As part of Budget 2015, the Irish Minister for Finance (the "Minister") announced the abolition of the controversial "double Irish" tax structure but also announced the introduction of a Knowledge Development Box ("KDB"). A KDB is essentially a preferential tax regime for certain IP revenues. It is hoped that such proposals will increase Ireland's competitiveness and ability to attract high value research and investment from multinational companies.
The concept of a Patent Box already exists in many other European countries, however, the EU and the Organisation for Economic Co-operation and Development (the "OECD") are currently finalising new rules for the design of such tax incentives, which are outlined below. Accordingly, the new rules will have to be considered carefully ahead of any plans by the Irish Government for the successful implementation of a KDB in Ireland.
The Department of Finance launched a Public Consultation on the introduction of the KDB on 14 January 2014, with a view to publishing legislation in the next Finance Bill. The Consultation Process will last for approximately twelve weeks and the objective of the process is to formulate and design an Irish incentive which will be "best in class and at a low, competitive and sustainable tax rate", while still ensuring the incentive remains fully compliant with international standards. In any case, it will be difficult to please all parties due to the constraints and competing interests involved in the project. What follows considers the requirements of the EU and the OECD, what investors might hope to see in terms of a KDB in Ireland, as well as making some observations as to what the future KDB might actually look like.
What the EU and OECD will require
1. BEPS Project
The EU/OECD are currently working on a project called the "Base Erosion and Profit Shifting" Plan (the "BEPS" Plan). The BEPS Plan looks at whether the taxable profits of multinational companies are being allocated to locations different from those where their business activity takes place and if so, why and how this is occurring. One aspect of the BEPS Plan in particular focuses on preferential intangible regimes (including Patent Boxes) and it is likely to impact on the design of the KDB. In September 2014, a report was issued (under Action 5 of the BEPS Plan) which recommended that preferential intangible regimes (such as the proposed KDB) should incorporate a "substantial activity requirement".
The basic premise of the "substantial activity requirement" is that it should assist in aligning substance with taxable profits. The report goes on to suggest three approaches to incorporating a "substantial activity requirement" into national law.
The suggested approaches are as follows:
- A value creation approach, which requires taxpayers to undertake a set number of significant development activities;
- A transfer pricing approach, which requires the taxpayer to undertake a set level of important functions in the jurisdiction, to have legal ownership of the IP and to bear the economic risk; and
- The nexus approach, which seeks to link any benefit afforded under a regime to the proportion of qualifying expenditure incurred by the taxpayer which contributes to that income. The nexus approach is linked to where the actual R&D activity takes place. The nexus approach proposed applies only to patents and similar intangible assets and does not apply to marketing-related intangibles such as trademarks.
The aim of this part of the project is to update the existing framework for evaluation of harmful tax regimes in EU Member States. It is hoped that the OECD review will be concluded by December 2015. This will be in line with the intention of the Minister to start publishing legislation in Ireland around the same time.
2. EU Code of Conduct
In addition to the OECD's work on harmful tax regimes, the EU developed a Code of Conduct for Business Taxation in 1997 (the "Code"). The Code is not legally binding but can be politically persuasive. It provides that where the effective level of taxation in a country is significantly lower than the general rate of taxation in the same country, it is to be regarded as being potentially harmful and as a result, it must then be examined under an additional criteria.
As a result of the Code, the European Commission recently questioned the compatibility of the UK Patent Box within the remit of EU rules. Upon examination, the European Commission concluded that that the UK Patent Box did not comply with the Code on the basis that the link between qualifying patent income and research undertaken in the UK was not strong enough. Furthermore, it was held that qualifying income could not include income which was not directly related to a Patent.
The EU Code Group have been working in conjunction with the OECD and accordingly, they have endorsed a version of the modified nexus approach. As a result, EU Member States are being asked to amend their existing regimes in 2015 to adopt and operate the Patent Box regimes, in line with modified nexus approach.
The Code Group also examined the compatibility of the modified nexus approach with EU law. In this regard, they concluded that the approach in itself was not incompatible with EU law but acknowledged the possibility of national laws incorporating the approach in a way that is potentially incompatible with EU law. Given the co-ordinated efforts of the EU/OECD to date, it seems evitable that the Minister will incorporate the modified nexus approach into the KDB in Ireland.
3. EU State Aid Rules
The Minister will also have to pay careful attention to EU State Aid rules when designing the KDB. The European Commission has, in the past, clarified that State Aid rules can apply to beneficial tax regimes introduced by EU Member States. Generally, a tax provision may be considered to be State Aid if it is selective in who it is been offered too. This is well illustrated in the case of Spain, where they sought confirmation that the Spanish Patent Box would not be in breach of State Aid prior to its implementation. The EU Commissioner for Competition in response, found that the tax regime was not selective nor did it favour to any one group of companies over another and therefore, it was not in breach of State Aid rules. Accordingly, it will be important for the Minister to ensure that the KDB is open to all businesses operating in Ireland equally. It is expected that the Minister will seek confirmation from the EU Commissioner for Competition that any such KDB regime in Ireland is not in breach of State Aid rules prior to its implementation here.
What investors will want
From a tax perspective, the more desirable outcome for the majority of investors would be a regime that allows for a broad base of income and a reasonably low rate of taxation.
1. Broad base
At present, Irish tax legislation provides relief in the form of capital allowances against trading income for companies incurring capital expenditure on the provision of intangible assets for the purposes of a trade. The scheme applies to a broad range of intangible assets including patents, copyright, trademarks, secret information and know-how. However, based on the suggested approaches above, the range of "qualifying assets" which may qualify under the new regime, may be limited to patents and assets that are functionally equivalent to patents. In addition, or alternatively, the qualifying IP assets would have to be derived from research and development activities undertaken primarily in Ireland. In this regard, the scope of "qualifying assets" may be reduced under the proposed KDB.
2. Lower effective rate of taxation
Although not confirmed, recent press reports indicate that the Minister is considering a rate of tax as low as 6.25%. This would be welcomed by investors in Ireland compared to our neighbours in the UK, where the effective rate of tax under the Patent Box regime is 10%. The Dutch Patent Box provides for a rate of tax at 5%, while in Belgium a tax deduction of 80% is allowable, thereby providing a comparable rate of tax at 6.8%.
What investors might get
Based on the information available to date, the following observations can be made:
- The KDB should be available in respect of proceeds from the sale of qualifying IP and infringement income (similar to the tax regime in place in the UK and Holland).
- The KDB should be available where income is earned on the licensing of qualifying or sale of products incorporating qualifying IP (although not necessarily deriving all of its value from the intangible asset).
- It is not yet clear if it will extent to income generated from products simply incorporating the qualifying IP (as opposed to products deriving their value from the qualifying IP).
- The KDB should incorporate a "substantial activity requirement". Based on the Consultation Paper published by the Irish Government, it seems likely that a modified nexus approach will be adopted by the Minister.
- The qualifying income should not be taxed at an effective rate of tax of more than 5% (in order to compete effectively, in particular with the Dutch Innovation Box).
- The relief should be made available on an enhanced deduction basis (as opposed to a low headline rate).
- The KDB should be available to all sectors as well as, to both domestic and international businesses.