Electronic copy available at: http://ssrn.com/abstract=1324242

Outsourcing from the Perspectives of International Protocols, Law, Intellectual Property, and Taxation

Amar Gupta Thomas B. Brown Professor of Management & Technology, University of Arizona

Gio Wiederhold

Professor Emeritus, Stanford University

David Branson Smith University of Arizona

Devin Sreecharana

University of Arizona

Comments and suggestions should be addressed to the first author at: gupta@arizona.edu

Electronic copy available at: http://ssrn.com/abstract=1324242

1. Introduction

“I am a programmer with a Masters degree from a prominent college in the United States. I work 10 hour days and come in on weekends on a regular basis for my company. I pay my taxes and still manage to give back to my community. So why is my country doing nothing when my job is being threatened by international competition?” “I am president of a company that took a hard look at cost numbers before embarking on outsourcing. Apart from the cost of labor, equipment, and incidentals, are there other aspects that we should have looked at? This paper attempts to delineate the relevant pieces of information needed to address the above types of questions, as well as other outsourcing1 related questions, such as:

What is the United States doing to encourage/discourage outsourcing? Are these actions legal under current international trading rules?

Is the United States a net beneficiary or net loser when outsourcing occurs?

How will the continued outsourcing of professional service activities impact different industries?

How can intellectual property be equitably protected in an economy that involves

growing levels of outsourcing?

How can intellectual property be equitably valued and shared amongst concerned constituencies in an environment characterized by significant outsourcing?

What is the ‘ultimate scenario’ for outsourcing, and how will this impact the jobs of

those in the U.S. and abroad? 1.1 Historical Perspective Outsourcing involves contracting work that can be performed in-house: this is a practice that has been occurring for several thousands of years. Before man could create ‘goods’ as we know them, the production of foodstuffs was outsourced via specialization among members of a tribe or a family. In the United States, the textiles and apparel industries have witnessed significant shifts of operations from factories located in New England to lower-wage, non-unionized labor areas in the Southeast; apart from the ‘lower cost labor’ incentive to outsource, there were two 1 In this paper, the term ‘outsourcing’ refers to outsourced offshoring (except briefly in Section 1.1). The term ‘offshoring’ by itself can mean either outsourced offshoring or in-house offshoring. A good model that describes the different varieties of outsourcing is found in [Cronin, 2004].

other factors: cheaper electric power on the Southeast and a non-unionized labor force. As transportation technology continued to evolve, it became more cost-effective to acquire textile and apparel from foreign countries. While products, agricultural or otherwise, have been imported from abroad, the outsourcing of services is a recent phenomenon and has been made possible mainly by the proliferation of very low-priced telephone and Internet communications technology around the world. In the late nineties, the demand for computer programmers needed to fix the ‘Y2K problem’ far exceeded the supply of programmers in developed nations. Because of the inflexibility in the time available to complete the conversion process, many companies in the US and other developed countries contracted with foreign companies. This led to a surge in outsourcing, and greater awareness of the availability of low-cost skilled workers abroad. In recent years, outsourcing has become a subject of concern, both economically and politically. During the economic contraction experienced by the U.S. from 2002-2004, some observers attributed the domestic layoffs to outsourcing, when in fact many companies were scaling down their workforces on a global basis. As the 2004 election drew near, contentions were made that offshoring was to blame for the woes of the workforce. Apart from financial and legal issues that relate to outsourcing, one sees that the ongoing outsourcing debate is characterized by many other facets, including political tensions, accounting conventions, health concerns, and sociological effects. 1.2 Multi-Layer Framework for Analysis This paper attempts to analyze the myriad of overlapping facets from the following vantage points: International Obligations: The United States is a member of the World Trade Organization (WTO), a consortium of nations whose common goal is to reduce tariff and non-tariff barriers and to promote free trade of both goods and services between nations. Membership in WTO and other international organizations implies inherent commitment to certain principles of these organizations. The first part of this paper examines in detail the ramifications on the outsourcing arena, along with the origins of these ramifications. Intellectual Property Issues: Marx focused on labor and financial capital as the primary drivers of economic activity; in today’s knowledge-economy, however, it is the intellectual capital that acts as labor’s counterpart. When work is outsourced, new issues of intellectual property arise. First, there is concern that the intellectual property may be compromised in a foreign country. Second is the issue of which governmental agency will protect the intellectual property in a foreign country and how relevant decisions will be enforced. Using examples from other arenas, a new model is proposed for handling intellectual property issues in a global economy.

Governmental Issues: In the US, different state governments have adopted dissimilar policies on issues related to outsourcing. Using several examples, this paper attempts to show the impact of these policies. This paper also attempts to analyze how far these policies are consistent with international obligations of the US and the provisions of the US constitution. Taxation Issues: Governments around the world are taking closer look at taxation aspects of outsourcing. This paper looks at the US situation in detail, and highlights how the issue of outsourcing has sparked a renewed interest in the area of valuation of software. Statistical Data: Outsourcing across national boundaries usually leads to a two-way flow with some jobs coming into the country, and other jobs going out. Available data are analyzed to assess the relative magnitudes of the two flows in the case of the U.S. The advent of new information technologies has led to outsourcing of many types of tasks related to information technology. In addition, the availability of new information technologies is enabling outsourcing in other service-oriented industries. Examples of such ripple effects are also considered in this paper. A top-down approach is used in this paper. First, the issues are considered at an international level, then at governmental level, and next at corporate level. Subsequently, the intellectual property and taxation aspects are considered in detail.

2. International Obligations

The international obligations are dictated by multilateral agreements and bilateral agreements. Multilateral agreements involve multiple countries, whereas bilateral agreements involve only two countries. In general, multilateral agreements involve more time and effort to evolve, based on the need for several countries to agree to the same terms and countries. In some cases, multilateral agreements may include special provisions, such as for developing countries or the waiver of certain provisions in emergency conditions. Multilateral international obligations related to offshoring are dictated primarily by the General Agreement on Trade and Tariffs (GATT) and currently coordinated under the aegis of the World Trade Organization (WTO). More than 100 countries, including the US and nearly all developed countries, are Contracting Parties of the GATT and Members of the WTO. 2. 1 Core GATT Principles The GATT can be viewed as a conduit for increasing market accessibility and reducing trade barriers. The GATT offers its member nations a means to enhance trade across national borders and to reduce, but not prevent, customs duties on imported goods. The current version of GATT reflects several core principles:

unconditional “most-favored-nation” (MFN) treatment among members (Art. I); non-discrimination and national treatment (Art. III); and a prohibition against most quantitative restraints (Art. XI).

Although there are many exceptions, the majority of trade restrictions, besides tariffs, especially quantitative restrictions and non-tariff barriers are fundamentally prohibited. Nondiscrimination serves as the most vital principle within the GATT/WTO system—including all interaction between Member Nations and between foreign and domestic goods producers and service providers. The process surrounding the proper use of the above principles, as well as the exception scenarios, has itself become intricate and contentious among WTO Members. The WTO’s Dispute Settlement Body (DSB) is a unique aspect of the GATT/WTO system and provides compulsory third-party resolution of trade disputes; member nations face sanctions if they fail to abide by the rulings of the DSB. In approximately the first thirteen years of WTO’s existence, the DSB has had over 365 disputes referred to it. MFN Treatment: Essentially, this concept (also known as “NTR” or “normal trade relations” under United States law) asserts that WTO Members must extend benefits offered to any other member country to all Members:

“With respect to customs duties and charges of any kind imposed on or in connection with importation or exportation or imposed on the international transfer of payments for imports or exports, and with respect to the method of levying such duties and charges . ..any advantage, favor, privilege or immunity granted by any contracting party to any product originating in or destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties.” (Art. I)

Consider an example. If the U.S. negotiated a 10% to 5% tariff reduction on Indian steel with India, assuming that India makes equal tariff concessions that are of interest to the U.S., the 5% rate, based on the MFN principle, would apply to steel imported by the U.S. from any other GATT/WTO Member; in addition, those members would not be required to make any reciprocating concessions. Tariff Bindings: Structuring for multilateral negotiations for the reduction of import tariffs and assertion that tariffs will not be raised after being reduced are two components in GATT Article II. A legal agreement is constructed, in the form of a country-specific schedule or annex that includes WTO Members that have consented to particular tariff reductions or concessions, during either WTO negotiations or accession. Tariffs that have been reduced or “bound” normally cannot be increased above the “bound” or guaranteed levels, but again there are exceptions. On average, duties range from about 3-5% for

developed countries to more than 30% for some less developed countries. That is not to say that developed countries always have low duties—U.S. duties on some apparel exceed 20% and some “plastic” footwear exceed 65%. National Treatment and Non-Discrimination: Article III incorporates the national treatment and nondiscrimination principles which are implemented to treat imported goods in the same manner as domestic goods, especially in regards to a country’s domestic taxation and regulation:

“The products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products. Moreover, no contracting party shall otherwise apply internal taxes or other internal charges to imported or domestic products in a manner contrary to the principles set forth in paragraph 1 [so as to avoid protection for domestic production].” “The products of the territory of any contracting party imported into the territory of any other contracting party shall be accorded treatment no less favorable than that accorded to like products of national origin in respect of all laws, regulations and requirements affecting their internal sale, offering for sale, purchase, transportation, distribution or use…”

For instance, if the U.S. imposes a 5% excise tax on imported steel, it must impose the same tax on internally produced steel. The GATT/WTO is designed to reduce tariffs and non-tariff barriers, while realizing that reductions of tariffs are ineffective if they are simply substituted with quantitative restrictions or other non-tariff barriers. Ban on Quantitative Restrictions: Generally, the GATT/WTO prohibits quotas, embargoes and other quantitative restraints. In situations where quantitative restrictions may be permitted, they must be employed on a non-discriminatory basis under Articles XI and XIII:

“No prohibitions or restrictions other than duties, taxes or other charges, whether made effective through quotas, import or export licenses or other measures, shall be instituted or maintained by any contracting party on the importation of any product of the territory of any other contracting party or on the exportation or sale for export of any product destined for the territory of any other contracting party.”

As a result, import or export quotas are prohibited unless under authorization of a specific exception to Article XI, similar to safeguards measures under Article XIX of the GATT. 2.2 GATT Exceptions

Exceptions to the GATT 1994 principles are highlighted in the following articles: VI and XVI (antidumping and countervailing duties), XII and XVIII (balance of payments) XIX (emergency action), XII (restrictions to safeguard the balance of payments), XX (general exceptions), XXI (national security), and XXIV (free trade areas and customs unions). Essentially, these exceptions permit the Members to depart from the nondiscrimination principle, but only in distinct and narrowly drawn situations. GATT and WTO dispute settlement panels have reviewed and permitted such departures narrowly. Balance of Payments: Article XII offers that:

“Notwithstanding the provisions of paragraph 1 of Article XI, any contracting party, in order to safeguard its external financial position and its balance of payments, may restrict the quantity or value of merchandise permitted to be imported, subject to the provisions of the following paragraphs of this Article.”

This states that special consideration must be given to Members in the form of a temporary exception to tariff level obligations during an emergency situation. For example, if a Member’s foreign exchange reserves drop to an extremely low level. While this article has been interpreted narrowly, keeping prevention of abuses in mind, Article XVIII: 2 offers developing countries greater flexibility in the protection of their balance of payments. Developing Nations: Developing nations are provided the flexibility for slightly restricted “special and differential” treatment under the GATT. WTO Agreements allow special treatment for such nations in the context of subsidies, intellectual property rights, investment, and safeguards, among others. Some developing countries were given supplementary time to fulfill specific obligations of the WTO agreements, and they were exempted from trade remedy proceedings if the quantity of their exports of the affected product to the importing state is small. For instance, in 1995, least developed countries were given 10 years to conform to the requirements of the Agreement on Trade-Related Intellectual Property (TRIPs). General Exceptions: Article XX offers other exceptions to the application of the GATT:

“Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this Agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures: (a) necessary to protect public morals; (b) necessary to protect human, animal or plant life or health; (c) relating to the importations or exportations of gold or silver; (d) necessary to secure compliance with laws or regulations which are not

inconsistent with the provisions of this Agreement, including those relating to customs enforcement, the enforcement of monopolies operated under paragraph 4 of Article II and Article XVII, the protection of patents, trade marks and copyrights, and the prevention of deceptive practices;

(e) relating to the products of prison labor; (j) imposed for the protection of national treasures of artistic, historic or

archaeological value; (g) relating to the conservation of exhaustible natural resources if such measures are

made effective in conjunction with restrictions on domestic production or consumption;

(h) undertaken in pursuance of obligations under any intergovernmental commodity agreement which conforms to criteria submitted to the CONTRACTING PARTIES and not disapproved by them or which is itself so submitted and not so disapproved.”

GATT members may deviate from certain GATT obligations under the preceding provisions and circumstances. This is true only consistently with the “Chapeau”, demanding that the exceptions not be “applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade [...]”. Note that the U.S. has occasionally banned the importation of certain Chinese products because it had been determined that that they had been produced with prison labor. Note also that the exception scenarios of Article XX have been interpreted narrowly by the Appellate Body of the WTO. National Security: GATT members may also partake in an exception, noted in Article XXI, if they have taken certain actions in the hopes of preserving national security. Such actions include preserving confidential information; “taking any action which it considers necessary for the protection of its essential security interests”; actions relating to nuclear materials; measures relating to the prevention of “traffic in arms, ammunition and implements of war...”; actions “taken in time of war or other emergency in international relations; and those relating to compliance with obligations under the U.N. Charter”. These exceptions have rarely been used. Free Trade Agreements: Article XXIV of GATT provides for an exception from MFN concept and the non-discrimination principle for free trade areas such as NAFTA, AFTA, China-AFTA, and customs unions such as Mercosur and the European Union. A free trade agreement (FTA) frees up trade amongst its members, but allows its members to decide the specifics of their own tariffs on trade with nonmembers. On the other hand, a customs union frees up intra-regional trade and provides a common external tariff on members’ trade with non-members). In accordance to Article XXIV, only FTAs and custom unions that satisfy the stipulations of this specific article are allowed. Unfortunately, the enforcement ability of WTO’ in the area of free trade agreements is weak. Further, the treatment of regional trade agreements amongst developing countries is more relaxed under the 1979 GATT “Enabling Clause”. This clause also permits members of developed

countries to propose non-reciprocal trade benefits, similar to those listed under the Generalized System of Preferences, and regional trade agreements among developing countries that do not meet the full requirements of Article XXIV. 2.3 Limits on Use of Subsidies and Other Trade-Restrictive Measures The use of subsidies by governments is limited by the WTO Agreement on Subsidies and Countervailing Measures (“SCM Agreement” hereafter) under Article 1.1: “yellow light” subsidies. A financial contribution is considered a subsidy if it is given by a government or public body and involves:

(1) a direct transfer of funds (2) the foregoing of government revenue (3) the provision of goods or services other than general infrastructure (4) payments made to a funding mechanism (including a private body) to undertake actions within (1), (2), or (3), assuming that the recipient company receives a benefit in each of the four cases).

