Boxing Clever? The Patent Box – Tax Relief for Intellectual Property Income – An update

John Moore, September 11th, 2012 John Moore

The new Patent Box regime offers qualifying companies the opportunity to reduce their corporation tax bill. However optimising your benefit requires getting “regime ready” in good time for the first accounting period affected. The legislation is now part of the Finance Act 2012 and from 1 April 2013 qualifying income and gains can benefit from the 10% tax rate.

The Patent Box regime, in addition to the R&D tax relief schemes already in place, is intended to make the UK more attractive as a destination for innovation as part of a drive to become the most competitive corporate tax system in the G20 group of countries.

We have previously published articles looking at the recent beneficial changes to R&D tax relief, such as increases in the amounts SMEs will be able to claim and the “above the line” proposal for large companies.

In a previous articles in July 2011 and December 2011 and in our webinar with Venner Shipley, a leading firm of Patent Attorneys, we reviewed the output from the Patent Box consultation process at that time on the potential form and effect of the proposed Patent Box.

This article will give an up to date overview of the main features of the regime following the publication of the Finance Act 2012 and will highlight some of the numerous practical considerations that companies should be thinking about before the start date of the regime on 1 April 2013.

Although the start date may seem a long way away, for companies with, say, a June year end, then this will apply for the accounting period commencing 1 July 2012. For such companies, there is a potentially valuable cash flow saving to be made if the company is able to anticipate and calculate the Patent Box tax reduction in the calculation of quarterly payments on account.

Companies will need to start planning now how they are going to be able to take advantage of the potential benefits. As you will see from the overview below there is much information that will need to be gathered in order to comply, and importantly to get the best results for your company. It is very unlikely that this will be a quick and simple exercise. Companies will need to understand the makeup of their patent and licence portfolio and how, under the calculation process proposed, this impacts on taxable profits. Planning will need to occur before the start of the regime on how to gather the information, which calculation methods are best for the company and whether the company’s Intellectual property (IP) portfolio is optimised to take advantage of the regime. Obtaining the optimal results under the new Patent Box will involve work on both the accounting and tax aspects as well as the patent strategy and clearly this will take time to implement.

Key features at a glance

  • Income from qualifying patents and certain other qualifying intellectual property rights taxed at a lower rate of 10%. A company’s normal tax rate on profits will otherwise be between 20 and 25%.
  • Applies from 1 April 2013 with the amount of profits in the box phased in (See below).
  • Companies must perform development activity on the patents in order to qualify.
  • For a company in a group of companies it must also satisfy the active ownership condition.
  • Companies will need to make an election for the Patent Box to apply. Understanding the best time to elect into the regime will be crucial.
  • Mechanical process for calculating qualifying profits.
  • Smaller companies may opt for simplified calculations to reduce the compliance burden.
  • Recognising the delay that can occur in obtaining IP rights, up to six years of additional qualifying IP profits may be brought into the calculations in the year in which the right is granted.

Qualifying companies

A company will be a qualifying company if either condition A or B is met. It is then able to elect into the Patent Box.

Condition A – A company needs to hold, or exclusively license in, qualifying IP rights at any time during the accounting period if it is to be able to elect into the Patent Box.

Condition B – A company has previously owned a qualifying IP right and has received income in respect of an event which occurred in relation to the qualifying IP rights when the company was a qualifying company and the company had elected into the Patent Box regime.

In addition if a company is part of a group, then it will need to meet the “active ownership” condition for the accounting period (See below). The aim of this is to ensure that passive IP holding companies are not able to benefit from the Patent Box. “Group” is defined more widely than just those companies that are required to be consolidated in group accounts under the 2006 Companies Act and incudes companies connected with each other by virtue of control or a major interest.

Following an election into the Patent Box regime it will apply equally to all trades of the company and for all subsequent accounting periods until revoked. Once an election has been revoked a company will not be able to elect back into the regime for five years.

Qualifying IP rights

An IP right qualifies if it is one of the following:

  • A patent granted under the Patents Act 1977.
  • A patent granted under the European Patent Convention and extended to certain patent rights granted by other EEA states which have a similar examination and patentability criteria as the UK.
  • Any other rights specified by HM Treasury. At present the legislation includes certain UK and European exclusivity rights regarding marketing and certain supplementary protection certificates for medicinal products, and marketing exclusivity rights in relation to veterinary and plant protection products.

In addition it has to meet the “development condition” in relation to the right.

Broadly speaking the development condition will be satisfied if the company or the group either creates, or significantly contributes to the creation of the protected item, or if it performs a significant amount of activity for the purposes of developing the protected item or any item incorporating the protected item.

