In the March 2012 Budget, the UK government confirmed the introduction of a new taxation regime for patents in the UK, the so-called “Patent Box.” The Patent Box will allow companies to elect to apply a rate of 10 percent corporation tax to profits attributable to qualifying intellectual property (IP). Whilst the new regime may result in a material reduction in the effective tax rate for a few UK-based IP-intensive industries, the regime is over-complicated, subject to numerous limitations and is unlikely to result in a significant influx of intellectual property into the UK.
The UK Patent Box was originally announced with some fanfare in the 2009 Pre-Budget speech, where the former Chancellor proudly claimed:
“[The UK] has a remarkable record of ideas and innovation. We’ve won more Nobel prizes than any country of our size. We need to do more to support this ingenuity and ensure this creativity is harnessed in this country. I want to encourage research and development in the pharmaceuticals and biotech industries. So, following consultation with business, I will introduce a 10 percent corporation tax rate on income which stems from patents in the UK.”
The announcement was welcomed by industry, although the reference to research and development in the pharmaceuticals and biotech industries was striking and the regime has been tailored to those patent rich industries. More than two years later, the devil in the detail has revealed a far more limited regime than the sweeping statement above might suggest, and even for its primary target it contains a fatal flaw:
- The regime applies to patents granted by the UK Intellectual Property Office and the European Patent Office (as well as certain other rights: supplementary protection certificates, regulatory data protection (also known as “data exclusivity”) and plant variety rights). Although the regime will extend to include patents granted by certain other EU patent offices, the regime will not cover any patents registered in non-EU jurisdictions, for example the United States. This makes it a poor tool for a worldwide licensing program: as non-EU/EEA patent rights are more valuable in the aggregate than EU/EEA patent rights for most products, more than half of any benefit is likely to fall outside the Patent Box regime. In practice, effective use of the Patent Box will generally require EU/EEA manufacture of the relevant product, which is not always the best commercial solution.
- The regime will also only apply to registered and not unregistered rights (notwithstanding that there may be strong commercial factors influencing why a company may not wish to register a patent for certain of its IP). Trade secrets are therefore excluded, although this is less of a problem than it may appear as in the IP-rich manufacturing industry there is often something that is patented even if trade secrets are the primary focus.
- Despite considerable lobbying, many IP rights (such as trade marks, copyright and design rights), will not fall within the regime, thereby largely excluding the creative industries.
- To qualify for the Patent Box regime, a “development condition” must be satisfied. Effectively, this will require the company claiming the benefit of the regime to have had a significant contribution to the creation or development of either the patent or a product that incorporates the patent.
- The mechanics for calculating the income to which the headline 10 percent rate will actually apply are complex. Once income derived from qualifying patents has been identified and appropriate expenses deducted, the taxpayer must subtract an amount representing a “routine return” of 10 percent and an additional sum representing a notional market royalty. It is only the remaining income after such deductions to which the 10 percent rate will apply.
- The regime will be phased in from the 2013/2014 tax year (when only 60 percent of the Patent Box benefit will be available) with the full benefits only becoming available as from the 2017/2018 tax year.
The regime is clearly less beneficial than equivalent regimes in other European jurisdictions, such as Ireland, Luxembourg and the Netherlands. Given the hedging of the benefits and the excessively bureaucratic claiming regime, the flat 12.5 percent corporation tax rate in Ireland (which can be reduced further) for IP-based companies, looks more enticing. The Patent Box is likely to benefit a small number of companies, principally the UK’s pharmaceutical industry. It may also be sufficient to deter certain companies from migrating IP out of the UK , although outside of the pharmaceutical industry, we would be hard pressed to understand why. The limited benefits of the regime, combined with its relative complexity, certainly mean it is unlikely to attract companies that have structured their IP outside the UK into (or back into) the UK.
