The UK Patent Box regime will enable companies to apply a lower rate of corporation tax on qualifying worldwide profits earned after 1 April 2013 attributable to qualifying patents and similar intellectual property (IP) rights. The relief is being phased in from 1 April 2013 when the effective tax rate will be 15.2% until it reaches 10% from April 2017.
The Patent Box tax regime was the subject of consultation for over a year. Olswang has directly participated in each stage of the consultation and remained close to the development process. HM Treasury and HM Revenue & Customs have been keen to market the competitiveness and generosity of the UK regime as compared to other European regimes, whilst acknowledging that there are (unfortunately) no plans to extend it to include other forms of IP.
Companies to whom the Patent Box may apply are recommended to start planning now by undertaking a review to determine whether and to what extent the regime can apply to them and whether the structure of their organisation will enable Patent Box profits legitimately to be maximised. Companies considering new investment opportunities that will potentially fall within the Patent Box regime are also recommended to take advice.
Key features of the proposed regime
To be eligible for the regime, a company must be the legal owner of a "qualifying IP right" or be an exclusive licensee of a "qualifying IP right". Exclusive licences must cover at least a whole territory.
If a company holds qualifying rights and is a member of a group, but has not itself carried out qualifying development work on its portfolio of qualifying IP rights (see further below under Qualifying IP rights), it must also meet the "active ownership" test to qualify for the regime. This test is met if the relevant company performs a significant amount of management activity in respect of its qualifying IP rights; however, crucially, this is tested against its whole portfolio of qualifying IP rights, not on a right by right basis.
There are special rules to deal with groups where IP is held centrally but actively managed and owned in the UK and for IP developed by partnerships, joint ventures or under cost sharing arrangements.
Qualifying IP rights
Key IP rights which potentially qualify are:
- patents granted by the UK Intellectual Property Office (IPO) and the European Patent Office (EPO);
- patents issued by other "approved" EU national patent authorities - currently Austria, Bulgaria, Czech Republic, Denmark, Estonia, Finland, Germany, Hungary, Poland, Portugal, Romania, Slovakia and Sweden;
- supplementary protection certificates granted by the UK IPO or the EPO;
- UK and European Community Plant Variety rights;
- certain UK and European regulatory exclusivity rights; and
- patent applications otherwise allowable but not granted by the UK IPO on the grounds of national security or public safety (these patent applications are treated as if they had been granted).
For an IP right to be a qualifying IP right, the "development condition" must also be met. To meet this condition involves:
- creating or contributing significantly to the creation of the patented invention; or
- performing a significant amount of activity for the purposes of developing the patented invention or any item or process incorporating the patented invention.
When determining whether a "significant" contribution has been made, expenditure is not the only metric. It is question of fact. If a step has occurred that made a genuine impact upon the creation or application of the patented invention, or has enhanced its viability or usefulness, this should qualify.
The development condition is to ensure that the benefits of the regime are limited to companies that have had some real involvement in the innovation leading to the creation of the patent or the origination of applications of the patented invention. As noted above, where a group company holds a qualifying IP right it must meet the active ownership test if it does not meet the development condition on its own.
Relevant IP profits
The profits eligible for the regime (the "relevant IP profits") will in most cases be calculated from the total profits of a company's trade using a seven step process, described further below. The Government have taken this approach to reduce the complexity that would be created by using a comprehensive transfer pricing analysis (although transfer pricing principles apply to some of the steps in the process).
Application of the patent box
Once the relevant IP profits have been calculated by the seven step process below, this figure is used to calculate a deduction that can be used in calculating the profits of the company's trade. This has the effect of taxing the relevant IP profits at the applicable patent box rate (e.g. 15.2% from 1 April 2013 reducing to 10% from 1 April 2017).
A company can claim the benefits of the regime in respect of profits arising from qualifying IP rights during the six years prior to the grant of a patent, provided that an application for a patent has been made and that the company had elected into the regime in those years. However, the benefit of the regime will only be applied in the year of grant, and will not be carried back to previous years.
Calculating relevant IP profits
Step 1 - determine gross income
- The first step is to calculate the total gross income of the company's trade for the relevant accounting period, excluding any financing income.
Step 2 - calculate the percentage that is relevant IP income
- Then the percentage of the total gross income that is relevant IP income is determined. Relevant IP income includes worldwide income arising from the sale of items protected by qualifying IP rights, income from licence fees and royalties in respect of any qualifying IP rights, income from the sale or other disposal of qualifying IP rights and amounts received in respect of an infringement or alleged infringement of a qualifying IP right.
- Encouragingly the regime also covers situations where a company generates income by using its qualifying IP, but where that income does not fall within the above categories. An amount equal to the "notional royalty" that would be paid to an independent owner of the qualifying IP right for the company's exclusive use of those rights to generate relevant IP income will be treated as relevant IP income of the company. When determining this amount, an arm's length transfer pricing approach is to be adopted. In other words, profits arising from patents used in internal processes or to provide services will be eligible for the regime, but only on this notional royalty basis.
