Thinking inside the box
Innovation or patent boxes are gaining in popularity as a way of using tax policy to encourage IP-backed R&D. With tax reform on the new administration’s agenda, the United States could be the next major market to introduce one
In 2017 there have been continued trends towards national protectionism among developed nations aimed at driving domestic policies which promote home-grown technology innovation, increased domestic manufacturing and efficient product distribution. In the United States, the Trump administration has already touted innovation and domestic tax reformation as key drivers for domestic growth.
This innovation push goes beyond technological products themselves and into aspects of manufacturing and product distribution. This is reflected in the rise of three-dimensional (3D) printing, which allows for local product reproduction and simplified distribution to improve the quality and sophistication of cost-effective end products. IP rights are critical to this drive, given their proven track record of promoting growth by allowing innovators to capture a larger return on R&D spend across global markets through effective international IP portfolio development. Patents are key to a cogent global IP strategy, given their broad scope of protection compared to other forms of IP rights. Yet despite the impact of IP rights on promoting innovation, there is still a long way to go in the public policy realm when it comes to aligning investments in technological R&D with the retention of increased economic benefits and concomitant tax revenues associated with increased employment and manufacturing.
In many countries the true value of patents is not effectively realised, for a variety of reasons. These include:
- the unavailability of effective, efficient enforcement mechanisms;
- the absence of a clear understanding as to the true cost of R&D; or
- laws which undervalue patents during the damages phase of litigation.
For example, the United States has focused on damages calculations in patent infringement actions which apportion a patent’s value from the perspective of the smallest saleable patent-protected component relating to the patent’s claim tree. This reflects something of a reversal of the traditional top-down approach based on royalty calculations which begin at 25% of a product’s profitability. Other pressures on the US patent system have made it difficult to establish protection for certain types of innovation, such as software and pharmaceutical innovations. More recently, there has been pushback in the form of court decisions interpreting the scope of the infamous US Supreme Court Alice decision and the categorisation of patent claims with financial terminology as protectable inventions within the scope of US subject-matter eligibility. While these interpretative court decisions have helped to mitigate the impact of the Alice decision, subject-matter eligibility issues remain.
A proper valuation of IP rights is essential for them to have a positive impact on innovation. For technology-based patents to continue to promote innovation, a proper return on R&D investment is essential. With diminished patent valuations which fail to properly value or capture the true cost of innovation, it is appropriate to consider other ways to encourage R&D innovation. Innovation box strategies, which seek to reduce the tax burden on income associated with IP exploited in the taxing jurisdiction, reflect such a focus in Europe and elsewhere around the world. They not only allow patents to regain some of their lost value in the wake of lower damages calculations, but can also be structured to promote domestic manufacturing in the geographic regions which are most logical for local distribution (even if existing innovation box regimes may not always do so). The attendant tax advantages of innovation box strategies can help domestic R&D centres to support nation building though domestic revenue growth.
Countries which have contemplated holistic approaches to connecting innovation expense recovery with domestic policies in order to increase employment and gross domestic product (GDP) are growing, and include innovation box regimes in the United Kingdom (adopted in 2013). While the United States has considered such regimes in the past, it has yet to formally implement one. Given the current global political and innovation-focused climate, it is timely to consider the pros and cons of existing regimes and the potential value of similar regimes to key markets such as the United States. In so doing, regimes which can balance variables such as innovation promotion, trade reform, tax reform and economic power may emerge within the United States and other major economies.
Role of IP rights in a global economy
Most multinational companies have a structured IP regime which enables them to protect their innovations in countries where they develop, manufacture or distribute significant product volume. IP rights are also typically sought in areas where multinationals have a presence through corporate affiliates and partnerships, such as joint ventures.
Currently, IP rights allow multinationals to relocate profits to the country of their choice. For example, by establishing a patent holding company in a region with lower income tax and subjecting corporate affiliates to arm’s-length licensing fees, multinational profits can – subject to admittedly significant transfer pricing tax considerations and the concomitant need to align profit allocations with risk-bearing and decision-making capabilities – be allocated to a jurisdiction with a more favourable tax consequence. This often results in a disconnect between the situs of corporate profits and regions where R&D talent is based, thereby undermining the local tax base which could otherwise serve the local infrastructure, and community and cultural development. This disconnect can be addressed, at least in part, by exploiting tax codes as a driver for legitimate domestic growth and to preserve innovation talent.
