The Patent Box - What it Means and How it Works
The Patent Box is an opt-in scheme for obtaining a reduced rate of corporation tax on certain IP-derived profits in the UK. The scheme is scheduled to start in April 2013 and is an area of tax law that any IP-active company will want to watch.
The reduced rate of 10% applies to a proportion of profits obtained from using patent rights, or from the sale of products incorporating a patented invention or made by a patented process. The UK Government’s aim is to ‘create a competitive tax environment for companies to develop and exploit patents in the UK and maintain the UK’s position as a world leader in patented technologies’.
On 6 December 2011, it released draft legislation refining its original proposals to include some beneficial updates discussed below, as we review how the Patent Box system works.
Who can benefit?
In line with the aim of stimulating UK investment in innovation, a company can qualify for the Patent Box if it owns or takes a licence for a UK or EP patent, providing:The company made a significant contribution to the creation or development of a product covered by the patent; or
- Updated – Subject to a group agreement, if a first group company undertook the qualifying development, then a second group company can qualify if it actively owns and manages the IP rights and receives their economic benefits; or
- If the company licences-in the rights, that the licence is exclusive.
Some other IP rights also qualify, including plant variety and data exclusivity rights. In the legislation these are treated like the patent rights for the purposes of calculating the tax reduction.
- Updated – The Government reports that it may now extend this provision to patents issued by other EU member states with comparable patentability criteria. This is excellent news as it will broaden the eligible patent portfolio. We await the Government’s list of states with interest.
- Updated – The development criterion in option 1 above has been made easier for those acquiring existing patents, by including a roll-over of development activity from the previous owner for the past twelve months.
- Updated – The active management of rights is now applied at a company level rather than a per-patent level, requiring a ‘significant amount’ of management activity across a portfolio.
What profits are eligible?
There are five types of qualifying IP income from which profits are eligible:
- Income from the sale anywhere of a patented item (or items from patented processes) or an product incorporating such an item;
- Fees and royalties from UK or EP granted rights over the patented item that are licenced to others (including the use of a patented process);
- Income from sale or other disposal of the UK or EP patent;
- Damages awarded for infringement of UK or EP granted rights; and
- A notional arms-length royalty for use of the patent to generate otherwise non-qualifying parts of the company’s total gross income where this is derived from exploiting the patented item.
The corollary is that some common income streams are ineligible and remain taxed at the standard corporation rate, including:
- Income from financial arrangements, such as financial return components of leases for patented products;
- Income from services sold with a patented product;
- Income from bundled parts or peripheral products sold with the patented product but which do not form a single patented product; and
- Income prior to the patent application or after expiry of the patent (though revocation does not result in the need to repay tax).
In addition to the above, many hoped that the Government would make income from design rights and (perhaps less practically) trade secrets eligible; however this has not happened.
These exclusions mean that for commonly bundled products, a dependent system claim to combine these with the main patented item may be useful in extending the eligible profits.
Similarly, end user licence agreements (EULA) may now critically determine whether or not a company’s activities qualify for the Patent Box benefits. For example, if a company with a patented cloud computing platform has an EULA stating only that they provide a service, they may be excluded from the scheme. By contrast, a corresponding EULA stating that the end user is licenced to access the platform may make their company’s profits eligible for the reduced tax rate. Similar considerations can be foreseen for telecoms, e-payment services and the like.
Clearly it is also important to manage your patent portfolio in order to maintain eligibility, and to factor the benefit of the Patent Box in to any annuity review process.
Consequently, if you wish to review the scope of a portfolio with regards to what eligible income streams it might cover, or wish to review service agreements with a view to compliance with Patent Box eligibility, please contact your normal D Young & Co attorney.
How are the qualifying profits calculated?
The government propose a three-step process that reduces IP-based profit down to a proportion of specifically patent-based profit as follows.
Step 1 – Pro-rata profit
Updated – A company can either apportion total profits according to a ratio of relevant IP income (RIPI) to total gross income; or it can allocate its expenses on a just and reasonable basis to two streams of income (RIPI and non-qualifying income) to arrive at a profit from the RIPI stream.
Hence pro-rata profit equals qualifying income minus qualifying expenditure (company expenditure for tax purposes), either for total income or divided per stream.
Step 2 – Residual profit
The residual profit is the pro-rata profit minus a ‘routine profit’ assumed to arise from owning IP and is calculated as a routine return based on certain qualifying expenditures, multiplied by a mark-up. Updated –The original mark-up was 15%, but the Government has now reduced it to 10% after agreeing it was too high.
Step 3 – Residual patent profit (RIPP)
The final profit is based upon a ratio of costs split between patents and other IP in the RIPI. Updated – For companies where marketing intangibles (i.e, branding etc.) contribute to 10% or more of residual profit, this is removed by deducting a notional marketing royalty.
Meanwhile for SMEs, an optional ‘small claims’ process on profits up to £1m assumes a 75/25 split in favour of patents. Whilst simpler to administer, this assumes a very high proportion of profit from non-patent IP.
According to the Government, many companies will not need this third step as they have no commercial brand, or they licence the IP to third parties without rights to such marketing intangibles. However, this may be wishful thinking on the part of the Treasury, and RIPP might constitute a significant reduction in eligible profits for many firms.
Phase-in and transitional features
The Patent Box relief is to be phased in over a five-year period, with the proportion of the full benefit incrementing in 10% steps from 60% on profits in 2013/14 to 100% in 2017/18. This avoids the alternative of setting a start date for eligibility, with the associated complex determinations of initial product commercialisation and/or patent subject-matter priority dates. The Government also recognises the frequent lag between cost and profit from R&D, and has attempted to reduce the disparities this may cause upon joining the Patent Box Scheme.
Firstly, in the first four years of a company using the Patent Box, their current R&D expenses will be compared to their average R&D expenses in the four years prior to opting into the Patent Box. If their actual expenditure drops below 75% of the pre-Patent Box level, then this threshold will be substituted for the actual R&D expenditure in the Patent Box calculations. This allows any higher costs incurred early product development to be used to artificially reduce the taxable profit in subsequent years. This is good news, particularly for start-ups.
Secondly, the Government recognises that products are commercialised while their patent applications are still pending. Consequently the Patent Box provides that for each tax year, a company can calculate what the RIPP would have been if the patent had granted that year, and then the aggregate RIPP for up to six previous years can be added to the RIPP in the actual year of grant. This provision is of course also good news as it allows pre-grant profits to be reappraised at the lower tax rate.
Will the Patent Box achieve its goals?
The Patent Box appears to combine some good tax incentives with provisions to avoid abuse by passive holding companies, and hence it appears well placed to encourage take-up by genuinely innovative firms in the UK who will benefit from increased net profits.
Increased profitability from the exploitation of R&D can only be a good thing for promoting the development of innovation in the UK, and we expect many UK businesses will exploit the new Patent Box scheme.