On December 9, 2015, the UK HM Revenue and Customs (HMRC) published a Policy Paper, Draft Finance Bill 2016, Clause 31, and Draft Finance Bill 2016, Clause 32, supporting changes to the UK patent box regime to comply with the OECD international framework for intellectual property and preferential tax regimes. These proposals will affect UK companies that hold and exploit patents, or patent-like rights, and claim relief under the Patent Box. The UK patent box was introduced in Schedule 2 of the Finance Act 2012, which proposed the addition of Part 8A of the Corporation Tax Act (CTA) 2010, Sections 357A-357GE.
The draft guidance proposes that the amount of profit from an IP asset that can qualify for the reduced 10% corporation tax (CT) rate available through the UK patent box will depend on the proportion of the asset’s development expenditure that the company incurs. Income generated by the IP and benefiting from the reduced rate will be linked to the level of research and development (R&D) expenditure incurred to develop that IP. The goal of the regulations is to ensure that sufficient economic substance exists and that the regime cannot be used for profit shifting.
The measure will affect new entrants to the patent box on or after July 1, 2016, as well as some IP assets (e.g., patents) acquired on or after January 2, 2016. A new entrant is either an IP asset created on or after July 1, 2016, or a company making an election into the Patent Box that relates to that, or a later, date. An IP asset will be deemed to come into existence when the relevant application (e.g., patent) is made. If a patent application has already been lodged on July 1, 2016, but not yet granted, this will not constitute “new” IP. IP not covered by the new patent box rules will continue to receive the benefit of the existing patent box for a period of five years, until June 30, 2021, except that some IP acquired on or after January 2, 2016, may receive the benefit of the existing patent box only until December 31, 2016.
The patent box legislation applies a lower (10%) CT rate to profits attributable to patents and equivalent forms of IP. The benefit is being phased in and companies will benefit fully from the 10% rate from 2017 to 2018. Companies need to identify the IP profits that will be eligible for the lower rate.
Current legislation allows the IP profits to be identified in one of two ways– the “proportional profit split” and the “streaming” methods. Under proportional profit split, the company’s taxable trading profits are split into IP and non-IP parts based on the ratio of qualifying income (QI) to total income (TI) (QI/TI x trading profit). Qualifying income is income from IP. Under streaming, the company identifies qualifying and non-qualifying streams of income and then splits its allowable deductions between those income streams on a just and reasonable basis. IP profit is then the income attributed to the qualifying stream minus deductions attributable to this stream.
Legislation will be introduced in the Finance Bill 2016 to modify the patent box computation rules so that they comply with the new OECD framework in the BEPS Action 5 recommendations. Specifically, it will remove the proportional profit split option so that the streaming approach applies in all cases at the level of an IP asset, a product, or a product family. The legislation says that, after separating out qualifying income and the corresponding deductions, companies must allocate these to “sub-streams” corresponding to the different IP assets (or products/product families) and calculate a profit for each sub-stream. The profit figures will be calculated similarly to the streaming option.
These figures will then be modified to reflect the proportion of the development activity of the asset (or product/product category) undertaken by the company itself. This will be done by applying a fraction N to the profit figures, defined as the lesser of 1 and:
N = (D+S) * 1.3 / (D+S+A+ R)
- D = in-house direct expenditure onR&D
- S = expenditure onR&D subcontracted to third parties
- A = expenditure on acquisition ofIP
- R = expenditure onR&D subcontracted to related parties
D, S, and R will be defined using the same definitions as for the categories of expenditure in the UK R&D tax relief. The final result will be the profit from the asset (or product/product category) eligible for the reduced CT rate of 10%.