Outline of Regime
The Patent Box is an elective regime so that companies that will not benefit significantly from it can avoid unnecessary and unwelcome administrative costs. There are two main conditions that a company must satisfy in order to be able to elect-in:
The company must have made a significant contribution to:
- the creation or development of the invention claimed in the patent; or
- a product incorporating this item.
- If the patent rights are merely licensed in by the company, the licence must give the company at least country-wide exclusivity for those rights.
A company can in some circumstances qualify where another group company has undertaken the qualifying development, if the first company undertakes a significant amount of management activity in relation to its portfolio of qualifying rights.
In order to qualify for the Patent Box regime, a patent must have been granted by either:
- The UK Intellectual Property Office;
- The European Patent Office; or
- Certain specified EEA countries whose domestic patents are considered to be prosecuted under comparable patent rules to the UK: Austria, Bulgaria, the Czech Republic, Denmark, Estonia, Finland, Germany, Hungary, Poland, Portugal, Romania, Slovakia and Sweden.
Existing as well as new patents will be included. In addition, the regime covers regulatory data protection or “data exclusivity,” supplementary protection certificates and plant variety rights — references to patents in this Client Alert should be taken to include these rights.
Although a company cannot benefit from items pending patent applications, when the patent is granted the company can calculate what the profits would have been for the six years before grant if the patent had been granted at that time. That aggregate figure can then be added to the relevant IP profits for the year in which the patent is granted. Those who wish to take advantage of the regime would be well advised to apply for a UK-only patent in parallel with a European patent as the UK Patent Office normally processes patents quickly to grant, thereby activating the Patent Box regime. Provided one granted patent covering the product or process subsists in the UK, the regime can be used to cover a UK-based development.
Calculating the Profits Benefiting from the Patent Box
There is a formulaic, albeit quite complicated, approach to calculating the profits that are deemed to have derived from qualifying patents. The calculation is split into several different steps and is summarised below.
Step 1: Calculate the relevant IP income
The relevant IP income (the RIPI) is the income that is derived from a company’s qualifying patents. Broadly, five specific types of income can qualify as RIPI:
- Income from worldwide sales of the patented item, or an item incorporating it, including in territories where the item is not protected by a patent or whose patents would not themselves qualify for the Patent Box;
Worldwide licence fees and royalties from:
- rights that the company grants others out of its qualifying patents or over the patented item or process; and
- other non-patent rights granted for the same purpose as the patent rights;
- Income from the sale or disposal of qualifying patent rights;
- Amounts received from others accused of infringing the qualifying patent; and
- Other compensation, including damages, insurance proceeds and compensation for lost income that would have been RIPI.
Companies using qualifying patents in the provision of services or in their business processes may designate a proportion of their total income as RIPI.
Step 2: Calculate the profits derived from RIPI
Two methods are available in order to determine the profits derived from RIPI. A company may either:
- Apportion its total profits according to the ratio of RIPI to total gross income; or
- Allocate its expenses between RIPI and non-qualifying income streams, to arrive at an appropriate profit derived from its RIPI stream.
These figures should exclude finance income and expenses and any deductions made under the R&D tax credits regime.
Step 3: Remove a routine return
The “routine return” represents the profit a company might be expected to make if it did not possess the qualifying patents.
Companies must remove the “routine return” (set at 10 percent) on certain specified expenses from the profits derived from RIPI. These expenses include corporation tax deductions made in respect of personnel, premises (if tax-deductible), plant and machinery (including capital allowances) and miscellaneous services. Any expenses qualifying for R&D tax credits are excluded.
Removing the routine return gives the “Qualifying Residual Profit” (QRP).
Step 4: Remove a marketing assets return
Once the QRP has been calculated, the company must deduct a sum representing its return on marketing assets (such as trade marks and customer information) by either:
- Determining and deducting a notional marketing royalty for use of marketing assets used to derive RIPI; or
- (If the company’s QRP is under £3m) remove 25 percent of QRP as a deemed marketing return, up to a maximum £1m “small claims threshold”.