Step 3 - apply the percentage to the adjusted profits
- The percentage calculated in step 2 is then used to apportion the profits of the company's trade to determine the profits of the trade relating to qualifying IP.
- If this "formulaic" approach does not give an acceptable estimate of the IP profits a company can elect for a "streaming" approach to be taken on a trade by trade basis which splits the income and expenses of a trade into two streams: one for relevant IP income and one for all other income (including non-relevant IP income), on a just and reasonable basis. In certain circumstances streaming will be mandatory (see further below).
- Any additional deductions provided by way of R&D tax credit relief are added back to the profits so that none of the benefits of the relief are clawed back by the regime. Also, if current year R&D costs (i.e. not additional deductions) do not provide a reasonable proxy for the development costs of current products (e.g. there was significant R&D expenditure prior to the commercialisation of the qualifying IP right) in the first four accounting periods following the company electing into the regime, there is a mechanism for adjusting the relevant IP profits to take this into account.
- In determining the relevant IP profits of a trade, any financing costs are added back and any financing income is deducted. These adjustments have the effect of providing for deductions at the applicable marginal rate of corporation tax for financing costs, not the reduced 10% patent rate.
Step 4 - deduct the routine return
- A "routine return" is then deducted from the profits calculated in step 3. The routine return is intended to represent the return a business might be expected to make if it did not have access to unique IP. The routine return is calculated by taking 10% of the aggregate of certain defined expenses deducted in calculating the profits of the trade and then apportioning the result between relevant IP income and all other types of income using the percentage calculated in step 2. These defined expenses include personnel costs, plant and machinery costs and any expenditure on utilities supplies, consultancy services and computing services. The figure resulting from the deduction of the routine return from the profits calculated in step 3 is known as the "qualifying residual profits".
Steps 5 and 6 - deduct the marketing assets return
- These steps seek to determine how much of the qualifying residual profits relate to relevant IP rights and how much relate to brand and marketing assets. The aim is to exclude the sometimes very substantial profits that can be generated using established brands.
- Broadly speaking, where qualifying residual profits are lower than £3m, it is possible to elect for "small claims" treatment whereby the relevant IP profits are deemed to be equal to the lower of 75% of the qualifying residual profit and £1 million. However, companies with larger profits in some years (more than £3 million) cannot use the small claims treatment for years when it provides a beneficial result compared to calculating a normal "marketing assets return" (see further below). If the election for small claims treatment is not made, a "marketing assets return" must be deducted from the qualifying residual profit to arrive at the relevant IP profits.
- The marketing assets return is calculated by deducting the actual marketing royalty from the notional marketing royalty, being respectively (i) the amounts that were actually paid by the company to acquire or use a marketing asset (or the amount an asset is written down for corporation tax purposes) and (ii) the appropriate percentage of the company's relevant IP income that it would pay a third party for the exclusive right to exploit the relevant marketing assets if it would not otherwise be able to exploit them. An arm's length transfer pricing approach is used to determine the notional marketing royalty.
Step 7 - add pre-grant patent profits
- Step 7 takes into account that there may be a number of years between the application for a patent and its grant. It allows a company to claim additional relief in the accounting period in which a patent is granted to recognise any qualifying income arising from the exploitation of the relevant IP right during the "patent pending period" falling within the six years prior to the grant of the patent (provided that this pre-grant patent profits rule only applies to years in which the company had elected into the regime).
The (potential) reduction in complexity in using this formulaic seven step approach is not to the detriment of larger, more complex companies as they can opt for the "streaming" method as noted above. This should provide a more accurate calculation of the profits attributable to qualifying IP rights (and therefore eligible for relief under the regime). Further, the streaming method is mandatory in the following circumstances:
- where the income of a company's trade includes a significant amount of IP licensing income which is in respect of non-qualifying IP;
- where the company's accounts do not recognise a substantial amount of revenue from the trade that is taken into account in computing the profits of the period for corporation tax purposes; or
- where the company's total gross income from the trade includes income that is not relevant IP income, and a substantial amount of relevant IP income in the form of licence fees or royalties received under an agreement granting rights to another person over IP rights, where the company itself only holds an exclusive licence in respect those IP rights.
Patent box losses
If a company has patent box losses it can set them off against the relevant IP profits of other trades carried on by the company or against the relevant IP profits of group companies, or it can carry them forward. However, it is not possible to set off patent box losses against anything other than relevant IP profits. This is a key point to bear in mind when a company considers whether to elect into the patent box regime.
Similarly, if there is a risk of patent box losses becoming stranded, it may be advisable to elect out of the regime sooner rather than later. Although, once a company has elected out of the regime, it cannot elect back into the regime for five years.
The regime also contains anti-avoidance rules that restrict the benefit of the regime where any steps are taken with a tax avoidance purpose such as where the main purpose of incorporating a patented item within a product is to benefit from the regime or where there is an attempt to secure a mismatch between the times at which relevant IP income and expenditure in respect of the qualifying IP right are brought into account for tax purposes.