Tax Services 26 October 2015 Consultation on modified UK patent box Executive summary A joint consultation document published by HMRC and HM Treasury on 22 October 2015 sets out the Government s proposals for modifying the UK patent box regime in line with the recommendations published by the OECD on 5 October 2015 in its report on harmful tax practices (see our alert here). The document seeks input from businesses on the detailed design and operation of the rules. The proposed new regime, which would take effect from 1 July 2016, would limit the benefits of the patent box according to a nexus fraction that is based on the amount of direct in-house and externally sub-contracted R&D expenditure incurred by the claimant (plus, to a limited extent, R&D sub-contracted to related parties and acquired IP). This fraction is applied to profits as calculated in the current regime. The nexus fraction would, however, be a rebuttable presumption, so that in exceptional circumstances a claimant may be able to apply a different calculation if it is considered to be more just and reasonable. To determine the nexus fraction it would be necessary to track and trace R&D spend on patents, products or product families and to split income to the same level. The document sets out proposals for dealing with the transition into tracking and tracing, but in many cases detailed tracking and tracing is likely to be required from 1 July 2016. The OECD proposals are designed to limit the benefits of preferential IP regimes where IP has been acquired rather than developed by the claimant. The consultation document suggests, though, that where groups merge for commercial reasons and consolidate IP into one company, this could be treated as own spend of the acquiring company (subject to certain restrictions) rather than an acquisition of IP. For five years the new regime would run alongside the current regime. Patents effectively filed before 1 July 2016, that are within the patent box at 30 June 2016 could be grandfathered for up to five years. However, IP transferred in from related parties after 1 January 2016 would not qualify for grandfathering after 31 December 2016 unless it previously qualified under an existing IP regime. Where a product includes patents that are within the regime prior to 1 July 2016, as well as patents filed after this date, it is proposed that both the current and the modified regime would apply to profits from that product, and so profits from the product would need to be split between the two. The consultation ends on 4 December and the changes will be legislated in Finance Bill 2016, though draft clauses are expected to be published with the draft Finance Bill on 9 December. There are a number of significant detailed issues to be resolved and HMRC and HMT are encouraging companies to make representations as soon as possible so they can be taken into account in the draft legislation.
Detailed discussion Background The current UK patent box regime provides a reduced tax rate of 10% (after the transitional period) on income from patents (and other similar IP rights). The regime applies to profits arising from sales of products, services and processes (i.e. not just profits directly related to the patent) which have at least one patented component that is either owned or exclusively licensed by the claimant company. The regime also applies to royalties. There is no requirement under the current regime for the underlying R&D that led to the creation of the patent to have been undertaken in the UK, though sufficient substance is required to demonstrate that active management of the patents takes place in the UK. Action 5 of the OECD BEPS project focused on countering harmful tax practices, which potentially includes preferential intellectual property (IP) regimes. In its final Action 5 report published on 5 October 2015 the OECD confirmed its recommendation that, from 1 July 2016, in order for preferential IP regimes not to be regarded as harmful tax practices, they must link their benefits to substantial activities being carried on by the claimant company. The OECD recommends that this should be achieved through the modified nexus approach where R&D is used as a proxy for substantial activities and accordingly the benefits of a preferential IP regime are limited by reference to whether that entity undertakes the R&D. Following the publication of the OECD s broad political agreement on the modified nexus approach, HMRC and HM Treasury (HMT) jointly issued on 22 October 2015 a consultation document entitled Patent Box: substantial activities which sets out in more detail how a modified UK patent box regime complying with the OECD s framework could operate. The consultation ends on 4 December 2015 and the relevant legislation to modify the regime will be included in Finance Bill 2016. Draft clauses in relation to this are expected to be published on 9 December 2015 as part of the draft Finance Bill. HMRC and HMT have stated that these draft clauses will be informed by comments received during the consultation, but a formal response will not be released until spring 2016, at which time any further necessary modifications will be made to the Finance Bill clauses (which are themselves subject to a separate consultation). Consultation proposals The Government proposes to amend the current regime rather than rewrite it. This means, inter alia, that the existing conditions with regard to development activity and active ownership would remain. Nexus fraction The modified UK patent box regime would be based around the modified nexus approach recommended by the OECD, whereby a nexus fraction would in principle determine the proportion of profit from the IP which may be included in the regime. The nexus ratio or fraction N is expressed in the document as follows: Where: N = D + S + U D + S + A + R D = in-house direct R&D expenditure (including any conducted through branches) S = R&D expenditure sub-contracted to third parties A = IP acquisition expenditure R = R&D expenditure sub-contracted to related parties U is the modification to the nexus fraction and is the lesser of A + R and 30% x (D + S) What this means essentially is that if all relevant R&D is undertaken by the entity itself, or is subcontracted only to unrelated parties (and IP is not acquired), then the fraction would be 1 and the full benefits of the patent box would be available. If the group sub-contracts R&D to a related party or acquires a significant amount of IP, then the benefits of the patent box could be reduced. There is, however, an allowance whereby, in effect, an amount of up to 30% of qualifying expenditure can be sub-contracted to related parties or acquired. Consultation on modified UK patent box 2
