The UK announced on Thursday (22nd October) its (rather long awaited) proposals to update the patent box to make it compliant with the OECD BEPS proposals on amendments to patent/knowledge boxes. The UK proposals set out a series of questions for consultation, with draft legislation to come in December.
tl;dr version: it’s more generous that it might have been on grandfathering, but companies had better get their accounting software ready to do some serious work in order to keep track once into the new regime. The added complexities that will be added may well put off companies from claiming.
There are no proposals to include software copyright as qualifying IP, although the BEPS project does permit this – and the Irish knowledge box draft rules, published on the same day, do include software (and the Irish knowledge box offers a 6.25% effective rate. Just in case you wondered).
The beginning of the consultation document indicates that take up is probably in line with government expectation, noting that claims so far have been made by 639 companies, between them claiming £335m of relief. The Budget 2012 impact note suggested relief claims of £350m in 2013–14, and the claims to date will almost all relate to that tax year, as the relief applies to profits earned from the beginning of the 2013–14 tax year.
Onto the consultation:
The BEPS proposals require that patent boxes be limited by the amount of economic substance/activity in the jurisdiction where the patent box is offered. As there are many ways that economic substance could be measured, the proposals opt for research and development activity as a proxy. Accordingly, patent boxes are required to limit the tax benefit in accordance with the proportion of r&d undertaken by the claimant in respect of the specific patent or product for which the patent box is claimed.
The UK will introduce the changes from 1 July 2016, but there are grandfathering provisions (see below) – the following will apply to IP that is not within the regime by 1 July 2016, and for other IP from 1 July 2021.
References to ‘patent’ below include other qualifying IP (plant variety rights etc) – the range of qualifying IP isn’t changing. It’s just quicker to type ‘patent’!
The UK follows the proposals exactly, setting out a ‘nexus fraction’ which must be applied to patent box profits to establish the deduction that will be available. This is set out as:
(D + S + U)
D + S + A + R
D = direct (in-house) r&d spend
S = r&d spend subcontracted to third parties
A = IP acquisition/licensing spend
R = r&d spend subcontracted to related parties
U = lesser of (A + R) or 30% of (D + S)
In summary: patent box claims will effectively be limited where the company outsources a substantial amount of r&d to related parties – even if those related parties are in the UK. Groups could well need to rethink their r&d arrangements accordingly. The limitation relating to acquired/licensed IP costs may, in practice, be less of an issue – if the company is spending that much, comparatively, on the relevant acquired/licensed IP, it may well not meet the development condition.
Expenditure on r&d co-development agreements is covered off, with funding costs being equated to acquisition costs or related party subcontracted r&d costs – it is only the co-developer that actually undertakes the r&d that will be able to classify costs as direct r&d spend.
For those familiar with the patent box, at first glance this doesn’t look too painful. It’s another calculation but not necessarily difficult … except that the patent calculation will no longer be on a trade by trade basis, but Will need to track and calculate patent box (nexus) on patent-by-patent basis, or product or product category basis – see below for more detail.
In effect, a UK company with one patent and one product, with no related party outsourced r&d or acquired IP won’t notice too much difference (but they will still notice some). Everyone else claiming it will notice.
What is r&d spend?
The definition of expenditure on r&d is aligned with the definition of qualifying expenditure for r&d purposes but is not limited to the expenditure actually claimed for r&d relief purposes on in-house r&d and outsourced r&d – principally because of the differences between the SME and large company relief.
At some point, some expenditure on r&d for a patent (product, etc) may no longer be reflected in the patent (product, etc) and the company will need to remove expenditure from nexus fraction when it no longer contributes to income. Thankfully, the proposal is that a simple rule be applied: expenditure is excluded from the nexus calculation 15 years after is first included. This is probably a sensible compromise, given the sheer difficulty that could arise in considering which expenditure still has influence.
The impact of this need to calculate on a patent/product/category basis is that streaming will be the only calculation option, and it will be necessary to do the streaming calculation per patent, per product, or per product category as appropriate. The current proportion of total profits (standard) calculation will not be available, even for small businesses – the reasoning being that, if they acquire IP or subcontract to related parties in future, their current r&d expenditure will need to have been tracked etc in order to calculate the patent box in future.
Which means: the company’s accounts will have to be able to allow expenses and income to be allocated to the relevant streams, which could mean some reporting changes needed in accounts. In particular, it will be necessary to track r&d expenditure on a patent, product, or category basis, and the methodology will need to be consistent year to year.
The default r&d based nexus calculation is rebuttable in exceptional circumstances where the company can show that it doesn’t reflect the real nature of the nexus of the company in the UK – it’s unlikely that many companies would be able to demonstrate such exceptional circumstances.
Level at which to track
A company cannot choose between patent, product and category tracking as such – it will be required to track nexus at the patent level unless that is unrealistic, requires arbitrary judgment or would track a category unrelated to innovation.
Where it can be shown to be unrealistic etc, the company will be required to track at the lowest realistic level of product or category.
When to start tracking
Where the company is doing r&d at 1st July 2016, but is not within the patent box (e.g.: has no qualifying IP yet) it must track r&d expenditure at the patent (product, etc) level from that date and, after three years data has been accumulated, calculate nexus on that basis. For the first three years, the company will be able to calculate nexus on the basis of total r&d spend, rather than patent/product/category r&d spend.
If the company does not do any r&d on/after 1st July 2016 but applies for a patent (or other qualifying IP) after that date and wants to use the patent box, it will be required to estimate nexus on the basis of its r&d expenditure before that date.
If a company has elected into the current patent box rules with effect before 1st July 2016, the current rules will continue to apply to IP that exists at that date until 20 June 2021 (the consultation asks whether this is too long a period; I assume HMRC isn’t realistically expecting many companies to say that it is). IP will exist at 1 July 2016 where (effectively) the date of application of patent is before 1st July 2016.
Note that the election just has to be effective before 1st July 2016 – the two years post-accounting period notice limit will still apply, so that a company will be able to elect into old rules within two years, even if the date of the election is after 1st July 2016.
Companies that have elected out of the patent box (already?! – unlikely to be many) will also be able to elect back in to the current regime, and the ‘no re-election within five years’ rule will be suspended for these companies to allow them to do so.
Post–1st July 2016 products which use pre–1st July 2016 IP and post–1st July 2016 IP will need to apportion profits and r&d between the two sets of rules if the company is tracking at the product level.
Some anti–avoidance (there will be more)
IP acquired from a related party on or after 1 January 2016 will be calculated on the basis of the new rules unless it is already within patent box.
It looks as if there will be rules similar to loss buying/streaming (or a main purpose) to deal with the situation where a group acquires a company with IP & r&d histories, to ensure that the nexus calculation is not ‘enhanced’.