The desirability of fashioning a tax code to favour IP-based income is not without its sceptics. While some level of scepticism can be healthy, care must be taken to ensure that it does not undermine rational policies for stimulating growth. For example, there was scepticism over the benefits of patents in the United States during the early part of this century, when so-called ‘patent trolls’ were able to exploit the absence of contained damages awards and the high cost of patent litigation in the United States to win high-value settlements from alleged infringers, which found it more cost effective to settle than to fight an illegitimate claim and prove their innocence. The patent system as a whole was consequently attacked by many who failed to understand its recognised value dating back to the US Constitution in the 18th century. Fortunately, this situation has been mitigated in the United States by measures such as damages apportionment, fee shifting (Highmark and Octane), enhanced patent infringement pleading requirements effective in 2016 and the more effective post-grant proceedings now available at the US Patent and Trademark Office following the full enactment of the America Invents Act in 2013. The patent system was not dissolved and its recognised value as an innovation driver was restored. The same level of intention should be applied to the possibility of using national and multinational tax codes to allow for a proper balance of IP rights and domestic policies designed to promote innovation and grow GDP.
Patent innovation box regimes allow a nation’s R&D to be aligned with returns on investment which can be realised by that nation when related manufacturing and sales activity are carried out therein. Tax policies which promote such activities need not undermine or reverse globalisation efforts. Rather, they can be used to deter the creation of artificial corporate centres which result from forum shopping for lower corporate tax rates.
Basic architectural considerations of current preferential tax patent or innovation box regimes
- Establish a preferential tax rate on qualified income.
- Identify the types of intellectual property covered by the regime to achieve its objectives.
- Identify the types of income which qualify for preferential treatment in the regime.
- Consider an appropriate link (eg, regional manufacturing, regional R&D and so on) between R&D efforts and qualified income eligible for preferential treatment.
Innovation box countries
Belgium, Cyprus, France, Hungary, Ireland, Italy, Liechtenstein, Luxembourg, Malta, Netherlands, Portugal, Spain, Turkey and United Kingdom
India and Singapore and South Korea
Current patent-based IP rights are not fully rewarded for various reasons
- Ineffective judicial proceedings.
- Lack of appreciation of R&D costs (eg, costs of failure).
- Reduced damages awards.
- Limited availability of preliminary or permanent injunctions.
2015 US legislation
- Tax benefit of 71% on innovation box corporate profit.
- Qualified intellectual property: includes patent, invention, formula, process, design, pattern, know-how, motion pictures, software and products using such intellectual property.
- Includes products or licensed IP rights.
- Qualified profits = portion of gross profits less lost and expenses.
- In contrast to the Organisation for Economic Cooperation and Development’s base erosion and profit shifting, no tracking of R&D expenditures to specific intellectual property is required – although tax preference is a function of R&D expenditures, including purchased or licensed IP rights.
Exemplary patent box savings
Under the 2015 proposed US legislation:
- 71% of innovation box profit at current 35% US corporation income tax rate;
- effective rate of 10.15% of qualified profit; and
- eligible profits = (R&D expenditures including purchased IP rights)/(total business-related costs) over a five-year period.
Existing innovation box regimes
Traditionally, most industrialised countries have structured their business income tax systems to provide incentives for R&D activity by way of accelerated deductions for what would otherwise be capitalised expenditures deductible only over the legal or economic life of the intellectual property being generated or by tax credits (dollar-for-dollar reductions in tax liability). However, these incentives do not always encourage production or sales activity within the taxing jurisdiction. In a global economy, this can be a problem because – subject to the enforcement of transfer pricing rules (which require companies that develop intellectual property to charge, for tax purposes, their foreign affiliates an arm’s-length amount with respect to the transfer of ownership or licensing of such intellectual property to those affiliates) – it is relatively easy to transfer IP rights within a multinational group for use in low-cost and low-tax jurisdictions, so as to maximise after-tax profits.
In the last 15 years or so, many industrialised nations other than the United States have adopted so-called ‘patent box’ or similar tax regimes, which have taxed certain income attributable to defined categories of intellectual property earned by resident taxpayers at preferential rates. Although the details of such regimes differ, their architecture involves four basic considerations. The first is the effective rate of tax on the income that qualifies for favoured treatment. Typically, this is some percentage of the country’s general business income tax rate and is derived by granting taxpayers a deduction or exclusion of a certain percentage of eligible income from the taxable income base. For example, in a country with a general 30% statutory income tax rate, the effective rate on qualifying income would be 15% if that country provided for the deduction or exclusion of 50% of the amount of the taxpayer’s qualifying income.