Generally, a subsidy must be “specific”, meaning that it is provided to a specific industry or industrial group, in order to be actionable under the countervailing duty laws of a member country. Export subsidies and subsidies directed towards the use of domestic materials—instead of import materials—are forbidden under the Subsidies Agreement; yet certain exceptions are stated under Article 3. For the years 1995-2000, examples of exempted subsidies include research and development grants, regional development programs, and environmental cleanup programs (Article 8). These exceptions are likely to be renewed when and if the current “Doha” round of WTO negotiations is concluded. The Subsidies Agreement offers two remedies for handling illegal subsidies. First, administrative “countervailing” or offsetting duty actions may be brought under domestic law by private parties within a Member nation. Second, member governments may seek the elimination of subsidies via the WTO Dispute Settlement Body (DSB). If the prosecuting member succeeds in convincing the WTO DSB that the subsidies are inconsistent with the SCM Agreement, the member whose subsidy is in question must abide by the decision, either by eliminating the subsidy or by facing trade sanctions. WTO Members have access to other trade solutions. For example, the Anti-Dumping Agreement (“AD Agreement” or Agreement on Implementation of Article VI of the 1994 GATT) allows members to introduce additional import taxes (anti-dumping duties) on foreign goods when such goods would cause material injury to a domestic industry by being sold at “less than fair value”. Successful implementation of the rule against a product sold at a cheaper price in an export market than in its domestic market would come in the form of punishment of international price discrimination. The Agreement on Safeguards

permits the “temporary” re-imposition of customs duties or quantitative restraints when imports are shown to cause or threaten “serious injury” to domestic industries. The Agreement on Trade-Related Investment Measures (TRIMS) successfully prevents most types of performance requirements. For example, it is generally illegal for a nation to require a domestic manufacturer to use locally produced materials only. It is also generally illegal for a nation to offer government benefits to a domestic industry for exporting a specific number of products.

2.4 Applicability to Outsourcing of Goods As discussed in preceding subsections, it is difficult for a nation to curtail the use of imported goods and promote the use of domestically produced goods. Raising tariffs above the accepted MFN levels is typically prohibited. Quantitative restraints, in regards to tariffs, are essentially banned. Tariffs that are charged at below the bound rates may be raised to the bound rates agreed to under Article II, but not above those rates. The WTO’s Dispute Settlement Body deals with the majority of other non-tariff barriers, like poor health and safety standards. Based on provisions in GATT Article III, if excise taxes are imposed on foreign goods, domestic goods must also be taxed at the same rate.

If foreign goods are sold for lower prices in the U.S. than in the exporting countries (“dumping”), themselves, then anti-dumping duties may be imposed to offset the disparity. The U.S. has applied anti-dumping duties at various times on, but not limited to, steel, orange juice, softwood lumber, cement, catfish, televisions and anti-friction bearings. Such duties are currently imposed on many products from China, as well. Due to the gradual phase-out of the majority of other protectionist actions and required compensation, the imposition of dumping anti-duties has become the popular solution for more than 100 WTO members, including the U.S., EU, China, and India. Penalty duties, similar in nature to the preceding ones, may be imposed if foreign goods are recipients of government subsidies. Theoretically, safeguards may be introduced, for up to four years, to protect against serious injury. Yet, such actions warrant legal review, as noted in WTO procedures, and can be overturned by the Dispute Settlement Body. In fact, such safeguards have been challenged on many occasions and often found to be illegal. Further, if a Member nation opts to subsidize certain industries in order to assist them to become more attractive, such subsidies can also be scrutinized and challenged by other member nations, as noted earlier. 2.5 Applicability to Trade in Services The General Agreement on Trade in Services (GATS) is geared to ensure that the primary provisions—MFN treatment, national treatment, subsidies, transparency—that were applied to international trade of non-agricultural products are also applied to services. GATS incorporates regulations on market access and national treatment restrictions at local, regional, and national governing levels. Members of the WTO agree to restrict use of market access and national treatment restrictions through a “positive list” approach.

GATS obligations are largely determined by the specific schedules of commitments of WTO Members. However, the proceeding obligations are the exceptions. Services obligations are typically categorized into three types:

• Mode 1 - cross-border services, such as when a Los Angeles, Illinois, lawyer sends a legal opinion by email or courier to Chennai, India; • Mode 2 - consumption abroad, as when an Indian lawyer or engineer travels to the University of Arizona to attend a graduate degree program; • Mode 3 - commercial presence, as when a U.S. bank opens a branch in Beijing; and • Mode 4 - presence of a natural person, as when an British attorney travels to Japan to establish a travel agency

GATS covers all services, except those guarded by governmental authority, national treatment (barring discrimination in favor of domestic suppliers), and MFN treatment. The obligations under GATS are, in fact, dissimilar to the parallel ones in GATT, especially in the following areas:

• National treatment commitments are not universal, but are limited by each government to the services specifically selected by that government. This contrasts with the GATT 1994, where national treatment is compulsory once the goods have entered the national market; • The degree of market access and national treatment can be regulated. For example, foreign banks may be permitted to own only 49% of a subsidiary, as opposed to a majority of the subsidiary. • Interestingly, MFN treatment was subject to exception for up to ten years, with an initial review of the exception after 5 years, or beginning in 2000.

Other notable GATS provisions include transparency, regulations being subject to judicial review, absence of restrictions on international payments for possible unrestricted services, but excludes provisions for balance of payments difficulties, and built in schedule for further negotiations. Financial Services: In 1997, GATS member-countries greatly expanded the scope of financial service commitments. These commitments include broad coverage of insurance, reinsurance, brokerage, agency services, actuarial services, all banking and stock brokerage functions. Note the growing coverage of services over time. Telecommunications Services: In this sector, commitments by member-nations are offered on an MFN basis. As such, many countries used their MFN status to take advantage of reservations (e.g., U.S., one-way satellite transmission; Brazil, distribution of radio/TV programming to consumers; Turkey, transit land connections and satellite ground station

use by neighboring countries; Bangladesh, Pakistan, India, Sri Lanka, Turkey, application of differential measures by governments in setting rates; Antigua, Barbuda, national treatment only for other CARICOM members, etc.) GATS is reflects work in progress and its coverage has been the subject of negotiation under the WTO “Doha Development Round” of WTO (that occurred from November 2001 to mid-2006, and periodically after that). These continuing negotiations focus on creating greater market access. A noted “gray area” in GATS is its partial coverage of subsidized service activities. 2.6 Implications of GATS for Outsourcing of Services Based on negotiations and discussions involving its member-countries GATS has made it easier to outsource service oriented jobs, although much of the outsourcing that has taken place does not really require GATS, but only the permission and encouragement of the host country or the enactment of appropriate national legislation GATS regularizes and facilitates the process. Organizations in one country can sponsor work to be done by a different organization in another country. In this paper, we refer to these two organizations as “sponsor organization” and “host organization” respectively, and the concerned countries as “sponsor country” and “host country” respectively. From the perspective of the sponsor organization, outsourcing can save time, effort, and money involved in owning and running operations abroad. The growth in outsourcing has been partially fueled by the opening of markets in GATS member-nations—either through GATS schedules or national legislation—thus bolstering direct foreign investment and boosting domestic economies. So, the sponsor organization and the host organization can be parts of the same multinational corporation.

Unlike the case of punitive actions that can be taken in the case of dumping of products in foreign countries, no efficient provisions exist for dealing with dumping or subsidizing services. So far, this has not been a problem, as there are no glaring instances of gross subsidies by government agencies to companies in the services sector. Note also that the “import” of services from abroad — such as information over the telephone on overcoming software problems with your computer or receiving a report on an x-ray from a radiologist in Australia—may be subject to weaker border controls than in the case of imports. However, this situation may change as governments are becoming increasing sensitive to security issues, and evolving data mining technologies make it possible to scan electronic transmissions more easily and quickly.

The overall theme of international agreements and protocols is to encourage freer trade, remove restrictions, and to enable sourcing decisions to be made by relevant market forces. Although some trade restrictions and “gray” areas continue to exist, member-countries of the WTO have been highly successful in this effort.

Based on the above, the imposition of restrictions on outsourcing of services will be in violation of binding WTO obligations. Hypothetically, if the U.S. Congress imposed certain restrictions on outsourcing or imports from countries like Japan or India based on exchange rates, such restrictions are likely be deemed illegal by the WTO’s Dispute Settlement Body. A more practical solution for governments of developed countries is to preserve and enhance the climate for innovation, investment, applied research and development, through a combination of incentives and taxes that lead to higher degree of productivity and competitiveness. Jobs that are outsourced to foreign countries, even to different parts of the same country, could be replaced by jobs that require specialized skill sets. Retrospectively, this is what happened in the United States at the end of World War II.

3. Action by Government Agencies in the United States

Recently, major foreign manufacturing facilities have been drawn to the U.S. due to large subsidies offered by state governments. For instance, BMW now has a facility in South Carolina and Mercedes has a facility in Alabama. Further examples exist where an existing industry or new industry was offered a subsidy by a state government, so as to entice the industry to resist from outsourcing. In such instances, some of the organizations take advantage of the subsidy and leave the state as soon as their contract with the government expires. 3.1 Impact of Action by State and Local Governments With respect to offshoring of information technology services, the Indiana case has attracted significant attention. In 2003, then Governor Frank O’Bannon authorized a contract of $15.2 million in favor of Tata American International Corp, a New York-based subsidiary of Tata Consultancy Services. This bid was between $ 8.1—$ 23.3 million less than the other bids. Just a few months later, his successor, Governor Joe Kernan, canceled the award. It was categorically stated that this cancellation of award was not based on improper execution of the project by Tata (Gupta, A. et al., 2007). State and local governments struggle between two conflicting goals: procure necessary services at the lowest possible price in order to keep costs down; versus employ more persons within the particular region in order attain low rate of unemployment. The decision of Governor Frank O’Bannon was based on the first goal, and the cancellation was justified based on the second goal. It should be noted, however, that none of the other bidders was from Indiana. Further, the bid categorically specified that all existing employees had to be retained. So, the potential flexibility of hiring individuals from abroad was limited in scope. If the difference in price between the lowest two bids is divided by the number of such ‘new’ employees, the cost difference comes to about $162,500 per employee (Gupta, A. et al., 2007). This figure represents the incremental cost that the taxpayers of that state must bear in order to keep that job within the state. In the above instance, another issue must be considered. Even if a decision is made by the decision makers in the state (or local) government to bear the incremental cost, the

concerned job may be performed in another state (or city) within the US. This is because the states enjoy limited ability to compel that the job be performed within the state. The founding fathers deemed it appropriate to include interstate commerce among the small set of matters over which the US federal government had exclusive control. In short, the federal government has sole control with minor exceptions over the regulation of interstate commerce and states in most instances are prohibited from interfering with such commerce. Thus, except with rare exceptions, no state can erect a trade barrier against another state. For example, the State of Texas cannot refuse to let non-Texas grown tomatoes across its borders. Arizona cannot keep Colorado garbage from entering its landfills. Florida cannot charge non-Florida residents more for a product than its state residents. Commerce between states must remain completely borderless, except as regulated by the federal government—such as in the rare exception of the right to preclude ordinary consumers from transporting fruits and vegetation into certain states based on very specific concerns. Further, based on the U.S. Constitution, the judgments of each state must be given full faith and credit in the other states. If a business dispute is adjudicated in Arizona, that judgment can be cited as precedent and enforced in all of the other states. So, there are examples where state governments in the US have canceled awards for professional services that were held by companies abroad; such services are now being rendered, at higher prices, by individuals in another state of the US. For example, based on pressure from media and others, the Governor of Arizona ordered the cancellation of all awards that involved the outsourcing of services. Some of the concerned work is now being performed in Florida and other states of the US. So, the taxpayers of Arizona are paying the incremental costs to support employment of persons in other states of the US (instead of persons in other countries). The mayor of Springfield, Massachusetts, opted to take the opposite position; he opted for lower costs by deciding that all pharmaceutical drugs for city employees will be procured from Canada, where the prevailing prices are between one-fifth to one-half of the corresponding prices in the US. Initially, the state government of Massachusetts was upset by this decision. However, after the initiative of the mayor of Springfield became a success, the state government opted to use the same model for all state employees. This meant lower costs, but a reduction of some workers in the US too. More than half the state governments in the US have adopted some form of legislation that inhibits outsourcing of government jobs. Since the U.S. Constitution mandates that all matters of foreign policy fall within the exclusive discretion of the federal government, it is questionable if these state governments had the constitutional ability to impose such restrictions. In short, the ability of the U.S. to influence or restrict outsourcing decisions is constrained by international agreements; second, the ability of the states to influence or restrict outsourcing is controlled by the federal government, based on the U.S. Constitution.

3.2 Data from US Government Source A common perception amongst Americans and computer programmers in particular, is that outsourcing has caused a great loss of jobs. Some observers believe that this is a misconception, as much of the realized job losses stemmed from three main components: an economic decline starting in 2001, the NASDAQ’s loss of approximately 75% of its value in the ensuing three years, and increased productivity of IT industries abroad. This misconception is reinforced when existing output and employment levels are compared with heightened levels of 2000 (Griswold, 2004). Rather than using the statistics of the 2000 employment boom, a more accurate comparison would be realized if the levels from the late 1990s were used. Like most markets, the job market operates in a cyclic manner as jobs are created and lost, given and taken away. From 1993 to 2002, employment in the U.S. private-sector rose by 17.8 million jobs. In order to generate a net increase in jobs, 327.7 million jobs were added and 309.9 million jobs were lost. More specifically, for every one new net private-sector job created during that period, 18.4 gross job additions had to offset 17.4 gross job losses (Lindsey, 2004). This trend is depicted in Figure 1.

Figure 1: Jobs Gained vs. Jobs Lost (Thousands) –

Source for Data: US Bureau of Labor Statistics As can be seen, after the spike in jobs lost, net job turnover had leveled off and has remained at 1990’s levels through 2006 (Bureau of Labor Statistics, 2008) In regards to this data, the following argument is sometimes made by economic analysts and critics: although jobs are being replaced, those new jobs offer lower wages in replace of the white-collar jobs that are now sent abroad. Yet, it is important to note that during this most recent period of globalization, the number of management and professional specialty

jobs have grown exceedingly fast. For instance, the number of such specialty jobs grew from 23.6 million to 42.5 million from 1983-2002, or from 23.4% of total employment to 31.1%. The Bureau of Labor Statistics projects that business, financial, and professional positions will grow from 43.5 million to 51.7 million during the period of time between 2004—2014 (Hecker, 2005). The clear shift of the U.S. economy away from manufacturing and towards the service industries creates concern that the U.S. employment will suffer as a result. Such concern can be accredited to the moving of some high profile service positions being sent abroad. However, the U.S. actually runs a trade surplus in the IT services that are most directly linked to outsourcing. For instance, in the categories of “computer and data processing services” and “data base and other information services,” U.S. exports rose from $2.4 billion to $5.4 billion from 1995—2002 – a 125% increase over an 8 year period – then shot up to $7.6 billion in 2006 – another 40% increase over a span of only 4 years.Druing this time, imports while imports increased from $0.3 billion (1995) to $3 billion (2006). As a result, these services led to a U.S. trade surplus expansion from $2.1 billion to over $4.5 billion (Lindsey, 2004; U.S. Dept. of Commerce, 2007).

