How should companies react to the new 10 per cent. tax rate on patent profits?

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1 slaughter and may How should companies react to the new 10 per cent. tax rate on patent profits? BRIEFING MAY 2012 The UK Government has recently confirmed that it will introduce a patent box, which will allow UK companies to apply a reduced tax rate to income from certain patents. When the patent box is introduced, in April 2013, the effective tax rate for qualifying income will fall from 23 per cent. to 15.2 per cent. It will then continue to fall over time, until it reaches 10 per cent. in April Although this new regime is routinely referred to as a patent box, it will in fact apply to a wider range of IP rights which, like patents, are normally associated with R&D activities. For example, companies holding supplementary protection certificates or certain marketing authorisations may also be able to benefit from the reduced tax rate. Companies holding UK patents, or other classes of qualifying IP, may wish to consider whether: they will benefit from electing into the patent box; and they should implement any restructuring to maximise their benefits from the patent box. Background The patent box forms part of a wider drive by the UK Government to develop the most competitive corporate tax regime in the G20. This project includes a steady reduction in the main rate of corporation tax, from 30 per cent. in 2007 to 22 per cent. by 2014, along with a number of targeted reforms intended to make the UK tax regime more attractive to multinational businesses. As shown in the chart below, there has been a particular focus on reducing the tax burden on mobile income, such as finance and IP profits, with the aim of attracting mobile activity to the UK (or, at least, encouraging business not to move mobile activity out of the UK). 35 UK corporate tax rates Tax rate (%) Headline rate Offshore finance income Patent income

2 Unlike similar IP box regimes introduced elsewhere, the proposed UK regime is limited to patents and a fairly narrow range of other IP (see What IP rights fall within the patent box? below). The Dutch innovation box, in contrast, can apply to a wider range of IP, subject to meeting conditions requiring R&D to occur in the Netherlands. The benefits of the UK patent box will, therefore, flow largely to patent-heavy industries, such as the pharmaceuticals and biotech sectors. However, as the UK patent box picks up a wide range of income associated with qualifying IP, other businesses which have developed patents or other qualifying IP may also obtain significant value from opting into the patent box regime. Who can opt into the patent box? A company should be entitled to elect into the patent box if it meets each of three conditions: an ownership condition, which is satisfied if the company: holds qualifying IP rights itself (see below for details of which IP rights qualify); holds an exclusive licence over qualifying IP rights in at least one territory, which need not include the UK (although, where this condition applies, the patent box tax rate is limited to income derived in the territories where the company has an exclusive licence); is a partner in a partnership which holds, or has an exclusive licence over, qualifying IP rights; or is party to certain cost-sharing arrangements where one of the parties holds, or has an exclusive licence over, qualifying IP rights; a development condition, under which the company, or another group member, must either (i) significantly contribute to the creation of the patented invention, or (ii) where a patent has been bought into the group, perform a significant amount of development on the patented invention, or any product or process incorporating it. Notably, this condition does not require the development to take place in the UK; and an active ownership condition, under which the company must either satisfy the development condition itself, or carry out a significant amount of management activity in relation to the IP. Groups may need to carry out some restructuring in order to fall within the patent box. For example, if patents are currently held in a passive IP-holding company, then that company would need to assume significant management responsibilities in relation to the IP in order to benefit from the reduced tax rate. Similarly, a group which licenses qualifying IP into the UK on an informal basis may need to formalise the licence terms, so that it demonstrably qualifies as an exclusive licence for these purposes. The patent box rules include anti-avoidance provisions, which are intended to prevent companies from artificially shifting profits into the patent box. HM Revenue & Customs have confirmed that these anti-avoidance rules should not generally apply where companies take reasonable and commercially appropriate steps to restructure in order to benefit from the patent box regime. We expect that companies implementing any pre-patent box restructuring will generally seek advance clearance that the anti-avoidance rules do not apply. 02