The second consideration is the type of intellectual property which is covered by the patent or innovation box regime. Almost every such regime covers patent rights and similar IP rights, including plant breeders’ rights and supplementary protection rights. However, many regimes also cover copyrights for software, know-how, legally protectable trade secrets and, in some cases, trademarks and other marketing intellectual property. Obviously, the choice as to the scope of covered intellectual property is based on the type of business activity for which the tax incentive is sought. A regime which was limited to patent-related income would typically seek to encourage home country manufacturing and production activity. The inclusion of know-how would encourage in-country performance of services. On the other hand, the inclusion of marketing intellectual property in an innovation box regime would provide an incentive for sales and sales-related activity as well. As discussed below, recently formulated international guidelines for innovation box regimes have sought to discourage the coverage of marketing IP-related income under such regimes.
A third consideration – related to the second – is the type of income generated by covered intellectual property which qualifies for preferential treatment. Developers can monetise their intellectual property in several ways:
- through use in their own operating business;
- through licensing to others (both related and unrelated parties);
- through outright sales of the intellectual property; and
- through combinations of these.
In addition, rights holders may receive income in the form of damages for infringement. As is the case when it comes to determining the type of IP right which is covered in a patent or innovation box regime, determining the type of covered income depends on the type of activity that the taxing jurisdiction wants to encourage. A regime which limits the type of income subject to favourable treatment to income generated by the taxpayer’s use of covered intellectual property in its own business would provide the greatest incentive to manufacturing or production activity (or, in the case of marketing intellectual property, to sales and distribution activity).
Modified nexus approach – linking tax benefit to proportion of development activity on IP asset undertaken by the company
As an example, the current UK patent box regime defines the R&D fraction of IP profit (ie, associated with a qualifying IP right) which qualifies for beneficial tax rate as the lower of 1 and:
(D+S1) * 1.3 / (D+S1+S2+ A)
- D = direct expenditure on relevant R&D;
- S1 = qualifying expenditure on relevant R&D subcontracted to unconnected persons;
- S2 – qualifying expenditure on relevant R&D subcontracted to connected persons; and
- A = qualifying expenditure on acquisition of the relevant qualifying IP right.
For example, if a company has incurred 100 on R&D expenditure associated with a qualifying IP right, 50 of which was spent on R&D directly undertaken by the company and 50 of which was paid for R&D subcontracted to a connected company, the fraction would be calculated as:
(50+0) *1.3/(50+0+50+0)= 0.65.
Consequently, only 65% of the IP profits linked to the IP right would be eligible for the reduced tax rate.
In the case of a patent or innovation box regime which covers income from a taxpayer’s use of IP rights in its own operating business, the regime must determine how much of the operating income generated by that business should be subject to preferential income tax treatment. The taxing jurisdiction could afford preferential treatment to all of the net income generated by the IP-using business, but that would overstate the economic contributions of the intellectual property and potentially promote abuse. With respect to intellectual property used in the taxpayer’s own business, most but not all jurisdictions limit eligible income to an amount equal to an imputed royalty for use of the intellectual property.
Finally, and most importantly, patent and innovation box regimes must consider the appropriate link between R&D efforts and the income which is eligible for the preferential tax rate. As initially enacted, many of these patent box regimes applied to income attributable to intellectual property, irrespective of whether the R&D was carried out within or outside the country, and in some cases irrespective of whether the taxpayer or an affiliated company developed the intellectual property itself or acquired it from a third party.
Given the relative ease with which multinational businesses can shift the ownership and use of intellectual property, the lack of any rigorous connection between the location of IP development and its tax-favoured exploitation or monetisation has prompted criticism of many patent box regimes by those concerned with possible harmful tax competition between countries. In particular, several regimes have attracted scrutiny from the Organisation for Economic Cooperation and Development (OECD), which consists of the United States and 34 other developed countries and which, among other things, has a mandate to establish global tax standards. In its most recent project, which it carried out in conjunction with the G20 countries, the OECD sought to combat what it refers to as base erosion and profit shifting (BEPS) by multinational enterprises, including preventing harmful tax competition between countries.
