Policy paper

Corporation Tax: Patent Box - compliance with new international rules

Published 9 December 2015

Who is likely to be affected

UK companies which hold and exploit patents, or patent like rights, and which claim relief under the Patent Box.

General description of the measure

The government is proposing changes to the design of the UK Patent Box to comply with a new international framework for preferential tax regimes for intellectual property (IP) set out by the Organisation for Economic Co-operation and Development (OECD).

This will mean that the amount of profit from an IP asset which can qualify for the reduced 10% rate of Corporation Tax (CT) available through the UK Patent Box will depend on the proportion of the asset’s development expenditure incurred by the company.

Policy objective

The government is committed to the G20-OECD Base Erosion and Profit Shifting (BEPS) project, which aims to modernise international tax rules to align taxing rights over profits with the economic activities that generate these, ensuring that multinational enterprises pay their fair share of tax, and cannot artificially avoid their tax obligations. Part of this work is to ensure that preferential tax regimes, such as Patent Boxes, require sufficient economic substance that they cannot be used for profit shifting. The UK has been a driving force in creating a new international framework to ensure that substantive economic activity is required as a pre-requisite for access to all preferential IP regimes. This is done by linking benefits afforded to income generated by IP under such regimes to the level of research and development (R&D) expenditure incurred to develop that IP.

This helps to level the playing field for tax internationally, prevent unfair tax competition while retaining the ability for countries to attract genuine activity that contributes to growth and prosperity.

Background to the measure

The UK Patent Box was introduced in the Finance Act 2012, effective from 1 April 2013, having been announced in the 2010 Corporate Tax Roadmap. Legislation is in Part 8A of Corporation Tax Act (CTA) 2010, sections 357A - 357GE.

With the UK playing a leading role, the G20 and the OECD began a coordinated multinational effort in 2013 to address base erosion and profit-shifting. This is the G20 OECD BEPS project.

The results of the project were announced in October 2015.

The UK government sought views on its preferred approach within the new international framework, and how this would affect companies in a consultation document, Patent Box: substantial activities, published on 22 October 2015.

Detailed proposal

Operative date

The measure will have effect for new entrants to the Patent Box on or after 1 July 2016, and also for some IP assets (e.g. patents) acquired on or after 2 January 2016.

A new entrant is either an IP asset created on or after 1 July 2016, or a company making an election into the Patent Box that relates to that, or a later, date.

For this purpose, an IP asset will be deemed to come into existence when the relevant application (such as for a patent) is made. So if a patent application has already been lodged at 1 July 2016 but not yet granted, this will not constitute ‘new’ IP.

IP not covered by the new Patent Box rules will continue to receive the benefit of the existing Patent Box for a period of 5 years, which is until 30 June 2021, except that some IP acquired on or after 2 January 2016 may only receive the benefit of the existing Patent Box until 31 December 2016.

Current law

The Patent Box legislation is in CTA 2010, Part 8A, Chapters 1-7, sections 357A to 357GE. It applies a lower (10%) rate of corporation tax to profits attributable to patents and equivalent forms of IP.

This is delivered by an additional deduction, based on the level of IP profits so that the benefit to the company is equivalent to that of a lower rate. The benefit is being phased in and companies will fully benefit from the 10% rate from 2017 to 2018.

The essence of the design is identifying the IP profits to which the lower rate is applied. The current legislation allows the IP profits to be identified in one of two ways. These are the ‘proportional profit split’ and the ‘streaming’ methods.

Under ‘proportional profit split’ the company’s taxable trading profits are split into IP and non IP parts based on the ratio of qualifying income (‘QI’) to total income (‘TI’) (QI/TI x Trading Profit). Qualifying income is income from IP.

Under ‘streaming’ the company identifies qualifying and non-qualifying streams of income and then splits its allowable deductions between those income streams on a just and reasonable basis. IP profit is then the income attributed to the qualifying stream less deductions attributable to this stream.

Proposed revisions

Legislation will be introduced in Finance Bill 2016 to modify the Patent Box computation rules so that they comply with the new international framework. In particular it will remove the ‘proportional profit split’ option so that ‘streaming’ applies in all cases at the level of an IP asset, a product or a product family.