4. Protection of Intellectual Property

IP is used by companies primarily to obtain market share and to increase revenue margins. IP is also used as a bargaining chip when attempting to obtain access to complementary technology via licensing agreements (Kamiyama et al. 2006). Finally, IP is leveraged when attempting to acquire new venture financing. In each of these cases, for a company to use its IP to the fullest extent, especially so when engaging in outsourced IP development practices, precise valuation is vital. To place the importance of IP in perspective, in 2002, tangible assets accounted for only 25% of the market value of all US firms, the remaining 75% coming from IP (Kaplan and Norton, 2004). In 1982, this figure for IP stood only at 40%, suggesting that IP is becoming increasingly important in today’s companies. The issues of proper assessment of the costs and risks associated with the IP are of relevance to companies engaging in or planning to engage in outsourcing of software development or maintenance projects. In a study by Studt (2007), nearly 60% of respondent companies decided not to pursue outsourcing engagement based solely on the issue of IP. Half of these same companies, however, stated that the assurance of adequate security for IP would increase their motivation to outsource. The proper valuation of IP can help to address several of the underlying risks associated with IP-related engagements; this valuation is also crucial to determine fair market price, to obtain financing, and to help optimize the strategy to exploit IP to the firm’s advantage. Other constituencies have a desire to establish equitable value for companies as well: the United States Federal Government lost over $33 billion in 1993 on transfer pricing abuse alone: with ‘pricing audits’ subsequently becoming more frequent, companies have an added regulatory need to properly value IP (Martinson et al., 1999).

4.1 Intellectual Property and International Agreements The World Trade Organization (WTO) plays a major role in the evolution of international policies for the protection of intellectual property (IP). The current policy comes largely from the negotiations of the 1986-1994 Uruguay Round (World Trade Organization, 2007a) when the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS) was introduced to specify international rules for the protection of IP rights. The Agreement sets a foundation for each member-country to offer a basic amount of IP protection for fellow member-countries. TRIPS is comprised of five general topics (World Trade Organization, 2007a):

how basic principles of the trading system should be applied how basic principles of other international intellectual property agreements should

be applied how to give adequate protection to intellectual property rights how countries should enforce those rights adequately in their own territories how to settle disputes over intellectual property between members of the WTO now

that the provisions of TRIPS apply to all WTO Member states.

The second section of TRIPS attempts to promote greater understanding of its conditions for IP protection amongst members, and defines different kinds of IP rights and modes of protection. The original tenets of TRIPS find their roots in the 1883 Paris Convention for the Protection of Industrial Property (World Intellectual Property Organization, 2007b). For instance, protection of patents and industrial designs were issues that were discussed at the Paris convention (World Trade Organization, 2007a). International copyright laws were introduced and discussed at the 1886 Berne Convention for the Protection of Literary and Artistic Works (World Intellectual Property Organization, 2007a).

In contrast to the Paris and Berne conventions, WTO has placed greater emphasis on enforcement issues, as noted specifically in Part 3 of the TRIPS Agreement:

“The agreement says governments have to ensure that intellectual property rights can be enforced under their laws, and that the penalties for infringement are tough enough to deter further violations. The procedures must be fair and equitable, and not unnecessarily complicated or costly. They should not entail unreasonable time-limits or unwarranted delays. People involved should be able to ask a court to review an administrative decision or to appeal a lower court’s ruling. The agreement describes in some detail how enforcement should be handled, including rules for obtaining evidence, provisional measures, injunctions, damages and other penalties.” (World Trade Organization, 2007a).

Member countries have experienced difficulty in their efforts to enforce the strict set of rules outlined by the WTO, partially because the TRIPS Agreement provides significant flexibility to member-countries (World Trade Organization, 2007a):

“[…] requires members to comply with certain minimum standards for the protection of intellectual property rights covered in it [; however,] members may choose to implement laws which give more extensive protection than is required in the agreement, so long as the additional protection does not contravene the provisions of the agreement […]”

From this, it can be implied that member-countries are simply required to abide by the minimum standards of the agreement. In addition, when member-countries abide by the minimum standards, they are granted “[…] the freedom to determine the appropriate method of implementing the provisions of the agreement within their own legal system and practice—taking into account the diversity of members’ legal frameworks (for instance between common law and civil law traditions) […]” (World Trade Organization, 2007a). As such, countries may take IP enforcement seriously and go far beyond the minimum TRIPS requirements, while some countries may only settle for meeting the minimum. Despite this inconsistency, both countries will be in compliance with the provisions of TRIPS. Some persons feel that member-countries must be on the same page when it comes to protection of IP; this should be accomplished with an imposition of a clear and consistent set of enforcement requirements and to discard the notion of the “minimum” threshold. 4.2 International Property Arguments at Country Level Friedman (2005) believes that the Chinese gained access to the WTO in 2001 with the intent of destroying an interior bureaucracy that impeded effective international trade, while bolstering political and economic malpractice (p.149). While the Chinese have improved their enforcement of IP rights (Wayne, 2004)., the US feels that the requirements of TRIPS are still not met. (China — Measures Affecting the Protection and Enforcement of Intellectual Property Rights (Complainant: United States), DS 232, April 10, 2007). In fact, a widespread perception exists in the US today that intellectual property of US corporations and individuals is being misused abroad, and the governments of some of these countries are not enforcing TRIPS requirements and existing laws. The US government has been a strong proponent of better enforcement of laws related to protection of intellectual property by foreign governments. In the context of stricter enforcement of existing laws, consider a case that involves U.S.-Cuba trade relations. The New York Times article “U.S. Permits 3 Cancer Drugs from Cuba” (from July 15, 2004 issue) highlighted that CancerVex, a biotechnology company, had licensed three experimental cancer drugs developed in Cuba; this was done based on an allowance made by the U.S. federal government. This allowance was a rare exception to a historically restrictive trade relationship, since the U.S. has instituted countless embargos

on Cuba, including the Cuban Liberty and Democracy Solidarity Act (1996). The latter act found fault with companies that had business relationships in Cuba, and prevented them from forming business relationships in the U.S. Members of the EU found this act to be objectionable at the very least, claiming that the U.S. was attempting to control how other nations conducted trade—which it was fundamentally doing. Consider another example. The traditional staple diet of hundreds of millions of South Asians is Basmati rice. Ironically, RiceTec, a Texas-based company, was awarded a patent by the U.S. Patent and Trademarks Office in regards to basmati rice on September 2, 1997. The language of the patent was unclear—granting rights to the exclusive use of the term “basmati” to RiceTec, an essential monopoly on Indian/Pakistani basmati varieties that were farm bred with other varieties in the West, and proprietary rights on the seeds and grains that resulted from any crosses of basmati rice (Uzma, 1998). According to research conducted in India and Pakistan at the time that the patent was awarded, exports totaled $350 and $250 million respectively (Chandola, 2006, p. 177). The award of this patent caused much disdain amongst the basmati companies of South Asia. Fearing bio-piracy from the West, the concerned parties brought three main issues with the patent to the forefront: “a theft of collective intellectual and biodiversity heritage of Indian farmers; a theft from Indian traders and exporters, whose markets are being stolen by RiceTec Inc.; and finally deception of consumers since RiceTec is using a stolen name, basmati, for rice that is derived from a variation of Indian rice but not grown in India, and hence of a different quality” (Vandana, 2001; Ray, 1998). The issues that India had found with the patent were in fact justified according to international law; as a result, RiceTec was not granted new rights, including rights that would allow them to promote their varieties as equal or superior to the basmati of India (Chandola, 2006, p. 178). A geographical indicator (GI) is explained in Article 22 of the TRIPS Agreement as: “[…] indications which identify a good as originating in the territory of a member, or a region or locality in that territory, where a given quality, reputation or other characteristic of the good is essentially attributable to its geographical origin”. Essentially, the GI must be an indication of a geographical place, but it is not necessary that it have the identical name of that place. In this example, the use of “basmati” signifies rice originating in the Indian subcontinent. Despite this, brands such as Texamati and Kasmati had been sold and marketed by RiceTec for over 20 years in 30,000 stores in North America (Chandola, 2006, p. 178). What stopped India from challenging the patent registration in the U.S.? According to Article 24.5 of the TRIPS Agreement:

“[…]where a trademark identical or similar to a GI has been applied for or registered or used in good faith before the application of these provisions of TRIPS in the member state or before the protection of the geographical indication in the country of origin, such a registration is valid and cannot be challenged” (‘TRIPS”).

Consequently, an infringement of the “good faith” provision had occurred and India would have been justified in both the trademarks. However, India was at a disadvantage because they would have had to dispute the trademarks in U.S. courts. The disadvantage stems from a history of U.S. courts favoring national companies as opposed to foreign companies acting as the defendant [see Mother’s Restaurants v Mother’s Other Kitchen, Inc. 218 U.S.P.Q. 1046 (TTAB1983); Person’s Co., Ltd v Christman 900 F.2d 1565 (Fed. Cir. 1990), 14 U.S.P.Q 2d, 1477 for correlating evidence] (Chandola, 2006, p.179). On the other hand, there are also examples where US courts have ruled in favor of foreign companies. For instance, in Bremen v. Zapata Offshore Oil, 407 U.S. 1 (1972), the U.S. Supreme Court forced an American firm to present its court action in Great Britain rather than in the U.S. after deferring to a contractual law case. Likewise, in Mitsubishi v. Soler Chrysler-Plymouth, 473 U.S. 614 (1985), the U.S. Supreme Court ruled in favor of a Japanese auto manufacturer after enforcing an arbitration clause against a U.S. auto dealer. Hypothetically, if the case had been tried in Indian courts, the costs to the plantiffs would have been much lower and RiceTec probably would have been held liable for the infraction. Overall, it is more difficult to institute legal action in a foreign country, and the potential legal costs can be a strong deterrent for plantiffs from developing countries to file cases in the US. Trade in services is subject to the same difficulties and cost tradeoffs as that in goods. For example, movies produced in America’s Hollywood are counterfeited to a massive extent in countries with lax intellectual property laws, with up to 93% of all movies sold in China being of the counterfeit sort (Lim, 2006). It has proven to be a large if not insurmountable problem for American companies to curtail this practice due to little or no regulation or enforcement, and the counterfeiting continues to occur. Conversely, in countries with some of the most developed intellectual property laws intellectual property violations in the film industry (to continue our example) are pervasive: companies based out of India’s Bollywood, the most prolific movie production city in the world, constantly complain of the lack of enforcement of U.S. IP rights pertaining to Indian movies being streamed online at sites such as Google Video, YouTube, and others (Schwender, 2006). The tensions can erupt into complex legal battles, such as the case of Chinese movie download service Jeboo.com, recently sued by five studios of the U.S. Motion Picture Association (MPA) for allegedly offering films for download on its subscription-based service without permission. After settling the dispute in February of 2008, Jeboo.com shot back by suing the MPA for “reputation infringement.” In an example of alternative solutions to these problems, Microsoft, with sales of 20 million PCs in China in 2005, should have booked roughly $1 billion (USD) in profit. Instead, sales of about $100 million were recorded due to piracy of the Windows operating system. Due to a perceived inability to equitably remedy this ongoing situation through legal means, the company has decided to invest more money into Chinese computers manufacturers and agencies governing the industry (Businessweek, 2006). Indeed, trade in services is subject to similar international complexities as is trade in goods. The TRIPS Agreement constitutes a foundation for government-to-government interaction, such as to deal with a situation where a national patent office may be systematically

discriminating against foreign patent holders. Yet, it is not useful for dealing with infringements at the level of individual companies. The results of IP litigation in national courts can be costly in terms of costs and time. Companies and other holders of IP rights are faced with enormous obstacles in the international IP realm. Companies and individuals, both in developed countries and in developing countries, feel that they are being treated unfairly. One potential mechanism to address the above problem is discussed later in this paper. 4.3 Intellectual Property Issues from Viewpoint of Companies Let us now look at the subject of protection of intellectual property from the vantage point of commercial business. Outsourcing of the production of goods was driven primarily by the search for lower-cost labor; in the services arena, however, outsourcing is now being driven by multiple factors –quicker time-to-market for new products, the availability of skilled labor outside of the U.S., and the ability to exploit time-zone differences to allow for 24-hour around-the-clock work with all individuals during day time in their respective countries. We look primarily at business and intellectual property issues related to information technology. At first glance, the outsourcing software development and support services appears to be a specific case of transfer of labor offshore. Note, however, that intellectual property (IP), too, may be transferred in such instances. The long-term generation and consumption of IP are significantly affected by decisions to pursue offshoring options; this makes it important to do proper valuation of these intangible assets. Because of a lack of consistent taxation and accounting regulations across national borders, this valuation fails to occur, and estimates of costs and risks associated with outsourcing engagements can become unreliable, and may lead to erroneous business decisions. Software, which accounts for significant value of many firms pursuing outsourcing engagements, is frequently transferred across borders, and thus should play a crucial role in decision making. This section discusses the factors that affect software IP valuation, and the relationship of software IP to outsourcing engagement structuring. 4.4 Intellectual Property Uses, Costs, and Risks The creation of new software may involve cross-border collaboration on an inter-company basis or an intra-company basis. Many companies are unaware – and thus fail to properly recognize – the inherent value being exported during the process of transferring the software development work abroad. When exploited in a new setting (e.g., a new country or a new industry), software of an offshore call center, of an accounting business, or of a search engine possesses real value to the importing party. This party receives rights to patents, copyrights, trademarks and trade secrets related to the concerned piece of software. A common vehicle for this type of transfer is a Controlled Foreign Corporation (CFC), an offshore entity related to (and often controlled by) the parent company that will use this software in a new market. After the transfer is made, these CFC’s have the ability to license, sell, and exploit the IP associated with this software; by doing so, they generate and

repatriate profits for the parent company in these offshore markets, and may potentially violate the tax regulations of US and other countries. From the viewpoint of government authorities, the profits generated by this software are not taxable in their new markets; further, an estimation is rarely ever made concerning the proper value of the software when it leaves its country of origin. Dubbed as “the last remaining hidden corporate asset,” IT is seen more of an item to be expensed; this option is supported under prevailing accounting standards (Stafford and Yuk, 2007). Even when an export of software is recognized, the value of the associated IP may be low-balled or mistakenly undervalued (which, due to the ambiguity and subjectivity of prevailing valuation techniques, happens often). The amount by which the property is undervalued is ‘lost’ and cannot be used to pay the original creators; further, less taxes accrue to the government of the country where the original software was developed. 4.5 Intellectual Property Outsourcing Models The outsourcing of IP occurs very frequently – in fact, the outsourcing of jobs is possible only when they are outsourced in tandem with IP applicable to these jobs. For example, take a call center maintenance hotline function: knowledge of the item to which maintenance being performed and the software being used by the call center employees – both very real items of IP – are shipped offshore along with the jobs themselves. For jobs such as those in software development, IP being shipped to and shared with overseas employees; further, IP is being created offshore as well. The latter IP then flows back to the first country – it is a two-way street. To further refine our example, let us assume a relationship where a sponsor company – the provider of the IP – outsources software development work to an offshore host company. In order to perform the work asked of them, the offshore host requires access to the sponsor company’s IP, becoming a de facto ‘consumer’ of this IP. There are two distinct ways to structure this type of relationship, each of which has differing implications for the sponsor company’s desired level of control and protection of its IP:

1. Outsource to an independent host, creating a client-vendor relationship. If the host contractor is located offshore, we use the terminology ‘Independent Foreign Company’ (IFC);

2. Outsource to an exclusively owned host, creating a parent-subsidiary relationship. If the host company is offshore, we use the terminology ‘Controlled Foreign Corporation’ (CFC).