Where the company is a member of a group it must also satisfy the active ownership condition for the accounting period. For this, all, or almost all of the qualifying IP rights held by the company must be ones where either the company performs a significant amount of management activity in relation to the rights or has carried out the qualifying development itself. Management activity means formulating plans and making decisions in relation to the development of the rights.

Calculating relevant IP profits

The 10% Patent Box rate only applies to a proportion of the taxable profits of a company’s trade or trades. What is clear is that, in order to be able to calculate the amount that falls into the Patent Box, companies will need to be able to access the information in as painless a way as possible and to model various scenarios that might be applicable to them. This is not only for the basic compliance once the regime starts, but also for the purposes of being able to plan, in the period before the relief is available, to optimise the impact of the relief given the particular fact pattern of the company and its patent portfolio.

The legislation has broken down the ultimate goal of identifying the relevant IP profits of the trade into several steps which we will look at in overview:

Step 1: Calculate the total gross income of the trade for the accounting period

Total gross income is any amounts recognised as credits for calculating the profits of the trade, plus credits on realisation of relevant intangibles and the profits from sale of patent rights and after deduction of credits in respect of finance income, which is widely defined.

Step 2: Calculate the percentage of total gross income that is relevant IP income

The formula to be used is relevant IP income (RIPI, below) divided by total gross income (from Step 1 above).

Relevant IP income is income from:

  • Sales of the items protected by a qualifying IP right (including an exclusive license) (“qualifying items”) or items incorporating or designed to be incorporated into qualifying items.
  • Licence fees or royalties from granting rights in respect of qualifying IP rights owned by the company including those received in respect of a qualifying process.
  • Sale or disposal of a qualifying IP right.
  • Compensation received as a result of infringement of a qualifying IP right where the right was held by the company at the time of the infringement and the company had elected in to the patent Box regime at the time of the infringement.
  • A notional royalty where the company uses qualifying IP to perform processes that create non patented products or to provide services. This is an amount equal to the royalty that would be paid to an independent owner of the qualifying IP rights used to generate this IP derived income.

Step 3: Apply the percentage calculated in Step 2 to the corporation tax profits (or losses) of the trade for the accounting period.

The profit apportionment basis

Under the profit apportionment basis the corporation tax profits are adjusted to remove finance returns and costs and any additional deductions under the R&D tax relief schemes. There is a possible further adjustment at this stage where R&D spend, per the disclosure in the financial statements, is less than the R&D spend averaged over the four years before election into the Patent Box. This adjusted taxable profit is then apportioned according to the ration of RIPI to total gross income calculated in Step 2 above.

Streaming

However where the application of steps 1 to 3 does not give an acceptable estimate of the company’s actual profits from the exploitation of its qualifying IP rights then the company can elect to apply the streaming provisions. Acceptable estimates may not be produced under steps 1-3 where, for instance, a company has a significant amount of non IP income that produces relatively little profit and a smaller proportion of income that is relevant IP income that produces a much larger level of profit.

Under the streaming election the company can allocate expenses and profits to particular income streams on a just and reasonable basis. Where the total gross income of the trade includes relevant income and a substantial amount of licensing income that is not relevant IP income the streaming approach is mandatory.

Step 4: Remove a routine return on expenses to obtain Qualifying Residual Profit (QRP)

This stage is designed to remove the return that a business might be expected to make if it did not have access to unique IP and other intangible assets. The removal of this routine return is necessary to arrive at the amount of profit that is attributable to intellectual property, both patent related IP and other, such as marketing asset IP. The calculation is based on “routine expenses” which include capital allowances, premises costs, personnel costs, revenue costs associated with plant & machinery costs e.g. leasing, modification, maintenance etc, Professional services and miscellaneous services including software costs, consultancy & professional (excluding “IP related” services), telecommunications, postal, computing transport and waste disposal services. However R&D expenses plus any uplift given under the R&D tax relief schemes are excluded from the calculations, as are loan relationship amounts.

The routine return is calculated as 10% of the aggregate of the routine expenses and then by apportioning the result by applying the percentage in step 2 above. The resulting figure is then deducted from the profit calculated at stage 3 to give Qualifying Residual profit.

Steps 5 & 6: Deduct a marketing assets return

These steps are designed to deduct from the potential patent Box profits the part of the residual profit that is associated with the brand and other marketing assets as distinct from the profits of the trade that relate to qualifying IP rights since both are included in the figure at the end of step 4.

The legislation provides two alternative methods for calculating this marketing asset return deduction.

Under Step 5, provided that the company meets the qualifying conditions it may elect to apply the “small claims treatment” with its simplified method of calculation. Under this approach the relevant IP profits of the accounting period will be the lower of:

  • 75% of QRP; or
  • The small claims threshold of £1 million (pro-rated for the number of associated companies in the Patent Box regime and for accounting periods of less than 12 months.)

Because this is a potentially less onerous option than Step 6 it should enable smaller companies to claim the relief more easily.

