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A KEY FEATURES
• The UK patent box is to provide a reduced UK corporation tax rate of 10% for companies exploiting patented inventions and certain other botanical and medical innovations.
• The patent box is optional - companies can elect into it. Companies which have elected in can later choose to opt out, but there are restrictions on subsequently electing back into the regime again.
• The benefit of the reduced corporation tax rate is given via an enhanced deduction in a company's ordinary corporation tax computation.
• The reduced corporation tax rate is to apply to a proportion of a company's profits derived from licensing or selling patent rights; selling products incorporating a patented invention; other use of a patented invention in the course of a company's trade, such as providing services; and to compensation received for infringement of a patent right.
• Profits attributable to routine manufacturing or development functions, and to marketing activities, will not benefit from the patent box.
• Patent box profits can be computed according to a formula set out in the legislation (which is intended to minimise the compliance burden), or optionally according to a tailored "streaming" calculation.
• Companies exploiting patented inventions collaboratively via partnerships and cost sharing arrangements can benefit from the patent box.
• The regime is to be phased in over a period of four years commencing April 2013. The full benefit of the regime will only become available in April 2017.
B WHO IS ELIGIBLE TO BENEFIT FROM THE UK PATENT BOX?
Companies that are within the charge to UK corporation tax are eligible for the patent box regime. This includes UK resident companies and non-resident companies that trade in the UK through a UK permanent establishment.
Other types of UK taxpayers, such as individuals and trusts, are not eligible for the patent box regime.
Companies within the charge to UK corporation tax that are members of groups and/or conduct their activities via a tax transparent partnership remain eligible for the
THE UK PATENT BOX
Plan now for 2013 and beyond
patent box, though additional rules apply to them. There are also specific provisions dealing with cost sharing arrangements.
C WHAT TYPES OF IP ARE COVERED BY THE UK PATENT BOX?
The patent box is to apply to patents granted under the UK Patents Act 1977 and under the European Patent Convention.
The Government has announced that it intends to introduce secondary legislation so that the patent box will also apply to patents granted under the laws of Austria, Bulgaria, the Czech Republic, Denmark, Estonia, Finland, Germany, Hungary, Poland, Portugal, Romania, Slovakia and Sweden.
Some European plant breeder and plant variety rights, and EU marketing authorisation rights of medicinal and plant protection productions, will also be included within the patent box.
D WHAT ARE THE OWNERSHIP REQUIREMENTS?
A company can benefit from the patent box if it owns or has the benefit of an exclusive licence of qualifying IP. This is expected to be the normal situation. Section E below explains when a licence will be "exclusive".
A company can also benefit from the patent box if it receives income in relation to qualifying IP which it no longer owns or over which it no longer has the benefit of an exclusive licence, provided that the event giving rise to such income occurred when the company did qualify for the regime. This would cover (for example) income received in a later accounting period in respect of the sale of patents in an earlier period. It would also cover damages received by a company for infringement of a patent where the company only received damages after the patent had expired.
Companies must also meet a "development" condition in relation to qualifying IP. The intention behind this condition is to limit the patent box to companies or groups which have been involved significantly in the innovation to which the patent relates.
The development condition requires the creation of, or a significant contribution to the creation of, a patented invention. The condition can also be met by performing a significant amount of activity to develop a patented
invention or any product or process incorporating the patented invention. What will be "significant" in these circumstances is a question of fact; something could be significant by virtue of the cost, time or effort involved; or by virtue of the impact of a particular contribution. HM Revenue
and Customs (HMRC) considers that simply applying for a patent will not be sufficient for these purposes, nor will acquiring rights to and marketing a fully-patented product.
A company satisfies the development condition either if it carries out development activity itself, or another company in the group carries out such activity.
If a company carries on development activity itself and there is a change of ownership of that company, there is an additional requirement that the company must continue to carry on the same type of activity for at least 12 months following the change of ownership. This is designed to prevent a company (or group) from benefiting from the patent box by acquiring another
patent-owning company in circumstances where no further development activity subsequently occurs.
Companies that are members of a group must also meet an "active ownership" requirement (see section F below). "Group" has a wider definition for the purposes of the patent box than elsewhere in
the corporation tax rules; the Government has said this is intended to allow joint venture entities and smaller groups that might not be fully consolidated for accounting purposes to benefit from the patent box.
02 | The UK Patent Box
Companies or groups seeking to benefit from the
patent box should maintain detailed written
records of their involvement with a patented
invention in order to be able to demonstrate that
they meet the development condition.
