Q&A : The UK patent box consultation

Background and overview

Why is the UK changing its patent box rules?

The changes are in response to the OECD’s Base Erosion and Profit Shifting (BEPS) Action 5 report. The findings are based on the work of the OECD’s Forum on Harmful Tax Practices (FHTP). While the FHTP accepts that preferential IP regimes can serve legitimate purposes, e.g. to promote economic growth and employment, it concludes that benefits under such regimes should be directly assessed by reference to a substantial activity requirement.

For IP regimes, the FHTP concludes that substantial activities should mean R&D activities and that regime benefits should be based on a ‘nexus’ principle.

What exactly is the ‘nexus’ principle and what is it intended to achieve?

The nexus principle limits benefits granted under a preferential IP regime, such as patent box, to a company’s proportionate contribution to the R&D activity underpinning the company’s profits. The principle relies on R&D expenditure as a proxy for actual R&D activity. It is given effect through applying a ‘nexus fraction’, which is interpreted as follows:

N = nexus fraction

D = expenditure on R&D undertaken by the company itself (good expenditure in the eyes of the nexus fraction);

S = expenditure on R&D undertaken by a third party subcontractor (good expenditure in the eyes of the nexus fraction);

A = IP acquisition expenditure (bad expenditure in the eyes of the nexus fraction);

R = expenditure on R&D undertaken by a related party subcontractor (bad expenditure in the eyes of the nexus fraction); and

U = an uplift amount equal to the lesser of A+R and 30% x (D+S).

Note the following points:

• The percentage representing N is applied to the profits of the ‘IP asset’ in question. Some flexibility is given in defining the IP asset – this can be taken to be profits from a specific patent, a patented product or, say, a family of patented products.
• The percentage N is recalculated for each period on a cumulative basis for amounts representing D, S, A and R. In other words, the percentage for period 1 is applied to the IP asset profits of period 1; and the percentage for period 2 (which could go up or down) is applied to the IP asset profits of period 2.
• For those confused by the inclusion of U in the fraction, this is simply to soften the negative impact of expenditure on acquiring IP and outsourcing to related parties being treated as ‘bad’ expenditure for the purposes of the fraction.

1. Company A generates profits of £2,000 in its 12 month accounting period 20XX.
2. Company A sells 2 products – product 1 and product 2, each generating £1,000 of profit in the 20XX accounting period.
3. Both product 1 and product 2 enjoy patent protection.  In both cases, the patent applications were filed post 30 June 2016.
4. Product 1 was developed in-house by Company A.  Company A’s R&D expenditure to date on product 1 amounts to £500.
5. Product 2 was bought in in a part developed state for £500 in an earlier period.  Company A itself has spent a further £250 in an earlier period on developing the product and has paid a sister company an additional £250 in the current period to develop the product under a sub-contract R&D arrangement.
6. HMRC has accepted that Company A can track and trace at product level and that Product 1 and Product 2 each represent an IP asset.
7. Product 1’s relevant IP profits (RP) in the period i.e. pre-nexus adjustment but having performed all other adjustments under the patent box rules eg to remove ‘brand’ profits are £800.  Product 2’s RP pre-nexus adjustment is also £800.

Is this good news for UK corporate taxpayers?

The good news is that those OECD members initially calling for the abolition of preferential IP regimes have been unsuccessful and that UK patent box is here to stay for the foreseeable future. There is bad news too, though. The new rules will be more complicated, as readers will have seen from the fraction above. Many taxpayers will also see the benefits they receive reduced, particularly those that choose to outsource R&D to group companies.

What will also frustrate a number of taxpayers is that nexus does not fully align with government policy intent, and a number of groups with a substantial UK footprint will lose out under nexus. In the consultation document itself (section 2.01), reference is made to the aim of promoting manufacturing activities and also commercialisation, i.e. exploitation of patents; and yet the nexus fraction focuses solely on costs associated with R&D.

When will the current regime close and the nexus based regime take effect?

In headline terms, the current patent box regime will close on 30 June 2016 for those companies not electing to use it for periods prior to this date. From 1 July 2016, the new nexus based regime will be available.

It is also important to be aware that for those companies that do elect to use the current regime for periods pre 30 June 2016, they will, subject to certain restrictions, be able to continue using it until 30 June 2021 under grandfathering provisions. Another key date is 31 December 2015: if a company acquires patent rights (including a licence interest) after this date, the company may not be able to rely on these rights to access the current regime (specific anti-avoidance provisions will determine this).

What should corporates do now?

It is really important that innovative companies that are using their patentable technologies review whether to use the current regime for pre 30 June 2016 periods (and in doing so enable themselves to continue using the current rules up to 30 June 2021). Companies should also be reviewing the current consultation document proposals and airing their views to the government. The consultation runs until 4 December 2015. Without feedback, the government has limited ability to craft a new set of rules which works for taxpayers (albeit within the constraints of nexus).

