Further to its initial announcement last November, 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 intellectual property (the Patent Box).
This client advisory is the last in a series of four articles summarising aspects of the proposed Patent Box regime, and outlines the proposed methodology for determining the profits that will qualify for the reduced Patent Box tax rate.
The first advisory, which provides an overview of the key features of the regime, can be accessed [here]. The second advisory, which describes the rights that will qualify for the reduced tax rate, can be accessed [here]. The third advisory, which describes the income that will qualify for the reduced tax rate, can be accessed [here].
CALCULATION OF PATENT BOX PROFIT
The consultation paper proposes a three step method for calculating Patent Box profits. The model is based on a "residual profit split" method, which is a recognised transfer pricing methodology when determining patent profits. The three steps are:
- dividing taxable (not accounting) profit by reference to qualifying and non-qualifying income (Step 1);
- identifying the residual profit (Step 2); and
- identifying the Patent Box profit (Step 3).
Step 1: The consequence of using taxable profits, rather than accounting profits, is that both the R&D tax credit enhancement and interest receipts and financing expenses will be excluded from the apportionment. Otherwise, the apportionment of profits will be on a simple pro rata basis. Qualifying profits will be the same proportion of total profits that qualifying income bears to total trading income. This is subject to any application of the divisionalisation rules (see below).
Step 2: Having calculated the profits attributable to qualifying income, it is then necessary to deduct a notional "routine profit" to determine the "residual profit". The routine profit is the level of profit that would notionally be earned if the company did not own any valuable IP. This will be done by applying a cost-plus methodology, where the mark-up applied will be 15%. The mark up will not apply to:
- functions that have been outsourced (as the service supplier's charges will include a profit element);
- raw materials and inventory; and
- patent and trademark licence fees paid by the company.
The fixed mark-up has been proposed as a simple approach that represents a reasonable return, and is therefore easier than applying different rates for different circumstances.
Step 3: The final step is to separate the profit attributable to qualifying patents and qualifying IP from non-qualifying patents and IP. This is another area where two options are proposed and responses invited. They are:
- to adopt a cost ratio approach and divide the residual profit by reference to the company's expenses attributable to each. Patent expenses would include R&D expenses and costs of filing, renewing and protecting qualifying patents. Other "brand" expenses would include marketing, sales and promotion costs, trademark registration costs and other costs associated with non-qualifying IP; or
- to apportion residual profit by reference to the contribution of brand and qualifying patents to the success of the product. No particular method is proposed; any method will be acceptable as long as it is reasonable and applied consistently. The paper proposes that if this approach is adopted, smaller companies with limited experience of such calculations could adopt a simple 50:50 split for claims of up to £500,000 per annum.
The consultation paper recognises that the pro rata apportionment in Step 1 may not always be appropriate, as it may lead to artificially inflated or reduced profits. Accordingly, in some circumstances, companies will be permitted to calculate Patent Box profit by reference to different divisions of the company. Where the standard approach would artificially inflate profits, divisionalisation will be mandatory. Divisionalisation rules will also allow companies to charge notional royalties (which will be qualifying income) for qualifying patents used in industrial processes.
The consultation paper acknowledges that divisionalisation will increase the administrative burden of the regime, as companies will have to produce tax computations for each division.
Companies will not be able to opt in and out of the divisionalisation rules in the absence of bona fide changes in the company's long term commercial activities.
PATENT BOX LOSSES
Companies' corporation tax liability will not be increased if the Patent Box calculation in any year results in a loss. Instead, the consultation paper proposes that such losses could either be carried forward and set off against Patent Box profits in future years or, where the loss-making company is in a group, offset against Patent Box profits of other group companies.
Pre-commercialisation costs should be taken into account in determining net patent profits. However, that would require companies to retain detailed, itemised records of expenditure in prior years. The consultation paper therefore proposes that, as companies tend to spend consistent amounts annually on R&D, expenditure will be measured on a year to year basis with no claw-back, to ensure that the regime is simple to use. There will be exceptions permitting claw-back for companies that do not have consistent levels of R&D expenditure.