When business is sent out to IFCs, subjective decisions regarding the structure of IP transfers, monetary transactions, and remuneration must be made. For initial IP transfer structuring, all IP can be sent out, a part of it can be assigned, or, as in licensing agreements, no actual transfer need be made and payments can be tied to IP use or to sales or services performed. These licensing agreements are by far the most popular structure being employed, accounting for upwards of 40% of all international IP-related transactions (royalties and fees) between unrelated companies (either as sponsors or as IFCs), twice the

amount seen only five years earlier (Kamiyama et al. 2006). The structure of these licensing agreements lead to various different monetary outcomes for both parties: Gopal (2003) empirically proves that time-and-materials contracts generate greater revenues for offshore vendors than for their clients, and are inefficient considering the information known when structuring the engagement. Beyond IP protection risk, other risks abound, and must be taken into consideration. Depending on the model for offshoring that is chosen, the costs, benefits and risks will differ. Information about current operations can provide the quantitative information needed. A call center, for example, holds employees with training experience, existing product improvement information, and sales leads: all items of IP that can provide valuable information for the offshoring decision. As the activities are transferred to an offshore site, the magnitude of the value of the relevant IP will be known, so that the additional risk can be quantified (Frank, 2005). The table below describes some common (and new) business models, and the IP issues associated with each model: Business Model

Description Valuation Issues Related Issues

Call Center Reduction of service costs; encourage further purchases; gather feedback

Initial software transfer; subsequent sales generate IP; maintenance costs

Both IFC and CFC models are in use

Software Localization

Localization to particular geographic area of pre-existing software for sales

Value added in localization process; subsequent marketing IP

Both IFC and CFC models are in use

Software Maintenance

Maintenance done at low-cost area to increase competitiveness; free up in-house designers to create novel software; income from maintenance licenses can eventually exceed the income from sales (as shown in figure 4)

Essentially all IP related to software must be transferred; high risk if IP transfer is less than perfect; trademarks, marketing know-how kept in sponsor country; IP added in maintenance considered

Establishing a CFC is preferred; hard to transfer all needed IP effectively

New Software Creation

Simpler than subsequent localization; requirements for new software are much easier to circumscribe and hence IP valuation is easier

IP created and thus attributable to foreign corporation; potential market knowledge IP should be shared

If software is novel and promising, CFC is ideal

Shared Software Development

A new phenomenon, in which software is developed concurrently across borders or with the passage of the sun; new paradigms such as the 24-hour knowledge factory emerge [Gupta and Seshasai, 2007, 2008]

IP imported, leveraged, and exported daily; no pre-existing framework for valuation; equivalence and metrics of work performed questions; varying levels of IP can be transferred; new transfer pricing rules are ambiguous

Does host have access to all IP? Does host focus solely on testing, or development as well?

Web Services

Functionality of software provided over the Internet to the users who require it; income generating op’s moved to partner; provides a means to protect the software itself

All the owners' intellectual property is transferred, and generates income at the host site; call center, maintenance, localization, marketing and sales are performed at the host

Having a CFC is preferable for accounting reasons

Table 1: Outsourcing Business Models and Related IP Valuation Issues. Legal restrictions can impact the decision to transfer IP offshore, and tax consequences are inherent in every transaction. Since offshoring causes a redistribution of income, there will be also consequences on taxation of that income, namely where and what taxes should be paid, leading to financial consequences. 4.6 Controlled Foreign Operations In order to mitigate the costs and risks associated with outsourcing to an IFC, and especially during engagements in which the value of the transferred IP is deemed to be high, establishment of a CFC – a captive (i.e., 50%+ owned) foreign subsidiary – to provide the outsourced service is preferred by large multinational companies. A CFC must keep its own books, and will transfer costs or profits to its owner as required; this monitoring, which is becoming strictly regulated by tax authorities in many countries, imposes new costs on the original company. Long-term costs, however, may be recaptured by the parent company, and the control provided by this form of strict ownership, even controlling for the difficulties faced under different laws and customs, is preferred. This is because it is thought that employees of the CFC will be less inclined to misappropriate the IP of the company that they see themselves as being a part of it. CFCs have the ability and expertise to function as a local marketing and sales arm in particular regional and language areas. Finally, feedback from a locally-owned entity is invaluable, as it allows for product adaptation to local conventions and refinement of marketing techniques. Additionally, once a CFC has been established, contractual agreements are easier to decide. The parent company can now be reimbursed either via a licensing agreement or through repatriation of IP. In fact, parent-subsidiary licensing is becoming very popular, with total

licensing receipts nearing $110 billion in 2004, up from $10 billion only 20 years earlier (Arora, 2005). We can now further refine our example: as this type of agreement is the most widely used, the issues involved in providing IP from a generating sponsor to a consuming CFC will be focused on. Three possible structures are shown below in Figure 2.

Figure 2: Three alternatives for IP locations.

The first structure shown is a typical licensing agreement, where IP ownership resides with the parent company. Payment for use of this IP is received as royalties from the subsidiary. Usually, these royalties include provisions for maintenance costs and product improvements. In the case of software IP, maintenance will typically be performed at the origin, and maintenance that need be performed by the offshore subsidiary can be reimbursed by the sponsor, effectively keeping the IP whole (i.e., not ‘sharing’ any of the IP rights through maintenance, which adds value and thus would entitle the subsidiary to a portion of the IP). The stipulated royalty rate should ideally match the expected cash flows from the software and other IP being offshored. The second structure shown describes a case where the CFC invests capital by importing the software IP. This is a de facto allocation of IP to the CFC based on local sales by the CFC, and the relative amounts can be determined by relative sales percentages. For example, if 25% of the total sales made in one year are attributable to the CFC, then the CFC owns 25% of the value of the shared IP. Maintenance costs will be shared by the parent company, and any extra costs that accrue to the CFC will be reimbursed by the parent. The third structure involves three parties: the parent company, the CFC, and a Controlled Foreign Holding Company (CFH). Whereas tangible property such as equipment must be

located in its area of use, intangible assets such as software can be used from anywhere regardless of their location, and therefore royalties can accrue in the location of choice of the parent. The end consumer of the IP – the CFC – pays royalties to the interposed CFH, which then acts as a vehicle for repatriation of these royalties to the parent company. Because the software is located with the CFH, maintenance costs must be borne from this interposed entity as well. This leads to multiple different scenarios in which the parent can control profit repatriation, taxation, and IP sharing very finely. For example, if royalty rates to be paid to the CFH are set high, the profitability – and thus the allocation of IP – to the CFC is reduced. Additionally, a CFH can be placed in a country with little or no taxation of income. This in effect imposes abnormally low taxation on revenues generated at the CFC but which are recognized at the CFH. 4.7 Intellectual Property Taxation and Outsourcing Perhaps the most important, and most complex, set of risks are those relating to the multiple (and many times unapparent) laws and regulations that may govern the information or knowledge that is being exported. Public laws are rarely explicit in their detail of specific issues, and voluminous regulations issued by multiple agencies must be consulted and analyzed with respect to actual transfers. For instance, the International Traffic in Arms Regulations (ITAR), the Export Administration Regulations (EAR), and multiple other US government regulations severely restrict the transfer to other nations of items that may compromise national security; many other industry-specific data transfer protocols exist, such as Graham-Leech-Bliley Act (which requires financial institutions to take steps to ensure the security and confidentiality of "customer" records and other works that overlap as IP) and the Health Information Portability and Accountability Act (HIPAA, a similar set of legislation that applies to health care providers). Abroad, consortiums such as the European Union (EU) have stringent data privacy laws that disallow the flow of personal data to non-member countries. In terms of valuing and outsourcing IP, transfer pricing regulations, which both ensure proper assignment of value – and thus ensure proper taxation – to IP transferred between countries are the most pervasive. These rules seek to make sure that work performed in a particular country is attributed to that country, and therefore that profits and costs that accrue to each location that a company operates in are taxed in those locations at prevailing tax rates. Companies, however, have a real incentive to structure their outsourcing operations so that profits accrue to low- or no-tax countries (i.e., via a CFH). As can be expected, the amounts involved in these favorable arrangements are very large (Economist, 2000). Transfer pricing regulations attempt to make sales of tangible property to controlled, subsidiary entities in foreign countries mirror sales to a ‘third-party,’ and thus attempt to apply local taxation rates to these de facto ‘sales.’ Sales of software IP as a non-marketable (i.e., internal use) product remains problematic in this respect, however, and is dependent on the establishment of consistent valuation practices. Outsourcing strategies based upon

the use of a CFH in a low- or no-tax jurisdiction are thus highly favored and promoted. By structuring an arrangement such that the CFH licenses IP to the CFC at an abnormally high rate, taxes in both the parent and the subsidiary country jurisdictions can be minimalized. Just as for tangible goods, when IP is sold to a related party, the onus is on the selling party to value the IP and establish an ‘arm’s length standard’ to dispel suspicion that tax minimization plays any role in this valuation. As previously discussed, a lack of any standardized IP valuation technique precludes consistent application of these principles, allowing for tax minimization and thus leading to poor estimation of outsourcing costs. As of 2008, new temporary (until they are voted into law) U.S. Treasury transfer pricing regulations (see: IRC §§ 1.482-1T(d), 1.482-4T(f), 1.482-8T), have added new profit-based transfer pricing models to their list of accepted methodologies. These models allocate value specifically as it corresponds to economic value added; while an improvement over traditionally allowed market and cost-based methods, this addition has increased the number of methodologies accepted, adding to the complexity in determining which should be used to value software IP. When transferring IP to a CFC or CFH, only the net value of transfers is shown, and no disaggregation of each transaction is visible on the parent company’s books (GOA, 1995). This further allows for profits to be extracted by manipulating royalty amounts tied to the IP via a CFH. This practice deprives developing countries of the tax income needed to grow their respective infrastructures (OECD, 1998); however some countries are beginning to combat this problem (Business Week, 2006). Many developing countries (such as Brazil) are beginning to impose special taxes on service or IP importation, and these must be taken into account while making strategic decisions related to software outsourcing (Bierce, 2006). Additionally, the U.S. is not the only high-income jurisdiction attempting to alleviate this problem via transfer pricing regulations: the EU is now imposing stricter documentation requirements (Konzernverrechnungspreise). Despite the continued lack of ‘litigation-safe’ valuation methods – that is, methods that will not be challenged by the Internal Revenue Service (IRS) in case of the the US, leading to possible penalties to be levied on companies – the IRS aggressively pursues back taxes and fines for poorly valued IP transfers. These costs can become staggering, enhanced by penalties of up to 40% of the tax underpayment. It is expected that up to 80% of all multinational companies will face a ‘pricing audit’ in the near future, with some large companies such as Merck already at the chopping block for amounts in excess of $1.87 billion (enforced by the Canada Revenue Agency) (Drucker, 2007). Companies who previously advocated aggressive positions can now expected to be challenged, and good-faith estimates of justifiable valuations will be increasingly likely in the near future. Transfer pricing determination encourages equitable IP valuation, and future outsourcing engagements are likely to be better understood in terms of the value being exported and future tax costs expected. 4.8 Elements of Software Intellectual Property

As we have previously shown, IP comprises a major component of multinational companies’ intangible assets. Human intellectual capital (know-how), customer loyalty, management expertise, residual purchase value (goodwill), and technical intellectual property all comprise intangible assets. The Financial Accounting Standards Board (FASB) allows for companies to recognize patented technology, trade secrets, software, databases, mask works, and even unpatented technology as technology-based intangible assets. In terms of computer software, specifications, design documents, source and binary codes, embedded databases, and trademarks for packaged software and domain names are all considered to be technical IP. Software later can become a formal, protected item of IP when it is: copyrighted for published software, supporting data, and documents; trademarked via registration; patented in terms of conceptual methods or processes; and/or given trade secret protection for internal materials such as code. Benefits from computer software are reaped in two distinct ways: via marketing and subsequent sale as product software to external parties, and via internal use by the producing company. Operating and database systems, compilers, and common desktop applications (the largest segment) are examples of common software products sold or licensed externally. Business management software, payroll applications, SCM/CRM applications, and CAD are all examples of software that is mostly utilized internally (Thornton, 2002). As one item of software can be comprised of multiple types of IP, and because no disaggregation of these types of IP is attempted or disclosed in financial statements, there is significant inherent subjectivity in valuation. The proper allocation of particular types of IP to the value of specific products, such as the instance of a brand name that gives value to an entire product line, is complex when combined with other competitive advantages (Damodaran, 2006). The process of combining those contributions requires an allocation of future income among the amalgamation of IP embodied in software. A separate and very complex aspect affecting valuation of software IP is that most software is slithery; i.e., software constantly undergoes maintenance in order to remain useful in current periods. Maintenance corrects errors, adapts software to changing external conditions, and perfects internal operation and user interfaces (Marciniak, 1994). The ability to update and enhance the usefulness – and hence the value today – of software created years ago changes the value of the software (Wiederhold, 2006). Because maintenance cannot be predicted with accuracy (as it occurs often in response to exogenous factors), future cash flows, and the total value accruing to the software will change and must be updated whenever maintenance is performed in order to properly value a company’s software IP. It is this ability to update software to deal with changes in context and business processes that makes it so popular and affords this asset a long life. Hardware would rapidly become unusable if it were afforded the same functionality (Panetta, 1989). Software valuation has, sadly, been afforded little guidance. Originally, it was left up to lawyers, software vendors, or promoters to quantify the benefits of software in commerce,

with the results being mostly inconsistent (Lev, 2001). Multiple methods exist: when entire software companies must be valued (as in a merger or acquisition), the market capitalization of the entire company is used to establish a base for the aggregate value of all IP, with specific value being assigned to those items with clearly delineated contributory properties. However, for outsourcing engagements, it is unnecessary to value an entire company only to obtain the value of the software being utilized abroad; new approaches must therefore be developed. As stated earlier, contractual agreements can play a very large role in the valuation process, and must be considered carefully. Additionally, preexisting physical property rights, which are largely inapplicable and adversely affect the drafting of current software outsourcing contracts, have been highlighted by Walden (2005). Finally, software is created and used not only in outsourced development projects, but in facilities management, integration, and implementation contracts as well. 4.9 Software Valuation Issues This subsection covers those issues underlying the estimation process of the value of offshored software IP. Items such as why companies frequently underestimated outsourcing costs when IP is transferred, why companies continue to fail to ascertain the value of software IP, and why software IP must be considered for proper estimation of costs are discussed. People have voiced their hostility against applying the term ‘property’ to software, which is basically nothing more than an applicable manifestation of knowledge. Free software is advocated by many in the computer science community, citing some of the world's most successful software (GNU/Linux) as being free (Gay, 2002). Economically, software is too profitable a business for companies to completely submit to open source demands; in 2002, for example, the U.S. software industry (SIC code 7372) alone posted sales in excess of $32 billion, with total annual commercial software purchases estimated at close to $250 billion (Compustat, 2004). So, the software that has not been designated as a free, public good is considered property, as it is owned in some way. As with other property that is of value to the owner, software IP should be protected from loss. Protection of software IP and other media content has been a topic of ongoing debate, not showing much resolution since early days (Branscomb, 1991). When offshoring, the cost of the necessary protection against the risk of loss-- along with the residual costs of the risk of loss that cannot be insured against-- should play into value calculations. Software and other intangible assets are easily copied, making the content housed by physical media warrant protection. For software in particular, the ratio of the total value of software to the cost of the corresponding physical media has diminished to practically zero, and distribution of content over the web incurs no cost at all. Our discussion therefore focuses solely on the content – the intangible part – of software. The regulatory and legal environment surrounding the use, valuation, and transfer of software IP is underdeveloped. Current accounting practices record only the cost of

