to be high, yet offer less protection than in the past. IP protection systems will not work unless most governments agree to implement them. A law that does not exist, or is not enforced, in country A is, in practical effect, a law that cannot be enforced by aggrieved country B and there is a danger of a shift of production to countries which less rigorously enforce IP laws. In extremes this may lead to trade wars, which is to the long-term detriment of IP owners.

Some Suggestions on IP Legal Development

It is no surprise that the debate on the development of IP rights is led by the US, the country that has the most to lose from the globalization of knowledge. The following arguments are prevalent in the US:

• To develop new products/processes/knowledge, individuals or corporations must have financial incentive to undertake the costs, risks and effort in R&D.
• As government funding of R&D decreases, the need for stronger incentives for private sector investment in R&D grows; the basic incentive has traditionally been monopoly rights leading to a maximum return on investment. A corollary of reduced state investment in R&D (less 'free' knowledge) is stronger private monopoly rights.

• In tension with the above, once IP exists the social imperative is to encourage use and rapid dissemination to the benefit of society at large. (If a real cure for cancer was discovered, it is unlikely that the state would allow monopoly rights to exist on the invention.)

  New IP rights legislation must balance conflicting objectives – stronger monopoly rights versus the social imperative. Legal thought processes alone are unlikely to lead to the optimum method of striking this balance. Lawyers tend not to think in economic and technological terms – their imperative is to establish new concepts within existing legal frameworks. A better approach might be, via state legislatures, to weigh the underlying economic realities of an industry against the national interest (or in an EU context, the European interest) to determine what IP incentives are necessary for successful technological development.

• Private monopoly power may be deemed to be less threatening to society at large now that anti-trust laws are better developed, governments are more willing to intervene and the free media is willing to focus on abuses of power. Technological proliferation has, in any case, undermined monopoly power by enabling 'technology substitution' (akin to the economic concept of 'product substitution') to a certain extent.

• IP laws need to be enforceable, or they should not be laws – so runs the slightly simplistic argument. But this still leaves one question unanswered – How do you protect what ought to be a right in a situation where enforcement is not possible? A partial answer might be by intergovernmental agreement, and, perhaps, by the levying of punitive international taxes against corporations that flout whatever agreements exist. This, however, will require a stable international situation and an unprecedented meeting of minds between governments on this complex issue!
• IP dispute resolution needs to be quick and efficient – a suggestion has been made by academe that patent fees should be set higher to ensure a higher quality (quicker and more certain) service. Variable fees, akin to a progressive tax system, could equalize burdens between large and small companies, as well as individual inventors. IP owners of inventions with short economic lives would benefit from speedy dispute resolution, so the argument runs. However, it is uncertain that the business community will welcome the idea of higher patent fees.
• Certain classes of information should be public domain: it is argued that the basic sciences should be publicly funded whilst developed products should be subject to private monopoly rights. This seems to be a sophisticated plea for a return to the classic pattern of science – universities and public bodies do research; industry undertakes development and brings products to market. The first objection is that this runs counter to the fundamental economic drift in most countries (especially the former G7 countries) that there should be a general withdrawal of government from economic activity. The second objection is that the suggestion requires agreed principles to determine what should be publicly available and what should be private – together with a methodology to reward those whose inventions must be made public domain. Then there is the question: how do countries decide what basic research is to be undertaken?

These suggestions would require increased public funding, compulsory purchase of certain classes of information and some form of adjudication to safeguard the interests of inventors, none of which seems particularly likely in the business/political environment of the early twenty-first century.

• A new global system of IPRs has been argued for – reflecting the needs of developed and developing countries. The developing nations' need for low-cost/high-quality medical technology/products is of an entirely different magnitude to their need for low-cost TVs. An IP system that treats these needs as equal fails both developing and developed countries and the suggestion has again been made that the relative importance of a technology to a recipient country should attract variable levels of royalty payment.

  Whilst this concept has theoretical merit, industrially developing countries may view this as being in some sense 'imperialistic' or paternalistic on the part of developed nations. It also runs the risk, if it increases the net financial outflows for technology of, in effect, increasing the already crippling burden of Third World debt. Why should developing countries opt to pay more when technology piracy is already a viable option?

• Multilateral patents could be devised to tailor IP protection to:
  • – different industries
  • – different types of knowledge
  • – different types of invention
  • – different parts of the world.

A cursory comparison of the needs of the pharmaceutical industry with the needs of the electronics industry quickly reveals that electronics need fast patent grant, fast dispute resolution, short duration patents and (perhaps) lower-cost patents – because revenue earning and product life cycles are short. Pharmaceuticals, by contrast, require long-term protection, may be more tolerant of patent and dispute delay (because clinical trials of necessity span many years) but require very long protection and (perhaps) new mechanisms to enable government agencies to grant licences of right to other manufacturers whilst also providing an agreed system to pay royalties to the prime patent owner.

Similarly, new inventions could be granted a different type of patent to logical developments of existing knowledge which represent a lower level of inventiveness. The argument is that true new inventions obtain a traditional long-term patent, because the inventor has arguably encountered most risk and uncertainty in undertaking the inventive step, whereas a logical extension to existing knowledge is rewarded with more limited monopoly rights for the owner – shorter term but probably cheaper protection.

IP and Tax Havens

In January 2004 talks between global pharmaceutical giant GlaxoSmithKline and the US Inland Revenue Service (IRS) over a long-running tax dispute broke down. GSK's share price dropped by 2% over the threat that the IRS might demand a back payment of a cool $5 billion in 'unpaid' taxes, penalties and interest. The dispute concerned the somewhat arcane area of transfer pricing, and particularly, the rate at which GlaxoSmithKline charged for marketing services supplied by its US affiliates from 1989 to 1996. The IRS case was that the GlaxoSmithKline transfer pricing rate was too low, which in turn greatly understated the company's income and so the tax paid. At the time of preparing this book the case remains unresolved.