Existing licence-holders should review their licences to
see whether they qualify, and if not, consider whether
they can re-negotiate the terms of their licences in
order to qualify. This is likely to be more readily
achievable where one group company has granted a
licence to another group company. However, simply
inserting a non-commercial exclusivity provision into a
licence in order to benefit from the regime is likely to
be caught by a targeted anti-avoidance rule.
E WHAT IS AN "EXCLUSIVE" LICENCE?
An exclusive licence can be granted by the owner of qualifying IP or by an exclusive licensee (in effect, an exclusive sub-licence can still be treated as an exclusive licence).
An "exclusive" licence must give the licence holder one or more unique rights (to the exclusion of all others) in one or more countries or territories. This rule recognises that a patent holder may grant exclusive licences in different countries or territories in respect of the same IP. The rule also recognises that a patent holder need not licence all rights in respect of a patented invention in a particular country or territory to the same licensee - it could grant concurrent licences to more than one entity. In such a case, the licences will only be exclusive - in the sense of being unique -if (as a matter of fact) they relate to different commercial fields of application. If a licence does not prevent competitors in the same market from exploiting a patented invention, it will not be an exclusive licence for the purposes of the patent box.
An exclusive licence must also grant the right either to bring proceedings for infringement or to receive the whole or the greater part of any damages for infringement. However, if rights to litigate or receive compensation for infringement are automatically conferred upon a licence holder by law, it is not necessary for those rights to be included in a licence.
The "exclusive" licence rules are relaxed to some extent in a group company situation. That is, one group company (A) is treated as granting an exclusive licence to another group company (B) if company A confers on company B all of company A's rights in respect of the patented invention, except for all or any of the rights to enforce, assign or grant a licence of any of company A's rights. This relaxation is intended to permit one company within a group (typically an IP holding company) to keep certain rights to manage a patent or patent portfolio while another company in the group exploits the patented invention.
The patent box includes a targeted anti-avoidance rule which prevents an IP licence from being treated as an "exclusive" licence where the main purpose,
or one of the main purposes, of granting the licence was to bring it within the scope of the patent box. Although the rule is drafted in very wide terms, HMRC intends to enforce it only in relation to cases involving spurious or commercially irrelevant exclusivity terms being included in licence agreements.
F WHAT IS THE ADDITIONAL “ACTIVE OWNERSHIP” CONDITION FOR GROUP COMPANIES AND CORPORATE PARTNERS?
Companies that are group members must meet an active ownership condition, which is intended to exclude passive IP holding companies from the scope of the patent box. In effect, group companies must have
developed IP themselves, or be actively managing it.
A group company meets the active ownership condition for an accounting period if in relation to all, or most, of its qualifying IP rights, it performs a significant
amount of management activity. Management activity means formulating plans and making decisions in relation to the exploitation of the qualifying IP rights and will include matters such as deciding on whether to maintain protection in particular jurisdictions; granting IP licences; and research into potential applications of existing IP. What qualifies as a "significant" amount of management activity will be a question of fact; it will not necessarily require a company to take all decisions in relation to qualifying IP, but could turn on matters such as the resources that a company uses for this activity and the scope of its responsibility for taking decisions in relation to qualifying IP. Regardless of the precise nature of any management activity, it is clear that there must be genuine, substantive responsibilities.
A group company can also meet the active ownership condition if it meets a modified development condition in
relation to all, or most, of its qualifying IP rights. That modified development condition requires that there has been no change of ownership of a group company since it created (or contributed to the creation of) a patented invention, or
performed a significant amount of activity to develop a patented invention or product or process incorporating a
EVERYTHING MATTERS | 03
Companies that are proposing to grant licences as part
of patent infringement settlement arrangements should
review their existing arrangements to ensure that they
do not change (even inadvertently) an existing licence
from an exclusive to a non-exclusive one.
Group companies seeking to benefit from the patent
box through active management of qualifying IP should
maintain detailed written records of their management
of a patented invention in order to be able to
demonstrate that they meet the active ownership
condition.
patented invention. If there has since been a change of ownership, the group company must have continued to carry on the same type of development activity after that change of ownership for a minimum period of 12 months.
Companies that exploit qualifying IP via partnerships must also satisfy the active ownership condition, regardless of whether those companies are members of a group - see section J below.
G HOW DO COMPANIES CALCULATE PATENT BOX PROFITS?
Patent box profits can be calculated according to a standard formula in the legislation or an alternative "streaming" method.
The standard formula involves three stages in the calculation of patent box profits, broken down into six separate steps. A seventh step is relevant only if profits were made before the grant of a patent. The diagram below summarises the six main steps.
