Patent Box regimes: why directors need to focus on IP

Written on 3 Feb 2016

From July 2016, the UK’s new Patent Box regime will apply. This new regime, along with other similar regimes in other EU Member States such as Italy, will require a greater focus on the value attributable to a company’s IP.

As a result, directors need to ensure that they have a proper appreciation of the IP that their company holds and benefits from.

The UK Patent Box

In 2013, the UK introduced a “Patent Box”, reducing UK corporation tax payable on profits attributable to patents to 10%. The aim was to attract investment to the UK for innovation, following the success of similar measures introduced in Ireland and France. Broadly speaking, the UK regime enables companies owning or exclusively licensing patents to claim the preferential tax rate on a proportion of profits arising from:

  • licensing or selling patent rights;
  • selling products incorporating the patented invention;
  • using the invention; or
  • damages awarded in relation to patent infringements.

To qualify, the company needs to have contributed significantly to the creation of the invention, or performed a significant amount of development work on it, or any product or process incorporating it. There is, however, no requirement that this research or development work must have taken place within the UK, or that the company concerned is a UK company.

Where the research or development was carried out by another group, company tax relief could still be available if the patent-owning company actively managed the IP: that is, was more than a passive asset-holding vehicle.  

The tax relief is available on patents granted in Europe or the US. The relief was set to be introduced progressively over the first four years of the regime, reaching full effect in 2017.

EU and OECD objections 

Before that introductory phase has expired, however, the European Commission objected that the Patent Box amounted to harmful tax competition. At around the same time, the Organisation for Economic Cooperation and development (OECD) published an Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan). This addressed practices in the UK and other countries similarly looking to use their tax systems to attract investment. It identified the UK Patent Box as a harmful mechanism giving the UK an unfair competitive advantage.

Specifically, Action Point 5 of the BEPS Action Plan focused on a requirement for “substantial activity” that must occur in a jurisdiction for a company to benefit from a preferential tax regime, which the UK’s approach arguably did not comply with.

The UK therefore agreed in November 2014 to close its existing Patent Box to new entrants by 1 July 2016 and terminate it altogether by 30 June 2021.

A new UK Patent Box from July 2016

In place of the existing Patent Box, the UK will implement a new regime, based on what is known as the “modified nexus approach”. Under this approach, tax benefits will only be available where substantial research and development is undertaken in the UK, which clearly links to the patent and product or process from which the profits to be taxed arise.

Computationally, this approach will require companies to “stream” their profits to show which are attributable to a particular patent (or, if multiple patents are implemented in a single product or product range, to show which profits are attributable to that product or range).  

The tax relief will be available on that fraction of the profits which corresponds to the proportion of research and development the company undertook (or outsourced) compared to research and development carried on by connected parties elsewhere.

Patent boxes proliferate: the Italian perspective

Alongside the UK, several other EU Member States have implemented their own tax practices to encourage investment. Italy, for example, has recently enacted its own Patent Box Decree. While respecting the OECD’s recommendations, this introduces tax breaks for the revenues obtained by developing and using a broad class of IP assets (not just patents).

The Patent Box Decree allows taxpayers to partially exempt income derived from qualifying intangible assets from corporate income tax (IRES), generally levied at 27.5%, and local tax (IRAP), generally levied at 3.9%. 

The general exemption will rise from 30% in 2015 to 40% in 2016 and 50% from 2017.

Qualifying intangible assets include: software protected by copyright, know-how such as processes, formulas, industrial, commercial, or scientific information, trademarks, designs, and models that are potentially capable of legal protection, as well as patents.

Tax incentives driving greater engagement by the Board

A side-effect of the various tax incentives applicable to IP is that they shine a light at board level on the value of the IP that their companies hold. For example,

  • The UK’s more detailed approach to the Patent Box will focus attention on the value of IP underpinning products by relating it to specific sales or activities.
  • The Italian Patent Box Decree will require senior management to be more aware of the broad IP portfolio on which they are seeking relief. 

An increased awareness of IP at board level can only be a good thing. Despite the increasing importance of technology as a driver of business success over the last decade, it is still relatively rare for board members to have an entirely clear understanding of what IP their company owns, and what that IP contributes to the business. But with shareholder returns tied more and more closely to the management and exploitation of IP rights, directors should be taking a more informed perspective.

Certainly an historic tendency not to identify and put a value on IP rights on the company’s balance sheet looks increasingly difficult to justify. Objecting that IP valuation is difficult to do, with no single approved methodology a Board can sign up to, does not adequately address the point. The answer is certainly not going to be zero; and even if it were true in one year, it is going to change over time.

Adopting a sound methodology and applying it consistently will give the Board the ability to track trends year-on-year, and assess meaningfully how the IP is (or is not) contributing to the company’s success. Even in the short term, once a value has been ascribed, then it is possible to measure the impact of business decisions, such as deciding to license the IP out exclusively or otherwise, or to move the IP into a holding company. Such a move may affect tax liabilities, and will certainly affect the balance sheet of the denuded company. If the assets in question were buildings or shares in another entity, any Board would have them clearly in mind despite the possible fluctuations in value. IP should not be treated differently.

What are a director’s duties when it comes to IP?

Particularly given the potential to benefit from IP-related tax relief, directors should consider carefully the extent to which an understanding of that IP falls within their statutory duties.

In the UK, for example, directors have a statutory duty to promote the success of the company for the benefit of its members as a whole. Some understanding of the IP that the company holds, and how best to exploit that IP (including by way of tax relief), will for many be important in order to promote the success of the company.

The precise ambit of the director’s duties will depend on the nature of the company’s business and industry, as well as the applicable national laws. Thus, for instance, the IP diligence and competence expected from the director of a biotech company will be higher than the one expected from the director of a more low-tech, traditional manufacturing business.

Directors who are intrinsically involved in the development of IP, such as founders of tech start-ups or research spin-outs, may also have different considerations. Directors in the UK, for example, have a statutory duty to avoid conflicts of interest. Where a director, who may be involved in more than one company, has been involved in developing IP, this can raise issues not only as to the legal and beneficial ownership of that IP but also the terms of any transfer or licensing of rights in the IP. Other directors may be called on to ratify any such actions, in which case they will have to pay regard to their own duties towards the company.

A joined-up approach

Businesses involved in research and development or other IP-heavy industries will need to consider the various tax and other incentives on offer in different EU Member States. As the UK Patent Box and the Italian Patent Box Decree illustrate, this focus on the value and treatment of IP should ensure that IP is firmly on the board’s agenda.