Innovation boxes and their potential role in international tax reform
Innovation boxes and their potential role in international tax reform
So-called “innovation boxes”—essentially, preferential tax regimes for income derived from intellectual property (IP)—have become a prominent topic in tax reform discussions, particularly in the international realm. While lawmakers are generally in agreement as to the importance of supporting efforts of U.S. businesses to engage in research and compete in an increasingly global economy, there is less consensus as to the merits of innovation boxes. This article provides an explanation of the mechanics of an innovation box regime as well as a summary of the arguments for and against implementing one.
Innovation boxes. IP is highly portable, and many companies have attempted to avoid the high income tax rate in their country of residence by employing various strategies aimed at relocating their IP to a low-tax jurisdiction. Many international tax reforms (or proposals) over the past few years are largely aimed at curbing this practice.
An innovation box, also referred to as an IP box, offers preferential tax treatment (i.e., discounted rates) on income attributable to IP. And, a “patent box” offers this treatment to patents. The extent of the discount and type of IP covered varies from one country to the next. Another variable is the activity that gives rise to favorable tax treatment—namely, the research and development (R&D) that went into generating the IP, or the ownership of it.
Innovation boxes have been around for a while, with the first version implemented by Ireland in the ’70s. They became increasingly prevalent over the past 15-20 years and can now be found in countries including Belgium, France, Luxembourg, Spain, and the United Kingdom, among others.
The BEPS project. The Organization for Economic Cooperation and Development (OECD)’s Base Erosion and Profit Shifting (BEPS) project is a multi-year project aimed at curbing international tax avoidance by, among other things, deterring BEPS behaviors by multinationals and taking a more coordinated approach to international taxation in order to better reflect today’s global business practices. The OECD has released a series of recommendations, and the final BEPS package was endorsed by the G20 finance ministers this past fall. (Whether and to what extent these recommendations will be implemented largely remains to be seen, and the recommendations have gotten a mixed reception from U.S. lawmakers.)
One of the “action items” that the BEPS project aimed to address was effectively countering harmful tax practices—notably including those relating to IP. The final recommendations, released last fall, include a modified nexus approach which “is intended to ensure that, in order for a significant proportion of IP income to qualify for benefits, a significant proportion of the actual R&D activities must have been undertaken by the qualifying taxpayer itself.” (See Weekly Alert ¶ 10 10/08/2015.)
Congressional reaction. The Senate Finance Committee International Tax Reform working group has stated that the modified nexus approach recommended by the OECD would, under current U.S. law, likely have “a detrimental impact on the creation and maintenance of intellectual property in the United States.” Testimonials cited in a report issued by the group in July indicated that U.S. businesses are pressured by stakeholders to avail themselves of favorable innovation box regimes, which could result in increased IP ownership overseas and a shift in R&D activities as well in order to qualify under the nexus approach. The group’s co-chairs ultimately concluded that “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 that encourages the development and ownership of IP in the United States.” (For more details on the report, see Weekly Alert ¶ 1 07/16/2015.)
The House Ways and Means Subcommittee on Tax Policy has also weighed in on the BEPS project and patent boxes. In a December hearing, Subcommittee Chairman Charles Boustany, Jr. (R-LA) stated that the OECD made “recommendations that will…encourag[e] countries to create patent boxes, which will effectively force worldwide companies to shift their business operations out of the United States.” (See Weekly Alert ¶ 28 12/03/2015.) Chairman Boustany and fellow Ways and Means member Richard Neal (D-MA) had introduced bipartisan draft legislation earlier in the year that would establish a U.S. innovation box. The “Innovation Promotion Act of 2015” would provide a favorable tax regime for “Qualified Intellectual Property,” which would include, among other things, patents, inventions, formulas, designs, and knowhow. Chairman Boustany offered a similar proposal back in 2012 with former Rep. Allyson Schwartz (D-PA).
What about the research credit? The research credit was enacted in ’81 as part of the Economic Recovery Tax Act of ’81. Code Sec. 41 provides a formula that essentially allows taxpayers a credit against taxes for their research activities. According to the accompanying Joint Committee on Taxation report (JCS-71-81), Congress’s purposes in enacting the credit were to reverse a “decline in research spending” and “overcome the reluctance of many ongoing companies to bear the significant costs of staffing and supplies, and certain equipment expenses…which must be incurred to initiate or expand research programs in a trade or business.” After years of being extended on a temporary basis, the research credit was made permanent by the “Protecting Americans from Tax Hikes” Act (PATH Act, P.L. 114-53). The credit had previously been subject to criticism on the ground that its temporary nature undermined its effectiveness. The PATH Act also made the research credit creditable against certain other taxes.
Administration’s take. In the past week, two Administration officials have publicly spoken out against the innovation box regime.
In a post to the Treasury Department’s website, Mark Mazur, Assistant Secretary for Tax Policy, said that “[m]easured against traditional tax policy criteria such as efficiency and equity, the innovation box comes up short as a desirable addition to the tax policy toolbox.” Notably, he said that the innovation box regime favors certain businesses and investments over others, making for a less fair and efficient system. He also pointed out that, unlike the research credit, an innovation box only rewards commercially successful innovations. It is also “backward-looking” in that respect, in that it rewards investments and behavior that have already taken place.
Mazur said that the innovation box also “offers little potential to improve the overall domestic economy,” pointing to reduced corporate tax revenues. He also stated that approximately 85% of R&D activities of U.S. companies are already performed in the U.S. and that many factors inform where a company locates its R&D activity beyond tax treatment. In the end, he called it “another variation on a “race to the bottom” in the taxation of multinational firms.”
Similar sentiments were expressed by Jason Furman, Chairman of the Administration’s Council of Economic Advisors, at a speech delivered at the Joint International Tax Policy Forum and Georgetown University Law Center Conference on March 11th. He distinguished the research credit from an innovation box in terms of subsidizing inputs vs. outputs, in that the credit awards research activities that aren’t ultimately profitable and doesn’t turn on “factors like luck and market power.” He also tied in the role of Federal funding for R&D, noting that such funding “tends to support investments in innovations that have large social benefits but may be difficult to directly commercialize” and that the research credit better serves this type of R&D. Furman also noted that the research credit is based on the amount of research, whereas an innovation box is based on the amount of return.
With regard to the effect on businesses, Furman stated that the credit can improve a company’s cash flow as it reduces current tax liabilities, freeing up capital to make the research investment. He also noted that the Administration wants to further simplify and expand the credit, which would reduce complexity, whereas introduction of a new innovation box regime would introduce more complexity.
What’s next? The Ways and Means Committee held a meeting late in February on the global tax environment and implications for U.S. international tax reform. Committee Chairman Kevin Brady (R-TX) has been a frequent critic of the current system and said in January that he wanted “to have a vote on an international tax proposal out of Ways and Means this year.” Rep. Boustany had indicated that the Subcommittee on Tax Policy was aiming to have a draft of international tax proposals done by the end of March, but this deadline has been pushed back.
As discussed above, Rep. Boustany has been a previous champion of a U.S. innovation box regime, so it seems at least somewhat likely that the forthcoming draft might include another proposal to implement one—and the Administration’s recent proclamations on innovation boxes seem to reflect an expectation that the issue isn’t going away anytime soon.