The legislation will provide that, after separating out qualifying income and the corresponding deductions, companies must allocate these to ‘sub-streams’ corresponding to the different IP assets (or products, or product families) and calculate a profit for each sub-stream. The profit figures will be calculated in a similar way as it currently is under the streaming option.

As an additional step in the calculation, this figure will then be modified to reflect the proportion of the development activity on the asset (or product, or product category) undertaken by the company itself. This will be done by applying a fraction N to the profit figures, defined as the lesser of 1 and

N = (D+S) * 1.3 / (D+S+A+ R)

Where
D = In-house direct expenditure on R&D
S = Expenditure on R&D subcontracted to third parties
A = Expenditure on acquisition of IP
R = Expenditure on R&D subcontracted to related parties

D, S and R will be defined using the same definitions as for the categories of expenditure in the UK R&D tax reliefs.

The final result will be the profit from the asset (or product, or product category) eligible for the reduced rate of 10% CT.

Summary of impacts

Exchequer impact (£m)

2015 to 2016	2016 to 2017	2017 to 2018	2018 to 2019	2019 to 2020	2020 to 2021

The Exchequer impact will depend on the final policy design and any behavioural responses by affected companies.

The overall impact is expected to be relatively small particularly in the early years as a result of the proposed transitional arrangements. The changes to the substantial activity requirement may result in less tax benefit in cases where a company’s nexus fraction is less than 1 and it does not make changes to undertake more R&D in house.

The final costing will be subject to scrutiny by the Office for Budget Responsibility, and will be set out at a future fiscal event.

Economic impact

The Patent Box is likely to encourage investment and economic growth as well as prevent the movement of intellectual property offshore by innovative companies who otherwise might invest elsewhere.

Impact on individuals, households and families

The measure is not expected to impact individuals, households or to affect family formation, stability or breakdown.

Equalities impacts

Patent Box is a corporate tax relief claimed by companies holding and exploiting intellectual property. As such, the government does not expect that the changes proposed will have any equalities impacts.

Impact on business including civil society organisations

This measure is expected to affect up to 2,300 patent holding companies which would be eligible for the modified Patent Box. Some companies may decide to restructure in order to maximise the benefits of the modified Patent Box. The compliance costs associated with these optional behavioural changes, which could be significant for individual companies, have not been included in the cost estimates below. Wider tax planning costs are also not included.

One-Off Costs

All patent holding companies are expected to incur a negligible (less than £3 million in total) one-off cost to familiarise themselves with guidance, make IT system changes and train staff on the new Patent Box rules. In addition (and as a one-off exercise) businesses would need to go through and stream their old patent accounts data before making the first nexus based Patent Box claim.

Ongoing Costs for all Companies

Patent holding businesses which claim the relief will incur additional ongoing administrative burdens. It is estimated that approximately 650 companies claim the relief annually and will have to comply with additional income and expenditure tracking rules and would face additional record keeping requirements annually. These tasks will include considering what R&D costs need to be included for streaming/nexus going forward, and computing the amount of company profit which can form ‘box profits’. Companies with grandfathered and ‘new’ intellectual property would need to operate both sets of rules at the same time.

The additional annual administrative burden costs from the changes are estimated to total £0.3 million (rounded to the nearest £100,000).

The tables below summarise the estimated costs.

Estimated one-off impact on administrative burden (£ million)

One-off impact	(£ million)
Costs	negligible
Savings	-

Estimated ongoing impact on administrative burden (£ million)

Ongoing average annual impact	(£ million)
Costs	0.3
Savings	-
Net impact on annual administrative burden	+0.3

Operational impact (HMRC or other)

It is likely that this measure will generate further enquiries to HM Revenue and Customs (HMRC) from customers and their agents given the new calculation required and potentially in respect of other elements such as the interaction with existing claims (grandfathering) or eligibility more generally. Work is ongoing to quantify these potential costs.

Other impacts

Other impacts have been considered and none have been identified.

Monitoring and evaluation

This measure will be monitored through information collected in CT returns, and through communication with eligible companies. HMRC will continue to engage with the OECD to ensure the legislation is operating as intended.

Further advice

If you have any questions about this change, please contact David Harris on Telephone: 03000 586834 or email: david.harris@hmrc.gsi.gov.uk.