internally developed IP, not the value, as is done with purchased IP. Most R&D costs to develop IP are expensed rather than capitalized (only the ambiguous period between ‘technological feasibility’ and subsequent completion and marketability is capitalized), and no ‘assets’ for the resulting property are recognized. Stringent accounting criteria that stress measurability and recognition tend to disallow many intangible assets from being shown in financial statements. Even fair market value (FMV) valuation techniques are insensitive to context, where value-in-use usually varies greatly from what a third party would pay. In practice, intangibles should be valued at the greater of their value-in-use or their fair market value (Laurie, 2004). For a software company, nearly the entire value of the entity depends on IP products. A first-order estimate of the value is the company’s market capitalization – the number of shares times the value of each share, as determined by its investors – which includes the value of the intangible assets owned. Other business categories, such as manufacturers and financial institutions, also depend substantially on software to generate revenues (e.g., CAD and transaction clearing, respectively). Any business that distinguishes itself from others by IP embedded in its software is inherently at risk of loss. Shareholders' assessment of a company’s intangibles – calculated as the excess of its market value over the book value – can be greater than 6 times the value of its net assets, or 2/3 of the $7 trillion market value of all public companies. For businesses operating in knowledge-intensive industries, intangibles can account for over 97% of all assets (Laurie, 2004). Losing a significant fraction of owned intangibles, IP, could therefore be devastating. The proper valuation of IP has implications both within an outsourcing engagement and to the company at large. It holds the potential to lead to better decision making in terms of intellectual asset management (IAM), one of the integral items to be considered in an offshoring engagement. Buy or build decisions can be affected by the amount of IP to be transferred or kept in-house, and can change the choice of entity in effecting an offshore endeavor. Thornton (2002) identifies six reasons for valuing IP:

Transactional reasons: establishing a purchase price, royalty rate, transfer price Financing reasons: assessing collateral value, value as part of a solvency opinion Taxation reasons: export income, purchase price amortization, charitable

contribution, assessment value for ad valorem property taxation Bankruptcy reasons: assessing solvency of software owner, identification of

licensing and spin-off opportunities Litigation reasons: quantifying copyright infringement or contract breach damages Management information reasons: identifying, quantifying and subsequently

managing the value of IP (IAM)

A justifiable valuation of IP is crucial for all of these decision-making processes. Offshoring has added a new dimension, since it can increase the risk of loss.

Confidential knowledge in an outsourced setting that enables an outsourcing host to perform work for the sponsor includes items that fall into a broad definition of software. Examples are design specifications; user guides; proprietary software for use in host operations; software code that is the basis for further development at the host; process descriptions guiding further development; and instructions transmitted under confidence that provide an understanding not obvious from primary material. If the host also resells the products in the foreign geographical area, then the rights to use established trademarks; literature that describes the products for the customers; business methods that make sales effective; and instructions on exploiting these business methods are part of the software. When this knowledge is not specifically documented, it is hard to distinguish what is common knowledge, and what is truly proprietary within the business interaction. Not included in intellectual property are activities that focus on human capabilities, even though they may have considerable value. Common applications for information technology involving software exports include: call centers, offshored production or operational settings, software maintenance, software creation, software localization, and web services (Basili, 1990). 4.10 Accounting Issues with Software IP Income-based methods must consider that any property depreciates in value over time. Software is unusual, since it is subject to refreshment of IP through maintenance, a feature that does not apply to other items of IP such as music (although new editions of books exhibit a similar renewal). This is the property that makes software slithery: a product has a different version today than that which was purchased even a few years ago. The interesting aspect of this is that most of the IP used in the earlier version is still employed in the current product version. The cash flows to be realized from a particular item of software can change drastically given the maintenance perform and the content of the new version released; the value of this software is thus subject to change, and must be updated frequently, especially at new version release dates and other milestones. While such maintenance refreshes the products value, it is costly, and the expense reduces the income available for other tasks (and ultimately reduces profit). Software maintenance costs can be estimated by tabulating development cost and maintenance expenses over the life of the software; these costs typically exceed original development costs by a factor of 2 to 7. Unfortunately most software developers misunderstand or ignore the importance of maintenance, and most executives completely discount the costs associated with this necessary activity. It is to be noted that the significance of maintenance is not taught in schools (Wiederhold, 2006). It is safe to assume that outsourcing does not contribute significantly to software obsolescence. Key losses of economic value are attributable to functional (utility compromised due to market standards), economic (market conditions or competition), and technological (outdated or inefficient programming language or hardware) obsolescence. While outsourcing does not contribute to obsolescence, the structure of these contracts can significantly affect the amount of rework needed within the development cycle. This can

have a positive or negative influence on future software maintenance needs (e.g., fixed fee contracts tend to result in less rework). This point and others dealing with contract structuring have a more pronounced effect on IFCs than on CFCs, due mostly to the fact that vendor-client relationships involve significant negotiations and must be handled completely at arm’s length. Obsolescence of software (and other items of IP) manifests itself in the form of diminution, or the relative reduction of initial IP by maintenance efforts. For example, if maintenance costs for an item of software over a period of time become equal to original development costs, then the original IP is said to have diminished by 50%. Since some original concepts embodied in software can live forever, we typically limit IP life to the time when less than 10% contributes to income, as indicated in Figure 3.

Figure 3: Diminution of the Value of the Original IP Contribution in Software.

For simplicity the diminution approach assumes that the value to the user of the product remains the same as it was originally. Maintenance costs lead to IP diminution having an effect on the assessment of the future cash flows of software. Additionally, unlike product income, software IP does not depend on unit sales. Income projections should assume that software maintenance will occur, and that the original value of the software IP will decline. When the cash flows attributable to any item of software become less than the incremental cost of its maintenance (a termed known as ‘impairment’), the effective life of the software – along with its contribution to IP value – ends (Spolsky, 2004). These maintenance costs thus have a very real determinant effect on the horizon for income projections. Maintenance contributions are measured in several different ways. Attributing R&D spillover costs towards ongoing maintenance is an easy to implement method, but in reality specifying all the inputs into product maintenance efforts is quite difficult. The output of the R&D (i.e., actual program code sizes) can be used as a proxy for the relative investment in particular items of software. One simple metric of size is lines-of-code (LoC), a well documented, functional metric (Jones, 1998). Software is comprised of old and new code: old code provides essential functionality for initial purchasers, but can easily become understood by outsides and then replicated; new code adds new value and keeps

competitors at bay. Since maintenance costs are often poorly accounted for, the LoC valuation method is the best approach available to indicate diminution, with the results having been validated (Wiederhold 2006). Note that the LoC valuation method is used to quantify the relative value of a particular item of software only, not to quantify the value of software IP. Figure 4 shows diminution from inception.

Figure 4: Income for a Software Company that Charges Maintenance Fees.

When software maintenance occurs, the amount of code grows; the unit price for software products tends to be stable, though. Combining continuous growth with constant price allows us to assess the remaining value of the original investment, and thus leads to the establishment of appropriate royalty rates in an outsourcing agreement. Successful software products see a lifespan of approximately 15 years, with as much as 7 significant version releases occurring during this time (with decreasing frequency). Software that is significantly dependent on exogenous conditions requires updates with a higher frequency, which leads to a higher royalty level (or more cost-sharing, if the contract is structured that way). Transfer of mature software, say versions three and beyond, will experience less future diminution than novel software. This scenario is actually typical for offshoring, because outsourcing is typically not considered during initial development phases. Only when software is successful (i.e., call center and maintenance demands grow) is outsourcing ever considered. As development between globally distributed teams becomes viable, though, outsourcing agreements will be considered in initial planning stages more frequently. 4.11 Software Valuation Methodologies The process of valuation is essentially the act of setting a fair price. When tangible goods (e.g., semiconductors) are transferred from a parent company to its CFC or CFH, the established public price for these goods is well known, and the company has a good understanding of the exact value that is being exported. Off-the-shelf pre-packaged and marketable software can similarly be valued in this manner. When software is exported to be developed further by an outsourced CFC, the market package price excludes the IP that is to be consumed, and the package replication and resale costs are similarly disregarded. Internal-use software similarly lacks a relevant price, despite the fact that this software embodies IP that allows companies to earn extra profits.

Many approaches for IP valuation compete; before deciding upon a valuation method, however, those fundamental inputs inherent in valuing IP must be examined. As we have shown above, in addition to the potential income to be made, the risk of loss, protection against said loss, and tax liabilities are the most important additional considerations that should factor into any valuation scheme. (Note that these three additional factors are directly proportionate to the value of the software IP). The valuation of software IP is markedly difficult. Software can be easily reproduced at negligible costs, and marginal profits are drastically – possibly more so than any other industry – higher than marginal costs of production. Due to current accounting regulations, and because of the natural subjectivities inherent in its appraisal, software IP value is calculated independent of its production costs. For example: a few brilliant lines of code can prove to be worth a great amount, while a million lines of code that perform some menial task such as generating a report could have very little value. Further, the multiple entities that own a part of a singular item of software must have their respective ownership percentages distinguished from other, and value for each entity must be consider independently. Where IFCs own part of the software, cannibalization via consumption of the IP occurs, leading to diminished value for the clients of that vendor (i.e., clients would benefit more if IP is used specifically for their interests (Walden, 2005). The threat of cannibalization is lessened when CFCs own software IP, as they enjoy well defined marketing and geographic domains, leading separate assignment of value amongst a large number of firms to be much less likely (but still possible, as a CFC may act as an IFC for other companies). When CFCs are owned by the company acting as the client, the threat of cannibalization is lessened even further. Such software IP is usually valued when it is consumed, i.e., used to generate income (Smith & Parr, 2000). IP must be valued by its contribution to the income of a business, and software can contribute to a company’s bottom line in two distinct ways. Income generated from product software depends on sales or leasing (licensing) revenue. Income generated from internal-use software is derived primarily from improved business processes (which are inherently difficult to define). For a product software supplier operating within an existing outsourcing engagement, some costs attributable to the software will be incurred at parent company and some at the CFC. For alternatives 2 and 3 of Figure 2, to compute cost-sharing payments to be remitted to the parent, all of the research and development costs are aggregated and then allocated according to revenues both at home and at the CFC, usually be geographic area. Any and all costs in excess of the revenue apportionment are then reimbursed from the parent. While this arrangement may seem simple, the equation becomes much more complex when IP has been contributed by multiple areas (i.e., more than one CFC). This is due to the fact that IP is also generated by brand and product marketing, which will have different life spans than those of the technological components. Since no amount of marketing can overcome poor product quality, we concentrate on the portion related to software.

Many businesses depend on internal software that is developed or built to order. Since the value of IP cannot be accurately assessed by its development cost, one has to focus on income. Only some fraction of a company's income can be attributed to this class of software, however, since contributions to income also derive from investments in creative people and machinery. Income attributed to software can be assigned based on the assumption that the management of a company is rational in the allocation of its resources (Samuelson, 1983). Assuming such optimality, corporate net income created by diverse expenses can be allocated according to the proportion of costs incurred. The fraction spent on software from year to year will vary, but such variations even out over the life of the software. As of 1998, IP infringement cost reached an estimated $1 billion per day, making the IP market inherently very risky (Mackintosh et al. 2000). Software in particular is easy to copy, and is at risk even if limited to internal use: the FBI estimates that 80% of all electronic design theft is attributable to sources inside the company that created the IP – and hence the IFCs they deal with and the CFCs they own. Offshoring IP to countries that have weak enforcement of IP protection laws will likely increase the risk of IP theft. The cost to protect against the risk of loss should be a direct input to the valuation model. Increased risk should have two quantified effects upon any valuation model: the discount rate used in calculating future income flows should be increased in direct proportion to the perceived risk inherent in the IP. Assessing the need for protection against loss requires valuation of the property subject to loss, the IP. Investments in IP protection, from any combination of patents, trade secrets, or other forms, reduce the risk of loss and increase the value of the IP. An example is a patent on an item of software. While obtaining an international patent costs anywhere between $50–100 thousand, the revenue attributable to the monopolistic position afforded by the patent increases the patent’s value. The inventor expects that the increase in value will greatly exceed the cost of the patent. The cost of maintaining trade secrets is harder to estimate. Although in the experience of one of the authors, trade secrets have been the mainstay for software IP protection (Merges et al, 2006). Several valuation methods exist for assessing the worth of the IP. Depending upon the facts and circumstances, one of these methods may be most appropriate for the particular situation. In addition to the methods listed below, Kwon and Watts (2006) conceptualize IT-based IP performance measurement in terms of ‘for efficiency’ or ‘for knowledge management’, each of which have different payoffs and thus suggest different valuation techniques (as described in Kwon and Watts, 2006)). For the more broad-based valuation focused on in this paper, we already reject a market price based approach. Assessment of Future Income: The determination of future income requires estimating the income accruing to the IP in each of all future years over its useful life, i.e., the amount sold and the net income per unit after routine sales costs are deducted. The estimation of the IP value of software requires estimates of the current sale price, future version frequencies,

maintenance cost expectations, and sales volumes over its life. If the IP is used internally, then the savings accrued by owning the IP can be similarly estimated. Within this ‘income method’, a variety of inputs and calculation differences exist, allowing it to adapt to many intangible assets that can stand alone and generate cash flows. Assets such as brand name, which provide value to an entire product line, however, remain difficult to segregate and value independently. Usually, the future income profile of truly novel software is uncertain, and hard to quantify (Laurie, 2004). While the future market is hard to assess for novel products, it works well for mature, established ones. Since all forecasts are discounted to net present value, less mature products will be subject to a higher discount rate than products or internal use software that is well established. Mature software will have less risk associated with offshoring, as it will be time-tested; these risks will be reflected in the cost of funds needed for the import. Risks are still present, however, and discount rates as high as 15% may be appropriate for such investments. This cost should be included in the valuation models. Research and Development (R&D) Spill-Over: This valuation method relies on two key parameters: the investment in R&D and the period that such an investment will contribute to future income. It can complement the output code metrics used to determine life by assessing the resource consumption of the code generation process. Determining the life of R&D benefits is difficult, and assigning a multiplier of income to specific R&D adds another layer of difficulty (Leonard, 2005). Early, high risk R&D should have a longer life than investments in short-range product alterations. R&D life values of about seven years have been cited, but these are based on an unanalyzed mix of R&D (Grilliches 1984). The R&D spillover approach also falls short in that current accounting practice allows for software development and maintenance costs to be lumped together as R&D costs (Lev, 2001). If maintenance costs, which comprise between 60 and 80% of software companies’ R&D expenses, would be logged as Cost of Goods Sold (COGS), a better understanding of the effect of R&D could emerge (Wiederhold, 2006). Until that time, valuation based on R&D spillover method is unreliable. Real Options (RO) Valuation: For less mature software and other intangibles that have future income generating ability, which are currently yielding zero or negative returns, real options (RO) valuation is an alternative. Based on the Black-Sholes stock option valuation methodology, RO views investment in IP as an option to develop the current asset depending on the facts and circumstances at option dates (most likely key development milestones). A DCF-based future income input is the foundation for the underlying value of the IP, with the added option value tacking on and growing as a direct function of the amount of R&D cost associated with development (Damodaran, 2006). A drawback is the myriad of variables inherent in options pricing, leading to heightened risk of improper valuation and pricing audits, especially for options not in the public view and marketplace. Divulging information regarding options for future expansion or cancellation of projects should be very unattractive to management.

