This guide provides an outline of the UK's patent box regime for the taxation of intellectual property (IP) which came into force on 1 April 2013.
Companies liable to UK tax can elect for their profits earned after 1 April 2013 from their patented inventions (and certain other innovations) to be taxed at a lower level of corporation tax. The relief is being phased in over four years leading to a tax rate of 10% by 1 April 2017.
However, as mentioned below, the regime will be changed for patents which come within the regime after 30 June 2016. There will be transitional rules allowing patents which fall within the current regime before 30 June 2016 to continue to benefit from the existing regime until 2021.
The Organisation for Economic Co-operation and Development (OECD) has been looking at favourable intellectual property (IP) regimes and whether they constitute harmful tax practices as part of its base erosion and profit shifting (BEPS) project. In October 2015 it published its final recommendations on harmful tax practices, recommending that favourable IP regimes, including the UK's patent box be closed to new products and patents by 30 June 2016 and that the existing regimes be abolished by 30 June 2021.
It recommended the 'nexus approach' as a way to ensure that businesses can only obtain the tax breaks associated with a favourable IP regime if they have conducted the 'substantial activities' which generated the income benefiting from that regime. R&D expenditure is used as the measure of substantial activity so that the benefits of an IP regime will only be available to the extent that the company has incurred the research and development (R&D) expenditure to develop the IP. This will mean that the new UK regime cannot be available to UK companies which manage IP developed by others.
The UK government intends to modify the patent box so that it will satisfy the OECD recommendations. It launched a consultation on the new rules in October 2015. The remainder of this guide considers the current patent box rules and not the new proposals.
Who qualifies under the current rules?
A company which owns 'qualifying IP rights' or has exclusively licensed in such rights, can potentially benefit from the regime.
However, where a company is a member of a group it will need to have either developed the IP rights itself or be actively managing them. This 'active ownership' condition is designed to ensure that passive IP holding companies cannot qualify for the regime. The active ownership condition will not be available under the proposed new regime.
A company will be treated as actively managing its IP rights if it performs a "significant amount of management activity" in relation to all, or almost all, of the qualifying IP rights that the company holds (including any exclusive licences).
This is an ongoing test and it is expected that in practice management activity will involve formulating plans and making decisions in relation to the development or exploitation of IP rights. Some examples of suitable activity will include decisions on whether to maintain protection in particular jurisdictions, grant licences, research alternative applications for the innovation or licensing others to do so.
Whether activity is considered "significant" will be determined in the light of all the relevant circumstances. However, it is clear that the company will not necessarily have to take all the decisions in relation to IP management in order to qualify.
Consequently, where a company has not carried on the development activity itself, it must play an active role in managing the IP rights that it holds. In the event that it is required to demonstrate it has carried out this activity, it should document both the plans and the decision-making process taken by it.
Which IP rights are covered under the current rules?
In addition to patents granted by the UK Intellectual Patent Office and the European Patent Office, the regime includes patents from certain EEA states including; Austria, Bulgaria, Czech Republic, Denmark, Estonia, Finland, Germany, Hungary, Poland, Romania, Slovakia and Sweden.
Certain supplementary protection certification, certain EU plant breeders or plant variety rights and certain EU marketing authorisation rights of medicinal or plant protection products will also be within the regime. For more details see HMRC's guidance.
Only companies and groups which have been properly involved in the innovation leading to the patent or the application of the patented invention can benefit from the regime.
This "development condition" can only be satisfied if the company intending to benefit from the regime (or in certain circumstances a fellow group company) has created, or significantly contributed to the creation of the patented invention or has performed a significant amount of activity to develop the patented invention or any product or process incorporating the patented invention.
It does not matter whether the development activity was carried out before or after the company (or another member of the group) became the holder of the IP right or the exclusive licence for the IP right.
Where the company holding the IP right has carried out the development activity, it must not have become or ceased to be a group member since this time. If the company has become or ceased to be a group member it must have continued with development activity of the same description (although not necessarily on the same invention) for at least 12 months after the change.
Where the company holding the IP right has not itself satisfied the development condition, the right will still be a qualifying IP right provided the company which carried out the development activity was a member, at the time of the development activity, of the same group of companies.
Which profits qualify under the current rules?
The lower rate of corporation tax will apply to the relevant IP profits ('RIPP') of the company. There are two possible methods for calculating RIPP.
The "standard" method involves the company working out the proportion the relevant IP income derived from its trade bears to its total income. The regime provides for a wide range of income to be IP income and includes income from the sale of items incorporating a patented invention, income from the sale of spare parts for such items, receipt of licence fees or royalties; sale of the IP rights themselves; or compensation received for infringement of IP rights. Where a company uses its patented invention in a way that does not generate income falling within the above categories, it may still have IP income under the notional royalties provisions.
RIPP is adjusted so that it does not include profits the company would have made if it did not have access to unique IP and profits generated from established brands. This is likely to lead to detailed calculations and discussions with HMRC to agree the relevant profit attributable to the IP.
IP profits arising for the period during which a patent is pending can in certain circumstances benefit from the regime.
The alternative method for calculation of RIPP involves "streaming" expenses to relevant IP income on a just and reasonable basis. It is mandatory in some circumstances, but optional to all regime users. Furthermore, in some circumstances it may produce a more beneficial RIPP, especially where relevant IP income produces proportionately more profit than non-IP income streams.