With regard to patent boxes, the BEPS project ‒ by way of the OECD’s 2015 report “Action 5: Agreement on Modified Nexus Approach for IP Regimes” ‒ has promulgated the requirement that there be a connection or nexus between in-country R&D and favourably treated IP income: the so-called ‘modified nexus approach’. To comply with this, countries with patent or innovation box regimes must limit preferential treatment to income properly allocable to eligible R&D activities conducted within the country. In most cases, only the percentage of otherwise eligible IP-related income which is represented by that portion of total R&D expenditures leading to the intellectual property which consists of expenditures that satisfy the modified nexus requirements is eligible for favourable tax treatment. Thus, if a taxpayer earned $100 of otherwise eligible income from a given IP right and incurred $80 of R&D expenditures in developing this, of which $64 satisfied the modified nexus criteria, $80 [$64/$80 x 100] of the income would be eligible for preferential treatment.
While this approach ensures that taxpayers cannot develop R&D in a high-tax jurisdiction – thereby generating high-value tax deductions and credits – and then obtain preferential tax treatment on the associated income by using the intellectual property in a patent box jurisdiction, it also means that taxpayers must be able to track their in-country R&D efforts and expenditures, trace those efforts and expenditures to specific intellectual property and further link this to specific income flows. Taxpayers must also identify any intellectual property which is not the result of such in-country in-house R&D efforts. Because the OECD report stated that preferential IP regimes should not apply to certain IP rights (ie, to trademarks or other marketing intangibles), taxpayers must exclude income attributable to ineligible intellectual property from the preferential treatment.
Recent developments: May 1 2017 US Congressional Research Service Report on Patent Boxes
A May 1 2017 report by the US Congressional Research Service (CRS) – an arm of Congress – addressed the few studies of existing innovation box regimes and noted that these tend to focus more on the effects of innovation activities than on production activities and fail to address the extent to which a patent box regime would incentivise host-country production activities. The underlying studies were conducted before existing regimes complied with the OECD modified nexus approach, which is intended to link production with in-country development activities. In reviewing the Boustany-Neal-Portman-Schumer proposal, the CRS Report cited a single study which assumed that because only 18.5% of the income of IP-using taxpayers would be eligible for the lower tax rate under the proposal, the effective overall tax rate on such taxpayers would still be higher than the overall corporate tax rate elsewhere. Nonetheless, even if the effective US rate on such taxpayers dropped from 35% to 30.4% – as that study concluded – that would still be a meaningful incentive. If the general statutory US rate dropped to even 25%, an effective rate for patent box-eligible taxpayers of 20% or 21% would make the United States quite competitive from a tax point of view. US consideration of a patent box regime therefore would likely continue as a measure relevant to Trump administration tax reform.
Existing innovation box regimes are in place in Europe in Belgium, Cyprus, France, Hungary, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Spain, Turkey and the United Kingdom; while in Asia, Korea, India and Singapore have recently introduced patent box regimes. With the exception of France – which has yet to change its innovation box regime, first enacted in 2000 – all of the European regimes purport to satisfy the modified nexus approach.
Effect of patent/innovation regimes on US tax considerations
With the increasing globalisation of the economy and the corresponding expansion of technological innovation capabilities, countries have sought to use tax policy as a way of attracting and retaining IP development and exploitation activity. The Trump administration has already signalled an interest in crafting tax reform to address, in part, perceived inequalities in global tax incentives.
US tax policy with respect to intellectual property has focused on tax incentives for R&D, including the offering of accelerated income tax deductions for R&D expenditures which might otherwise be considered capital expenditures amortisable over a period of years. US business taxpayers have long been able to deduct R&D expenses in connection with any current or future business in the year incurred, even if those expenses could lead to patents or other intellectual property which provides benefits for years to come. In addition, for the past 35 years, taxpayers have been able to obtain a credit (ie, a direct reduction in income tax liability) equal to 20% of the increase in the amount of their qualified research expenditures in relation to gross receipts during the year over the average level of such expenditures in relation to gross receipts over the previous four years. Qualified research expenditures for this purpose include in-house research-related salaries and supplies and, depending on the identity of the contract research organisation, between 65% and 100% of contract research expenses incurred to discover technological information which is intended to be useful in developing a business operation or function or in improving the performance, reliability or quality of a pre-existing business operation or function.