Market Capitalization: Subtracting a company’s book value from its total market capitalization gives a ‘market worth’ of the company’s intangible assets based on the stockholders assessment of future income, already discounted for risk. If the items to be valued are only part of the companies’ products, then an allocation by sales volume can be made. Such an allocation becomes invalid when the products being assessed differ substantially in type and market from the items being excluded from the transfer. Nevertheless, this top-down approach implies that shareholders have a better understanding about future income than analysts who aggregate corporate IP values bottom up. To what extent options known to management are valued by stock analysts and shareholders is also uncertain (Quick et al, 2005). The relative value of options in the overall financial picture of a corporation is hard to assess in a company with a mix of activities. The implications of proper software valuation in business practice are quite obvious and have been stressed throughout this paper. The optimal use of IP, as stressed in research on intellectual asset management, requires valuation to become applicable. Receiving an adequate return is also of great import to the developers of IP, especially in terms social utility and future research funding. Establishing the value added at different stages of the research process can allow for more efficient and proper allocation of future funding. Busquin (2003) states that modern R&D policy should foster knowledge creation, ensure efficient utilization in order to drive the creation of new products and services, and promote competitive entrepreneurship. Valuation is thus a good tool that can help drive optimal future business decisions beyond a particular item of software. Beyond business decision makers, IT researchers and developers need to be the vanguard in monitoring IP contracts in order to ensure fair exploitation of their efforts. As stated by Walden (2005), “The contract is the defining document of these [outsourcing] relationships. Understanding how it is created and how it should be created offers a remarkable opportunity for IT researchers and practitioners to help firms become more successful.”

5. Broadening Domains of Impact

The concept of offshoring of professional services began with the computer software industry. Over time, this concept has spread to additional industries. This growth has been made possible by advances in information technology. In this section, the impact on four industries is considered. 5.1 Computing Software and Services Industry The offshoring of computer programming services involves minimal infrastructure requirements, as most of the software process derives solely from the creation and sharing of knowledge (Gupta & Seshasai, 2004). Traditional literature on productivity and effectiveness of organizations has emphasized the need for geographic proximity of teams. The advent of new information technologies is impacting this situation in a major way. In fact, geographically distributed teams can now

outperform collocated teams. One such case example is described in the following paragraphs. For a period of one calendar year, two software developments teams at IBM were observed in detail. One of these teams was collocated at one development center in the US and the other was distributed between US and India. Both teams worked on nearly identical tasks. At the onset of this case study, it was felt that the collocated team would produce deliverables of higher quality, and the distributed team would lead to lower costs. The results of the one-year study show that the quality of the end-results in the two cases was very similar. Further, the distributed team outperformed the collocated team in terms of documentation and the knowledge repository. The communication patterns developed by each team were radically different. One pattern was not better than the other, but each pattern was geared to the respective geographic arrangement. Several quantitative measures were employed to study the two operating scenarios in great detail. In addition, the qualitative measures included “[…] interviews in which the stakeholders described their perceptions of the quantitative data and their motivations for decisions related to knowledge sharing” (Gupta & Seshasai, 2004: JECO etc). An analysis of the quantitative and qualitative measures revealed that the spatial and temporal separations were leveraged as a strategic advantage. Such advantages were noted in interviews with the distributed team: “ […] an increase in documentation and history retention; the ability to share short term tasks which required immediate attention so that work could be performed around the clock; and a more structured definition of work tasks and distribution of work items” (Gupta & Seshasai, 2004). The success of using two teams in two continents motivates detailed analysis of operating scenarios that involve more teams spread around the globe. As sequential and concurrent development occurs in multiple countries, one is faced with new realities of intellectual property. Some companies tend to file for patents in each of the concerned countries. The problem gets further complicated when different companies are involved in the various countries. This subject of legal protection in a global environment is considered later in this paper. 5.2 Pharmaceutical Industry Faced with decreasing returns on investments, expiring patents, and the need to introduce new drugs, major multinational companies in the pharmaceutical industry are increasingly adopting the offshoring option for research, development, and other specialized tasks. For this purpose, these companies are utilizing both the captive model and the vendor model, each of which introduces new intellectual property issues. Further, in some cases, the multinational companies are undertaking joint activities with companies in developing countries. GlaxoSmithKline, for example, has an arrangement with Ranbaxy, an Indian company, for commercialization of jointly developed compounds; this arrangement

surmounts the acrimony that occurred when the two were fighting a patent dispute, only a few years earlier. Between 1987 and 2006, the cost of developing a new drug in the US leaped from $ 131 million to $ 1 billion, based on a report written by the Tufts Center for Drug Development. Only one out of every 1000 potential drugs progress from the pre-clinical trial phase to the post-clinical trial phase; and only one-fifth of the survivors will receive regulatory approval. Based on these data, companies want to offshore as many of the tasks as possible. And emerging information technology facilitates the processes of offshoring and collaboration between the concerned teams. The offshoring of pharmaceutical services is governed by the regulations of the US Government in the form of 21 CFR Part 11 that specify the guidelines of the Food and Drug Administration on electronic records and electronic signatures. It requires all the concerned parties involved in the development of pharmaceuticals—the drug makers, the medical device manufacturers, the biotech companies, and the biologics developers—to develop and install controls, including audits, validation systems, and documentation for software and systems. The Human Genome Projects relies heavily on advances in information technologies; these same technologies also provide the ability to conduct the work in an offshore mode. This research is likely to lead to a new generation of pharmaceutical drugs. 5.3 Media and Entertainment The fields of media arts and entertainment have experienced significant growth as a result of offshoring. PricewaterhouseCoopers (2006) estimates that these industries will grow steadily at a 6.6 percent compound annual growth rate to $1.8 trillion in 2010. Again, outsourcing of these processes has become a reality because of advances in information technology. IT provides the ability to quickly transfer and process information to foreign associates. For example, Digital Music Group, Inc. started in 2006 as a digital media distributor—it buys digital rights to media, specifically music, and sells them to online music stores. Developments in internet technology, such as this case, allow for faster uploads, downloads, and wider global communication. Both production and distribution tasks are now primarily digital in nature, as 70 per cent of all media production is now digital. The animation process is another area that has witnessed rapid growth in the use of offshoring techniques. The growing use of digital techniques makes this industry increasingly prone to theft and misuse of intellectual property. This problem occurs both in developing countries as well as in developed countries. For example, websites operated by Brandon Drury and Luke Sample allowed individuals to download movies illegally. These two individuals bought

advertizing space from Google, along with appropriate search words. Further, Google derived revenues when anybody clicked on the advertisement for these websites (Kamitschnig and Angwin, 2007). New movies from India and other countries show up on searches on Google Video. If Hollywood movies could be downloaded in the same manner, the culprits would be subject to immediate prosecution. However, foreign film companies do not have the same legal representation. 5.4 Legal Services Corporations and individuals can now use the Internet and the Voice over IP technologies to seek legal services from providers in other countries. Offshoring is changing the landscape of this seemingly unrelated industry as exemplified in the following subsections. 5.4.1 Case Examples of Offshoring of Legal Activities Bickel & Brewer, originally based in Dallas, was the first law firm to extend its operations abroad (Brook, 2005). The firm opened their overseas office in Hyderabad, India in hopes of solving issues with “handling the millions of pieces of information that confront us in each case” (Brook, 2005, p. 1). The India based office has actually become Imaging & Abstract International, a distinct operating unit that still does work for Bickel & Brewer, as well as for other U.S. based firms.

Some U.S. companies are unwilling to have their legal work performed by a company abroad, due to the possibility of receiving negative press (Jain, 2006). Other U.S. companies are offshoring their legal work abroad and spaying 15- 20% of what U.S. companies would charge for similar services (Rowthorn, 2005). In 2001, GE Plastics became the first U.S. based corporation to set up shop abroad in Gurgaon, India. Within two years, GE allegedly saved “nearly $2 million in legal fees that otherwise would have gone to outside counsel” (Flahardy, 2005). A snow-ball effect ensued, as other U.S. corporations followed suit in hopes of reaping similar benefits.

DuPont has hired lawyers in the Philippines to work 24 hours a day (in three, 8 hour shifts), seven days a week (Engardio, 2006, p. 42). These lawyers conduct first level document review for upcoming cases. This includes preparing documents and coding potential evidence for such cases. Understandably, the benefits of sending work abroad to such offices—such as saving time and money—increases as the amount of data that needs to be researched and reviewed in a case increases. DuPont is hoping to cut down the time involved in processing from 18 to 3 months and to achieve a savings of 40-60%, or $6 million, of their annual budget.

Rhodia, a Paris-based producer of specialty chemicals, signed a six-year contract with Accenture to outsource a majority of its legal and accounting work to Prague, Czech Republic in order to keep up with increasing work (Stein, 2003). Essentially, Accenture initiated their standardization process by moving Rhodia’s 15 existing systems to Prague. In less than two years, the concept of a shared service center allowed for a cost reduction of over 35% (Cooper, 2003).

Admittedly, most of the legal work that has been outsourced has been simple tasks including transcriptions, document conversions, and legal data entry. Yet, there has been a shift towards higher level services, such as work in patent law that has been conducted in Indian firms (Sandburg, 2005). Pangea3, an Indian patent law firm, received $4 million in funding from private firms (Kannan, 2006). Such funding bolsters the idea that the market of outsourcing of legal services will increase to $11.5 billion per year by 2010 (Jain, 2006). 5.4.2 Legal Tasks and Opinions Generally, the law industry as a whole is comprised of research, writing, and litigation. However, most lawyers are not litigators but are involved in negotiating intricate legal disputes among private parties and organizations. In the United States, over 90% of civil legal disputes are settled outside of the courtroom. In addition to litigation, lawyers often assist clients with constructing such documents as, but not limited to, will, trusts, corporate charters, and contracts. Understandably, writing, research, litigation, and constant interaction with clients can cause fatigue from a hectic work schedule heavy work load that results from research, writing (Waldmeir, 2003). Fatigue may arise during the trial phase of a case in which a lawyer must conduct constant research in order to construct an appropriate defense or offense. Outside of trial practice, those attorneys and paralegals that deal with mergers and acquisitions, SEC and patent law, and contract law also work with comparable workloads.

Financial functions and the legal tasks necessary for successful litigation are considerably alike. For the interest of this paper, both tasks benefit greatly from outsourcing. Specifically, both require the accumulation of immense amounts of information (electronic and hard copies) that needs to be reviewed and indexed for quick retrieval. Logically, allied tasks should be able to be outsourced at low costs if the same can be done for financial tasks.

Lawyers may outsource services abroad to a non-lawyer and not break any ethical considerations, as long as the lawyer obtains advance permission from the client, carefully monitors the non-lawyer, and bills the client accordingly (New York City Bar, 2006; San Diego County Bar, 2006). Unique issues are raised during patent filing, as a result of restrictions from technology export laws. The US Commerce Department allows export waivers for technology, as well as blanket export waivers, to avoid such issues. In fact, blanket export licenses have been obtained by many multinational corporations in order to support their transactions (Harris, 2005). 5.4.3 Trends in the Legal Industry A current trend in the legal industry is to conceptualize legal tasks as a set of commodities. More specifically, clients can designate certain tasks that they want one law firm to perform and then select another law firm to perform another task. This process has been termed “unbundling” and is based on client’s assessment on a firm’s cost or quality. Consider a specific case. At one point, DuPont needed external help in managing documentary evidence for product liability cases. Since the work was not extremely complex and did not

require a legal background to complete, DuPont employed Office Tiger, a large business process outsourcing provider. Interestingly, DuPont added the stipulation that the Office Tiger staff working on DuPont cases could solely work those cases and DuPont related matters (The Metropolitan Corporate Counsel, 2006). This decision-making process took approximately two years to execute, due to a detailed examination of several factors. One factor, as previously mentioned, involved the restraints that surround the amount of information on new technologies that can be sent abroad, as dictated by U.S. export control laws. DuPont, a company founded and driven by technology, was concerned with this issue and reacted by hiring a U.S. law firm to conduct those tasks that could not be completed abroad. On the other hand, when work was sent abroad, DuPont conducted onsite interviews and employed its own staff to offer hands on training to the foreign employees.

If an international standard for the outsourcing of legal services was imposed, personalized trips and training would no longer be necessary. In the meantime, some standards have been put in place in the hopes of separating those who are best suited in the legal services market from those who are not. For example, the new Global Legal Professional Certification test has recently been introduced in India in order to aid in distinguishing the most talented of the nearly 200,000 law school graduates each year.

It should be noted that legal outsourcing is not only a means to lower costs, but also to make the most efficient use of time. Consider the following example. Andrew Corporation, a communications equipment manufacturer, acquired a division of Deltec Telesystems, a New Zealand manufacturer, and decided to use local IP firm that Deltec had originally used for filing patents (Fried, 2004). This particular IP firm was well known in the U.S. and other world markets for filing radio frequency patents. Due to the firm’s golden reputation, Andrew Corporation sent it all of their U.S. radio frequency patent work. Moreover, due to the differing time zones, the IP firm could research or review drafts and send them to Andrew Corporation before their work day began the following day. Clearly, this decreased the total amount of time involved in filing patents and acts as a case study to the notion of a true 24-hour knowledge factory that is discussed in the next section of this paper The adoption of the offshoring model for legal tasks serves as the harbinger of the day when corporations will offshore other business functions to foreign locations in order to cut costs, improve quality, and provide greater dividends to their shareholders. Human resources, marketing, advertising and strategic planning are examples of business functions that were traditionally performed in-house and will gradually witness phased migration to foreign pastures. Traditional spatial and temporal considerations will become notions of the past, with growing blending of on-shore and off-shore activities.

