UK to modify Patent Box in line with OECD recommendations

Its approach includes a new "nexus principle", as agreed by the multinational Organisation for Economic Cooperation and Development (OECD). This is designed to ensure that the benefits of the UK tax regime are only available where the research and development (R&D) expenditure required to develop that innovation also took place in the UK, according to a new consultation.

"Rather than establishing a totally new patent box regime, the government confirms that it is going to amend the existing rules so that they comply with OECD recommendations," said tax expert Catherine Robins of Pinsent Masons, the law firm behind Out-Law.com. "This means that, although companies will have to cope with considerable changes, the framework of the regime will at least be familiar."

"Companies which are currently claiming the relief will also be relieved that, although it is consulting on the point, the government is proposing to allow relief on the current rules for as long as permitted – that is, until 30 June 2021 for those already within the current regime at 30 June 2016. There had been concerns that the government might close the current regime down earlier than they had to," she said.

The UK introduced its Patent Box in the 2012 Finance Act, with effect from 1 April 2013. The regime allows companies liable to UK tax to elect to have profits earned from their patented innovations, and certain other intellectual property (IP) rights, taxed at a lower level of corporation tax. It applies to patents granted by the UK Intellectual Property Office and the European Patent Office, as well as to patents granted by certain states within the European Economic Area (EEA).

Relief available through the Patent Box regime is being phased in over four years, ultimately leading to a tax rate of 10% by 1 April 2017. To date, 639 companies have benefited by a total of £335 million to date as a result of the relief with "large investments into the UK being attributed to the existence of the Patent Box", according to the consultation document.

The changes have been prompted by the OECD's programme of work on base erosion and profit shifting (BEPS), which is aimed at ensuring that multinational companies are taxed in the same jurisdiction as where their actual business activities take place. BEPS refers to the exploitation of gaps and mismatches in national tax rules by multinational companies, in order to artificially shift profits to low tax locations where there is little or no economic activity. In November 2014 the UK agreed to close its current patent box in a concession to German concerns about artificial shifting of profits between European countries.

The nexus principle, as developed by OECD member countries, is based on the principle that businesses should only be able to benefit from a preferential tax regime if they carried out the "substantial activities" that generated the income benefiting from that regime in that country. The agreed approach uses R&D expenditure as a proxy for substantial activity. The UK has proposed that affected companies 'track and trace' turnover, expenses and R&D related to IP assets, and is consulting on the best way in which to do this.

Under the proposals the proportion of the company's profits which would benefit from the reduced rate of corporation tax would be calculated by reference to the "nexus fraction”. The numerator of this fraction would comprise the taxpayer’s own direct R&D expenditure on the IP plus any R&D subcontracted to an unrelated party, known as 'qualifying expenditure'. The denominator would be the qualifying expenditure plus any R&D subcontracted to a related party and any acquisition or licensing costs, or the 'non-qualifying expenditure'. If a company carried out 70% of the R&D itself the nexus fraction would be 0.7. The profit from the IP would be multiplied by 0.7 to calculate the profits to which the 10% rate would apply.

In calculating the fraction it is proposed that some non-qualifying expenditure may be included as an 'uplift' to the numerator, if it does not exceed 30% of the qualifying expenditure and providing the costs have actually been incurred.

"The new approach will require companies to keep detailed records tracking their expenditure by IP asset, or in some cases product or product family," said tax expert Catherine Robins. "It appears that even companies within the 'grandfathered' old regime from 2016 to 2021 will have to keep these detailed records from 2016 as they will need this information when the new rules apply to them after the end of the current regime."

Helen Cline, an expert in innovation and the life sciences sector at Pinsent Masons, said that companies' concerns in relation to the proposed approach would depend on their size.

"Smaller life sciences companies that develop UK-based IP in the UK and commercialise it from a UK base will most likely be unaffected, as the nexus between the R&D expenditure and the qualifying income is there," she said. "However, larger companies which often, for very good commercial and scientific reasons, outsource some of the development to centres of expertise abroad may well be more concerned as the expenditure that may qualify will be restricted if offshore group companies are involved."

She added that 'tracking and tracing' R&D expenditure by individual patent, product or product family could be a challenge for some life sciences companies.

"Currently, there generally isn't a clear delineation between a company's expenditure on drug A to expenditure on drug B," she said.