The Patent Box regime was introduced in April 2013 for UK companies with profits from exploiting certain qualifying intellectual property (IP) rights, generally UK and EU patents. The relief provides an effective 10% tax rate on the qualifying profits. The relief is being phased in over a 4 year period with full relief becoming available from April 2017.
With UK corporation tax rates reducing, currently at 20% but announced to reduce to 17% in 2020, the overall benefit of the regime is diluting. However significant savings are still available for many companies with claims being very worthwhile.
Why is the relief changing?
The current regime does not directly link the relief to the research and development (R&D) carried out in relation to the patented invention. There is only a requirement for the company to ‘actively’ hold the IP in order to meet the development condition. Commercialisation activities will often meet this condition; therefore a company could acquire qualifying IP, invest in bringing the product to market and be able to claim the relief.
Because of this the Organisation for Economic Co-operation and Development (OECD) identified the regime as a potentially ‘harmful tax practice’ which would be contrary to Action 5 of the wider base erosion and profit shifting (BEPS) project which commenced following global concerns in respect of tax avoidance by multi-national enterprises. All G20 members, including the UK, along with many other countries have agreed to implement the recommendations of the BEPS project and therefore the elements of the UK Patent Box regime which are perceived to be harmful needed to be changed in order to be ‘BEPS compliant’.
The OECD concluded that for companies to benefit from a preferential IP regime, their economic activities in respect of the IP should be substantial and this is defined as being R&D activity. The OECD advised this could be resolved with a nexus principle, which is the approach adopted by the UK in the new regime.
The key changes
Under the new regime the relief will be reduced by way of a nexus fraction where the R&D which is subcontracted to connected parties is more than 30% of the R&D contributed by the Patent Box company itself or subcontracted to unconnected parties. Most notably there is no distinction made between UK connected or group companies and overseas connected or group companies. Therefore UK only groups will be disadvantaged if they separate the R&D activities and commercial activities between different group companies.
The nexus fraction is applied on a cumulative basis in respect of R&D expenditure over a 15 year period. Therefore R&D expenditure each year will be split between a) internal or subcontracted to unconnected parties, and b) subcontracted to connected parties. This is then added to previous cumulative balances and the nexus fraction recalculated.
The administrative burden for claimants will increase as the new regime requires the Patent Box adjusted profits for each patent (or family of related patents) to be streamed separately, a method which could previously be applied voluntarily by election. The nexus fraction is then applied to each stream. The simpler standard method of calculation under the current regime will not be available. This enables companies to apply the percentage of qualifying sales over total sales to the Patent Box adjusted profits. This standard method is favoured by SME’s, sometimes to the detriment of the tax relief achieved, as it is far easier to administer.
When the new rules apply and grandfathering of the current regime
Draft legislation to enact the changes is included in Finance Bill 2016 and will come into force on 1 July 2016.
The new rules will apply to all companies in respect of qualifying IP rights registered or acquired from 1 July 2016. Patents registered as pending prior to 1 July 2016 will be eligible under the current regime. It will also apply to all qualifying IP held by companies electing into the regime for the first time in respect of accounting periods commencing after 1 July 2016. HMRC have confirmed that if an election is first made for an accounting period which straddles the 1 July 2016, the current regime will apply in respect of qualifying IP held as at 30 June 2016.
The current regime will be grandfathered for a period of 5 years to 30 June 2021 in respect of qualifying IP held on 30 June 2016. The time limit for electing into the regime is 2 years from the end of the accounting period. It is not necessary to have made the election by 30 June 2016, as initially indicated by HMRC. The latest opportunity being 2 years following the end of an accounting period which straddles the 1 July 2016.
Companies which continue to develop and register new qualifying IP after 1 July 2016 will find themselves in the complicated scenario of applying both regimes until 2021.
From 1 July 2021, the new regime will apply to all qualifying IP. For old IP becoming subject to the new rules at the end of the grandfathering period, there will be a requirement to include R&D expenditure from 1 July 2016 in the nexus fraction. Therefore even where businesses are applying the grandfathering there will be a requirement to track and stream R&D expenditure during this period if the company intends to make Patent Box claims under the new regime from 1 July 2021. Putting together this information at the time of the first claim under the new regime is likely to be difficult therefore we recommend companies adjust their accounting procedures to track the expenditure on a streaming basis as early as possible.
What should companies be doing now?
To maximise the availability of relief under the grandfathering of the current regime, and plan for the new regime, companies should be considering the following matters:
- Reviewing current development activity and registering potential patent applications before 30 June 2016.
- Review group arrangements and ensure that the IP and R&D activities are held in the correct companies to optimise patent box reliefs under the current and the new regime.
- If there is a need to move IP or grant exclusive licences between connected companies to ensure a company is eligible under the current regime, do so before the 30 June 2016 and ensure the transferor company also elects into the Patent Box regime such that it is in force on the 2 January 2016. I.e. for a December year end, ensure an election is in place for the accounting period ended 31 December 2015, or earlier.
- Identify which accounting period to make the election into the regime for, if not elected already, and ensure it is made within the statutory two year time limit.
- Adjust accounting systems to enable streaming of Patent Box profits to be more easily identifiable by tracking R&D expenditure to patents and get the systems ready to allocate income and expenditure to product sub-streams.
For more information please contact your usual Francis Clark tax advisor.