The Government has published a consultation document which sets out the detailed framework for the UK Patent Box tax which will apply to profits arising after 1 April 2013.
The Patent Box regime will broadly provide for an effective 10% corporation tax rate on profits attributed to UK and EEA registered patents. It is part of the Government's plan to demonstrate that the UK has a competitive tax system and to encourage investment and growth in the UK by incentivising companies to locate high-value jobs and activity associated with the development, manufacture and exploitation of patents in the UK.
Companies seeking to benefit from the regime should consider (amongst other things):
- Undertaking a due diligence exercise to ascertain what patents and what patent income / profits will be within the Patent Box.
- Evaluating whether the UK regime (combined with the advantageous UK research and development (R & D) relief) is the best place to locate those patents.
- Ensuring the accounting records are in place to accurately calculate the income / profits subject to the Patent Box.
- Reviewing intra-group arrangements to identify which entities own the IP, which entities use it and whether there are appropriate intra-group pricing arrangements in place.
- Carefully monitoring income connected with IP rights currently the subject of a patent application as these profits may fall within the regime if derived after 1 April 2013.
The proposed scheme is not as simple or as cost effective as some would have hoped and this may mean that the take-up may not be as great as anticipated. It is not immediately clear whether the regime will be subject to challenge by the EC.
Under transitional provisions, where an accounting period straddles 1 April 2013, companies will be able to benefit from the Patent Box in relation to those profits arising after 1 April 2013.
Responses to the consultation are due by 2 September 2011 and draft legislation to implement the Patent Box is due to be published in autumn 2011. If you would like assistance drafting a response to the consultation document, please contact us.
The November 2010 Consultation Document
The original Patent Box consultation document set out the proposed structure of the Patent Box including:
- Confirming that the Patent Box would extend to patent licence income and patent income embedded in the sale proceeds of a patented product.
- Providing a formula to enable taxpayers to identify the level of profits and types of income that would be attributable to patents so as to add certainty and clarity to the process and reduce compliance costs.
- Promising to minimise uncertainty, avoidance, risk of dispute and compliance costs.
Key developments since the November 2010 Consultation Document
There are a number of notable developments since the earlier consultation document:
- The Government has confirmed that it will not extend the benefit of the Patent Box to other intellectual property rights (although it has extended it to rights that are 'comparable to patents' including regulatory data protection.
- The Patent Box regime 'will be extended to all qualifying patents'.
- The benefits provided by the Patent Box will be phased in over five years.
- Under transitional provisions, where an accounting period straddles 1 April 2013, companies will be able to benefit from the Patent Box in relation to those profits arising after 1 April 2013.
The Patent Box in more detail
The current consultation document sets out in much more detail what the regime will look like. What follows is a broad summary of the key Patent Box features:
- Claimants must be within the scope of UK corporation tax.
- The Patent Box will operate on a company by company basis (i.e. not on a group basis).
- Claimants must actively hold a qualifying patent or other qualifying IP and must receive income related to that patent (for commentary on the definition of 'active' holding see below under 'Development Criteria'). Qualifying patents will include (i) UK patents and European patents with a UK designation (in future the Patent Box may be extended to national patents of other EU member states), (ii) those under the protection of a Supplementary Protection Certificate (SPCs) and (iii) certain rights which demonstrate innovation in the same way as patents but which are unable as a point of intellectual property law to be patented – including regulatory data protection granted to new pharmaceutical and agrochemical products; and plant variety rights.
- The profits within the Patent Box will be restricted to those that can be effectively isolated as profits directly attributable to the patent (as compared to returns derived through routine business activities). This is referred to as the 'residual profit'. The Patent Box will 'protect' the worldwide income earned by UK businesses from inventions covered by a qualifying patent and will not be restricted to income that falls within the territorial limitations of the particular IPO or EPO patent. Detailed rules will be introduced to assist claimant companies make this calculation. Once done, those companies deduct a simple fixed percentage (yet to be determined) return on routine activities carried out by the company from the profit allocated to qualifying income.
The claimant company must be able to demonstrate that it remains actively involved in the ongoing decision making connected with the exploitation of the patent. Further, the company (or a group company) must have undertaken significant activity to develop the patented invention or its application. Groups may transfer patents between group companies without losing Patent Box eligibility.
A company may achieve this by undertaking activities that extend beyond activities related to the management of a financial investment or the legal protection of the patent. Alternatively, it can show that it was involved in the active decision-making functions related to the management of risks associated with the project. Whether this test is satisfied will always be a question of fact.
The patent income falling within and outside the regime may be summarised as follows:
Income within the Patent Box regime – subject to 10% effective tax rate
- Worldwide income earned by UK businesses from inventions covered by a qualifying patent, (thereby avoiding the need for companies to track sales made in each jurisdiction separately).
- Income from a patented process. This will include all royalties or licence fees received for use of an invention covered by a qualifying patent.
- Income derived from the sale of equipment incorporating a patented process. The incorporation of the invention or inventions into the product must be genuinely commercial and the patent must not have been added just with the intention of making the product qualify for the Patent Box.
- Income embedded in patented products including sales of spare parts for a qualifying product.