Either of these calculations produces a figure representing the Relevant IP Profits which can then benefit from the Patent Box.
Applying the Patent Box to Relevant IP Profits (RIPP)
The Patent Box tax deduction is calculated from the RIPP figure. There will be a phased introduction of the relief with 60 percent of the benefit applying from 1 April 2013, increasing in 10 percent increments per year until the full benefit becomes available from 1 April 2017.
If there is a negative RIPP figure, this must be offset against any other RIPP of the company derived from a different trade, of other group companies, or against future RIPP of the company or other group companies.
Given how much income is likely to arise in the pharmaceutical industry from licensing patents and know-how outside the qualifying area, (for example arising from the US, Japan, China etc.) a significant amount of income from many qualifying inventions is likely to fall outside the regime and would have to be sheltered in other ways.
Anticipated Impact of the Patent Box
The government anticipates an annual net loss in tax revenue of £910 million by 2016-17 as a direct result of the introduction of the Patent Box. This will represent a significant windfall for companies in the targeted IP-intensive industries such as pharmaceuticals and life sciences. In electronics and defence it will only benefit companies to the extent the relevant subject matter was developed in the UK, made in Europe and is patented. Electronics tend to be made outside Europe and the defence industry has a lesser tendency to patent, although the regime may cover certain cases where a UK patent is not granted on the grounds of national security or public safety.
However, the government’s key aims in implementing this policy are to attract high-value jobs associated with the development, manufacture and exploitation of patents and to stem the flow of companies moving their IP offshore. It seems unlikely that the new Patent Box will be generous enough, simple enough and inclusive enough to achieve these outcomes.
Equivalent regimes in other European countries are, on the whole, significantly more generous than the UK Patent Box:
- The reduced UK tax rate of 10 percent is materially higher than the effective tax rates imposed on IP profits in Belgium (6.8 percent), the Netherlands (5 percent), and Luxembourg (5.72 percent), and the phased introduction of the benefit will further reduce the initial impact. Against Ireland’s 12.5 percent corporation tax rate covering all IP rights (which can be reduced further), the UK Patent Box offers little advantage except for a very limited class of beneficiary in the pharma and life sciences industries, as well as potentially some medical device manufacturers.
- Whereas the UK Patent Box applies only to patents granted by patent offices in the UK or EU, the regimes in Belgium, the Netherlands and Luxembourg (and the equivalent regime in Ireland) have no such restrictions. In addition, these countries extend the reduced tax rate to IP rights other than patents, such as trade marks and copyrights in Ireland and Luxembourg and “R&D Certificates” in the Netherlands.
- The UK Patent Box deducts previous years’ IP losses from the current year’s IP profits when calculating the level of deduction to make. This is also the case in the Netherlands and Luxembourg. However, in Belgium and Ireland only the current year’s figures are taken into account and this can result in much larger deductions being available to companies in those jurisdictions.
Although there are some ways in which the UK Patent Box compares favourably to these other regimes (for example in allowing deductions where the company merely possesses an exclusive license to a qualifying patent), it is clearly less generous and less extensive in many respects. As a result there will continue to be significant tax incentives for companies to base their IP elsewhere and any increase in UK investment as a result of these changes is likely to be limited.
Potential Steps to Consider
Notwithstanding the limitations of the regime, companies with valuable registered patent rights in the UK or EU would be well advised to consider the UK Patent Box and whether it may represent an alternative to the company’s existing IP holding regime. UK-based companies that are likely to be able to benefit from the regime should also consider taking steps to maximise the benefits from the regime. This could be done by maximising revenue allocable to the Patent Box, for example by:
- Optimising licensing arrangements;
- Identifying hidden value in patents;
- Income tracing and constructing defensible expense allocation;
- Optimising R&D costs that qualify for UK R&D tax credits (as such costs are excluded from the “routine return” mark-up); and
- Optimising sub-contracting arrangements (as certain sub-contracted costs do not suffer the “routine return” mark-up).