3 What IP rights fall within the patent box? The patent box will apply to: patents granted by the UK Intellectual Property Office or the European Patent Office (in each case, covering new patents and patents which already exist in April 2013); and a number of specific IP rights relating to medicinal, veterinary and plant protection products, including SPCs and certain EU marketing authorisations, such as those which benefit from data exclusivity. The UK Treasury is also able to apply the patent box to patents granted in other EEA member states. It is slightly surprising that this power is limited to the EEA, so that an extension to cover US or Japanese patents, for example, would require primary legislation. Fortunately, the wide definition of relevant IP income falling within the patent box (discussed below) should ensure that this has little practical impact: where a product incorporates items protected by a qualifying patent, sales of that product anywhere should fall within the patent box. Additionally, if a company generates income from a patentable invention while a patent application is pending, it can bring up to six years pre-patent income into the patent box. Unsurprisingly, this right cannot be used to reduce the tax on pre-april 2013 profits. Which profits will benefit from the reduced tax rate for patent box profits? The starting point in determining patent box profits is to identify the company s relevant IP income, which comprises: Worldwide sale proceeds of the patented item. This includes sales of any products incorporating the patented item, or which are designed to be incorporated into any such products. (For example, if a company sells a printer which includes a patented invention, then sales of printer cartridges by that company should also qualify for the patent box.) This head extends to sales in territories where the item is protected by a nonqualifying patent (such as US sales under a US patent) and in territories where the item is not protected by a patent at all. It does not, however, apply to products generated by a patented process, unless the product is itself protected by the process patent. Licence fees and royalties. Unlike the sale proceeds category, this includes income generated from process patents. It also picks up worldwide licence fees/royalties in relation to products/processes which incorporate qualifying patents. Notably, where a licence also covers non-patented items which are licensed for the same overarching purpose (e.g., a patent licence which also includes a licence of related know-how), then the full royalty should qualify as relevant IP income, so long as the patent is unexpired. In other words, there is generally no need to apportion royalties between qualifying and non-qualifying IP. Proceeds from selling qualifying IP. In contrast to the two categories above, this is limited to the qualifying IP itself: if, for example, a company sold its worldwide patent rights, the proceeds from selling the Japanese patents would not qualify as relevant IP income. Infringement income. This potentially covers a broad range of compensation payments, such as damages or licence fees received in relation to allegations of infringement (including settlements and cross-licensing arrangements), and insurance proceeds. 03

4 Notional royalties for process patents. If a company uses a process patent to provide services, or to produce goods which do not include any patented items, then the company s profits would not fall into any of the classes of relevant IP income above. This could force the group to restructure so that the process patent is actually licensed by one UK company, in return for a royalty, to another company which then uses it to provide services or non-patented goods. To avoid the need for this sort of restructuring, a company using process patents can calculate a notional royalty for the process patent, which will be treated as relevant IP income. This will be equal to the royalty which the company would have paid a third party, at arm s length, for use of the patent. Calculation of patent box profits The conversion of relevant IP income into a profits figure which is subject to the patent box tax rate is, inevitably, the most complex part of the new regime. The standard approach, which is summarised in the diagram below, involves the following steps: 1. Identify the proportion of the company s non-financial trading turnover which is represented by relevant IP income. 2. The same proportion of the company s non-financial trading profits is then treated as profits attributable to relevant IP. The remainder of the company s profits are taxed at the headline corporation tax rate. (This formulaic approach will, in some cases, be replaced by a just and reasonable allocation of profits between patent and non-patent profits.) 3. From the patent profits figure in step 2, the company then deducts: a routine return (equal to 10 per cent. of certain routine expenses incurred in generating the patent profits), which is taxed at the headline rate; and a marketing assets return (effectively, the value generated by brands and other marketing assets), which is also taxed at the headline rate. Finally, the remaining IP profits are then taxed at the patent box rate. 04

5 Conclusion Some companies in patent-intensive industries have been involved in the development of the UK patent box for several years, and will be well aware of the benefits which the patent box is expected to generate. However, the wide definition of relevant IP income falling within the patent box, and the extension of the regime to some patent-like IP, should mean that its benefits are not restricted to a narrow range of patent-heavy businesses. Any group which has developed patents, or other qualifying IP, may be able to generate value through opting into the patent box regime, particularly where they do so before the introduction of the reduced tax rate in April In some cases, this may require a degree of restructuring to ensure that the group qualifies for the full intended benefits of the patent box. If you would like to discuss the implications of the UK patent box in more detail, please contact: Intellectual Property Susie Middlemiss T +44 (0) E susie.middlemiss@slaughterandmay.com Cathy Connolly T +44 (0) E cathy.connolly@slaughterandmay.com Tax Sara Luder T +44 (0) E sara.luder@slaughterandmay.com Steve Edge T +44 (0) E steve.edge@slaughterandmay.com Dominic Robertson T +44 (0) E dominic.robertson@slaughterandmay.com Slaughter and May 2012 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. sxxm161.indd512