The nexus fraction would be cumulative, i.e. it would be updated each year to include expenditure incurred to date. However, the consultation document suggests that expenditure should be removed from the nexus fraction 15 years after being included (based loosely on a 20 year patent life). Income to which nexus ratio is applied The nexus ratio would be applied to the profit within the patent box, calculated as it is currently by stripping out routine and marketing returns. However, whilst the current regime provides for two methods of calculating the profits within the patent box proportional split and streaming - under the modified regime only streaming would be permissible, as the Government considers it is the only method that would give the required link between profit and R&D expenditure. Profit streaming would need to be done to the most granular level possible (e.g. by IP item, product, product category or a mixture). Within each stream or parcel, the relevant profit eligible for the patent box would be calculated broadly as it is under the current regime. Claimants would then need to track expenditure on developing the IP corresponding to each stream so as to calculate the nexus fraction that is applied to the profit. Rebuttable presumption As recommended by the OECD, the consultation document proposes that the nexus fraction is seen as a rebuttable presumption, i.e. in exceptional circumstances the claimant can rebut the use of the nexus fraction if a different approach would be more just and reasonable. This would be available where the nexus fraction is at least 25% (ignoring the uplift of up to 30%) and would need to be reviewed annually. The consultation document proposes that the circumstances under which the rebuttable presumption is given effect are not defined in an exhaustive list, but instead are left more open, supported by guidance and examples of where it might be used. Joint development The consultation document confirms that a claimant s eligibility for the patent box under a modified regime should not be disadvantaged if it incurs expenditure developing IP assets under a cost sharing or joint development arrangement. However, where the company contributes funding or other non-r&d activity as part of this arrangement (over and above its R&D contribution), these would be treated as IP acquisition costs or related party sub-contracting expenditure rather than R&D expenditure, and so could affect the calculation of the nexus fraction. Expenditure The consultation document proposes that the definition of qualifying expenditure (direct or subcontracted) would be based on the definition of R&D used for R&D credit purposes, as supplemented by guidelines issued by the Department for Business, Innovation and Skills, and that it would need to be relevant R&D (i.e. related to a current or future trade), again as defined for R&D credit purposes. It would not, however, be based on the actual amount of the company s R&D credit claim. A claimant s in-house direct R&D expenditure would be defined as expenditure on: Staffing costs Software or consumable items Externally provided workers, and Payments to subjects of a clinical trial Third party sub-contracted expenditure would follow existing rules in the SME R&D credit regime so that the qualifying proportion would be 65% of the total, whereas the qualifying proportion of related party sub-contracted expenditure would be the lesser of the amount paid and the actual R&D spend by the sub-contractor. The OECD report suggests that third party expenditure disbursed by a related party should not lose its character as qualifying expenditure. However, the consultation document suggests that this should only be the case where the related party is not managing the third party. Groups may therefore need to review their third party outsourcing arrangements. Consultation on modified UK patent box 3
IP acquisition costs It is proposed in the consultation document that IP acquisition costs should include any amounts paid, whether to purchase an IP asset outright or to purchase a right to use IP (including royalties). However, only payments relating to IP that would itself eventually be in the patent box regime would be included (and so acquisition costs for other IP such as trademarks or software could be excluded). The consultation document has recognised, though, the potentially detrimental impact on the nexus fraction of IP acquired as part of a merger or trade transfer. In this regard it states that it seems appropriate, where two companies merge, each owning IP with an established spending history, that this should be regarded as own spending for nexus fraction purposes. However, the document recognises the potential this creates for structuring a simple acquisition of IP as, for instance, a merger. To deal with this the document proposes three alternatives: Rules analogous to those for loss streaming so that when a company acquires a trade including IP with an R&D expenditure history, that history and corresponding income, together with its own nexus fraction, is kept separate (possibly for a limited time) A purpose test so that if a merger or other transaction is regarded as a contrived alternative to the acquisition of IP, it is disallowed for patent box purposes Rules analogous to the loss buying rules such that the nexus fraction is retained on an acquired business unless certain restructuring takes place Timing of expenditure As recommended by the OECD, the nexus fraction would be calculated based on expenditure as it is incurred. The consultation