- Income from the licensing of a bundle of intangible assets which are genuinely inter-related and licensed as a single product, including for example, a licence permitting the use of all proprietary technology required to make a patented product but this must incorporate rights to use at least one invention covered by a qualifying patent which must be an integral part of the bundle.
- Compensation and damages paid by third parties for infringing a qualifying patent where the compensation represents lost income which would otherwise have qualified for the Patent Box.
- Any income arising between the date of patent application and the date of grant (for up to 4 years prior to grant).
- Income from the sale of patents. Where the patent falls under the post-2002 IP regime, the income from the sale will be treated as a normal trading receipt or expense as the tax treatment follows the profit or loss reflected in the statutory accounts. However, the sale of older patents may give rise to an income charge or be dealt with under the capital allowances rules for patents. Where disposal of a patent right or a licence gives rise to an income charge, balancing allowance or balancing charge, then these will form part of the Patent Box calculation.
Income out side of the Patent Box regime - subject to the main rate of corporation tax (currently 26% but will be 24% by 2013)
- Any income arising from financial arrangements, including interest, interest equivalents (such as amounts relating to credit for the sale of products), income from financial assets, and any other type of finance income.
- Service income - the Government considers that the provision of services is not covered by patent protection under UK law and would extend the Patent Box to activities only peripherally linked to the development of patented technology. Where services and products are sold together, the income will need to be apportioned between the two elements in a just and reasonable way.
- Income from the sale of parts, components or separate items which are aggregated for sale but which do not constitute a single composite product in which they are functionally interdependent.
- Patented inventions which are not incorporated into products but which are used by the patent holder in industrial processes. Where an arm's length royalty fee is paid, this income may be eligible. The Government considers that including this would extend the benefit of the Patent Box to income from a wide variety of generic goods and commodities where the profits are not directly associated with the patent itself or with technical innovation.
- Any income or profits which fall within the North Sea ring fence regime. However, any other income related to patented technology in the extractive industries will qualify in the same way as any other patented product or process.
- Profits derived prior to the patent application.
- Income from a patent where the patent or associated SPC has expired. If a company loses rights to a patent after it is granted, for example due to a successful legal challenge, no further Patent Box benefits may be claimed but benefits already accrued will not be clawed back.
- The idea is to use existing accounting records to ascertain what income is inside and outside the regime – rather than require separate identification of income from individual patents.
Calculation of profits
The calculation of profits falling within the Patent Box will be determined under a three step process which is referred to as the 'residual profit split'. The consultation document sets these steps out in great detail. Broadly, claimant companies must isolate the income connected to qualifying patents. This can be done by comparing the level of qualifying profits as a proportion of total profits.
Then companies will be asked to ascertain the amount of residual profit – i.e. the amount of profit derived by possession of valuable IP rights. This will be done by using a predetermined formula aimed at separating out normal or routine profits from such companies. Then companies will need to determine what percentage of this income relates to IP qualifying for the Patent Box and what does not.
Where the proportionality limb leads to unjust results, companies may apply the 'divisionalisation' test which effectively allows them to look to divisions within the company rather than at the company as a whole.
A company must use the whole company or divisional basis consistently and will not be able to change methodology on a year-by-year basis. Companies using the divisional basis must produce a tax computation for each division.
Complex rules will govern the treatment of losses triggered by the Patent Box calculation. Broadly speaking, it is proposed that Patent Box losses must be calculated and carried forward, and Patent Box profits in later periods will be reduced by Patent Box losses carried forward until these are used up. The Government also proposes to require Patent Box losses to be set off against Patent Box profits in other group companies although this is still under consideration. The Government does not intend to restrict or claw-back losses incurred prior to entry into the Patent Box, other than to the extent these are taken into account by the claw-back of excess pre-commercialisation expenses.
Pre-commercialisation expenses (including R & D) will be taken into account when considering appropriate net patent profits. Reasonable R & D costs will be allowed. Anything beyond this will be clawed back although the mechanism for doing so remains subject to consultation.
Opting out of the regime
A company will be free to opt out of the Patent Box at any time. No further calculation of Patent Box losses is required. A company will not be able to opt back in to the Patent Box for five years after opting out. This restriction will also apply where any other associated company acquires the trade or assets of the company which has previously opted out of the Patent Box.
Double Tax Relief (DTR)
Double tax relief for withholding tax suffered on royalties will continue to be available up to the lower of the overseas tax suffered and the tax payable in the UK on profits deriving from the licensed assets after taking the Patent Box deduction into account. Similarly, relief for tax paid on the profits of a non-exempt overseas branch will also continue to be available, also up to the lower of the tax paid overseas and the final tax payable on branch profits in the UK.
All companies claiming Patent Box benefits must comply with the Transfer Pricing regime in their transactions with associated companies. It is possible that the existing exemption from the transfer pricing regime for SMEs will be abolished for Patent Box purposes. Although, HMRC expect that these powers would only be used in cases of clear tax avoidance.
Anti-avoidance rules and clearances
The Government is considering the need for targeted anti avoidance rules in order to maintain the intended scope of the Patent Box and will particularly focus on qualifying patents, manipulation of expenses, income and intra group transfers of patent assets. HMRC will operate a non-statutory clearance system on the Patent Box in response to applications from businesses.