Taxpayers might also want to think about calling for a review of the 10% rate, and the abolition of the phase-in provisions which mean that full benefits under the current regime will not be enjoyed until 1 April 2017. Readers may recall that the cost of the regime was initially budgeted at some £800m pa steady state; and yet the consultation document indicates that, so far, only £335m of benefits have been claimed. That seems to give real scope to revisit things. Also, the Action 5 OECD report accepts that regimes can extend beyond patents and in particular that benefits could extend to novel software development. So far, the government has given no indication that the UK regime will be extended; but to keep the regime competitive, taxpayers may well want this revisited. If so, that voice needs to be heard.

The detail

What will the nexus based regime look like?

The government has said it will retain core aspects of the current regime, modified to incorporate the ‘nexus approach’. So the new regime is likely to include the same types of qualifying IP, i.e. patents and patent equivalents, and the same three stage approach to calculating the patent box profits. The good news is that the approach to identifying qualifying income in relation to a product will broadly be retained so that, as long as one patent is incorporated into a product, the whole of the sales income from that product can qualify.

A key difference will be that a separate patent box calculation will be required for each IP asset. Streaming will therefore be the norm, with income and expenses needing to be allocated to each IP asset (as highlighted above, what precisely is taken to be the ‘IP asset’ will differ taxpayer to taxpayer).

Will the changes mean that the UK regime will mirror other IP box regimes across Europe and more widely?

To comply with the OECD Action 5 report, all other preferential IP Box type regimes will need to incorporate the nexus approach linking benefits to R&D activities. However, we expect there to remain some differences in approach; for example, some regimes, like the Netherlands, may include a wider range of qualifying IP. Also the mechanics of the calculation are likely to differ regime by regime.

Will the nexus fraction need to be applied in all cases?

In most cases, yes. Companies that have undertaken all of their R&D in-house and have not acquired any patents should be able to (easily) ascertain that they have a nexus fraction of 1/1. Their patent box benefit in such case should be the same as under the current regime. Where a company’s fact pattern is more complex and the nexus fraction gives an unfair result, then the company can seek to rely on ‘rebuttable presumption’ provisions, which will enable the fraction to be adjusted in the taxpayer’s favour.

A word of caution here though, as the ‘rebuttable presumption’ will only be available in ‘exceptional’ circumstances; and also where the nexus percentage, i.e. N (without the uplift, i.e. before adjusting for U in the calculation set out above), is at least 25%. It remains to be seen if and how ‘exceptional’ circumstances are defined in the new rules. Personally, we would want to see flexibility in the legislation, with clear examples of what will and will not be accepted in HMRC guidance. Certainly, we would want ‘exceptional’ to include foreseeable circumstances; for example, where development activity must be carried out in local markets for regulatory purposes (and consequently is outsourced to local group companies).

Will the qualifying IP assets definition be expanded, as the OECD BEPS Action 5 report seems to allow this?

The government has signalled that it doesn’t intend to change the definition of qualifying assets. However, as we suggested in our earlier comments, we need a competitive regime and taxpayers need to share their views on what this means to them.

Will the grandfathering provisions mean taxpayers using the current regime are unaffected until 1 July 2021?

Unfortunately, no. This is probably the most controversial area of the government’s proposals, because messaging to date has signalled that broadly anything benefiting from the regime at 30 June 2016 would be grandfathered until June 2021. Worryingly, one of the examples in the consultation document (see case 4 at 4.25, 4.26) indicates that companies would have to apply both the old and the new rules to a single product sold pre and post 30 June 2016, where it has been upgraded post 30 June 2016 with new patented technologies.

Example: A company sells version 4 of a mobile phone, which incorporates nine patents. It elects into the patent box regime for the period ended 31 December 2013 onwards and so benefits from grandfathering. On 1 August 2016, it applies for patent number 10 and starts selling version 5 of its mobile phone (which incorporates all 10 patents) from 1 January 2017. Under the government’s current proposals, the company will have to split the income it receives from the sales of version 5 of the phone between the nine old patents and one new patent. The income from the new patent will be subject to the nexus regime. This will create horrible questions around valuations – it takes us back to the debate had when legislating the current regime, where this sort of approach was rejected on grounds of complexity. In our view, it also goes beyond what the wording of the OECD Action 5 report requires.

How will tracking and tracing work under HMRC’s proposals?

The nexus approach is designed to link R&D expenditure on an IP asset to the associated income, so there are two sides to the tracking and tracing required: expenditure; and income. For most businesses, tracking expenditure at patent level and then tracing that to income from the specific patent will be extremely difficult, hence the flexibility permitted in defining IP asset. Many taxpayers will no doubt deem individual products to represent IP assets.

However, companies will not simply have a free choice in defining IP asset and hence the level at which they track and trace R&D expenditure and IP asset income. They will need to demonstrate to HMRC both the reasonableness and appropriateness of their approach.

The BEPS Action 5 report requires tax authorities to exchange information on the use of IP regimes. Is this relevant to UK taxpayers using patent box?

Generally speaking, the Action 5 report focuses on information exchange in the context of rulings granted by tax authorities. Under the current patent box rules (and likely the new rules), HMRC will not grant formal rulings. That said, HMRC is likely to be required to exchange information in two situations. The first is in relation to certain taxpayers that will benefit from grandfathering. The second situation will be where a taxpayer has relied on the rebuttable presumption provisions. 

For the consultation document, see www.bit.ly/1GvpDRL. Comments are invited by 4 December 2015.