Originally published on IAM on 15 February 2024
Re-published on my website on 17 March 2024
Since this article was published, the Nikkie index on the Tokyo Stock Exchange has reached record returns for 2024. While there is correlation with the tax reform, its cause could be several things. Japan’s GDP for the 4th quarter of 2023 was revised positive. The Yen has gain strength, and the Bank of Japan is considering abandoning its negative interest rate policy, which are all potential causes of the Nikkie price increases.
The below article was written for IAM Magazine on 15 February 2024
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Regulatory changes related to patents, other intellectual property, taxes and AI vary from country to country. They can have a variety of outcomes, often with unexpected results, depending on the intent of the regulations.
Moreover, IP holders have very different motivations when deploying IP into the marketplace, and most regulators do not understand the impact because motivations with IP assets vary widely. For example, IP is a helpful tool for large multinational enterprises (MNEs) to optimise an effective tax rate. For individual and small inventive entities, IP is used to protect against infringement and to protect market share.
These two purposes can pull in different directions, and lawmakers do not understand some of the unintended consequences of these countervailing forces that seep into IP and tax regulations.
Most recently, Japan has enacted wide-sweeping patent, IP, tax, and AI reforms that will be closely watched by global observers, such as the Organisation for Economic Co-operation and Development. This article looks at the potential impact of Japan’s regulatory changes based on a few key policy initiatives.
The standard IP tax playbook versus uncharted waters in tax incentives
Japan’s recent legislation to incentivise the use of intellectual property through tax incentives should lead to broader use of patented technology, but it is too early to tell if it will have a positive and meaningful impact. Trying to understand the impact of a large regulatory change in IP is an awkward thing to estimate.
For 20+ years, my career has been based on the regulatory decisions of law makers that have enormous impact on IP valuation. The “known unknown” of significant regulatory IP change often results in unintended consequences because balancing the outcomes of IP laws on an equal basis across all market participants is incredibly difficult. It is quite easy to have things skew in favour of one group, and it usually isn’t realised until well after the law has been put in place.
Consider a few of the historical law changes related to IP that have happened over the last three decades, and we can begin to understand how unknown the outcomes are. They are often varied for individuals, small, and medium-sized businesses as compared to massive incumbents as compared to research institutions.
However, what do we know for certain about regulatory changes in IP is that large, incumbent companies will do their best to exploit the new laws to the highest possible returns for their investors. This is the certainty that comes with every regulatory change in IP and tax law for decades, and Japan’s new tax reforms are no different.
In the past, regulatory changes like the Bayh-Dole, American Invents Act (AIA), Sarbanes-Oxley/IFRS 3, and OECD guidelines for valuing IP assets have all caused additional confusion and misunderstanding about IP value. The reforms enacted by Japan may cause patent values to go much higher as demand for such assets increases based on the tax reforms that incentivise use and adoption.
However, are the regulatory reforms a permanent change to how patents are viewed in a business context? Or are the patents values artificially inflated through tax code for purposes of limiting tax exposure through transfer pricing? It is hard to tell where the primary motivator will lie with regards to the Japanese reform.
My experience suggests that the hodge-podge of regulatory oversight by well-intentioned bureaucrats with limited real-world experience dealing with IP assets has made understanding IP assets difficult at best and dark magic wizardry at worst. These challenges are heightened by the inherent double standard in regulations of IP value when it comes to IP assets. What do I mean by that?
Internally-generated intangible assets hold incredible value for MNEs and acquired target companies in an M&A. However, if that same MNE is accused of using another inventors’ patents, the value of the third-party’s IP becomes much lower. Maybe not even valid. It is called “Not Invented Here” syndrome, and it is a global issue that limits third-party licensing.
However, that may not be an issue for MNEs who are licensing internally-generated IP using Japan’s new “Innovation Box” regime. At first glance, it looks a lot like the Irish Knowledge Development Box, which provided an extraordinarily low tax rate on qualified income, typically related to IP. Will the implementation of Japan’s Innovation Box be much different than Ireland’s? Maybe, but only time will tell. It certainly gives many large MNE Japanese innovators a chance to create profit-shifting entities using this tax reform.
A notable example of how a MNE might use Japan’s “Innovation Box” is the case the US Internal Revenue Service brought against Microsoft in Puerto Rico. The IRS has floated a $29 billion fine, that includes $39 billion in profits shifted from the US to Puerto Rico. That’s almost $3 billion in missed tax profits every year for seven years through a “Check The Box” IP regime, which is legal, assuming the IP is worth $39 billion in profits.
What IP did Microsoft Puerto Rico invent that was that incredible? It is not disclosed so it must not be that exciting. Typically, an innovation that creates as much profit as the one Microsoft invented in Puerto Rico would be something Microsoft would celebrate with a splashy marketing campaign to highlight their own inventive genius, but that never happened. A Microsoft subsidiary with that much profit is the equivalent of 3% of Puerto Rico’s GDP on a cash flow basis alone.
Something is off with that and it is fairly obvious why the IRS would pursue recourse in this case. It is an issue that will certainly come up with a different player(s) for the Japanese taxing authorities in three to five years from now, unless they are well ahead of it.