However, unlike the European countries which have adopted patent or innovation box regimes, the United States provides no income tax rate incentives for income which is attributable to a taxpayer’s R&D efforts or to its IP portfolio in general. Whether that income is derived from self-exploitation or licensing of intellectual property, it is taxed at ordinary income tax rates – currently, a maximum rate of 35% in the case of corporations and 39.6% for individuals. In certain cases, gain from the sale (or exclusive perpetual licensing) of intellectual property is eligible for long-term capital gain treatment; but this does not benefit corporations, which are taxed at regular rates even on their long-term capital gain. US corporate taxpayers are already at something of a disadvantage because the 35% maximum US federal corporate tax rate significantly exceeds the maximum income tax rates of other developed countries (eg, 20% in the United Kingdom – scheduled to fall to 17% by 2020; 30% in Germany; 25% in the Netherlands; and 12.5% in Ireland). While there is a consensus that the general US corporate income tax rate should be reduced to bring it further into line with the rates imposed by the country’s major trading partners – and the Trump administration has recently proposed a 15% maximum corporate tax rate, it remains to be seen whether there is the political will to do so, particularly in a way which is revenue neutral or which reduces tax revenues by an acceptable amount.
Future of innovation boxes as protectionism and de-globalisation
The United States has contemplated patent box strategies in the past ‒ most recently with the introduction of legislation in July 2015 by Charles Boustany and Richard Neal (US House of Representatives) and separately by Rob Portman and Chuck Schumer (US Senate). Under this proposal, US corporations would be entitled to a deduction equal to 71% of their innovation box profit for the year, which at the current 35% US corporate income tax rate would result in an effective tax rate of 10.15% on qualifying income. Under this proposal, innovation box profit would be a portion of the corporation’s gross profits (as reduced by cost of goods sold and allocable expenses) from the sale, lease, license or disposition to unrelated parties of any patent, invention, formula, process, design, pattern or know-how – or the sale to any person of any product using such intellectual property – motion picture or computer software. The portion of such profits eligible for the favourable tax treatment would be the fraction represented by the taxpayer’s expenditures on R&D in the United States in relation to its total business-related costs over a five-year period. Thus, the bill would not require tracing and tracking R&D expenditures to specific intellectual property, but would generally extend favourable treatment to US corporations which both conducted R&D activities in the United States and sold or exploited any of the enumerated types of intellectual property. It seems probable that some modifications would be required to comply with the OECD modified nexus approach, although it would certainly condition favourable tax treatment on US-based R&D activity, which was a key goal of the OECD’s report.
The Boustany-Neal-Portman-Schumer proposal would not necessarily maximise the economic activity from the exploitation of intellectual property developed within the United States, because the income subject to preferential treatment would include profits from the sale or licensing of IP rights irrespective of where manufacturing and sales activity took place. However, corporations that incurred R&D expenditures in the United States – those that purchased or licensed IP rights from third parties, as well as those that used self-developed intellectual property in their own business – would get an increased tax benefit from the proposed innovation box regime, to the extent that they earned more profits attributable to covered IP rights which were subject to US tax. Because conducting manufacturing and sales activity outside the United States would likely subject those corporations to foreign country tax on profits attributable to such activity, there would be some incentive to perform manufacturing and other production and sales-related activities within the United States. A more targeted version of the Boustany-Neal-Portman-Schumer proposal which extended tax benefits to income from sales and licensing of IP rights only to the extent that the purchaser or licensee exploited the rights through economic activity in the United States would be cumbersome, and difficult for the licensor or seller to enforce and document.
Because a new Congress was installed earlier this year, the Boustany-Neal-Portman-Schumer proposal is not formally pending. In addition, Boustany is no longer in Congress. Therefore, although that proposal is the most detailed US legislative innovation box proposal to date, the prospects for enactment of anything like it are uncertain.
The Trump administration took office in January 2017, with tax reform as a prong in building domestic growth. Europe has driven domestic industry through tax-based strategies which have included patent and innovation box legislation, while reformations in those legislative introductions have been instituted following the OECD’s BEPS guidelines of 2015. The time may be ripe for all global markets – most notably, the United States – to reconsider a patent or innovation box strategy. IP specialists should consider how such a strategy could affect their structuring of an effective IP rights portfolio to withstand such evolutions in global IP law.
Potential benefits of evolving patent box tax regimes can be maximised as follows:
- Create internal communication pathways between IP rights generation (eg, chief IP officer), R&D (eg, chief technology officer) and finance (eg, chief financial officer).
- Develop patents with claim sets of varying scope to fully exploit innovation with respect to patent box strategies.
- Develop other forms of IP rights with an eye towards innovation box policies in relevant countries.
- Identify countries of interest to your global strategy by focusing on R&D, manufacturing, distribution and sales.
- Evaluate each country’s evolving innovation box policies and consider IP rights appropriate to those policies.
- Maintain a database mapping IP rights to product by region.