On 22 December 2014, the Italian Parliament approved the Budget for 2015. 5 Among other measures, the Law introduces the possibility of an exemption from corporate income tax (IRES, generally levied at 27,5%) and local tax (IRAP, generally levied at 3,9%) on income derived from qualifying intangible assets (such as patents, know-how and other intellectual property rights)6. The regime is eligible for taxpayers who perform research and development (R&D) activities and is characterized by a five year lock-in period. An advance clearance is required in a number of circumstances.
By means of this law, Italy has introduced the Patent Box regime, based on the OECD Nexus Approach. 7 This helps determine what income qualifies for the reduced tax rates. Specifically, the qualifying income is calculated by multiplying the overall income derived from the IP asset by the ratio of “qualifying R&D expenditures” over the “total expenditures incurred to develop IP”.
Italian law had already provided for tax credits for R&D expenses to incentivise technological development by Italian entities. There where however no incentives on the revenue side. This meant that multinational groups maintaining R&D centres in Italy so as to benefit from tax credits, subsequently transferred the mature IP to other countries, where the taxation on royalties was lower. This mechanism implies a loss of the tax base for the Italian tax authorities.
The new patent box regime aims to stop this phenomenon so that intangible assets remain in Italy, and potentially those currently held abroad by Italian and foreign multinational groups may be repatriated.
The new regime is optional and can be accessed by all entities carrying out business activities in Italy, under the condition that they carry out R&D activities either directly or through agreements with universities or other research entities. Foreign entities carrying out business activities in Italy through a permanent establishment can also benefit from the regime, provided that they are resident in a country that has a double taxation treaty in force with Italy and undertake to effectively exchange information with Italy.
Opting to participate in the regime is irrevocable and applies for the subsequent five fiscal periods. After the first five fiscal period, an extension is likely to be allowed.
The Italian Patent Box Regime is applicable to any kind of patent, to certain brands “functionally similar to patents”, as well as to processes, formulas and know-how related to industrial, commercial or scientific fields that can be legally protected. Also, income deriving from exploitation of copyright appears to be included.
The Italian Patent Box Regime clearly takes inspiration from similar regimes already in place elsewhere in the EU.
The concept of a Patent Box was first introduced in 2000 by Ireland and in 2001 by France as a reduced rate of tax revenue form IP licencing or the transfer of qualified IP.
Currently IP-Box regimes in Europe have been introduced by Belgium, Hungary, Luxembourg, Netherlands, Spain and the United Kingdom.
In particular the Patent Box regime in UK is a tax incentive introduced in 2013 designed to encourage companies to make profits from their patents by reducing the UK tax paid on those profits. Qualifying patents must have been granted by an approved patent-granting body, including the UK Intellectual Property Office, the European Patent Office and designated European territories: Austria, Bulgaria, The Czech Republic, Denmark, Estonia, Finland, Germany, Hungary, Poland, Portugal, Romania, Slovakia and Sweden.
The Patent Box excludes patents registered in territories such as USA, France and Spain because of differences in the search and approval process for patent applications.
OECD Level and EU references
Action Item 8 of the OECD initiative aimed at tackling Base Erosion and Profit-Shifting (BEPS) has established that IP regimes should not be considered harmful if the grant of a tax benefit depends on the performance of substantial activities in the relevant jurisdiction providing for the tax benefit. However finding the appropriate preferential IP regimes has proven elusive and work it is still on-going both in the OECD and in the EU.
While Member States are making extensive efforts to agree on the features of a model IP regime that is not excessively harmful and at the same respectful of the EU fundamental freedoms such as freedom of establishment and freedom to provide services protected by Articles 49 to 55 TFEU, and 56 to 62 TFEU, little or no reflection has been put in considering the prohibition to grant State aid incompatible with the internal market pursuant to Articles 107 and 108 TFEU. This is a grave weakness of the on-going discussion because unlike the coordination efforts to tackle harmful taxation and the infringement proceedings run by the Commission pursuant to Article 258 TFEU where the Commission enjoys a large margin of discretion in deciding whether to pursue or not possible infringements of the fundamental freedoms, State aid rules give little discretion to the Commission particularly with respect to the deciding whether a tax measure is aid or not.
The issue of state aids for the Patent Box is discussed in the next article of this edition of Across (see page 6).
As background, Member States are discussing BEPS within the EU’s Code of Conduct on Business Taxatio, 8 a coordination forum between Member States’ tax authorities to fight against harmful tax competition and, in respect to tax incentives for intangibles, to find a common approach to define the substantial activity requirement. Following a proposal made by the United Kingdom to the OECD Forum on Harmful Tax Practices (FHTP), which is the group within the OECD entrusted to counter harmful tax practices, the Code of Conduct has embraced the idea of a Substantial Nexus. This Nexus links the tax benefits to be foreseen by the preferential IP regimes to the amount of R&D expenditure incurred by taxable entities in the relevant country. Consensus was found on the substantial nexus approach. Under this approach a model IP regime is not harmful if the benefits of a lower rate on royalty income are conditional on there being substantial R&D activities in the concerned country, where expenditures incurred in that country stand as a proxy for substantial activities made within the meaning of the substantial nexus approach. Many Member States are taking inspiration from that approach to design their IP regimes.
A distinction should be made between different forms of tax incentives, including the Input or Back-End (tax) Incentives and the Output or Front-End Incentives.
A most common example of Input or Back-End Incentive is the tax credit (for R&D expenditure). The incentive is proportionate to the expenditure made and reduces the tax liability that normally results from the taxable income of a beneficiary, or its net amount of income after the gross income has been reduced by the allowable deductions, multiplied by tax rate. Unlike a deduction the value of which depends on the particular taxpayer’s applicable tax rate (so that the value is greater for higher tax-bracket taxpayers), the credit has the same value for all taxpayers.
An Output or Front-End Incentive is an exclusion or exemption of certain revenues deriving from an activity to be incentivised from the gross or net taxable income. Since the incentive insulates the qualifying income from the general business income, this type of tax incentive is also called the IP or Royalty Box. This value of this type of incentive is variable depending on the profitability and tax-bracket of the beneficiary taxpayer and is potentially unlimited because it is not calculated as a percentage of the expenditure incurred but it is in function of the tax rate applicable on income excluded or exempt from tax.
Since IP revenues, benefiting from tax exemptions under the Front-End Incentives, derive from activities that are mobile, these incentives not only have the highest value for taxpayers but are also less expensive from a tax revenue point of view. These forms of exemption can induce multinational groups (MNEs) to change the location of activities which were previously taxable elsewhere. This can have the effect of eroding the tax base of other countries without losing any of its own tax revenues. It is for this reason that the Royalty Boxes are the favourite form of IP Regimes.
It is for the competitive pressure that Front-End Incentives puts on tax jurisdictions, that these incentives have been subject to review under the harmful tax competition initiatives at OECD and EU levels to limit their possible harmfulness. As a result, a third type of IP regime can be identified as a type of Front-End Incentive, however corrected by the Substantive Nexus requirements, which is now inspiring many of the Patent Boxes in the EU Member States and in non-EU countries.
This form of IP regime is a milder form of Output Incentives in the sense that it also provides for full or partial exemptions or exclusions of the qualifying income deriving from IP activities, however is considered not to be harmful taxation.