BEPS and IP regimes - a new era in intellectual property

July 2016

The EU has set itself an objective to enhance investment in research and development (R&D) inside the EU. Europe 2020 - a ten-year strategy to advance the EU economy - outlined the importance of R&D in increasing innovation and the competitiveness of EU member states. Measures to enhance investment in R&D include favourable tax treatment of licence income in the form of 'patent box', 'licence box', or 'IP box'.

What is a patent box?

A patent box regime is simply one where a jurisdiction encourages businesses to invest in, and create, local jobs and activity associated with researching, developing, and creating patents. Preferential tax treatment allows a business to pay a lower rate of corporation tax on profits it can directly attribute to the patent box activities.

However, Action 5 - Countering Harmful Tax Practices More Effectively, contained in the OECD's report into base erosion and profit shifting (BEPS) suggests patent box regimes are preferential regimes that potentially give an unfair tax advantage over those jurisdictions that have no equivalent. BEPS is a tax avoidance strategy that artificially shifts profits from a high-tax jurisdiction to a low-tax jurisdiction.

The current conflict

Many EU member states have encouraged R&D activity with favourable tax rates between 0% and 15%. With normal rates of corporation tax as high as 45%, this offers an attractive opportunity to reduce group tax, especially given that patent box companies do not typically generate a high level of costs.

There is a downside: this system is open to abuse. Companies produce patents in a high-tax jurisdiction, creating tax-deductible expenses. They then shift the profits to a low-tax jurisdiction. This means the country that carries the expenses burden does not benefit from any tax revenue from the profits.

This conflict needs careful handling: how to root out harmful tax avoidance while continuing to encourage innovation. This is what BEPS Action 5 - Countering Harmful Tax Practices More Effectively aims to do.

Solving the conflict

In 2014 the UK and Germany developed the modified nexus approach. The OECD and the G20 countries endorsed this model as part of the BEPS regime.

The modified nexus approach insists that for a taxpayer to benefit from a patent regime in a given jurisdiction it must engage in a significant proportion of R&D activities, and incur actual expenditure, that contribute to profits in the same jurisdiction.

Where countries have implemented the modified nexus approach the emphasis has shifted from one of just favourable tax rates to one of favourable tax rates and qualified employees and positive infrastructure.

OECD countries now must implement this model for their own patent box regimes. Since 1 July 2016 any patent box regime that does not comply is no longer accessible, although businesses that currently benefit from existing concessions can continue to do so until 30 June 2021.

Assessing the impact

So will the modified nexus approach lead to a race to create new and adapted patent box regimes?

The UK moves quickly

The UK has been quick to implement the changes. Previously there was no development condition to be met, but since 1 July 2016 any tax benefit will be directly proportional to the R&D spend. Further, only patents and similar assets will qualify; trademarks are no longer eligible.

Will the US recognise the potential?

While patent box regimes have been common in Europe, the US has so far ignored them. Although the US Congress proposed what it termed an innovation box, with a 10% tax rate on income from intellectual property (IP), it is unlikely to see the light of day.

What about Germany?

Patent box regimes and other incentives to enhance R&D activity have been talked about in Germany but without any definitive outcome. There appears to be more of an appetite among business leaders to incentivise the activity itself rather than the profit generation.

Historically, Germany has rather frowned upon foreign patent box regimes and has employed an increasing number of anti-avoidance measures to deal with creative tax planning models. For example, a business can only move intellectual property from a German parent to a foreign group company at fair market value. This triggers tax in Germany. But that's not the end: controlled foreign corporation (CFC) rules stipulate that any profit the foreign entity earns from licence income may also generate tax at the German parent's level unless sufficient substance abroad is documented. Further, shifting functions abroad from Germany can lead to tax on expected profits, risking double taxation.

The modified nexus approach in some countries, combined with the safeguards in place in Germany, should ensure a thorough approach from both sides to pre-empt tax-avoiding IP tax planning.

A brave new world in intellectual property taxation?

The acceptance and endorsement of the modified nexus model may encourage wider adoption of patent box regimes. However, the decision making process now needs to consider not just the tax-rate in a location but also availability of the right people and infrastructure.

But it also raises another question: do the patent box regimes in EU member states run contrary to EU rules designed to prevent state subsidies? We wonder if there will be a future scenario where patent box companies have to repay tax benefits.