On 6 December 2011 the government published draft Patent Box legislation. The legislation follows closely the core design characteristics outlined in its June 2011 Consultation Document. The proposed 10% rate and basic formulaic approach to calculating patent profits remains unchanged. The rules do however include a number of improvements over the initial proposals with specific aspects of the patent profit calculation being refined. The government has however declined to extend the regime beyond UK, EPO and certain EU patents. Consultation on the draft measures closed on 10 February 2012. Final legislation is to be included in Finance Bill 2012 with the rules being phased in from April 2013.
In this article we outline the shape of the new UK Patent Box regime which will enable companies making use of the rules to benefit from a 10% tax rate on patent profits. The rules will apply from April 2013 and will be phased in over five years with 60% of the benefits available in FY 2013 increasing to 100% in FY 2017.
For readers familiar with the June 2011 Consultation Document proposals, we will touch on key clarifications and changes now reflected in the draft legislation.
The rules follow closely the core design characteristics outlined in the June 2011 Consultation Document. They do, however, include a number of clarifications and changes which are mostly favourable to the taxpayer.
Of particular note are the changes to the Step 2 routine profits calculation which now excludes reference to R&D costs and applies a 10% mark up rather than the 15% previously proposed and the switch to a transfer pricing based notional marketing royalty calculation in order to identify any brand profits excluded from Patent Box benefits. The divisionalisation concept has also now morphed into a simpler streaming approach.
Figure 1 outlines in flowchart form the following commentary. The starting point for determining qualification is to establish whether the company (or group) holds relevant patent interests.
Qualifying company
The draft rules define what constitutes a ‘qualifying company’, ie, a company which holds relevant patent interests. Broadly, a qualifying company will be one which holds either:
The exclusive licence provision is likely to be particularly helpful to UK subsidiaries of foreign owned groups. Helpfully, the rules also widely define exclusivity, enabling a variety of arrangements to satisfy the definition.
A qualifying IP right is further defined in the rules. To meet the definition a company must hold:
Note that companies party to cost sharing arrangements are treated under the rules as holding qualifying IP rights (or an exclusive licence) where one of the parties to the cost share holds such rights and certain other conditions are satisfied.
Also, the rules enable a corporate partner to elect for the Patent Box rules to apply to partnership income and profits.
The rules also enable companies which have previously held (but no longer hold) qualifying IP rights or an exclusive licence to qualify for Patent Box benefits; the scenario envisaged here being that some time after the sale of patent rights a company may receive damages for a patent infringement occurring when the company did hold the patents.
Development condition
The development condition reflects the policy intent behind the rules, that being to encourage the creation of high value UK jobs in the development, manufacture and exploitation of patented technologies. Broadly, the rules require that the company claiming Patent Box benefits, or a member of its group, either creates or significantly contributes to the creation of the patented innovation or, that the company, or group member, performs a significant amount of activity to develop the patented innovation, its use or, the product it is used in. The rules set out four ways in which the condition may be satisfied. It is helpful that the condition itself does not impose a strict self-development requirement. In other words, companies acquiring patents may also meet the development condition.
Active ownership
Where a company is a member of a group, in addition to demonstrating that it holds qualifying IP rights (or an exclusive licence over such rights), a further active ownership test must also be passed. This is deemed to have been met if the company satisfies the development condition (see above) on its own account. Alternatively, the company must show that it has, during the accounting period in question, performed a significant amount of management activity in relation to the qualifying IP rights (or licence).
Assuming a company qualifies in principle for Patent Box benefits it is then important to understand how patent profits are calculated to assess what tax savings might be achieved.
The rules identify three stages broken down into seven steps to be undertaken in order to calculate the amount taken to represent a company’s patent profits. Figure 2 summarises this.
The three stages are as follows:
Stage 1, Step 1: Identify the total gross income of the trade of the company
Total gross income of the trade is defined in the legislation and is made up of trading revenues, credits brought into account for tax purposes on realisation of intangible assets and profits from the sale of pre-2002 patent rights. Income streams arising from lending activity and financial assets are specifically excluded.
Stage 1, Step 2: Identify the proportion of Relevant IP Income (RIPI) as a percentage of gross income of the trade
This step requires companies to identify RIPI and determine this amount as a percentage of the gross trading income figure arrived at Step 1. The rules prescribe four heads of income qualifying as RIPI (any North Sea ring-fence income or non exclusive licence fee income is excluded), these being:
It should be noted that in cases where qualifying items are sold (or a single agreement is entered into) for a single price and such a price includes non-trivial amounts due for non-qualifying items an apportionment under mixed sources of income rules is required.
Stage 1, Step 3: Apportion the relevant proportion of the profits of the trade to RIPI
Prior to any profit apportionment, the rules require a number of adjustments to be made to a company’s taxable profits. In particular an add-back of any R&D tax credit relief super deduction is required. (This works in the taxpayer's favour as it increases the amount of profit benefitting from a 10% rate). Trading loan relationship debits or credits are also stripped out of the trading profits figure as is any other financial return economically equivalent to interest.