6. The Ultimate Scenario: The 24-Hour Knowledge Factor

In each of the examples given, from computer development to legal services, and from media to pharmaceutics, offshoring of these activities is and has traditionally been done using a single center as the basis for the outsourced activities to be performed. However, gradually as work becomes atomicized, as faster time-to-market (TTM) is demanded in an ever-increasingly competitive global market, and as companies realize the benefits of time-zone separation, offshore outsourcing will begin to model a “24-Hour Knowledge Factory.” This new global work paradigm is discussed below. 6.1 What is the 24-Hour Knowledge Factory? A “24-Hour Knowledge Factory” is a global work paradigm in which members of a globally distributed team perform work on a project around the clock. Each member of the team works the normal workday hours that pertain to his or her time zone and then passes the work to a fellow team member located in the time zone that is ‘waking up’ just as the workday is ending for the first worker. In a sense, the notion of the 24-Hour Knowledge Factory originated in the concept of continuous assembly line, an outgrowth of the industrial revolution. In the 17th century, installed equipment was scarce and costly, and employees were scheduled to work in shifts in order to make use of manufacturing facilities on a round-the-clock basis. Call centers embraced this notion by routing calls based on time of the day, allowing all employees of geographically distributed call centers to work during daytime in their respective countries. The notion of multiple centers was subsequently adapted for supporting global communications networks, and can now be applied for professional tasks that are higher up in the value chain. Note that the concept of the globally distributed call centers became feasible by the advent of inexpensive Voice over Internet Protocol (VoIP) technology. In fact, Internet technology is fundamental to allowing white-collar work to flow from location to location, and individuals in the system to work during the hours they are most effective (usually 9 am to 5 pm). The 24-Hour Knowledge Factory concept can also be used to create next-generation Internet technologies. For example, by involving specialized microchip design engineers located at multiple places around the world, a semiconductor chip design firm has access to high-talent designers who would otherwise have to move to a different country, or work at odd hours of the night. Overall, new chips can be designed and manufactured in much shorter periods of time; these chips, in turn, can be used to create succeeding versions of the infrastructure for Internet. Accordingly, internet technology is both the driver and a beneficiary of the 24-Hour Knowledge Factory framework. Whereas a manufactured item was the end-product in the case of the “24-Hour Factory” that emerged as a consequence of the “Industrial Revolution”, knowledge-based services and knowledge-based products are the end-deliverables in the case of the current “Information Revolution”; hence the term “24-Hour Knowledge Factory”. The factory

concept emphasizes shifts of workers who have the required technology base to transfer knowledge between the shifts and accomplish tasks in a decomposed model. Figure 5 shows a continuing experiment that involves faculty and students in three countries: the Wroclaw University of Technology in Poland (WUT), the University of Arizona, Tucson, USA (UA) and the University of Technology, Sydney, Australia (UTS). (Chaczko, Klempous, Nikodem, & Rozenblit, 2006). In such an operating environment, the distributed personnel can work on an incremental basis on their joint academic research. Each geographic location can either work incrementally on the same task, or be responsible for separate tasks.

Figure 5: A 24-hour tri-foci scenario.

In Figure 5, the overall efficiency of the project is enhanced, in comparison to a single site basis, because each location perceives that progress is made “overnight” when workers at that location are asleep. The time required to meet sponsor or journal deadlines is reduced, and expertise available around the world is leveraged. Note that it is not sacrosanct that each collaborating center performs work on a problem for exactly eight hours at a stretch; the involvement could be for shorter or longer durations of time. Further, an individual task does not need to be completed in less than one shift for it to be useful to the overall endeavor. The ability to exchange components of tasks over a 24-hour period allows the turnaround time to produce knowledge-based assets to be substantially reduced in many types of knowledge-based industries, not just the field of information technology. This can cut down the time to market new products and services, while simultaneously reducing the operating and development costs. Further, the ability to transcend geographic and temporal boundaries offers the potential to change the face of many industries. This innovation will dramatically impact the manner in which companies build, test, sell, and support their products and services.

24-hour knowledge factory

Tucson, USA 16:00-24:00 GMT 9:00-17:00 local

Warsaw, Poland 8:00-16:00 GMT 9:00-17:00 local

Sydney, Australia 24:00-8:00 GMT 11:00-19:00 local

The 24-Hour Knowledge Factory, requiring the immediate cross-borders transfer of knowledge – and thus IP – that it does, will invariably be subject to the current gamut of regulatory and legal challenges, and will no doubt give birth to many new considerations. 6.2 Necessary International Framework Let us look at the healthcare sector as a test case. The FDA regulates drug issues at a national level in the United States. Yet, the credentialing and registering of medical professionals is mostly done at the state level. Taking offshoring into consideration, a radiologist may issue an initial opinion from abroad, but the final opinion still needs to be issued by a radiologist within a patient’s state and who holds the privilege to practice there. So, two radiologists may need to get involved, especially if the first opinion is needed in a hurry. This increases the overall cost to the patient is increased (Gupta et al., 2008).

Moreover, there is a common feeling among innovators around the world that others are exploiting their IP. This may occur when courts based in different countries offer contradictory judgments due to some bias towards the party that is also based in their own country. This is comparable to contradictory decisions that occur in the U.S., as a result of judges showing bias towards the party from their respective state. Consider the following example. Child custody cases were decided at the state level prior to the 1970s. If the parents of the child resided in two different states, State X might decide in favor of the father (who is a resident of that state) and State Y might decide in favor of the mother (who is a resident of that state). It was not until 1992, when the Uniform Interstate Family Support Act (UIFSA) was introduced and accepted by all U.S. states, that a state had the ability to go beyond its borders to establish and enforce support orders. A nation-to-nation agreement similar to the UFSA, in theory, would be beneficial to the enforcement and protection of IP; unfortunately, this type of agreement is yet to emerge. Members of the EU have tried for 40 years to reach a consensus regarding patent statutes and still have not achieved an agreement acceptable by all member nations.

Putting aside this specific concern within the realm of intellectual property, consider the more general subject of the historical growth of laws, regulations, and norms. All rules were at the village level three thousand years ago, and the village served as the foundation of the area’s economy. If an individual strayed from the guidelines, they would be forbidden to use the village well. With no access to the well, the individual had two options: die of thirst or plead vehemently with other village members. Thus, retraction of an individual’s membership to the well was one way to enforce the village norms during that time period. As time went on and the population grew within a region, the concept of a manor was introduced. A manor consisted of roughly a dozen villages that functioned together for security and economic purposes. As time progressed further, manors were replaced by principalities and principalities were then replaced by nation states. Legal regulations and enforcement also grew in order to keep up with the population dynamic. Overlapping provisions within the new legal systems sometimes occurred. This is noticeable today as a resident of Chicago may be governed by up to four sets of regulations:

City of Chicago, Cook County, the State of Illinois, and The United States of America. Also implied in this system is that a resident of the U.S. need not travel to Washington, D.C. to seek legal remedies, but simply cannot appear before a federal court located in their home state.

This type of historical consideration brings up an interesting question: Why was one layer of legal infrastructure adequate three thousand years ago, but multiple layers of infrastructure (see Figure 6) needed today? The answer can be found in the current complexity of society and ever-growing circle of influence amongst individuals and organizations. For example, if one drives through a stop sign, the legal system at the city level can adequately address the issue. If a company in State X manufactures goods and sells those goods in State Y, then the legal system at the federal level, particularly the provisions concerned with interstate commerce, will suffice in regulating that situation. Thus, as globalization continues to evolve and its sphere of influence increases, new legal provisions must be devised and implemented. In fact, this is occurring in certain cases. A supranational layer of legal infrastructure may be present in the realm of IP in the form of the WTO’s Trade Related Intellectual Property Agreement. Although the agreement is not applied directly to the U.S., it definitely has an impact on U.S. IP law.

By again turning our focus to IP and effective enforcement, an international regulatory system that keeps offices in large cities around the world may be the ultimate solution. This system would deal with particular IP issues that reach across national boundaries and could be an extension of the WIPO or WTO, or even an entirely new entity. It may even be beneficial for different organizations to deal with issues regarding to their area of expertise. For instance, an agency could be created under the World Health Organization (WHO) to handle issues pertaining to the healthcare arena.

As previously mentioned the WIPO and the WTO could serve as the foundation for initiating new legal mechanisms that would more efficiently coordinate various emerging practices and even possibly under the auspices of the WTO’s GATS. We can count on professional services of diverse types traversing across national boundaries as the need to perform these services quickly, efficiently, and for low cost increases. Nation states and large organizations around the world would greatly benefit from the international coordination of IP regulation and enforcement that the proposed mechanism would make available.

Figure 6: International Legal Framework

The figure above represents an idea that requires the coordination of many countries and a strong commitment to the responsibilities that come with instituting such a mechanism, in order to become a reality. Considering the present political and economic realities of major trading nations, the institutionalization of such a mechanism in the short-run seems inconceivable. Among other factors, countries which have endorsed a very high level of protection of IP would be concerned about the “least common denominator” effect of negotiating a broadly based international agreement with broader enforcement powers; the result of such uniform rules would likely be a watering down of IP protection for the high level of protection states. Of course, it is not necessary that all the countries of the world subscribe to this idea, nor is it even necessary for the large trading nations to subscribe to the idea initially. Typically, the most established organization or country has the strongest reservations about a new idea or system, but may be more inclined to join after a majority shows interest. Admittedly, an international IP regulatory system without the presence of the U.S., EU, or Japan would be weak and not practical.

Matters requiring the participation of many countries have progressed at a slow pace, when viewing this issue from a historical perspective. For instance, the law of seas “[…] developed in the 10th to the beginning of the 11th century where the city-state of Amalfi

Local/City Infrastructure

County/District Infrastructure

State Infrastructure

National Infrastructure

International Legal Infrastructure

[…] had a code of maritime law, which served as the model for laws on the Mediterranean Sea” (UN Atlas of the Oceans, 2007, p. 1). Later, these laws were conformed to benefit the major world power of the particular time period. Surprisingly, a final set of regulations was developed in the 1980s during the closure of the UN Convention on the Law of the Sea (UNCLOS III) (The Peace Palace Library Centennial Exhibition, 2004). The U.S., the world’s largest power in the seas, has not acceded to this law. It should be noted that there are other examples where matters involving the coordination between many countries have progressed quickly.

Coordination amongst many nations is definitely possible, as noted in the formation of the European Economic Union. Member nations gave up many of their traditional powers for the betterment of the group as a whole, despite the thoughts of naysayers. Despite a few countries—the UK, Sweden, and Denmark—preserving their national currencies, the concept of the common currency was widely accepted, as countries moved from their national currency to the Euro in an extremely short period of time. It is noticeable that cooperation amongst large nations is possible when considering regional trade agreements and partnerships such as NAFTA or Mercosur. These cases lend support to the idea that countries could, in fact, give up some of their engrained customs, traditions, and regulatory systems and accept control from an entity outside of their national borders in order to benefit the international community as a whole.

Although international coordination is possible, a more plausible, short-term approach would be to build on an existing mechanism. TRIPS could be expanded to not only include minimum standards for protection by Members, but also uniform standards for the registration of patents, trademarks, and copyrights. These uniform standards could be incorporated into the domestic law of Members and could be enforced by national IP entities, which already exist. In this sense, the wheel is not being reinvented, but rather the rotation perfected. Furthermore, this approach to uniform law does not raise nearly as much concern regarding “sovereignty” as placing offices of an international entity in the large cities of Member nations across the world. Also, it is relieving to know that this approach has been successful in the past, specifically in regards to the Convention on the International Sale of Goods. However, there is likely to be some resistance in regards to IP uniformity, as there is typically resistance amongst uniformity in major regional trading groups that have been formed and operating for years (i.e. the EU). If countries would indeed resist joining a uniform approach to regulate IP and combat enforcement, their trade with countries instituting such reforms would most likely suffer over time and may cause reconsideration.

7. Conclusions: Politicians and others make loud public statements committing that they will ban or severely restrict offshoring. However, such potential bans and restrictions will be in violation of commitments made by national governments at the international level. Further, in the case of the US, the federal government possesses exclusive rights over all matters

concerning foreign relations. So, restrictions imposed by state governments on offshoring are potentially in violation of the separation of powers doctrine of the US constitution. Offshoring leads to more jobs coming from abroad to the US, as compared to the number of jobs going out from the US to other countries. Since an average job coming in carries higher wages than an average job going out, the US is a net exporter in terms of the service sector. Apart from the national level, decisions related to offshoring should be considered at other levels: individual level, local level, state level, and company level. The increased incidence of offshoring motivates a closer look at the financial and legal aspects of intellectual property. Intellectual property is the most important asset for many companies in the arena of information technology; still it cannot be places on the books of companies in the US. This leads to a distorted financial picture, especially in situations that involve an intermediate company located in one of the tax haven countries. In turn, this can lead to lopsided decisions while deciding or whether or not to outsource professional services to a different country. The growth of offshoring in diverse industries – software development, pharmaceutical drug development, media and entertainment, and legal services – is creating concern among some constituencies. But, as in the case of the Y2K challenge, as the workforces of other countries prove their worth in these fields, companies will do what is necessary to obtain their expertise at cost-effective prices. In the past, competitive advantage was derived on the basis of products that a particular country was good at nurturing and exporting. Gradually, countries will be evaluated on the basis of competitive advantages that they possess in terms of rendering services for the global economy. This will be determined by the culture of its residents, the legal environment in which its businesses operate, and the characteristics of its educational system. Plus, it will be determined by the manner in which such critical success factors are modulated by the rigors of cross-border transactions and collaborations. Conventional literature has emphasized that geographic proximity is a necessary prerequisite for high efficiency and productivity. This notion is being increased by the rapid growth of technologies that can be used to effectively link collaborators located far from each other. Spatial and temporal separations were previously deemed to be a performance bottleneck; now, they are considered as opportunities to be leveraged. The notion of the 24-Hour Knowledge Factory can be employed to support round-the-clock operations with the important caveat that all individuals work exclusively during the daytime hours in their respective time zones. The latter work protocol is a powerful substitute for the graveyard shift, which incidentally has been linked to higher rates of prostate cancer in men and breast cancer in women, by the World Health Organization in December 2007 and by the American Cancer Society in January 2008. As individuals from different countries work together in a synchronized fashion, as companies enter into new partnership arrangements with peer companies in faraway lands,

and as services of diverse types are provided to ordinary citizens from distant lands by persons whom they have never seen or met, one sees new challenges in terms of legal, financial, and allied frameworks. Society developed originally with enforcement mechanisms at the village level. Today, we live in a four-tier society that has laws and enforcement mechanisms at the city level, the county level, the state level, and the national level. We now need to think of extending this framework to include a new mechanism at the international level. The framework of the European Economic Community is an example of a framework that encompasses multiple countries. As technology continues to facilitate the breaking of international barriers – as our world becomes ‘flatter,’ as some would say – offshoring will flourish to a greater extent. The ‘spurts’ of offshoring will become more frequent, and the man-made barriers between countries will be crossed with greater – and to some, with more alarming – frequency. References

Arora, A. (2005), “Patents: Who Uses Them, for What and What Are They Worth?” presentation at EPO-OECD-BMWA International Conference on Intellectual Property as an Economic Asset: Key Issues in Valuation and Exploitation, 30 June-1 July 2005, Berlin, www.oecd.org/sti/ipr.)

Basili, V. (1990). Viewing Maintenance as Reuse-Oriented Software Development. IEEE Software, 7(1), 19-25.

