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The Patent Box proposals

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On 10 June 2011 the government released further details of the proposed Patent Box regime to be introduced in the UK in April 2013. Under the regime aimed at encouraging the conduct of high tech R&D and manufacturing activity in the UK, profits arising from patents will be taxed at a preferential corporate tax rate of 10%. Under the proposals, an elective regime will be applied on a company-by-company basis. To benefit from the regime a company is required to hold interests in qualifying patents (or certain other specified rights) from which it derives income. Assuming these qualifying conditions are fulfilled, the straw man model operates by applying three patent profit quantification steps.

Andrew HickmanJonathan BridgesManaging expectations

The proposals presented in the June Condoc build upon those put forward by the government last November. The spirit of the Condoc and model regime is encouraging.

In a number of areas the latest proposals go further than previous government commitments. For example, acquired patents will now fall within the scope of the regime, income arising on the sale of patents will also qualify for the 10% rate and it is proposed that the exclusion of patents commercialised prior to November 2010 is withdrawn.

Views from business on the Patent Box proposals

This is all very good news. Fundamentally, however, it needs to be remembered that the government has yet to accept that the regime should extend beyond patents.

Those calling for a Dutch style ‘Innovation Box’ will be disappointed. Equally, in restricting the regime to UK IPO and to EPO patents, high tech innovators holding (US) software patents will also be disappointed – this seems at odds with a cross-sector policy intent focused on fostering technological innovation.

What’s more, as we look into the proposed mechanics of the model, expectations regarding the overall reduction in tax burden are somewhat lowered.

In the government’s first example in the Condoc (summarised in Figure 3 below) of what the Patent Box might achieve we are presented with a set of facts in which a company generates 70% of its sales from patented products and yet ultimately achieves a tax rate of 21% on its taxable profits (this assumes a MCT of 24% applies. Eg, consider taxable profits of 225 and calculated patent profits of 44. (44 x 10%) + (225-44 *24%)/225 = 21%). The 21% rate is clearly some way off the headline grabbing 10% rate which sounds so attractive. 

An overview of the proposals

The Condoc outlines an elective regime to be applied on a company by company basis. Under the proposals, to benefit from the regime a company is required to hold interests in qualifying patents (or certain other specified rights) from which it derives income.

Assuming these qualifying conditions are fulfilled, the straw man model operates by applying three patent profit quantification steps these being:

  • Step 1: Determine how much (adjusted) taxable trading profit is attributable to qualifying income, ie, apportion total profits between qualifying income and non-qualifying income.
  • Step 2: Calculate residual IP profit (calculated by deducting ‘routine’ profit from the Step 1 figure by applying a mark-up on a specified cost base).
  • Step 3: Of the residual profit identify how much relates to patents and how much relates to other forms of IP, in particular brands.

Having calculated the total Patent Box profit figure, the model envisages that the 10% rate will be given effect by companies claiming a patent box deduction in computing taxable profits.

For example, assuming a company has non-patent box profits of 100 and patent box profits of 100, and that the prevailing MCT rate is 24%, this might give rise to a taxable profits computation looking something like that set out in Figure 1.

Qualifying patents

Current proposals restrict qualifying patents to those granted by the UK Intellectual Property Office (IPO) and the European Patent Office (EPO).

Views are, however, sought on allowing patents from certain other EU Member State patent offices to qualify. One would also hope that the definition will be extended to the proposed EU Community Patent.

All income from qualifying patents (both self-developed, and acquired, subject to satisfying certain active use and ongoing decision-making criteria) will fall within the scope of the Patent Box.

In other words, where a UK IPO attaches to a product sold in the UK and worldwide, all income will be taken into account irrespective of whether local patent registrations are held in each of the territories in which sales are made.

In addition to qualifying patents, the holding of Supplementary Protection Certificates, data protection rights and plant variety rights will also give entitlement to benefit from the regime.

As regards ownership requirements, the government proposes that eligibility will not be limited to legal owners, but will extend to exclusive licence-holders, and to companies entitled to exploit patents through cost-sharing arrangements.

The government has also introduced a ‘development’ benefit of the Patent Box must remain actively involved in the ongoing decision-making connected with exploitation of the patent.

The sub-contracting of R&D activity does not prevent the criterion from being satisfied, but the company needs to manage the risks associated with the project.

Readers familiar with the control of risks concept in the new Chapter IX in the OECD Transfer Pricing Guidelines will see parallels here.

Considerations for potential beneficiaries of the regime:

  • Do you have a policy of patenting innovations? Do you submit applications to the IPO or EPO or other patent offices? If current company policy is not to patent in order to preserve confidentiality does company policy need to be reviewed?
  • Where is legal ownership of your patents held? When acquiring patent rights are exclusive licences sought? Does group policy need to be re-visited?’

