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CRS questions whether U.S. patent box would be effective tool against profit shifting

CRS Report R44522, A Patent/Innovation Box as a Tax Incentive for Domestic Research and Development.

The Congressional Research Service (CRS) has issued a report on the potential use of a patent/innovation box regime to incentivize research and development (R&D) activities in the U.S. The CRS report explains why the recent innovation box incentives, proposed by House Ways and Means Committee members Charles Boustany (R-LA) and Richard Neal (D-MA), may not be very effective in discouraging the shifting of U.S. profits to low-tax foreign jurisdictions.

Background. The CRS report explains that a patent box provides a lower tax rate on income from patents, and in some cases, from other intellectual property (IP). It notes that a number of countries (including the U.K., France, the Netherlands, and China) have adopted a patent box regime. The tax rates for IP-related income generally range from 5% to 15% under these regimes.

The CRS report notes that patent boxes may be referred to as innovation boxes when they cover income from non-patented as well as patented IP. In this regard, patent boxes can have narrow coverage (providing a lower tax rate on royalties and licenses from patents) or broadly cover income attributable to IP, including that used directly by the company in production.

The purpose of a patent box is to encourage R&D and, in some cases, to encourage the location of profits from IP in the country. However, in response to concerns about preferential tax regimes that encourage artificial profit shifting, the Organization for Economic Cooperation and Development (OECD) has set forth a minimum standard to assess whether there is substantial activity in a preferential IP regime. This “nexus” approach uses expenditures in the country as a proxy for substantial activity and aims to ensure that taxpayers benefiting from such regimes did in fact engage in R&D and incurred actual expenditures on such activities.

CRS’s report. The CRS report analyzes the effects of a patent box on encouraging R&D in the U.S. and includes discussions on current U.S. R&D incentives, the justification for R&D subsidies, the potential impact of a patent box as a supplement to or substitution for current R&D tax incentives, and the effect of patent boxes on the location of R&D and amount of profit-shifting by multinational enterprises. All of the discussion considers a patent box that is restricted to domestic innovation and manufacture.

Current U.S. tax provisions favoring R&D. The CRS report provides that U.S. tax law currently contains two provisions that benefit research spending:

  • The expensing of intangible costs (constituting the bulk of the cost of R&D) under Code Sec. 174; and
  • A credit for R&D expenses (the R&D credit) under Code Sec. 41.

The CRS report explains that expensing allows R&D costs to be deductible immediately rather than being recovered over the life of the assets from investment. However, when the R&D investment is marginal (i.e., it earns just enough to break even), expensing is the equivalent of a 0% tax rate.

On the other hand, the R&D credit, formerly a temporary provision that was made permanent in the Consolidated Appropriations Act, 2016 (P.L. 114-113), allows companies to choose between two types of credits:

  • A credit of 20% in excess of a fixed base amount that is unrelated to prior R&D spending and thus, has a marginal effective rate of 20%; and
  • A credit of 14% in excess of 50% of the past three years average of R&D expenditures.

Because additional R&D spending increases the base amount in the future, reducing future credits, the marginal effect of the R&D credit is smaller, estimated at 7.9%. Weighting the R&D credit by the spending on the 20% and 14% credits results in an effective credit of 11.3%. A full basis adjustment is made, meaning that the amount of the deduction for R&D is reduced by the amount of the credit.

Proposals for a patent box in the U.S. The patent box generally provides a lower tax rate on the profits from innovation.

The CRS report notes that proposals for a patent box in the U.S. include:

  • The Innovation Promotion Act of 2015, sponsored by Representatives Boustany and Neal, to allow a corporation to deduct 71% of the lesser of (i) its innovation box profits derived from qualifying IP (including patents, inventions, formulas, processes, knowhow, and computer software) or (ii) 71% of the corporation’s taxable income (determined without the 71% deduction), thus translating into an effective tax rate of approximately 10% on all innovation box profits (i.e., after the 71% deduction, the 35% corporate tax rate applies to the remaining 29% of income for an overall rate of 10%).
  • Proposed legislation in the 112th Congress by Senator Diane Feinstein (D-CA), providing a 15% tax rate on income from patents developed and used for manufacture in the U.S.
  • A bill introduced in 2013 by Representative Allyson Schwartz (D-PA) in the 113th Congress, which would also generally allow a 71% deduction to produce an effective 10% tax rate for corporations.
RIA observation: Representative Boustany is currently the chairman of the House Ways and Means Tax Policy Subcommittee. Upon being appointed to this role in November 2015, Mr. Boustany stated, “Under my leadership, the Tax Policy Subcommittee will look for ways to stop driving American businesses away from our shores, stop harming the very small businesses that are the economic engines of our recovery, and stop the gross overreach into pocketbooks of families who are struggling to put food on the table.” His Subcommittee has hosted a number of hearings on U.S. tax reform.

Effectiveness of a patent box. According to the CRS report, the expected effectiveness of a patent box on R&D depends on its design. To the extent that a patent box has been adopted to discourage profit shifting to low-tax foreign jurisdictions, the aforementioned Boustany-Neal innovation box proposal (which is based on a net profit approach) may not be very effective. If an additional R&D dollar is shifted to the U.S., it would not be taxed at the approximately 10% effective tax rate, but rather, at a tax rate between the regular 35% and the 10% under the cost allocation formula, said the CRS report. Estimates suggest that the tax rate would still be relatively high. In fact, Peter Merrill of Pricewaterhouse Coopers LLP estimated that the lowest tax rate across the industries he examined was 27%.

Another issue that arises with profit shifting is the incentive effect of a patent box at the margin if part of profits are already shifted abroad, perhaps to a zero-rate country. It is possible for R&D to take place in the U.S., but have profits allocated abroad through cost-sharing arrangements, where the company’s foreign subsidiary contributes to the cost of U.S. R&D in exchange for a share of the profits. When the transaction is the equivalent of an arms-length one, and the cost-sharing payment is equal to the present value of the expected profits, nothing in the analysis above changes. If, however, the cost-sharing payment is too small, profits are shifted abroad.

In this case, a patent box based on net profit is likely to discourage investment in the U.S., as R&D costs are now being deducted at a 10% tax rate rather than a 35% tax rate with no corresponding decrease in the tax rate on the profit that has been shifted to another jurisdiction. This penalty is offset (but only partially) because additional R&D spending also produces a benefit in that it reduces the weighted average tax rate on all profit. This effect is more drastic as the share of non-R&D spending increases.

The R&D credit is more valuable in reducing effective tax rates than a lower tax rate applied to net profit, said the CRS report.

RIA observation: Earlier this year, two Administration officials voiced opposition to an innovation box regime as a matter of tax policy, contrasting it to the newly-permanent R&D credit. (See Weekly Alert ¶  3  03/17/2016 for more details.)
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