Subject to application of the streaming rules (see below) the percentage as calculated at Step 2 is applied to the adjusted taxable profits of the company to arrive at the proportion of trading profits associated with the company’s RIPI.
Stage 2, Step 4: Remove routine return to determine the Qualifying Residual Profit (QRP)
Profits attributable to routine activities are calculated by taking 10% of the aggregate of certain costs listed in the rules, these being:
Stage 3, Steps 5 and 6: Removal of marketing assets return
The final stage of the calculation is to remove any profits relating to marketing assets.
A company can opt to elect for small claims treatment (Step 5) which deems 25% of QRP as a deemed marketing return, leaving the remaining 75% (up to a maximum of £1m) of QRP inside the Patent Box.
Alternatively, an arm’s-length return on marketing assets must be determined to arrive at a notional marketing royalty amount to be deducted from QRP.
Marketing assets are defined in the rules as being:
The calculation allows you to deduct any actual marketing royalty paid from the notional figure.
Stage 3, Step 7: Identify any profits arising before grant of right
Patent Box benefits may only be enjoyed once a patent has been granted. However, the rules recognise that patent profits may be generated between application and grant. Therefore, subject to certain conditions (including a six year look back cap) the rules allow any such profits to be given relief in the period in which the patent is granted. Under Step 7 this amount is added to the profit figure arrived at having worked through Steps 1 to 6. The final figure forms the company’s Relevant IP Profits (RIPP) of the trade for the relevant period which benefit from a 10% tax rate.
Streaming
In some cases the Stage 1 steps described above may under or over allocate trade profits to RIPI. A streaming option is therefore available (mandated in certain circumstances where a company receives substantial amounts of licensing income not qualifying as RIPI). Broadly, streaming requires a just and reasonable apportionment of a company’s expenses rather than adopting a simple pro rata approach as described above. This may (depending on the profitability of the company’s patented products (or licensing arrangements)) increase or decrease the amount of trading profits which are further adjusted through Stages 2 and 3 of the calculation to arrive at a RIPP figure.
Relevant IP losses
In some circumstances the Patent Box calculation may produce a loss (referred to as a set-off amount). The rules specify how such losses must be used. Essentially they are ring fenced and must be used against other Patent Box profits of the company or group companies in the current or future periods.
Anti-avoidance
The rules include three anti avoidance provisions
The first counters the conferment of irrelevant exclusivity under an agreement.
The second counters qualifying items being incorporated into a product with the main intent of generating RIPI.
The third and main rule applies where a main purpose of a scheme is to secure enhanced tax benefits from Patent Box.
Jonathan Bridges, Associate Partner, KPMG
Rhiannon Jones, Manager, KPMG
Why GSK supports the new regime Kullervo Maukonen
Director Intellectual Property
Global Tax
GSK
GSK believes the new Patent Box regime will drive growth through new investment in innovation. We have been encouraged by government’s receptiveness to working with stakeholders through the consultation process in order to develop a set of rules which is both attractive and workable. The HM Treasury/HMRC Patent Box working group, of which GSK has been part alongside a number of other UK companies, is a great example of what can be achieved through legislative consultation: the Treasury and HMRC have succeeded in designing a regime which promises to be pragmatic in its implementation and of benefit to a wide range of innovative industries. However, in order to secure a successful regime, it is important that HMRC’s policy team and CRMs continue to work closely with industry to move from policy to implementation between now and April 2013.
Of particular importance to GSK, and no doubt other taxpayers in different industries looking to make use of Patent Box, is clarity on the definition of qualifying IP income. The draft rules (and accompanying technical note) helpfully go in to some detail on this point; they illustrate the number of different forms of income that can attract Patent Box benefits. Businesses generating sizeable after-sales profits will be pleased to see that Head 1 includes spare parts revenues within the box as long as the product for which the parts are used is patent protected. For life sciences companies, the fact that Head 1 also includes income flowing from medicinal products where either active ingredients or delivery mechanisms are on patent is obviously important.
Of equal importance are the exclusions from Patent Box income, one of which is the exclusion for marketing profits. The arm’s length approach now taken in order to extract ‘brand’ profits and arrive at relevant IP profits qualifying for Patent Box benefits appears less arbitrary than the original, albeit simpler, proposals which were based on a current year R&D and marketing spend ratio. That said, we would welcome draft guidance outlining the circumstances in which HMRC might expect the rules to give rise to a return on marketing assets
One aspect of the regime where we would invite the government to reconsider its position relates to the definition of qualifying patent rights. While we welcome the commitment to extending the definition of qualifying rights to patents granted by certain other EU Member States, in our view the attractiveness of the regime would be enhanced if qualifying rights were extended beyond the EU, for example to include certain US or Japanese patents.
