If you’re not yet familiar with the term “patent box,” you and your head of tax compliance should pull up a chair—the idea will be coming to a tax return and financial statement near you soon.
Patent boxes (also known as “innovation boxes”) are tax regimes that allow companies to use discounted tax rates on the income generated by some intellectual property. About a dozen countries have implemented patent boxes, including Belgium, Spain, and Britain, according to a recent report from the Senate Finance Committee International Tax Reform Working Group. Lawmakers in Washington have taken notice and are starting to think the United States needs one too.
The reduction in tax rates can be significant. For instance, while Britain’s standard corporate rate is 20 percent, the patent box rate is 10 percent. In France, the standard corporate tax rate drops from 38 percent to 15 percent.
The countries establishing patent boxes hope the compelling differences will prompt organizations to locate intellectual property within their borders. A report from the U.K. government states: “The government intends to introduce a preferential regime for profits arising from patents, known as a patent box. Encouraging innovative business to invest in the U.K. will play a key part in supporting a strong, growing private sector.”
While the tax benefits of patent boxes can be substantial, companies that leverage these regimes need to consider a number of implications—legal, financial, and operational.
Start with the potential effect on operations. Some countries require businesses to conduct research and development or other economic activities within their borders to qualify for the patent box rate; it’s not enough simply to hold their patents in the country, says Ryan Dudley, partner and practice leader of the international tax group with accounting firm Friedman. The value gained from the patent box needs to be enough to make this a reasonable move.
For publicly traded companies, disclosure requirements can also arise. Case in point: in April, the U.S. Securities & Exchange Commission asked GlaxoSmithKline to explain why the benefit of its intellectual property incentives, as a percentage of profit before tax, changed dramatically from 2013 to 2014. Glaxo was candid in its reply: “Since 2012, the company has centralized pharmaceutical intellectual property and product inventory ownership into the United Kingdom, following the introduction of a U.K. patent box regime.”
In another letter to the SEC, Glaxo said it would explain patent boxes and their benefits in future filings.
Dave Taylor, senior counsel with the law firm Chamberlain Hrdlicka, says the SEC may have wanted to ensure the information was disclosed accurately. Or “it may just be the SEC being curious,” he adds. The United States does not have a patent box regime, and the SEC might simply want to learn more about them and how they will affect corporate financial disclosures.
“There’s an inherent tension between the desire of governments to use the tax system as a tool for competitive [advantage] and a desire to use the tax system as a means to raise revenue.”
Martin Hamilton, partner at the law firm Proskauer Rose
Tax payments are another concern. “The IRS is heavily focused on companies shifting intangible property offshore,” Dudley says. A company that aggressively strips profits from other areas of its business to take advantage of a patent box overseas likely will raise red flags, he says.
If the intangible property is held through a foreign subsidiary and used to generate passive—rather than active—income, a U.S. parent company still may still be subject to U.S. tax on the income as it’s derived, Dudley says. This could be the case with, say, a book or film, as well as with products under licensing agreements, such as drug formulas or software.
Most organizations transferring existing intangible property into a patent box likely would do so through a sale to a subsidiary, Dudley says. The United States and many other advanced countries have comprehensive transfer pricing rules that require the sale to occur at an arm’s length price. That can lead to a gain against the book value of the property and can result in a substantial tax liability.
In addition, “patents are not international animals. They’re domestic,” says Edward Weisz, co-chair of the patent prosecution group with Cozen O’Connor. In considering in which countries to hold their patents, companies need to take into account the size of market for their products and the likelihood they’ll be able to enforce the patent, as well as the presence of a patent box. “Companies need to be strategic in deciding where they need patents,” he says.
Speaking of a Domestic Market
Support for patent boxes is growing in the United States. The Senate’s International Tax Reform Working Group Final Report states, “We must take legislative action soon to combat the efforts of other countries to attract highly mobile U.S. corporate income through the implementation of our own innovation box regime.” And U.S. Reps. Charles Boustany (R-La.) and Richard Neal (D-Mass.) recently released a discussion draft on innovation box legislation.
Unlike other legislative proposals, patent boxes have garnered “strong bipartisan, bi-cameral support,” says Jorge Castro, founder and principal with Castro Strategies, a tax consultancy. “This proposal has received a significant amount of attention from the tax-writing committees, making it an issue to watch this fall.”
Even so, patent boxes have raised public policy concerns. “There’s an inherent tension between the desire of governments to use the tax system as a tool for competitive [advantage] and a desire to use the tax system as a means to raise revenue,” says Martin Hamilton, partner at the law firm Proskauer Rose. While the term “patent box,” is a convenient shorthand, “it’s really just a preferential tax regime for certain types of income,” he adds.
Indeed, one goal of the OECD’s Base Erosion and Profit Shifting project is “to discourage the migration of intellectual property to achieve tax benefits,” Hamilton says.
Many countries have expressed interest in seeing the BEPS project move forward, the United States among them. “The United States has a great deal at stake in the BEPS project and a strong interest in its success,” Robert Stack, deputy assistant secretary with the U.S. Treasury, said before the Senate Finance Committee in June 2014.
One provision within the BEPS project would have companies report financial data on a country-by-country basis. This would help tax authorities everywhere identify companies taking advantage of a country’s preferential tax treatments, even when they have little or no operations in the country.
It also could mean companies that leverage preferential tax regimes increasingly will need to conduct economic activity within the countries, rather than simply hold intellectual property there.
COMPARISON TO R&D CREDIT.
Below, a look at how patent boxes compare to R&D credit.
Although patent boxes have the same general aim as the R&D tax credit already in place in the United States (namely, to reduce taxes on activities related to innovation) they go about it a little differently. The R&D credit is a reward for undertaking innovative activity, and can apply to some of those investments whether they’re commercialized or not, says Douglas Holtz-Eakin, president of the American Action Forum, a center-right policy institute. In contrast, “the patent box reduces taxes on the income flowing from innovation,” he says.
“As governments become more aggressive in auditing [companies’] behavior, they’ll look at the number of employees in other countries,” says Josh Odintz, partner with the law firm Baker McKenzie. They’re looking for “nexus” or “substantial activity”—that is, some correlation between a company’s intellectual property and its operations. “It will be an important defense to an audit that, in fact, the company can point to activity taking place there and explain it’s not just a postal box,” he adds.
Like Castro, Odintz predicts a vigorous debate about implementing a patent box within the U.S. this fall, as part of the discussion around the Highway and Transportation Funding Act. “There are serious people putting their stamp on it. It’s worth watching.”