First there were patent trolls, now there are patent boxes.
The discussion over how to best overhaul the U.S. tax system has taken a sudden and, to some, unexpected turn toward a tax incentive policy that already is ubiquitous in Europe: the patent box. Almost overnight, the policy has gained significant backers—including Sen. Chuck Schumer (D-N.Y.), the Senate’s second-most powerful Democrat—and industry groups have begun a heavy push on lawmakers to enact it, either as part of a comprehensive tax overhaul or simply on its own.
To understand the policy and why it has suddenly gotten so much focus is to understand how much the ground has shifted in the global tax debate.
First of all, “patent box” is a bit of a misnomer. Typically, it encompasses many types of intellectual property—patents, trademarks and copyrighted material—as well as other intangible assets that a corporation might own or control. The policy grants the owner a discounted tax rate on profits from those intangibles, “boxing” them off from the rest of the system.
So why would a government want to give a tax discount on properties that already are extremely valuable?
Intangibles don’t exist in the physical world—they’re concepts or ideas. And one of their key characteristics is that they can be easily “moved” from one jurisdiction to another. Many, if not most, of the problems that flare up regarding the international tax system arise from this fact. Intellectual property plays an outsize role in the global marketplace today, and corporations have a powerful incentive to move it to low-tax jurisdictions.
Patent boxes are, to a degree, an attempt to deal with this reality. Ireland first began toying with the idea in the 1970s, as part of its extremely successful strategy to use a business-friendly tax environment to lure high-tech businesses to the Emerald Isle. Today, nearly a dozen European countries have adopted some form of the policy, with tax rates that typically range from 5 percent to 15 percent.
Does the policy really encourage research and development in a territory? Or is it just a way for a country to underbid its neighbor, entice IP migration, and earn tax revenue from activities that are never, in a practical sense, really there?
That’s something the Organization for Economic Cooperation and Development is looking into right now. Part of its sweeping project to combat base erosion and profit shifting, or BEPS, is to examine “harmful tax practices”—in essence, policies individual governments use to become tax havens.
It’s a tricky line. One country’s blatant cash grab is another’s aggressive but legitimate business-friendly tax policy. The OECD has indicated that it will look at a recent agreement between the U.K. and Germany over the former’s patent box as a way forward. That agreement, reached to last November, used what’s called the modified nexus approach: corporations can use the patent box only if they show that significant research and development occur in that same jurisdiction.
That, the OECD says, is the right balance between a country’s sovereign right to enact the tax policy it chooses and the need to ensure that taxable income is allocated in a way that reflects genuine economic activity. These rules will be just recommendations—the OECD has no official power over nations—but those recommendations carry weight in the world of global commerce.
In setting forth an acceptable form of patent box, the OECD may have made them easier to pass—or so some lawmakers are claiming. And if the U.S. doesn’t react, it could find its IP migrating across the Atlantic at an even greater pace—and jobs along with it, as corporations seek to satisfy the modified nexus requirement with legitimate R&D. That, ostensibly, is what’s driving much of the current U.S. discussion around patent boxes.
“I want our jobs to remain red, white and blue—not the EU!” said Sen. Schumer during a March Senate Finance hearing on tax competitiveness.
It certainly is a legitimate concern. But anyone who has followed the debate closely and talked to those involved with it will start to see a slightly different dynamic at work.
The U.K. enacted a patent box regime as part of a larger tax plan, which shifted its system from a tax on worldwide profits to one that exempts profits made overseas—often called a territorial system. (For more on the difference, read here.) A territorial system, however, encourages companies to move all of their intangibles offshore—why wouldn’t they, if the income is exempt?
Some counterbalance is needed, and the U.K. elected to use a patent box as a sort of a counter-lure: Keep your IP here, and we’ll give you a lower rate.
That’s one way to handle it. Another way is to pass rules that try to capture intangibles moved offshore and tax them anyway. These kinds of laws are called controlled foreign corporation rules, and most countries, including the U.S., use them—although the U.S. system has some significant wrinkles. Many proposals floating around Congress, both from Republicans and Democrats, call for enhanced CFC rules to ensure that income from intangibles is taxed at some minimal rate, normally from 10 percent to 15 percent.
So on the one hand, you have the patent box--the carrot--and on the other hand you have the CFC rule--the stick. What becomes evident from these proposals is that the carrot and the stick start to look similar, approaching a point where they’re identical. One way or another, both find ways to ensure that intangibles are taxed at a basic level, no matter where they are moved.
In fact, the draft tax plan presented by Rep. Dave Camp (R-Mich.) last year includes a sort of hybrid carrot and stick approach, achieving a 15 percent tax rate for “foreign intangible income” held by U.S. corporations, whether the intangibles are legally held at home or abroad.
Given the current global climate, corporations expect that the days of stashing their valuable IP in the Caribbean, with near-zero tax rates and little to no actual operations, likely are over—and soon. Whether it’s due to the BEPS project or Congress’ interminable tax overhaul efforts, countries are likely to become much more aggressive about trying to capture this income. Given this reality, U.S. corporations may view keeping their valuable IP right here at home—under a discounted rate—as being the lesser of many possible evils.
“For certain taxpayers, the rates that are generally associated with a patent box are more aligned with their goals than the 15 percent we had in the Camp draft,” said Warren Payne, who worked on the draft as policy director for the House Ways and Means Committee, and is currently with Mayer Brown LLP.
As a policy, the patent box has many critics, who claim that it’s nearly impossible to distinguish between intangible-related returns and normal returns—and corporations will find inventive ways to classify as much income as possible as the former.
“The patent boxes are authentically terrible ideas, for two reasons,” said Ed Kleinbard, a professor of taxation at the University of Southern California School of Law. “One, they’re simply an acknowledgement of defeat in the role of tax administrations worldwide, in allocating income to the geographic source where it actually is earned. And second, it simply encourages creative accounting and the total erosion of the corporate tax base.”
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