For multinational corporations transfer pricing is the most important current tax issue. According to industry experts, the IRS's decision to take GlaxoSmithKline to court reflects new thinking by the US tax authorities. The rules would radically change how the US tax authority treats services supplied to parent companies by affiliates in other tax jurisdictions, including jurisdictions that offer sufficient tax advantages to be considered as tax havens. At the time of writing there is concern that the rules may not be workable and that they might subject multinationals to huge US tax increases.

Under present EU and US tax rules, transfer pricing of services can be reported at cost providing those services are considered to be integral to the business. Those that are integral must be priced as if they were offered by a third party, which usually amounts to cost plus a mark-up that would be appropriate in arm's length transactions. What is integral is, of course, subject to interpretation, as is the question of what is a suitable mark-up.

The proposed new IRS rules eliminate the safe harbour for non-integral services and instead require these services to be priced at cost plus. The mark up must be demonstrably close to what is available from a third party. If a third party mark-up exceeds 10% a company would have to use one of four other, rather more complex, pricing methods:

1. manufacturing, production, construction or extractive pricing;
2. reselling, distribution, sales agency, purchase agency or commission arrangements;
3. R&D, engineering or scientific pricing;
4. insurance, reinsurance, or financial transactions including guarantees.

The IRS believes that additional tax burdens for multinationals will be realistic and appropriate. Looking at the GlaxoSmithKline case again, observers note that the company relies extensively on marketing and distribution in the US market through local GlaxoSmithKline affiliates. However, the company's R&D activity is conducted mainly in the UK. It is the IRS's contention that much more value for GlaxoSmithKline's drugs is derived from marketing (US) operations than from R&D (UK) operations. GlaxoSmithKline's transfer pricing does not reflect, according to the IRS, the value of work done in the US. Clearly if the IRS view is upheld, there could be added tax burdens for many multinational corporations. Under the new rules multinationals would have to add a mark-up based on an estimate of what it would pay a third party for the services provided by its local affiliates. But the company would have to prove that the mark-up was appropriate, based on market prices or 'comparables'. If it cannot do this with some degree of accuracy, additional tax may be due. Ignoring the mathematics, the sums at sake could be considerable.

The IRS is trying to overcome a legal precedent established in a contract research case in 1992. The case involved Westreco, a subsidiary of the global food giant Nestlé. At dispute was some contract research that Westreco undertook for its parent Nestlé, which was later reported in the annual accounts at cost plus mark-up. The IRS took the view that the mark-up was too low, but the court pronounced in favour of Nestlé. The IRS's real target in its current moves, some observers suggest, are US companies that have established manufacturing operations in tax havens so as to avoid US tax. Under the IRS's current approach, these companies could face hefty new tax bills based on profits generated in the US, if they are deemed to have transferred engineering or scientific know-how in the process. The IRS might then require a parent company to report not the cost of employee salaries who transferred the engineering or scientific know-how, but a proportion of the profit that would reflect the value of a typical licence agreement that a third party would pay for the 'intangible asset' involved. All very complex and somewhat arcane, but a subject worth noting for those who are involved in buying in knowledge services from overseas. A further danger is that if different tax authorities take different views on transfer pricing, multinationals could face double taxation.

To conclude this section on the tax havens and the smoothness of some tax consultants, consider this quote from the UK Financial Times (special report on intellectual property, 30 April 2003). Quoting a tax advisor, the FT noted:

The European Patent

On 3 March 2003 EU member states concluded 30 years of deliberation to reach an outline agreement on a single harmonized patent that will be valid throughout the EU. Companies in particular should benefit from a cheaper, more efficient one-stop shop for patent services, rather than having to apply for many patents throughout the EU zone. However, the patent will not come into force until 2006 at the earliest and the proposed European Patent Court will not be formed until 2010. There will be a need for transitional arrangements, yet to be defined.

Under new rules, EU companies will have to pay €25 000 for the new community patent. This is still higher than in the US and Japan, but is approximately half the average current cost of applying for patents across Europe. EU member governments hope this will encourage EU firms to increase R&D spending and help to convert the EU zone into the world's most dynamic economy. Time will tell whether this ambitious target will be met, but there remains a glaring disparity between the EU and the US in intellectual property. Although the EU and the US generate a similar number of patents, there are significant disparities between EU member states. For example, Sweden generates twice the number of patents per head than does the US, but Portugal and Greece generate just 1% of the patents of their Swedish EU partners.

The difficulties of doing a final deal are not to be underestimated. There are cultural and philosophical differences between the approaches of the member states. In the past countries such as France and the Netherlands have looked favourably on claims of patentees and trademark owners. In the UK the interpretation has been less liberal. Furthermore, some EU lawyers believe that the benefits of a community patent are already beginning to be negotiated away. Community patents will need to be translated (expensively) into all the official EU languages (19 now that the EU has reached 25 member states).

For EU companies, the cost of safeguarding IP rights is just one of a growing list of bills that they must meet as 'knowledge-based assets' increase in significance. Spurred by the idea of 'buried IP treasures' larger businesses (and some smaller ones) have trawled their patent portfolios in the hope of rediscovering winning ideas that will have future commercial potential. Elsewhere in the EU discussion continues on possible methods for balance sheet valuation of IP assets, but there is as yet little consensus on the subject. Finally the whole question of IPR enforcement is under scrutiny. Attempts continue to be made at EU level to devise a viable centralized model. According to a Danish government study the annual economic gains could be as high as €21 billion across Europe. The accuracy of this has been questioned, but what is clear is that the potential economic benefits are very large.