Details of the Knowledge Development Box (“KDB”) were announced in Budget 2016. The Finance Act 2015 came into effect on 1 January 2016, giving legislative effect to the KDB provisions. Interestingly, the KDB introduced by Ireland was the first such KDB (or Patent Box as it is known in other jurisdictions) to comply with the OECD’s “modified nexus” standards, as set out in the final reports of the OECD’s Base Erosion and Profit Shifting (“BEPS”) Project. The “modified nexus” approach allows a company to benefit from the KDB relief only to the extent that the company itself incurred qualifying research and development expenses that gave rise to the Intellectual Property (“IP”) income.
In brief, where a company qualifies for the KDB relief, it is entitled to a 50% allowance on its qualifying profits (as defined) which in effect, results in a 6.25% corporate tax rate on those qualifying profits. As attractive as this rate may appear, there are a number of conditions which must be satisfied to avail of the KDB and these are detailed below.
The KDB provisions apply to accounting periods which begin on or after 1 January 2016 and before 31 December 2020. The KDB applies to “qualifying assets”, being intellectual property, other than marketing related intellectual property, which has resulted from research and development activities.
Intellectual property is defined as:
- a computer program, within the meaning of the Copyright and Related Rights Act 2000 (this includes computer programs which represent a derivative work or an adaption of an original work);
- an invention protected by a qualifying patent or certain supplementary protection certificates;
- plant breeders’ rights within the meaning of section 4 of the Plant Varieties (Proprietary Rights) Act 1980.
A “qualifying patent” includes a patent which was granted following a substantive examination for novelty and inventive steps. Accordingly, not all patent systems may fall within this scope. A short term patent is not regarded as a “qualifying patent”.
The KDB relief will apply to qualifying profits made in the course of a specified trade (as defined) which consists of one or more of the following –
- the managing, developing, maintaining, protecting, enhancing or exploiting of intellectual property;
- the researching, planning, processing, experimenting, testing, devising, developing or other similar activity leading to an invention or creation of intellectual property; or
- the sale of goods or the supply of services that derive part of their value from activities described in (i) and (ii), where those activities were carried on by the relevant company.
For the purposes of the KDB relief, each qualifying asset will be treated separately. However, where a number of qualifying assets are so interlinked that it would be impossible to identify the overall income or expenditure regarding each qualifying asset (and where the company so opts), the relief can operate in respect of a “family of assets” instead of a qualifying asset.
In order to ascertain the amount of profits arising from qualifying assets which can avail of the KDB relief, the below formula is used:
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QE is the qualifying expenditure on the qualifying assets. This is the expenditure incurred wholly and exclusively by a company in the research and development activities of the qualifying asset, such activities having taken place in the EEA. Companies should note that outsourcing to unrelated parties in any jurisdiction can be included and this differs from the treatment for the purposes of research and development credits. Certain items are excluded from the definition of qualifying expenditure including acquisition costs, interest and intra group expenditure. However, some excluded expenses can be “saved” to some degree by means of the uplift expenditure.
UE is the uplift expenditure. This is the lower of 30% of the qualifying expenditure or the aggregate of acquisition costs and group outsourcing costs (as defined).
OE is the overall expenditure on the qualifying asset being the total of qualifying expenditure, acquisition costs and group outsourcing costs.
QA is the profit of the specified trade relevant to the qualifying asset (before taking account of any KDB allowance)
By means of illustration, take the straightforward example of an Irish company which spends €1,000,000 on research and development activities, which resulted in a qualifying patent. This entire sum was incurred by the company itself and the company generated a net profit of €2,000,000.
As all research and development expenditure was incurred directly by the company (no outsourcing or intra group assistance), the company will not seek uplift expenditure.
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Thus, this company’s qualifying profits for KDB purposes is €2,000,000.
In computing for the purposes of corporation tax, an allowance of 50% of the qualifying profits will be made, such allowance being treated as a trading expense of the trade. Effectively, this will mean that the corporation tax payable in the above instance will be 12.5% of €1,000,000 (being the €2,000,000 qualifying profits less the 50% allowance). This will result in a corporation tax liability of €125,000 (i.e the same conclusion being reached by applying a corporation tax rate of 6.25% on the qualifying profits).
The income arising from the qualifying assets is deemed to be the income of the specified trade. Any expenses incurred in earning the overall income from the qualifying assets must be attributed to the specified trade and this will necessitate the making of apportionments on a just and reasonable basis. In so doing, the specified trade should be treated as a separate trade carried on by the company dealing at arm’s length and any methods of apportionment should be applied on a consistent basis from year to year. Given the nexus approach applicable, in practical terms, it will be necessary to determine a nexus between multiple strands of income and expenditure, where only some strands may be qualifying expenditure and this will present practical issues for companies. Guidelines are expected to issue from the Irish Revenue Commissioners shortly which may clarify the practical implementation.
Conversely, where a company suffers a loss on the activities that qualify for the relief, this loss is available for relief on a value basis. This value basis is achieved by reducing the loss by 50%.
A claim in relation to the KDB relief must be made within 24 months of the period end to which the claim relates. It is imperative that a company which intends to make a claim for KDB relief maintains detailed records which sufficiently document and trace all expenditure and income linked to the qualifying asset. Such documents should be retained for a period of six years. These tracking requirements do not apply to expenditures incurred prior to 1 January 2016.
As for transitional measures, when ascertaining the qualifying profits for accounting periods between 1 January 2016 and 31 December 2019:
- acquisition costs and group outsourcing costs incurred prior to 1 January 2016 shall be included in the calculation
- qualifying expenditure on a qualifying asset is calculated with reference to qualifying expenditure on all qualifying assets in the 48 month period ending on the last day of the accounting period
However, if a company can track and trace the pre 1 January 2016 expenditure with the same level of certainty which is required of post 1 January 2016 expenditure, such actual expenses may be used instead of the transitional arrangements outlined in the legislation.
The Irish Revenue Commissioners are empowered to consult with experts on certain aspects of the KDB regime. The legislation contains a right of appeal where a company believes that such a disclosure would be prejudicial to its business.
Large companies will be obliged to apply transfer pricing rules in documenting and substantiating the arm’s length nature of any price and any apportionments of income or expenses. There is also provision for an additional category of assets (being IP not protected by patent) to be added to the above definition of IP regarded as IP for small and medium sized enterprises which meet certain criteria. This provision is subject to enactment of a ministerial order.
Overall, the KDB is to be welcomed as it bolsters Ireland’s competitive tax regime and complements existing tax benefits for IP such as research and development relief and the capital allowances available in relation to intangible assets. Given the limitations where research and development is carried out by group companies, in the first instance, the KDB relief may be more beneficial to indigenous companies. However, with proper planning, the relief may also prove to be of benefit to multinational enterprises.