On 10 June HM Treasury published a consultation document on a patent box in the UK. Broadly speaking there is to be an optional 10% tax rate on patent profits (including those arising on sale of a patent) in the UK arising after 1 April 2013. This is to be achieved by a tax deduction in the corporation tax return of the relevant company.
It was initially proposed that the regime should apply to patents commercialised after 29 November 2010. However, the Government is now instead consulting on whether to apply the regime to all patents (whenever first commercialised) but phase the benefit of the regime in over a 5 year period. Therefore 60% of the benefit will be available in 2013/14 and 100% will be available by 2017/18.
The regime is to apply to worldwide income relating to qualifying patents. It is initially proposed that qualifying patents are to be those granted by the UK Intellectual Property Office and the European Patent Office. The regime will also extend to supplementary protection certificates which extend such patents as well as regulatory data protection and plant variety rights. To benefit from the regime the relevant company needs to have legal ownership of the patent or an exclusive license to exploit a patent (although such licence can be limited by territory or field of activity provided it procures market exclusivity). Interestingly a company which has full beneficial ownership of patents without legal title or an exclusive licence would not seem able to qualify on the basis of the current condoc.
The rationale for restricting the benefit to UK IPO and EPO patents is that these have been "independent validated as innovative and useful". Additionally certain other regimes include a wider scope of inventions which may be patented (eg business models). The Government is, however, consulting on bringing other patents into the regime.
A requirement of the regime is that the company claiming the benefit of the regime will need to remain actively involved in the ongoing decision making connected with the exploitation of the patent. In addition the company or another group company must have performed significant activity to develop the patented invention or its application. In this respect account will be taken of management of risks as well as R&D activity – although it is specifically stated that subcontracted R&D will not necessarily prevent a group from meeting the requirement. It remains to be seen how the group provisions will work in detail without draft legislation (eg does one look at the group relationship at the time of the development activity or at the time of making the claim). Groups should therefore be careful when looking at structuring and post structuring M&A activities to ensure that they do not lose the benefit of the regime in respect of target companies.
Qualifying income under the regime is to include royalties and licence fees as well as income embedded in patented products. The focus of the regime is on products as this should allow companies to calculate profits from embedded patents more easily. The regime will apply to all income from a product if it incorporates at least one invention covered by a current valid qualifying patent. The incorporation of the patent must be commercial and not simply to benefit from the regime. In this respect the consultation document refers to "parts, components or separate items...aggregated for sale" and which "constitute a single composite product in which they are functionally interdependent". So in this respect a patent in a car radio is unlikely to make the whole car qualify, whereas a patented product in the engine should make the car qualify. On the definition in the document, a patented invention in the car wheel would seem to make the whole car qualify. It will be interesting to see if the final draft legislation is as generous in this respect.
As well as the products themselves spare parts (which could potentially cover consumables such as ink cartridges for printers) should be covered by the regime.
Patents used in industrial process are not covered. However, it should be noted that companies would be allowed to "divisionalise" such that a deemed division of the company would be treated as licensing such process patents. The royalty income in this division should then qualify under the rules. Divisionalisation will be mandatory in some cases and in others will not be available. It is not entirely clear yet as to the boundaries of the rights and obligations to divisionalise in this respect.
The regime will apply from date of grant of a patent. However, once a patent is granted it will be possible to look back to the date of the application (up to four years) and obtain a benefit for any income in such period. The benefit is however taken in the tax year in which the grant is made.
To avoid complex transfer pricing issues as to the level of income that relates to patents, a more mechanical formulation is suggested whereby patent box income is calculated as follows:
- Calculate the profit attributable to qualifying income. This is achieved by allocating profits and expenses pro-rata between qualifying income (i.e. from patents/patented products) and non qualifying income
- Deducted from this profit is the profit that the company would have made without the valuable IP. It is suggested that this "routine profit" is calculated by applying a mark up of 15% on costs. However certain costs are excluded from this calculation. Notably costs of outsourced supplies, inventory and licence fees. It is not clear whether amortisation of capital expenses is subject to the mark up or not. The "residual profit" which arises after deduction of the "routine profit" is what goes forward to stage 3 of the calculation
- Finally, the profit from patents is separated from the profit from other valuable IP. As a measure of this it is suggested that the profit is split pro-rata according to the level of R&D spend against marketing spend. The amount allocated to the R&D side is then subject to the patent box.
It is envisaged that losses in the patent box should effectively be used against current year non patent box profits if any. If that is the case they would be carried forward to reduce future patent box profits. This in turn would increase future non patent box profits and therefore recoup the additional tax deduction obtained in the year of first offset.
As always, it is proposed that anti-avoidance rules may be required to avoid manipulation of the rules, eg by artificially including patented inventions in products, artificial manipulation of income and expenses and avoiding restrictions on losses through intra-group transfers.
The patent box must be seen in light of other Government developments which are making the UK's corporation tax regime significantly more business friendly. As well as a reduction in corporation tax rates to 23% by 2014/15 and the recent dividend exemption rules, the Government is also consulting on the CFC rules with further proposals on this imminent.
Comments on the patent box consultation document are invited by 2 September 2011.