The UK Patent Box taxation regime introduced by the 2012 Finance Act will take effect from 1 April 2013. Under the regime a company will be able to elect for its profits from qualifying patents to be taxed at a separate 10% rate of corporation tax.
Background and context
In November 2010, the government published its initial proposals for the UK Patent Box regime. The proposals came in the wake of certain high-profile corporate emigrations from the UK to jurisdictions with a lighter tax burden on IP profits.
The stated aims of the introduction of the regime were to enhance the competitiveness of the UK tax regime and to encourage UK companies to commercialise existing patents, to develop innovative products and to locate the high-value jobs in development, manufacture and exploitation of patents in the UK.
The 10% rate will be phased in gradually by applying at first to only 60% of the relevant profits, increasing by 10% per year to 100% for 2017.
The Patent Box legislation is fairly complicated and businesses must prepare themselves in advance of 1 April 2013 in order to take full advantage of its benefits.
The headline points to which the government has adhered from the outset of the consultation process are as follows:
- Scope – The regime will apply to a wide range of royalty income and also, notably, to “embedded” income – i.e. income wrapped up in the sale proceeds of a patented product.
- Formulaic Method – The fact that embedded income is to be covered means that there needs to be some method of determining the level of profit to be attributed to patents. This will therefore add a certain level of complexity to applying the regime, but the legislation provides a formulaic approach in the hope of providing certainty and diminishing administration. Also, an alternative method of calculation is available by election to prevent anomalies from the formulaic method.
- Application to patent profits – The Patent Box tax rate will apply by way of a deduction from trading profit, which has the effect of applying a 10% rate to relevant IP profits, thus reserving losses for use elsewhere.
- Encouraging innovation – The elective regime will encourage companies to be actively innovative. Passive owners of patents will not benefit from the preferential tax rate on their patent income.
How to qualify
The Patent Box tax regime is theoretically available for any business within the scope of UK corporation tax. In order to claim the preferential tax rate on profits, a company must elect into the regime and must own, or have exclusive licences in at least one entire national territory to use, qualifying patents or other qualifying IP.
- Territories – The Patent Box will contain patents granted by the UK Intellectual Property Office and the European Patent Office. The government has also produced a white list of other EU states whose national patent offices apply similarly rigorous standards of examination.
- Qualifying IP – Supplementary protection certificates, which extend the protection granted by qualifying patents, are also be included in the Patent Box. Certain non-patentable items, such as regulatory data protection and plant variety rights, which are subject to similar standards of examination for novelty and which are centrally registered, can also qualify.
Trade marks and copyright will not be included and design rights (although curiously not mentioned) also seem to sit outside the Patent Box. However, know-how may be included if licensed together with qualifying IP.
- Ownership – Subject to the development criteria (see below), the regime will be applicable not only to legal owners of patents, but will extend to exclusive licensees and to patents developed under partnership, joint venture and cost-sharing arrangements.
- Development – The regime applies only to companies or groups involved in creating or developing inventions or items or processes incorporating them. A group company that has not carried out or does not carry out such creation or development must be actively involved in managing the qualifying IP. People who merely finance innovation will not benefit.
In order to determine the income which is subject to the preferential rate of tax, a distinction needs to be made between patent income and general income. Although the contents of the Patent Box are to be determined according to UK and EU patenting standards, all worldwide income deriving from the relevant patents is eligible for the preferential rate.
Sensibly, the formulaic method of determining IP profits focuses on income from all patented products in aggregate, rather than forcing companies to attempt to identify income from individual patents. The ratio of qualifying gross income to total gross income is applied to profit in order to determine the amount of profit that is attributable to qualifying income. The intention is that it should therefore be possible to extract the qualifying income from accounting records reasonably easily.
However, for a situation where the gross income-based split determined by the formulaic method would produce a distorted result (e.g. a company whose gross IP income is relatively low, but whose net IP profit is relatively high), a company may instead elect into the streaming method of calculation, broadly based on identifying IP profits on a just and reasonable basis.
In addition, once a qualifying patent is granted, the Patent Box benefits will be applicable to any qualifying income earned between application and grant for up to 6 years before grant to compensate for the time lag.
The following types of income will qualify:
- All royalties and licence fees received for the use of an invention covered by a qualifying patent, including both product and process patents;
- Notional arm’s length royalties for the use by a company of its own patents in industrial processes or tooling;
- Income embedded in the sale proceeds of products incorporating at least one invention covered by a qualifying patent (but “embedded income” will not cover income from products made by a patented process);
- Income from the sale or disposal of spare parts for a qualifying product (whether or not the spare parts themselves are covered by a qualifying patent); Income from licensing of bundles of intangibles which are related and are licensed as a single product e.g. licensing a qualifying patent together with related know-how;
- Compensation and damages for infringement of a qualifying patent; and
- Income from the sale of qualifying patents.
The calculation of Patent Box income involves a three-stage process. This note does not examine this process in detail, but it is broadly as follows:
- Step 1 – Determination (either by the formulaic method or the streaming method) of the portion of the company’s corporation tax profits attributable to qualifying income;
- Step 2 – Identification of “residual profits”. The “residual profit” is calculated by deducting a 10% notional return on routine expenses from the corporation tax profit attributed to the qualifying income. This step has been designed to reflect the fact that a certain level of profit would have been realised even if the company did not have valuable IP.
- Step 3 – Attribution of the “residual profit” between that earned by the patent and that earned by non-qualifying IP (e.g. the brand). In order to alleviate the administrative burden of the calculation, companies with “residual profits” below certain thresholds may elect for profits taxable at the Patent Box rate to be the lower of 75% of the “residual profit” and £1 million (divided among group companies so electing). Furthermore, if less than 10% of “residual profit” is attributable to non-qualifying IP, such as the brand, no deduction is required.
Undoubtedly the proposals are a step in the right direction in encouraging innovation in the UK and incentivising IP-rich UK companies to stay put.
However, it is well-known that certain other European jurisdictions, in particular the Benelux countries, Ireland and Malta offer generous IP regimes in terms of both the tax rates and the scope of IP included.
Finally, we must also bear in mind that the Patent Box cannot be viewed in isolation and whether we can keep innovation in the UK will also depend on how well the concurrent enhancements of R&D tax credits is received.
How can we help?
There is work to be done in advance of 1 April 2013. In particular:
- it would be worth identifying currently unpatented IP and considering whether it is still possible to apply for a patent;
- licences should be drafted to make clear the level of royalty or licence fees applying to qualifying patents, and to ensure, if possible, that the exclusive licence criteria are fulfilled;
- asset sale agreements should distinguish consideration for qualifying IP;
- contracts may be drafted to make embedded patent income more easily traceable;
- ensuring that the right group company owns the qualifying patents; and
- ensuring that the patent owning companies are not degrouped from the company that developed or develops the IP.