As part of its ongoing review of the taxation of innovation and IP started in November 2010 the Government’s intention is to allow companies to tax profits attributable to certain patents at the substantially reduced rate of 10% from April 2013. The latest consultation document looks at the potential mechanics of the scheme and invites responses from interested parties. It is clear that, at this stage, there are many complexities and uncertainties that require further input from business and that the relief may not be as generous, in practice, as companies may be expecting.
In order to assist companies exploiting technology in understanding how the proposal might affect them this article gives an overview of the proposed regime and highlights some practical steps that companies, or their advisers, should be undertaking to assess the impact of the proposed regime on them. This will potentially be important for any company forecasting future tax cash flows as well as in undertaking planning around where and whether patents are applied for.
As the consultation process continues it is becoming clear that the Government is listening to the views of business. Whilst it is not proposed to apply the reduced tax rate to intellectual property other than patents granted by the UK’s Intellectual Property Office and The European Patent Office, income arising from acquired patents and from the sale of patents is now being considered for inclusion.
In addition the originally proposed exclusion of patents commercialised prior to November 2010 is being withdrawn. This will be of interest to those companies who feared that, having taken many years to bring a patented product or process to market, they would miss out on qualifying for the reduced tax rate due to the imposition of an arbitrary start date.
The Government are planning to introduce the regime in April 2013 however, with the dropping of the November 2010 cut off date, it is proposed to phase in the amount of income subject to the reduced 10% rate as follows:
This proposal does at least recognise the issue of the imposition of a cut off date, and importantly would give certainty over the ability to qualify for the reduced rate against a reduced benefit in the early years of the regime.
Overview of the Proposals
Businesses will be able to elect for the Patent Box regime to apply to their trading profits. Businesses must hold a qualifying patent or other qualifying IP and have income relating to that patent or IP. Qualifying patents and qualifying income are discussed in more detail following this overview. The consultation document proposes a three step method for quantifying those taxable profits attributable to patents and subject to the patent box regime:
- Step One – Determine the part of the company’s profit attributable to qualifying income, apportioning total taxable profits between qualifying and non qualifying income. Certain adjustments will be made before apportionment such as excluding any R&D tax credit enhancement as well as interest receipts and financing expenses.
Where this simple apportionment produces anomalous results, then in certain cases, it is proposed that the apportionment of expenses and profits can be calculated on suitable ‘divisions’ of the company. Where the model would lead to fewer profits being attributed to patents than appropriate then companies will have the option of defining divisions and applying the model separately to each one. An example is given of profit margins in different areas of the business being significantly different. This divisionalisation approach will also be able to be used where a company makes use of a patented process but the products it produces are not covered by any patent. The company will be able to treat the patent owned as a separate division using an arm’s length royalty charge as income and appropriate allocation of expenses to calculate the qualifying profit under the regime.
- Step Two – Calculate the residual profit, which is a measure of the profit created by IP rather than through more routine business activities. This is calculated by applying a fixed mark up of 15% to tax deductible expenses after excluding certain costs such as ‘outsourced costs’ (definition to be consulted on), the cost of goods purchased for resale, and license fees paid to use patents or trademarks. This ‘routine’ profit is then deducted from the apportioned profit calculated in Step 1 to give the ‘residual profit’.
- Step Three – Taking the residual IP profits calculated in Step Two, further apportionment of this is required to consider how much of this is due to the patent and how much is due to other non patent assets such as brands. The Government’s suggested approach uses the ratio of expenditure on R&D and patents compared to the expenditure on marketing, selling, promotion, trademark development and those design costs not classified as R&D.
This approach is problematic as the definition of marketing expenditure is wider than brand development and investment, there is also already a reduction relating to brand profit in Step Two, by the application of the 15% mark up on all expenses. There is also an assumption that profit is generated equally from expenditure on both R&D and brand. This is unlikely, in practice, to be the case. It is also likely that practical identification of the types of expenditure will not be straightforward. The Government have recognised that this approach has limitations and have invited business to put forward alternative ideas.
Tax computation – overview
It is proposed that companies will claim an additional Patent Box deduction when calculating the level of taxable profits. These reduced profits will then be taxed at the normal rate of corporation tax. The Patent Box deduction will be calculated as:
Where a company is taxed at the small profits rate then this is used instead of the main rate in the calculation.
Losses – overview
Where the net result of the Patent Box calculations produces a notional loss then these will be ring fenced and carried forward, reducing Patent Box profits calculated in future periods until the losses are used up.
Calculation of Patent Box profits – Practical considerations
- Can you readily identify the income from the sale of products incorporating at least one invention covered by a qualifying patent?
- How will the ability to use divisionalisation impact on your claims?
- If you decide to divisionalise a patented process how will you determine an arm’s length royalty to bring into the calculations? Are the associated costs readily identifiable?
- The calculations will require a significant amount of analysis and computation each year potentially increasing the internal/external cost of compliance.
- The consultation contains numerical examples that show the overall benefit to companies may be less than the headline rate of 10%. The first worked example, in which 70% of the company’s sales come from patented products, actually achieves an effective tax rate of 21%, only 3% below the main rate applicable of 24% and this is before the phasing in of the relief currently proposed! Companies will need to model the effects of the relief, and options such as divisionalisation, in order to determine whether the Patent Box election will be worth the additional annual compliance burden work required to perform the calculations. The consultation notes that companies will not be able to change from a whole company to a divisional basis on a year by year basis and so an investment in upfront calculations and modelling will be required in order to determine the best methodology for future years.