Stage One, Step One - Gross trading income
A company's total gross trading income (TI) for an accounting period is the sum of income falling into the following categories:
• revenue recognised under GAAP which is brought into account in computing taxable trading profits;
• insurance receipts and other compensation which is brought in account in computing taxable trading profits;
• credits arising from the realisation of intangible fixed assets; and
• profits from the company's sale of the whole or any part of any patent rights held for the purposes of the company's trade.
TI specifically excludes finance income - ie income from ordinary lending activities, income from financial assets (recognised under GAAP) and income which is
economically equivalent to interest.
Stage One, Step Two -Relevant IP income as a proportion of total gross trading income
The second step requires a company to identify the proportion (expressed as a percentage) of its total gross trading income (TI) determined at Step
One that comprises relevant IP income (RIPI). RIPI is itself the sum of certain categories of income (excluding north sea oil income and income from non-exclusive IP licences), namely:
• income in respect of qualifying items (ie items protected by patent), products incorporating one or more qualifying items and other items wholly
04 | The UK Patent Box
Computing patent box profits
Income arising from patented items and processes will
generally be readily identifiable - but identifying income
arising from products which incorporate one or more
patented items can be more challenging. Companies
will need to establish systems to "trace" patented
inventions into their products and maintain accurate
sales data recording income from the sale of those
items.
or mainly designed to be incorporated into a qualifying item or a product incorporating a qualifying item, such as spare parts;
• licence fees and royalties arising from patent licences and rights granted in respect of qualifying items and qualifying processes (ie process protected by patent);
• income arising from the sale or disposal, or grant of an exclusive licence over, a qualifying IP right;
• income arising from the infringement or alleged infringement of a qualifying IP right, and insurance receipts and other compensation in respect of a qualifying IP right; and
• if a company elects to recognise such income, a notional arm’s length royalty for the use of a qualifying IP right to generate trading income for a company which does not otherwise qualify under the above categories.
This last category of income should enable a company that uses qualifying IP in providing services to its customers or in other business processes to qualify for the patent box on part of its turnover by applying an arm’s length (notional) royalty rate to the use of its qualifying IP.
Stage One, Step Three - Trade profits or losses attributable to relevant IP income
At this step, a company's taxable trading profits for the accounting period are first adjusted to exclude the effects of financing arrangements - so deductions arising from borrowing money and under derivative contracts are added back, and income arising from lending, financial assets and arrangements which give returns economically equivalent to interest are deducted. Any enhanced R&D tax credit relief is also added back.
For the first four years after opting into the patent box, a company will need to compare its actual R&D expenditure (being the amount brought into account in computing the company's trading profits, ignoring any enhanced R&D relief) with the average of such expenditure over the previous four years. If the actual R&D expenditure in any of those first four years is less than 75% of the average R&D expenditure in the previous four years, there will be a corresponding
(downwards) adjustment of a company's taxable trading profits for the purposes of the patent box rules.
Once a company's adjusted trade profits (or losses) have been determined, the percentage calculated at Step Two is applied to it.
Stage Two, Step Four - Deduct routine return
The aim of this step is to remove that element of a company's trading profits which is attributable to "routine" activities - ie profits that a company might be expected to make even if it did not have access to patented inventions and other intangible assets. After deducting this "routine return", a company should be left with profits - referred to as "qualifying residual profits" or "QRP" - that are attributable to its IP assets.
Determining what constitutes a "routine return" involves a formulaic approach with three steps.
• Aggregate certain routine deductions made by a company in computing its trading profits. "Routine deductions" include capital
allowances; cost of premises; personnel costs; plant and machinery costs; costs of professional advisers, such as lawyers, insurance advisers, valuers and actuaries; and utility costs, such as water, fuel and power, telecommunications, computing services, postal services, transport and waste disposal services. Deductions in respect of loan relationships, derivative contracts, and certain R&D expenses are specifically excluded from the scope of "routine deductions".
• Multiply the amount determined in the previous bullet point by 10%. In doing so, the patent box is effectively adopting (for simplicity) a "cost plus" model, with a 10% mark-up, as being a representative routine return for businesses.
• The percentage calculated at Step Two is then applied to the amount determined under the previous bullet point to give the "routine return". The routine return is then deducted from the amount determined at Step Three to give a company's qualifying residual profit (QRP).