It begs the question, will large MNEs attempt to use Japan’s tax laws to conduct similar efforts to profit shift for lower taxes? Of course they will, but the OECD is making efforts to limit those loopholes, and Japan’s laws seem to comport with the OECD guidelines. When Japan’s new tax laws get into the nitty-gritty, they will be sure that a certain number of jobs will be made possible by the tax savings generated.
Pretty typical stuff. But what else is unique about these regulatory changes?
The AI unknown
Artificial intelligence is going to impact society in myriads of untold ways. IP in the space of patents and copyrights are only a few steps into a great journey with AI, and the laws will need to evolve along with it.
Japan’s AI law leaves open the idea of AI created content becoming copyrightable. Meaning, as an example, if a human requests the creation of a character that is then built and designed by AI assistance using a human prompt, that output copyright belongs to the human, and can be monetised by the human. This is similar to a recent AI court case in China about a woman who found an unauthorised copy of her AI character on a different social media sites advertisement. The AI content creator sued and won minimal damages, but it was a watershed moment for AI-use creators.
Would this happen in the US or Europe? The laws and guidance is changing rapidly. Between originally writing this and publishing it, new guidance on patents generated with AIs help has been published, per the Executive Order of USPTO Director Kathi Vadal, on 12 February this year. A link the the USPTO’s guidance is here.
A few weeks ago, I got to use Beautiful.ai’s presentation software that incorporates the AI Dall-E image creator. I asked its Dall-E enable picture creator to make me an Inventor that most Americans would recognise:
AI Generated Inventor Man
I used the following prompt to create the image: "A man standing in the Superman Pose with hands pulling his button down shirt apart and his strong chest out. He is transforming from office man into Superman but he has an I on his chest. His glasses are still on."
All kinds of questions give rise to the creation of a picture I had made at my prompt inside of AI software: Who owns the copyright? Can I use the AI superhero again to make a character? As the character grows and develops its own AI responses, who owns it? If I know how to draw the same picture, can it be copyrighted? Is the prompt and the character image’s stance violating copyright? Or is it fair use and AI generated, so there cannot be a response? These are just a few of the quick base questions regulators are still working through. I’m sure readers can generate more thoughtful worries than I can, with responses that will span the oceans in disagreement.
At least the Japanese reforms are incentivising their people to be creative in their use of AI. I am cheering for their success in these reforms and regulations, and if they do not work, I hope they adjust quickly.
Ever-elusive liquidity
Valuing, monetising, and pricing the use of AI is an incredible challenge in its own right. Having a regulatory framework that is built on equitable technology development for all levels of citizen should be the goal of all invention and innovation centers operated by governments, but it is a tough pace to keep up with.
Japan’s leadership in this regard is well noted and should be appreciated by all who work in the space of IP. However, will their laws turn out to be fair and just? Only time will tell, and if the laws create inequities, it will be incumbent on their regulators to re-adjust its laws for a balanced system of equity and justice. The same could be said for all government systems writing the laws of AI and IP, but there are stark disagreements in many regards.
In my opinion, a regulatory system that brings legitimate and meaningful liquidity to IP investments is the regime that will transform business investment. Japan’s laws inch us closer to that idea, but liquidity in IP investments is one of the few asset categories that has seen massive and substantial decreases in overall liquidity the last decade.
This is particularly true for patents, but less so for copyrights and trademarks. And there is no shortage of IP owners looking to create a monetisation instance with their IP. Japanese efforts to recognise and promote IP monetisation is necessary to continue to spur creative ideas amongst the population.
However, issues of transparency and IP pricing mechanics are a known unknown as it relates to liquidity of non-legally protected IP (eg, know-how, open-source software, workforce, or customers). Until regulators require technical accounting of incorporated technology and IP into products and services, the regulations will continue to fall short of creating IP liquidity. Why is there liquidity in the stock and bond markets? Because regulators require certain levels of disclosure to ensure investor confidence, creating a fair market for trading.
Why don’t investors invest in IP-backed securities? Because there is no disclosure of incorporated IP into commercialised products (ie, freedom-to-operate), and the same equivalent types of information disclosures for stocks and bonds do not exist for IP.
Interestingly, the Japanese Tokyo Stock Exchange is taking the first steps in valuing intangibles on balance sheets that are reflective of fair market value, but it will take time to fully develop meaningful value and pricing mechanism for a balance sheet. There is also the ongoing issue of unidentified and unauthorised infringement.
Japanese IP reforms will certainly create unique and interesting situations that we will all be pressed to see how they deal with the problems that come up. Hopefully it leads to standards-based solutions. Since I look at everything through the lens of IP value, I believe that absent a meaningful oversight regime to prevent unauthorised use of third-party IP in connection with AI, liquidity will remain elusive for IP assets and the investors who back them.
However, the regime that brings meaningfully strong IP protection to inventors and content creators of all sizes, the better and more equitable the system will be for all. And the higher the likelihood that IP assets can become transactable and liquid investment vehicles.
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