If a company does not elect to apply the small claims treatment, or is unable to because it does not meet the qualifying conditions for the election, then it must, under Step 6, calculate the amount attributed to marketing assets, being the difference between the notional marketing royalty calculated in accordance with arm’s length transfer pricing principles, and the actual amount payable by the company for the use of the brand. However If the difference is less than 10% of the QRP then the marketing assets figure is nil. A company with a QRP of less than £1.33m (£1.33 X 75% = £1m) may not in fact be exploiting any marketing asset, perhaps being in a B2B situation, and may find that Step 6 is relatively easy to calculate and therefore may prefer not to elect, as it could, for the small claims treatment.

Step 7: Add any profits arising in relation to a patent that was waiting to be granted and was granted in the accounting period

This acknowledges that there may be a number of years between the application for a patent and a grant (Patent pending period). In the period in which the grant occurs the company can elect to add an additional amount to its relevant IP profits in respect of the additional profits for accounting periods ending up to a maximum of six years prior to the grant. The election can also be made if the company received income while the patent was pending but disposes of its right before the patent is granted. Somewhat perversely, the legislation requires that the company can only include periods where it was already elected into the regime. This may therefore require some planning by companies such as start-ups with patents pending and others to ensure that they will be in a position to take advantage of the regime once the grant is given.

Reduction in taxable profits – taxed at 10%

The steps above calculate the Relevant IP profits (RIPP) of the company. To this is applied a formula to calculate the additional trading deduction that the company can take leaving net profits chargeable to corporation tax to be taxed at whatever rate is applicable to the company’s profits. The formula uses the main rate of corporation tax. So in those circumstances where a company is charged at less than the main rate i.e. the small company rate, or the full rate with marginal relief, the Patent Box profits may, in fact, be charged at a rate slightly below 10%.

As mentioned above the full benefit of the regime will be phased in by applying the appropriate percentage to the RIPP for the accounting period as follows:

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Other points

Anti-avoidance

The legislation contains three anti avoidance provisions. Where the main purpose, or one of the main purposes of granting an exclusive licence is to obtain the Patent Box benefit, or the main, or one of the main purposes of incorporating a patented item into a product, is to bring income from the sales of that product into the Patent Box, or where the company seeking to make the Patent Box deduction is party to specified types of scheme one of the main purposes of which is to increase the Patent Box income, then the patent box will not apply.

Relief for losses

Where a company has Patent Box losses under the above calculations, then the amount of the losses reduces the profits calculated for any other trades of the company which are entitled to benefit from a patent Box election. Where there are still excess losses then these are used to reduce the profits of group members which can benefit from the Patent Box. Any remaining losses are carried forward to offset against future Patent Box profits of the company.

Next Steps for companies wishing to optimise the opportunity

Any company with patents, or with the potential to file for patent protection, should act now to evaluate the impact of this on their business. It is an elective regime because for some companies the additional compliance costs will outweigh the tax savings. You will need to evaluate whether you wish to take advantage of the opportunity or not.

For companies making quarterly payments on account there will be an immediate positive cash flow impact for any accounting period end after 1 April 2013. Companies should evaluate how they are placed to be able to gather the information required and model the impact under the various alternative routes available for calculation. Importantly companies should see this as an opportunity to review their patenting strategy. This will involve other professionals such as specialist patent and IP lawyers. It is clear from the above that there will be opportunities to arrange that income and profits are capable of being included in the Patent Box by ensuring that qualifying IP rights are created where perhaps these are not at present.

Having created a methodology for calculating the Profits for the Patent Box, companies may also want to enter into discussions with HM Revenue & Customs with a view to agreeing the methodology for use in the first few accounting periods of the business. Such a process will assist in creating certainty on the impact of the regime in the company and in turn will enable the Patent Box to act as an incentive in planning future innovative activities in the UK.

Getting “regime ready”, to be able to optimise the benefits, will take time and resource. You need to understand the additional benefits, compliance costs, system changes and patent strategy changes before making the decision to elect into the regime. We advise that companies start planning for the implementation of the Patent Box now. As specialist advisers in this area we would be glad to meet with you to discuss the detailed aspects of the proposed regime and how we can advise and help you to optimise your potential to benefit from it.

Please do not hesitate to contact John Moore on 0207 292 8850 or at john.moore@kinglybrookesllp.co.uk if you would like to discuss the implications of this for your company.

This briefing is prepared by Kingly Brookes LLP, a limited liability partnership. For further information on any of the material contained in or referred to in the briefing, please contact us. This briefing note is intended to keep our readers up to date with the developments in this area, but it is a general guide only and is not intended to be a comprehensive statement of the law and practice in this area. No liability is accepted for the opinions it contains or for any errors or omissions.