Stage Three, Steps Five and Six - Remove Brand Value
The final stage of the calculation removes profits relating to marketing assets. The aim here is for the patent box
Companies will need to ensure that they can identify
and quantify their R&D expenditure for the four years
prior to the one in which the company opts into the
patent box regime. Companies will also need to adopt
a consistent basis of identifying and recording their
R&D expenditure for the first four years within the
regime.
EVERYTHING MATTERS | 05
regime to benefit patented inventions and exclude profits generated via established brands.
If a company opts for "small claims" treatment (Step Five), 25% of its QRP is deemed to be a marketing return, leaving the remaining 75% of qualifying residual profit within the patent box. This is subject to a cap of £1 million - applied across the company andits associated companies in the accounting period -of QRP remaining within the patent box.
Alternatively, an arm's length marketing assets return must be determined and then deducted from QRP to arrive at an amount that qualifies for the patent box (Step Six). The marketing assets return is a "notional" marketing royalty (NMR) less an "actual" marketing royalty (AMR) for the period in question - though the marketing assets return will instead be nil if AMR exceeds NMR or the difference between the two is less than 10% of the qualifying residual profit determined at Step Four.
To determine a notional marketing royalty (NMR), a company must first identify all of its "marketing assets" -ie UK and foreign trade marks, other signs or indications that may designate the geographical origin of goods or services and any information about customers or potential customers of the company or other members of its group which is intended to be used for marketing purposes. To the extent that the exploitation of such marketing assets gives rise to IP-related trading income of the company for an accounting period, they will be "relevant" marketing assets in computing NMR.
The NMR for a company's trade for an accounting period is the appropriate percentage of relevant IP income for that accounting period. The "appropriate percentage" is the proportion of any relevant IP income that the company would pay another person, dealing at arm's length, for the right to exploit relevant marketing assets in that accounting period (assuming the company were not otherwise able to exploit them). This percentage needs to be computed in accordance with OECD transfer pricing guidelines.
The actual marketing royalty (AMR) is a percentage of the sums actually paid by a company to a third party for the purpose of acquiring any relevant marketing assets
(or the right to exploit them), and which were deducted in computing the company's trading profits for an accounting period. The percentage that is applied is the same as that computed at Step Two.
The output at Step 6 is the profit of a company which qualifies for the patent box - referred
to in the legislation as a company's "relevant IP profits" (RIPP) - and hence qualifies for the 10% effective rate of tax.
Step Seven
Although the benefit of the patent box may only be enjoyed once a patent has been granted, the rules
recognise that a company may nevertheless derive relevant IP income in the period between patent application and formal grant. Accordingly, subject to a number of conditions - including a six year "look back" period -relief can be given in the period in which a patent is granted for
profits arising between such grant and application. The rules grant relief by adding such pre-grant profits to the figure determined after Step Five or Step Six (as appropriate) to give the final RIPP amount which qualifies for the effective 10% rate of tax.
H WHAT IS STREAMING?
The patent box rules recognise that in certain cases, the simple ratio of relevant IP income (RIPI) to total gross trading income (TI) will not give an acceptable measure of a company's profit from the exploitation of qualifying IP. This could occur where a company has significant non-IP income which generates little profit and less IP income that is far more profitable. This could also occur where, conversely, a company's IP income is less profitable than its non-IP income.
Companies will need to ensure that they identify all of
their relevant marketing assets. Thought will also need
to be given to what constitutes an "appropriate
percentage" of IP income that a company would need
to pay an independent third party to exploit those
marketing assets if the company didn't already have
the right to do so. A proper transfer pricing analysis is
likely to be required, with an appropriate level of
supporting evidence and analysis.
Groups may consider restructuring their qualifying IP
holdings so that all qualifying IP is held by a single
group company which then licences that IP to other
group companies, as appropriate. Provided that the IP
holding company meets the other patent box eligibility
criteria, its relevant IP income (RIPI) should not be
"diluted" by non-IP income.
06 | The UK Patent Box
Where the ratio of relevant IP income to total gross trading income does not give an acceptable measure of a company's IP profits, the company may elect to use a "streaming" method to determine its relevant IP profits (RIPP) in place of Steps One to Four described in section G above. Use of the streaming method is mandatory where any one of a number of specified conditions are met, including where a company receives a substantial amount of licensing income in respect of non-qualifying IP.
Where the streaming method applies, a just and reasonable apportionment of a company's expenses, rather than the simple pro rata approach based upon the ratio of RIPI to TI, is required. The method is otherwise similar to the "standard" RIPP calculation in that it seeks to exclude a routine return and brand value from the profits qualifying for the patent box.
