Boxed In? The U.K. Introduces a Modified Nexus Approach in Response to Critiques of its Patent Box

Summary of UK Patent Box

The Patent Box, or Innovation Box, or Knowledge Development Box—call it what you will—is a way for national governments to encourage the commercial exploitation of intellectual property by offering generous tax breaks on the profits derived from that IP. 

The Patent Box regime was first introduced in Ireland, in 2000, and has since been introduced in many EU Member States, including the United Kingdom, France, Belgium, Hungary, Luxembourg, Netherlands, Spain, and Italy.

The United Kingdom’s version was introduced in 2013 and stands out for its particular generosity towards IP holders. Amongst other features, the following are notable: 

  • It allows any profits made worldwide by a U.K.-based company off the back of a recognized patent to be taxed at 10%.
  • The patents do not need to have been registered in the U.K., as long as they are registered at a recognized patent office, either the U.K. Patent Office, the European Patent Office or thirteen designated European territories.
  • The patents do not need to be the result of U.K.-based R&D expenditure.
  • Patents that have been acquired externally are eligible.

Criticism and Comparison

This relaxed approach is not true of all patent box regimes. Italy’s regime, for example, applies only to entities that are resident in that company, and Ireland’s applies only to patents resulting from R&D carried out by Irish companies.

The absence of a nexus element in the U.K.’s regime has therefore, not surprisingly, come in for a great deal of criticism, as while it ostensibly exists to encourage patent holders to leverage their IP for commercial gain, it appears to have had the consequence of freeloading off those tax jurisdictions where R&D budgets are spent and where R&D departments (and their workers) are based.

Which brings us to…

BEPS Action 5: Agreement on Modified Nexus Approach for IP Regimes

In an effort to answer critics of nexus-free patent boxes, the U.K. and Germany put forward a proposal in November, 2014, to require a nexus element to be incorporated into all IP tax regimes (the “Modified Nexus Approach”). The proposal would ensure compliance with Action 5 of the OECD’s BEPS Action Plan.

Under this approach, schemes such as the U.K.’s will be closed to new patents from July 1, 2016. Existing patents will still be covered, until July 1, 2021, when the patent box scheme as it currently exists will be closed to all patents, regardless of eligibility. It currently looks as though patents in the patent box, but without a nexus element, will on that date cease to enjoy the tax benefits of the patent box, and we await draft legislation to confirm this or to set out an alternative path.

The U.K. has amended its Patent Box accordingly, with the changes to take effect from June 30, 2016.

All patents filed by June 30 will be eligible for the U.K. Patent Box under the existing rules, whereby companies could report one income stream deriving from a number of patents, and enjoy reduced taxation.

However, all patents filed after that date will be subject to the new rules: 

  • Each profit stream from each patent must generally be calculated separately, to meet transparency requirements; and
  • Each profit stream will be multiplied by the nexus fraction, resulting in the eligible profit that benefits from the patent box.

The nexus fraction will be based on an equation in which qualifying expenditure subcontracted R&D and IP acquired externally will negatively affect expenditure on in-house and 3rd party R&D. The resulting fraction will limit the proportion of the profit stream which can claim the 10% rate.

What is qualifying expenditure? 

The answer to this is not always clear, but it seems that the following are included in the meaning of the term:

  • basic staffing costs, such as salaries, wages, Employers Class 1 NICs and payments to pension funds;
  • payments made to qualifying entities such as universities or independent R&D establishments;
  • materials and equipment used in the R&D process which do not necessarily form part of the patented product/process; and
  • subcontracted R&D payments, which can be claimed, usually for 65% of the cost.

The cost of externally provided workers may be eligible, but the parameters are unclear.[1]

Qualifying R&D expenditure can also apply to patents that have already been filed and to products that use those patents that are already on sale. This is because the expenditure, as well as applying to the development of the original patent, can also apply to development of methods to use that patent (or product) or development of any item or process that incorporates an already-filed patent or product. So profits generated several years after the filing of a patent can still be allocated to the R&D of that patent.

The nexus fraction will include an uplift element, aimed at mitigating the increased tax liabilities effected by the restrictions of the nexus approach. It is included to recognize that a company which acquired IP from, or outsourced R&D to, a related party, may itself have created part of the value that resulted in the profit stream, and that the nexus fraction should not unfairly disadvantage groups that have operated in this way under existing rules.

Any grants or subsidies received by the cost centre in respect of the R&D in question may impact upon this R&D relief uplift.

What does this mean for IP Holders in Terms of Their R&D Spend?

The adoption of the Modified Nexus Approach will result in patent box benefits being tilted towards profits derived from IP developed in the state offering the benefits, and away from IP acquired from outside the company. Consequently, if a company spends less on acquisition of IP and more on in-house R&D, the more of its profit stream will be eligible for that 10% rate.

The point of all this is that R&D expenditure, either in-house, or contracted out to unrelated third parties, is seen as desirable. If countries want patent holders to exploit those patents commercially, tax breaks are one way to achieve this. It certainly appears sensible that entities which spend on R&D should be looked upon favorably by those countries which have benefited from the proceeds of that R&D expenditure. Moreover, the Modified Nexus Approach clearly meets the needs of the OECD in terms of Action 5 of BEPS.

On the face of it, then, the Modified Nexus Approach imposes additional burdens on taxpayers. But the prize, for the next five years, at least, is the continued generous tax rate offered in respect of applicable patents. There may be further opportunities to enjoy the benefits of the patent box through appropriate corporate restructuring, perhaps by MNEs transferring their IP to their R&D arms, or through the transfer of R&D workers from connected entities to the company seeking patent box relief.

Draft legislation has not yet been published and this will hopefully clarify a number of issues surrounding restructuring opportunities, in particular, the treatment of R&D expenditure history. In the meantime, though, the prevailing guidance indicates that patents that have not yet been filed should be filed before 30 June 2016.

The OECD has published its paper on the Modified Nexus Approach Here:

Alex Miller is a Managing Editor at Bloomberg BNA.

Thanks to Joanna Norland of Bloomberg BNA and Claire Hooper of EY for their assistance with this post.