document proposes that the R&D credit rules be used to define this, on the basis that they do not directly define when expenditure is incurred but do define when it is deductible for R&D credit purposes (and allow a deduction for capitalised expenditure). To deal with the possibility of claimants artificially bringing forward expenditure to maximise the nexus fraction, the Government is considering using the existing anti-avoidance rules in the patent box regime. Tracking and tracing The consultation document proposes that the modified regime should offer companies a choice as to whether to track income and expenditure against individual IP assets or against products (including product families). However, where a claimant is not tracking against individual IP assets it would need to show why individual tracking is inappropriate. However, it is proposed that legislation would only set out broad principles in this respect (for instance to prohibit tracking against total income except where a company has only a very narrow range of products) and leave the detail to supporting guidance. Transitional issues The OECD recommendations allow IP regimes to take account of the fact that companies may not yet have adequate records of R&D expenditure to the level of detail required going back to the start of work on all their IP. The consultation document proposes the following to deal with this: Where a company begins activity on an IP asset on or after 1 July 2016, tracking at the appropriate level should begin immediately and no special rules would be required. Where a company has been incurring pre-1 July 2016 expenditure on non-grandfathered IP, it would be required to track post 1 July 2016 expenditure on the appropriate basis, and once it had three years of data it would use that ratio in its patent box calculation. Until then, the company could, if necessary, use total R&D spend for the previous three years to determine the nexus fraction. If the company has no post 1 July 2016 expenditure then it could base the fraction on its best estimate of pre-1 July 2016 expenditure. Where a company has grandfathered IP, it would be expected to track expenditure from 1 July 2016 so that it can apply the nexus fraction once grandfathering ceases. Where there is no post 1 July 2016 expenditure then the company would need to make its best estimate of pre-1 July 2016 expenditure until it can be replaced by new data. Consultation on modified UK patent box 4
Where a company tracks by product or product family and the product has both grandfathered and new IP then income streams would need to be split between the grandfathered and new regimes. Grandfathering The consultation document proposes that a grandfathering period of five years (to 30 June 2021) be available to companies, but requests views on whether a shorter three year period would be sufficient. It proposes that companies that have already elected into the current regime at 30 June 2016 should continue to benefit from the current regime for profits arising before 30 June 2021 from any qualifying IP that exists as at 30 June 2016. For this purpose, exists refers to the effective filing date for the patent from which it will have legal force (which must be before 1 July 2016) rather than the date the patent is granted. This will generally be the date it is filed with the patent office unless the application takes priority from an earlier application. The modified regime would then apply to profits arising from other qualifying IP. Any company that has not elected into the current regime at 30 June 2016 would still be able to make an election to be in the regime, and hence grandfathered, provided it does so within normal time limits (two years from the end of the accounting period) and satisfies the conditions to do so at 30 June 2016. Otherwise it would be subject to the modified regime for all profits, regardless of whether the IP existed at 30 June 2016. Conclusion We welcome the fact that the consultation has addressed some of the concerns we expressed during the various working group meetings we attended with HMRC and HMT in the run-up to the release of this consultation. For instance, the potentially adverse impact of IP acquisition costs arising on an acquisition or merger may be alleviated by one of the special rules being proposed. However, there are a number of detailed issues relating to the modified regime which are not covered by the consultation and which will need to be carefully considered. HMRC and HMT are asking a number of consultation questions in relation to all the aspects covered by this alert. We will be submitting our own representations to the consultation document but HMRC and HMT are particularly interested in hearing directly from businesses and you may therefore wish to consider making representations. The patent box will still provide significant benefits to many groups but there will be a higher associated compliance burden associated with the regime going forward. There may also be benefits for groups in restructuring their operations, and advantages to doing this before 1 July 2016 (or in some cases 1 January 2016). Additionally (and in accordance with OECD recommendations), any IP acquired after 1 January 2016 from a related party would not be eligible for grandfathering after 31 December 2016 unless it already qualifies for benefits under an existing IP regime. This is to prevent groups moving IP into a territory to take advantage of the grandfathering rules. Consultation on modified UK patent box 5
EY Assurance Tax Transactions Advisory Further information For further information, please contact one of the following or your usual EY contact: Claire Hooper chooper@uk.ey.com 020 7951 2486 Sarah Churton schurton@uk.ey.com 020 7951 4064 Rob Peers rpeers@uk.ey.com 0113 298 2259 About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC300001 and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London, SE1 2AF. 2015 Ernst & Young LLP. Published in the UK. All Rights Reserved. ED None In line with EY s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. ey.com/uk Consultation on modified UK patent box 6