Bienefeld, S. (2003). Higher education is a human right-Not a commodity!: Student views on access, equity and student related issues. Retrieved May 18, 2007, from http://www.aic.lv/ ace/ace_disk/Bologna/Bol_semin/Oth_conf/UNESCO_Oslo/Stefan%20Bienefeld%20Speech.pdf.

Bierce, W. (2006). “Biggest Outsourcing Legal Issues of 2006.” HRO Europe. Jan., 2006. Retrieved from http://www.outsourcing-law.com/articles/1023_biggest_legal _issues_2006.htm

Branscomb, L. (chair) et al. (1991). Intellectual Property Issues in Software; Computer Science and Telecommunications Board, National Research Council, National Academy Press, from http://books.nap.edu/books/0309043441/html/.

Brook, D. (2005). Made in India: Are your lawyers in New York or New Delhi?. Legal Affairs. Retrieved May 15, 2007, from http://www.legalaffairs.org/issues/May-June-2005/ scene_brook_mayjun05.msp.

Bureau of Labor Statistics (2008) “Labor Department statistics on business employment dynamics,” Obtained online from http://data.bls.gov/cgi-bin/surveymost?bd on April 28, 2008.

Busquin, P. (2003). “The Relevance of Intellectual Property Rights for the Research Community” IPR Helpdesk Bulletin. No. 8, May, 2003.

Chaczko, Z., Klempous, R., Nikodem, J. & Rozenblit, J. (2006). “24/7 Software Development in Virtual Student Exchange Groups: Redefining the Work and Study Week,” In ITHET 7th Annual International Conference. Sydney, Australia.

Chandola, H.V. (2006). Basmati rice: Geographical indication or mis-indication. The Journal of World Intellectual Property, 9(2), 166–188.

Compustat (2004). Financial Results of Companies in SIC code 7211 and 723.

Cooper W. (2003). Rhodia makes its move. Outlook Journal. Retrieved May 11, 2007, from http://www.accenture.com/Global/Research_and_Insights/Outlook/By_Alphabet/RhodiaMakesItsMove.htm.

Cronin, Bruce et al. 2004. “Outsourcing and Offshoring.” CESifo Forum. Summer. 5(2). 17-21.

Damodaran, A. (2006). Dealing with Intangibles: Valuing Brand Names, Flexibility and Patents Working Paper. Stern School of Business Reports. Jan., 2006.

Damodaran, A. (No date). The Promise and Peril of Real Options Working Paper. Stern School of Business Reports. No date. Retrieved on May 31, 2007 from: http://pages.stern.nyu.edu/~adamodar/

Drucker, J. (2007). “Lifting the Veil on Tax Risk: New Accounting Rule Lays Bare A Firm’s Liability if Transaction is Later Disallowed by the IRS” The Wall Street Journal. 25, May, 2007. Retrieved June 22, 2007 from http://webreprints. djreprints.com/sampleWSJwr.html

Economist (2000, January 27). Gimme Shelter. Survey, The Economist.

Economist (2007, February 2). Places in the Sun. The Economist.

Engardio, P., & Shameen, A. (2006, September 18). Let's offshore the lawyers: DuPont is farming out legal services to Asia—and saving a bundle. Business Week, 42.

Field Jr., T.G. (2006). What is intellectual property?. Retrieved February 14, 2007, from http://usinfo.state.gov/products/pubs/intelprp/.

Flahardy, C. (2005). Overhyped, underused, overrated: The truth about legal offshoring. Corporate Legal Times. Retrieved August 28, 2007, from http://www.mindcrest.com/July%202005% 20Corporate%20Legal%20Times%20%20Overhyped,%20Underused,%20Overrated,%20The%20Truth%20About%20Legal%20Outsourcing.pdf.

Frank, S.J. (2005). Source Out, Risk In. IEEE Spectrum, 60-62.

Fried, J. (2004). Offshore outsourcing hits the legal marketplace. Delaware Law Weekly.

Friedman, T.L. (2005). The world is flat: A brief history of the twenty-first century-updated and expanded. New York: Farrar, Straus and Giroux.

Gay, J. (editor) (2002). Free Software, Free Society: Selected essays of Richard M. Stallman: GNU Press.

Gilbert, A. (December 8, 2005). Study: IT outsourcing services multiply. Retrieved March 23, 2008, from http://www.news.com/Study-IT-outsourcing-services-multiply/2100-1011_3-5987824.html GOA (1995, April). International Taxation: Transfer Pricing and Information on Nonpayment of Tax. U.S. Government, GOA/GDD report 99-39. Gopal, A., Mukhopadhyay, T., Krishnan, M.S. and Goldenson, D. (2002). “The Role of Communication and Processes in Offshore Software Development” Communications of the ACM, Vol. 45, No.4, pp. 193-200. April 2002. Gopal, A., Mukhopadhyay, T., Krishnan, M .S., and Sivaramakrishnan, K. (2003). “Contracts in Offshore Software Development: An Empirical Analysis”, Management Science, Vol. 49, 12. Pp. 1671-1683. 2003.

Grilliches, Z. (1984): R&D, Patents, and Productivity; Univ. of Chicago Press.

Griswold, D. (2004). Why we have nothing to fear from foreign outsourcing. CATO Institute. Retrieved August 23, 2007, from http://www.freetrade.org/node/104.

Gupta, A. et al. (2007). Offshoring: The transition from economic drivers toward strategic global partnership and 24-hour knowledge factory. Journal of Electronic Commerce in Organizations, 5(2), 1-23.

Gupta, A., & Seshasai, S., (2007). 24-hour knowledge factory: Using internet technology to leverage spatial and temporal separations. ACM Transactions on Internet Technology, 7 (3), 2007. Gupta, A. et al. (2008). Outsourcing in the healthcare industry: Information technology, intellectual property, and allied aspects. Information Resources Management Journal, 21(1).

Harris, S. C. (2005). Patent outsourcing and offshoring: A summary of the issues. San Diego: Fish and Richardson P.C.

Hecker, D. E. (2005) “Occupational Employment Projections to 2014,” Monthly Labor Review, Vol 126, No. 11, Nov, 2005. Obtained online from http://www.bls.gov/opub/ mlr/2005/11/art5abs.htm on April 28, 2008. Hefflinger, M. (2008) “Chinese Movie Download Service Jeboo Sues MPA,” Digital Media Wire, March 25, 2008. Obtained online from http://www.dmwmedia.com/news/ 2008/03/25/chinese-movie-download-service-jeboo-sues-mpa on April 28, 2008.

Horn, H., &Mavroidis, P.C. (2006). The WTO dispute settlement system 1995-2004: Some descriptive statistics. Retrieved May 18, 2007, from http://siteresources.worldbank.org/INTRES/ Resources/4692321107449512766/HornMavroidisWTODSUDatabaseOverview.pdf.

Ihlwan, M. (2006, December 4). Public Scorn for Private Equity. Business Week.

Jain, A. (2006). The emerging Indian legal offshoring opportunity. The Financial Times.

Kamiyama, S., Sheehan, J, and Martinez, C. (2006). “Valuation and Exploitation of Intellectual Property.” STI Working Paper 2006/5. Statistical Analysis of Science, Technology and Industry. http://www.oecd.org/sti/working-papers

Kannan, S. (2006). Legal outsourcing firm gets funding. The Hind.

Kaplan, R. S. and D. P. Norton (2004), Strategy Maps: Converting Intangible Assets into Tangible Outcomes, Harvard Business School Press, Boston, Mass.

Kharif, O. (2006) “Microsoft’s China Card” BusinessWeek, April 26, 2006. Obtained online from http://www.businessweek.com/technology/content/apr2006/ tc20060426_405461.htm?campaign_id=bier_tca on April 28, 2008. Kwon, D. and Watts, S. (2006), “IT Valuation in Turbulent Times.” The Journal of Strategic Information Systems. Vol. 15, Issue 4 pp 327-354. Jones, C.T. (1998). Estimating Software Costs; McGraw-Hill. Laurie, R. (2004). “IP Valuation: Magic or Myth?” Intellectual Property Issues in M&A Transactions. April. Leonard, Gregory and Lauren Stiroh (editors), (2005): Economic Approaches to Intellectual Property Policy, Litigation, and Management; National Economic Research Associates (NERA), White Plains, NY. Lev, B., (2001). Intangibles, Management, Measurement and Reporting; Brookings Institution Press. Lim, L. (2006) “Chinese Crackdown Fails to Stern Counterfeit Goods” National Public Radio Morning Edition, August 23, 2006. Obtained online from http://www.npr.org/ templates/story/story.php?storyId=5693207 on April 28, 2008.

Lindsey, B. (2004). Job losses and trade: A reality check. CATO Institute. Retrieved August 23, 2007, from http://www.freetrade.org/node/65.

Lohr, S. (2006, February 23). Study plays down export of computer jobs. The New York Times, pp. C11.

Mackintosh, I. et al. (2000). “Intellectual Property Protection: Schemes, Alternatives and Discussion. VSI Alliance Intellectual Property Protection Development Working Group

Marcianak, J.J. (1994). Encyclopedia of Software Engineering. Wiley.

Martinson, O.B., Englebrecht, T.D., and Mitchell, C. (1999). "How multinational firms can profit from sophisticated transfer pricing strategies". Journal of Corporate Accounting & Finance Vol. 10, No. 2. Pg. 91-103. 1999.

Merges, R. P., Menell, P. S., Lemley, M. A. (2006) Intellectual Property in the Technological Age, 3rd ed.; Aspen, 2006, page 995.

The Metropolitan Corporate Counsel. (2006). DuPont legal again sets the pace—outsourcing judgment based tasks. 14(11), 59.

New York City Bar. (2006). The Association of the bar of the city of New York committee on professional and judicial ethics, formal opinion. Retrieved May 1, 2006, from http://www.nycbar.org/Ethics/eth2006.htm.

OECD (1998). Organization for Economic Cooperation and Development (OECD): Harmful Tax Competition, An Emerging Global issue; OECD.

Panetta, K.L. (1989). Karen Panetta Lentz: Observation "Hardware is petrified software".

The Peace Palace Library Centennial Exhibition (2004). Collection as a mirror of the historical development of international law: The law of the sea. Retrieved March 1, 2007, from http://www.ppl.nl/100years/topics/sealaw/.

Quick, Perry D., Timothy L. Day, Brian J. Cody, and Susan R. Fickling (2005). Using the Market Capitalization Method To Value Buy-Ins: Beware of ‘Thing Three’, Transfer Pricing Report, Vol.14 No. 02 July 2005.

Rowthorn, R. (2005). The impact on advanced economies of north-south trade in manufacturing and services. The Social Science Research Council. Retrieved May 10, 2007, from http://www.ssrc.org/programs/ifd/publications/DevImperative/Rowthorn.pdf.

Ray, S.G. (1998). The stealing of basmati. Retrieved March 1, 2007, from http://www.rediff.com/ business/1998/mar/12rice.htm.

Samuelson, P.A. (1983). Foundations of Economic Analysis: Harvard University Press, 1947.

Sandburg, B. (2005). India inked: Local law firms and their clients save money with Indian patent shops. Retrieved August 28, 2007, from http://www.law.com/jsp/article.jsp?id=1105364113219.

San Diego County Bar Association. (2006). Ethics opinion. Retrieved May 1, 2006, from http://www.sdcba.org/ethics/ethicsopinion07-1.htm.

Schwender, A. (2006) “Outsourcing Entertainment to India” December, 2006. Obtained online from http://next.eller.arizona.edu/courses/InternationalManagement/ student_papers2.aspx on April 28, 2008.

Seshasai, S., & Gupta, A. (2007). The role of information resources in enabling the 24-hour knowledge factory. Information Resources Management Journal, 20(4), 105-127.

Seshasai, S. and Gupta, A. (2008). “The Critical Role of Information Resource Management in Enabling the 24-Hour Knowledge Factory” Information Resources Management Journal (IRMJ). No. 1, 2008. Stafford, P. and Yuk, P.K. (2007). “Study calls for rethink on IT valuations.” The Financial Times, Nov. 5, 2007.

Smith, G., & Parr, R. (2000). Valuation of Intellectual Property and Intangible Assets (3rd ed.). Wiley.

Spolsky, J. (2004). Joel on Software. Apress.

Stein, T. (2003). Inside out: Businesses look to outsourcing for more and more business processes. Optimize. Retrieved March 17, 2007, from http://www.optimizemag.com/issue/020/execreport.htm.

Studt, T. (2007). “R&D Outsourcing Becomes More Strategic” R&D magazine, June 2007, pp.26-29, www.rdmag.com

Thornton, E.A. (2002). “Valuation of Software Intangible Assets.” ASA International Conference. San Diego, CA. August.

Trillmich, P. (2003). “Where do they want you to go these days, Alma Mater?” IPR Helpdesk Bulletin. No. 8, May, 2003.

UN Atlas of the Oceans. (2007). History of Maritime Law. Retrieved March 1, 2007, from http://www.oceansatlas.org/servlet/CDSServlet?status=ND0xMjg2OC4xNDUwNSY2PWVuJjzPXdlYi1zaXRlcyYzNz1pbmZv.

U.S. Department of Commerce, Bureau of Economic Analysis, International Economic Accounts, U.S. International Services: Cross-Border Trade 1986-2006.

Uzma, J. (1998). Biopiracy: The patenting of basmati by RiceTec. Commission on Environmental, Economic and Social Policy—South Asia & Sustainable Development Policy Institute.

Vandana, S. (2001). The Basmati battle and its implication for biopiracy & TRIPS.Retrieved March, 7, 2007, from http://www.globalresearch.ca/articles/SHI109A.html.

Vardi, M.Y., Mayadas, F., & Aspray, W. (2006). Globalization and Offshoring of Software, A Report of the ACM Job Migration Task Force, ACM.

Walden, E. A. (2005). “Intellectual Property Rights and Cannibalization in Information Technology Outsourcing Contracts” MIS Quarterly, Volume 29 Number 4, December 2005, 699-720.

Waldmeir, P. (2003). Lawyers argue the case for a lifestyle revolution. Financial Times, 15.

Wayne, E. A. (2004). Address to Senate Judiciary Committee. Retrieved March 1, 2007, from http://usinfo.state.gov/ei/Archive/2004/Mar/24-488795.html.

Wiederhold, G. (2006). “What is Your Software Worth?” Communications of the ACM, Vol. 49 (9), pp. 65-75.

World Intellectual Property Organization. (2007). Berne Convention for the protection of literary and artistic works. Retrieved March, 1, 2007, from http://www.wipo.int/treaties/en/ip/berne/ trtdocs_wo001.html.

World Intellectual Property Organization. (2007). Paris Convention for the protection of industrial property. Retrieved March 1, 2007, from, http://www.wipo.int/treaties/en/ip/paris/ trtdocs_wo020.html.

World Trade Organization. (2007). Frequently asked questions about TRIPS. Retrieved February 20, 2007, from http://www.wto.org/english/tratop_e/trips_e/tripfq_e.htm.

World Trade Organization. (2007). What are IPRS? Retrieved February 20, 2007, from http://www.wto.org/english/tratop_e/trips_e/intel1_e.htm.