- Fluctuations in R&D and marketing spend will affect the residual profit allocation at Step Three. For instance in sectors such as pharmaceuticals the large and perhaps non annual launch costs of a product would adversely affect the calculation of Patent Box profits. This may particularly affect smaller companies with a more infrequent pipeline of launched products.
- The Government recognises that current year costs of development may not provide a reasonable proxy of the prior year costs of developing current products in determining pre commercialisation expenses. They are producing claw back rules over the summer. This will introduce an added element of uncertainty for companies which do not have a similar level of spending on R&D each year.
- The Government is proposing a non statutory clearance system which to some extent recognises the complexities that companies may encounter in performing these calculations in practice.
The proposals aim to put in place safeguards against the inclusion of patents granted in jurisdictions that do not meet certain standards as well as ensuring that only certain types of invention are included. It is therefore proposed that the regime should only include patents granted by the UKs Intellectual Property Office and the European Patent Office. Views are sought as to whether this requirement will cause significant commercial distortion and whether patents granted by other EU national patent offices should be included. However the Patent Box regime will include worldwide income arising from inventions covered by a qualifying patent, not just the income arising in the territories covered by the patent. It is proposed that acquired patents will also be included.
The consultation recognises that other IP associated with patents exists and it is currently proposed that Supplementary Protection Certificates (SPCs) extending a qualifying patent, regulatory data protection rights and plant variety rights will also fall within the regime. The Government has specifically ruled out the inclusion of other forms of IP such as trademarks or copyright.
The proposed ownership requirements have been set widely enough so as to aim to prevent any distortion to the normal commercial arrangements that exist around patent ownership. The Government proposes that the Patent Box will be available through legal ownership, through holding a licence to commercially exploit a patent, and to patents developed under partnership, joint venture or cost sharing arrangements where there is either ownership or the holding of an exclusive license. Views are sought as to whether this will be wide enough in practice.
In order to target the benefits of the regime away from those companies that are merely passive recipients of income from just holding patents it is proposed that the company claiming the Patent Box deduction must remain actively involved in the ongoing decision making connected with the exploitation of the patent. In addition the company, or another group company, must have performed significant activity to develop the patented invention or its application. In determining whether a company has performed significant development activity it is proposed to take account of the active decision making functions related to the management of risks associated with the project, as well as with R&D activity. The intra group subcontract of R&D and the transfer of patents will therefore be potentially within the regime. Views are sought on how significant development activity by the claimant company would be demonstrated in the situation where a patent has been acquired or developed in collaboration with unrelated companies.
It is proposed that a patent will qualify from the date of grant. Once the patent is granted the company will be able to claim the Patent Box benefits for any income arising between the patent application and the date of grant for the period four years prior to the grant. This benefit will be available in the accounting period when patent is granted.
Qualifying patents – Practical considerations
- Does the company currently patent innovations? In practice this does not always occur for a variety of commercial reasons.
- Which patent offices do you submit patent applications to?
- Are all qualifying patents and associated qualifying IP readily identifiable?
- Which companies have legal ownership of your patents?
- In future will you need to obtain exclusive licenses?
- How will you document /show significant development activity?
- Do your patent applications currently take longer than four years? If so income may fall out of the regime.
The following types of income will fall within the proposed regime:
- Worldwide income earned from the sale of products incorporating at least one invention covered by a currently valid qualifying patent.
- Income from the sale of spare parts for a qualifying product.
- Income from the licensing of intangible products incorporating the right to use at least one invention covered by a qualifying patent.
- Damages received from third parties for infringing a qualifying patent.
- Imputed income from patents used in industrial processes.
- Income from the sale of qualifying patents.
- License income from patented processes or income from the sale of production equipment that incorporates the patented process.
Despite representations from business the Government is not willing to include service income as within the Patent Box. So where services and products are sold together the income will need to be apportioned in a just and reasonable way.
Qualifying Income – practical considerations
- Can you readily identify the income from the sale of products incorporating at least one invention covered by a qualifying patent?
- Can you identify income from bundles of related intangible assets that are licensed as a single product? These can be qualifying income.
- Where patented products and services are sold as a package are you able to identify the product related income that would qualify?
The proposed Patent Box regime clearly has potential merit and is another example of the Government using the corporation tax regime to encourage the development of innovative technology to benefit UK plc. Whilst some of the uncertainties regarding the method of calculation raised in the first round of consultation have been addressed the currently proposed regime is not without its complications and does not appear to offer the headline befits that many may well have been expecting. In order to ensure that this regime ends up being as effective as possible companies will need to engage with the Government to suggest areas for improvement. We suspect that the only way that a company will be able to determine whether it decides to take advantage of the regime from 1 April 2013 will be to model the effects and to explore what the optimal methodology is given the particular fact pattern for the claimant. This will require an up front, but potentially valuable, investment of resources.
The Government is inviting responses to the questions posed in the detailed consultation document (see below) by 2 September 2011. The legislation will then be included in the Finance Bill 2012 ahead of the proposed commencement date of 1 April 2013. We would be glad to meet with you to discuss the proposals in more detail and how they may affect your company.