1.1. This advisory, which summarises the principal features of the UK Government's proposed Patent Box tax regime, is the first in a series of four short articles outlining key aspects of the proposal. Future advisories will describe in more detail the proposals for:
- Qualifying patents and other qualifying intellectual property (IP);
- Qualifying income; and
- Calculation of Patent Box profit.
The Consultation Paper
2.1. On 10 June, the Coalition Government published a consultation paper on its proposal to charge corporation tax at a reduced rate of only 10% on company profits derived from qualifying patents and analogous IP (the Patent Box). This is significantly less than the standard rate of corporation tax, currently 26% but reducing to 25% from 2012, and even the small profits rate (formerly called the small companies rate) of 20%.
2.2. The consultation paper addresses one of the main proposals in the Government's review of innovation and IP, a key aspect of its "Plan for Growth". It outlines the principles the Government has adopted in the design of the Patent Box and describes the proposed scope of the Patent Box and how it would operate.
2.3. The Government seeks answers to twenty-four questions in the consultation paper, to inform the final decisions on how the Patent Box should work. There is therefore still scope to influence the final form of the Patent Box in a number of important areas. The consultation period will remain open until 2 September 2011. It is expected that draft legislation will then be published later in the autumn.
UK corporation tax
2.4. Companies will only be eligible for the Patent Box if they fall within the scope of UK corporation tax. Corporation tax is charged on taxable profits, which encompass trading profits, investment profits and capital gains. It is payable by companies based in the UK and other companies that have a branch (or "permanent establishment") in the UK. Companies based in the UK pay corporation tax on their worldwide profits, whereas companies with a branch in the UK pay the tax only on profits from UK-based activities.
2.5. The standard rate of corporation tax is 26%, reducing to 25% in the tax year commencing 1 April 2012. It applies to companies whose taxable profits exceed £1,500,000. A small profits rate of 20% applies to companies whose taxable profits are less than £300,000. Profits that fall between the two rates are taxed on a sliding scale.
The design principles
2.6. The Government's principal aims in the design of the Patent Box are that it should cover a wide range of patent income, encourage and reward innovation and be easy and inexpensive to administer. Consequently, four key design principles were identified and have informed the Government's approach. The principles are:
- that the regime should have a broad scope. Thus, both licence income and income from the sale of products will qualify;
- insofar as possible, that the regime should operate by means of a formulaic approach, so that the administrative burden of applying the regime is limited.
- that the regime should apply to profits, not to receipts.
- that the Patent Box should be available to companies that actively develop and exploit patents, rather than those that merely acquire and exploit them financially.
3. THE PATENT BOX – HOW IT WILL WORK
3.1. If a company wishes to make use of the Patent Box, it must:
- fall within the scope of UK corporation tax;
- hold a "qualifying patent" or other qualifying IP;
- receive "qualifying income" related to that patent or IP; and
- opt into the Patent Box regime.
3.2. The 10% tax rate applies only to net profits directly attributable to the qualifying patents and IP, not to gross profit, gross revenue, or even all IP-derived profits. It does not apply to all profits related to a licence of qualifying IP or to all the sales revenue of the products that have been patented or that contain patented inventions. Instead, the regime will require companies to assess the extent to which their profits have been enhanced by the relevant patent, compared to a notional similar product that does not benefit from the qualifying patent. Then, only the "extra" profit (which the paper calls "residual profit") that is attributable to qualifying patents and IP will benefit from the 10% tax rate.
3.3. So, in the case of a patented pharmaceutical product, the likely comparison will be with a notional generic version of the patented drug: the residual profit will be the element of profit that that drug would not be able to earn if it were a generic drug. Given the volume of available statistical evidence of pricing and the effect of going "off-patent" in the pharmaceutical industry, that should be a relatively straightforward exercise. However, not all patented products (or licence income) will be so easy to assess.
3.4. Profits will be calculated on a company-by-company basis. This differs from some other "patent box" regimes, for example, in the Netherlands, where it operates on a product-by-product basis. The UK Government believes that such a product-based approach would increase the administrative burden of applying the regime.
3.5. In summary, it is proposed that qualifying profits will be calculated as follows:
- first, the company will assess the proportion of its total trading income that is attributable to qualifying patents and IP;
- it will then divide its profits before finance costs and R&D enhancement in the same proportions (unless divisionalisation rules apply, in which case further adjustments are made) to determine the attributable gross profit;
- the company will then deduct the proportion of this gross profit that is attributable to "routine business activities" i.e. non-IP related profit, leaving the residual profit;
- finally, the company will split the residual profit into profit attributable to (i) qualifying patents and IP, and (ii) non-qualifying IP e.g. brand, trademarks. Only the profit related to qualifying patents and IP will be taxed at the 10% rate.
4.1. Companies may elect in and out of the Patent Box regime. However, to avoid opportunistic behaviour, if a company opts out, it may not opt back in for at least five years. Similarly, if a company opts to use (or not use) the divisionalisation rules, it will not be permitted to chop and change from year to year in the absence of good commercial reasons.
4.2. The Patent Box will apply on a company by company basis. It will therefore be necessary for companies to comply with transfer pricing rules in transactions with other group companies. It is proposed that small companies that are currently exempt from transfer pricing rules will be required to comply with the rules applicable to medium-sized companies if they wish to enjoy the benefit of the Patent Box.
4.3. The Government is concerned to ensure that the regime is not manipulated by companies. Accordingly, it has asked for views on whether it will be necessary to introduce specific anti-avoidance rules for the Patent Box.
5.1. The Patent Box will apply to profits arising after 1 April 2013. It is anticipated that the aggregate tax saving for companies in 2013/14 will be £500 million, rising to £900 million in 2015/16 and eventually to £1.1 billion per annum.
5.2. It was originally proposed that the Patent Box would only apply to patents first commercialised after 29 November 2010. However, this was considered inappropriate as:
- it would be difficult in many cases to determine the date of initial commercialisation of patents;
- there would be no incentive for companies to retain "older" patents in the UK; and
- it would lead to complex transitional rules that could last for over twenty years (until all the older patents will have expired).
5.3. Accordingly, the consultation paper suggests an alternative, simpler and more pragmatic proposal. There would be no exclusion for older patents, but the regime would be phased in over five years, with 60% of the full benefit being available in the first year, increasing by 10% a year thereafter over five years.
5.4. Respondents are invited to express views on which proposal they prefer.