Qualifying income

The following types of patent income will fall within the scope of the regime:

  • all royalties or licence fees received for use of qualifying patent protected innovations (extending to both product and process patents);
  • income from the sale of any products incorporating at least one invention covered by a valid qualifying patent;
  • income from selling spare parts for a qualifying patent protected product;
  • compensation for loss of profits arising due to qualifying patent right infringements;
  • income from sale of qualifying patents.

One notable income source omitted from the above list is service income.

While calls have been made for service income to be included on the grounds that some business models are based on selling complex patented products at low margins with a view to securing high margin service contracts, the government has so far rejected them.

Instead, where patented products and services are sold as a package, the income will need to be split on a just and reasonable basis with only product-related income qualifying.

The proposals do however envisage that income streams from the ‘bundling’ of intangibles will qualify.

The government has recognised that commonly single royalty streams may be payable under licences enabling the production and sale of patented products and which also necessarily permit the use of other IP including know-how.

It is very positive that the government proposals envisage that all income arising from the licensing of bundled intangibles will benefit from the patent box regime.

There will however be boundary issues around just what is integrally bundled and anti-avoidance measures are foreseen. 

Different views have been expressed as to precisely when qualifying income should benefit from the preferential patent box tax rate.

Business has called for the trigger date to run from the date of patent application, while the government’s preference has been to set the date at the date the patent is granted.

The Condoc confirms that the government intends the relevant date to be the date of grant (contrast here the Luxembourg regime which applies from the date of application).

However, recognising the potential loss of benefit to business, it is proposed that any income arising between the date of application and date of grant (looking back up to four years) will benefit from the patent box rate in the period when the patent is granted. 

Considerations for potential beneficiaries of the regime:

  • Can you track qualifying and non-qualifying income?
  • Does current company policy regarding the timing of patent applications need revisiting? Do company patent applications typically take longer than four years?

Calculation of qualifying profit

It is proposed that the calculation of the Patent Box profit will involve a three-step process. The formulaic steps are intended to act as a proxy for determining residual patent-related profit.

While the approach is clearly intended to make the regime workable, it will nevertheless not be simple – quite how complicated it gets we will see when the draft rules are released, hopefully before the end of the year.

The three-step approach also appears to strip out a large element of profit, arguably undervaluing patented innovations.

Interestingly, in the Condoc tax impact assessment, the government recognises that it has limited data from which to accurately assess how much profit does in fact arise from patents and welcomes views and evidence from business.

To recap, the three steps involve:

  • Step 1: Determine how much (adjusted) taxable trading profit is attributable to qualifying income. Total taxable trading profits, as adjusted, are split pro rata by reference to qualifying and non-qualifying income.
  • Step 2: Calculate the residual profit element of profit attaching to qualifying income as per step 1 by deducting a 15% return on routine activities from the total profit attaching to qualifying income figure.
  • Step 3: Identify how much of the residual profit relates to the patent and closely related IP and how much from other forms of IP, ie, branding.

The summarised numerical example in Figure 3 provides an illustration of how the steps work as proposed.

Step 1

Although the proposed starting point is a company’s taxable profit, before any apportionment between qualifying and non-qualifying income is performed, certain adjustments are proposed. Interest costs and receipts will be excluded.

An (add back) adjustment will also be made for the super deduction element associated with any R&D tax credit claim – this is helpful and has the effect of increasing the overall level of profit which ultimately benefits from the Patent Box.

In cases where a pro-rata allocation of profits and expenses gives an unreasonable result, the proposals include a ‘divisionalisation’ concept.

Taxpayers may elect to use divisionalisation and it is suggested that HMRC may have the right to require it in certain circumstances.

Divisionalisation will entail identifying discrete divisions within a company and applying transfer pricing principles to allocate income (including notional royalties) and expenditure to each of the divisions.

This is likely to be advantageous, for example where valuable process patents are held but which are used in the production of unpatented products which themselves do not fall within the scope of the patent box. Divisionalisation may also reduce or eliminate some of the disadvantages inherent in the proposed steps 2 and 3.

Step 2

This step entails calculating a level of profit which the government considers routine and as such not eligible for the preferential Patent Box tax rate.

This profit figure is arrived at by applying a 15% mark-up to a limited cost base. Excluded from this cost base are outsourced intra-group and third-party costs, the cost of raw materials and patent/trademark licence fees.

Notably amortisation costs on acquired patents appear not be excluded which seems inconsistent.

Although the concept of trying to exclude profits unrelated to the patent profits is reasonable, the 15% mark-up on unrelated costs to measure such profits is arbitrary.

It may also disadvantage those UK companies which carry out R&D activities themselves, since the cost of outsourced activities may not include such a high mark-up.

There is a strong case for arguing that the R&D costs are, in any event, directly related to the generation of Patent Box profits and there are no grounds for separating those profits in a routine, excluded element, and a non-routine, included element.