I HOW CAN PATENT BOX LOSSES BE USED?
If the patent box calculation produces a loss, the rules limit the use of such loss in the current year to a set-off against the patent box profits from the company’s other trades and patent box profits of other group companies. Excess losses can be carried forward and set-off against future patent box profits of the company and other group companies.
J WHAT ABOUT COMPANIES THAT TRADE IN PARTNERSHIP AND COST SHARING ARRANGEMENTS?
Qualifying IP rights will not always be developed by companies or groups on a "stand alone" basis - they may sometimes be developed collaboratively through partnerships or cost sharing arrangements. The patent box permits companies which participate in partnership and cost sharing arrangements to qualify for the enhanced benefits afforded by the patent box.
In the case of a corporate partner, so long as the partnership meets both the "development" and "active ownership" conditions discussed in section D and section F above, that corporate partner can elect to be taxed as though the partnership had opted into the patent box regime. Additionally, the development condition can be satisfied by the partnership, or a corporate partner entitled to at least 40% of partnership profits or losses. The effect of an election by a corporate partner is that the profit allocated to such a corporate partner would be
reduced through the ordinary patent box calculation and benefit from an effective 10% rate of tax. The election is personal to each corporate partner in a partnership - so some partners may elect in and others may not.
Cost sharing arrangements that amount to simple contractual arrangements (rather than being structured via companies or partnerships, to which the rules described earlier would instead apply) are also subject to special rules. Where one of the parties to a cost-sharing arrangement holds a qualifying IP right, and each of the parties to the arrangement is required to contribute to the development of that right or any product incorporating it, then each of the parties to the arrangement is treated as though it held the qualifying IP right itself. This is subject to the proviso that each party to the cost sharing arrangement must be entitled to a proportionate share of income from exploiting the qualifying IP right. Each company participating in the cost sharing arrangement will then be eligible to claim the benefits of the patent box under the normal company rules described above.
K ARE THERE ANY ANTI-AVOIDANCE RULES?
We have already noted that the patent box includes a targeted anti-avoidance rule designed to prevent a qualifying IP licence from being treated as "exclusive" through the insertion of spurious or commercially irrelevant exclusivity terms.
The patent box includes two other targeted ant-avoidance rules. The first of these is designed to prevent income arising from the sale of an item being treated as relevant IP income (RIPI) simply by incorporating a patented invention into that product without any significant commercial rationale for doing so. HMRC's guidance
suggests that this rule is not intended to affect any "reasonable commercial choice".
The second of these two anti-avoidance rules (which is the main anti-avoidance rule) applies where there is a scheme, the main
purpose of which is to secure or enhance the tax benefits arising under the patent box. Once again, HMRC considers that this rule should not apply to "practical and commercially appropriate" transactions, even though they may have the (incidental) effect of creating or enhancing the benefits of the patent box. Clearly this is a rule to be considered on a "case by case" basis, though HMRC accepts that the following transactions should not be impugned:
If a company is likely to have patent box losses in the
early years after opting into the regime, it may be
preferable to delay opting in to a point where the
company is likely to have patent box profits, so as to
maximise the value of those losses.
EVERYTHING MATTERS | 07
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• opting into the patent box regime or delaying such an option until the point where a company makes relevant IP profits rather than losses;
• opting out of the patent box regime if a company starts making relevant IP losses rather than relevant IP profits (though it would then be impossible to opt back in for five years);
• creating IP holding companies to crystallise royalty income from qualifying IP;
• separating trades with profitable qualifying IP income streams and those with non-profitable income streams into different companies to allow decisions about whether to elect into the regime to be made more easily;
• bringing qualifying IP into the UK; and
• restructuring existing commercial arrangements to take advantage of the patent box, provided that similar commercial arrangements would have been put in place had they been set-up from scratch.
L TRANSFER PRICING
The patent box regime will provide an incentive for a group of companies to "shift" profits to a patent box company within the group which qualifies for the 10% rate of tax - eg by increasing royalties payable to the patent box company.
The UK's transfer pricing rules apply on both a cross-border and domestic basis. Groups interested in opting into the patent box may therefore have to revisit their transfer pricing policies to ensure that intra-group patent licensing arrangements (both domestic and cross-border) are on an arm's length basis and will withstand HMRC scrutiny.
M CONCLUDING REMARKS
The UK patent box could provide valuable tax benefits for many UK corporate taxpayers which hold patents and exclusive licences in respect of patents. Early preparation by companies to identify assets within the regime and the income arising from them should maximise the benefits flowing from the regime come April 2013 and beyond.