Step 3

The final step attempts to determine how much of the residual profit calculated at step 2 strictly relates to patents as opposed to other IP, and in particular brands.

The proposed approach applies a current year R&D and marketing expenditure ratio to allocate residual profit to patent or brand IP. 

There are significant problems with the approach: there is already an element of brand profit carved out of the Patent Box profits by means of the 15% mark-up on all costs; second, the definition of marketing expenditure is very wide and goes beyond brand investment, and third, the assumption that £1 of brand expenditure generates the same amount of profit as £1 of R&D expenditure in a patent-protected business is difficult to support.

The proposals aim to address the government’s concern to exclude brand profits from the Patent Box, but the method may give credence to the contentious issue of marketing intangibles arising from marketing expenditure, and the allocation is a clumsy tool.

The allocation would penalise Pharma companies when launch costs kick in, and the effect would be exacerbated for smaller groups with few products in circumstances where there are big swings in relative spend on R&D and marketing.

The Condoc recognises the limitations of the proposed approach and suggests that other reasonable allocation methods might be used. Business is invited to put forward ideas.

Divisionalisation may provide a better outcome since it changes the impact that Step 3 might otherwise have, but it also changes the starting point.

Businesses will have to work through how the two methods might impact on them. 

Considerations for potential beneficiaries of the regime:

  • Do you hold process patents for which no separate royalty is currently paid?
  • Would divisionalisation be beneficial in streaming more profitable trading activity? Are costs associable with particular divisions?
  • How lumpy is your R&D and marketing spend? Is this likely to distort the residual profit allocation proposed at step 3?


Further aspects of the proposals


While the commitment to introduce the regime in April 2013 remains, the government now proposes that the regime will be phased in over five years. In the first year 60% of the regime’s benefit will be available, rising to 100% in year five of its operation.

This approach is put forward as an alternative to the previously announced and somewhat unpopular provisions serving to exclude from the regime patents commercialised pre 29 November 2010.


The Patent Box profit calculation may, in some circumstances, produce a notional loss. The proposals recognise this and provide for such losses to be ringfenced and carried forward for the purposes of the patent box calculation only.


Inevitably the computation of Patent Box profits will give rise to uncertainty, despite the efforts made to make the system formulaic.

Issues around the required amount of development management, the definition of marketing expenditure, and, perhaps most of all, the pricing of notional royalties under the divisionalisation approach, may not be clear-cut.

It is, therefore, welcomed that the government proposes to operate a clearance system.

Next steps

The Condoc invites responses to the questions posed up to 2 September. We might then expect draft legislation to be released in late 2011, say November/December. The government has committed to legislating the regime in Finance Bill 2012.

Jonathan Bridges, Associate Partner, International Tax Services Group, KPMG

Andrew Hickman, Partner, Global Transfer Pricing Services Group, KPMG

An arbitrary calculation mechanism?

Tim Watts
Chief Financial Officer
Archimedes Pharma plc

Archimedes Pharma was pleased to see in the latest consultation document that the 29 November 2010 cut-off date for first commercialisation is likely to be replaced by a phase-in of the reduced tax rate.

Having spent many years bringing a patented new product to the market, which we launched in October 2010, we would have been aggrieved had our product failed to qualify for the Patent Box for the sake of a few weeks.

While we could argue that the cut-off date could be brought forward, on balance we are happy with the trade-off of certainty of qualification against the slower phasing-in of benefits.

However, although understanding the government’s desire for a simple formulaic approach to calculating Patent Box profits, we are not impressed with the proposed methodology, in particular steps 2 and 3.

These appear to be more an arbitrary mechanism to reduce the Patent Box profits than an attempt to establish the true profits flowing from the patent.

Step 2 in particular seems likely to create perverse behaviour such as doing less R&D in respect of future products and/or to outsource as much work as possible with the risk that it moves outside the UK. 

Clarity needed on losses and group relief

Simon Upcott
Head of Tax
Cookson Group plc

I welcome this development, and particularly the intentionally inclusive and flexible design that surrounds it.

I suspect there will be a lot of discussion around how the scheme will work in practice, both internally within companies and with HMRC, and I would hope that the results of such discussions will not narrow the positive intent of the Patent Box.

The ability to obtain benefit for patented process is a particularly helpful recognition that there is as much ingenuity in how things are made as in the design of product itself.

I’m not convinced of the need to stream patents between UK/EPO registrations and those of other countries, it looks unnecessarily cautious, so I would support a white list of approved registration authorities, particularly within the EU where the spectre of challenge through the ECJ leaves us with a prospect of uncertainty.

We need some clarity around how the scheme works with tax losses and/or group relief; the computational intent of the scheme is to tax patent income at 10%, but it is not obvious how the benefit of the scheme works its way through if a company is in a tax loss or break-even position.

This could have implications on a corporate’s deferred tax position. 

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