Trust Bloomberg Tax for the international news and analysis to navigate the complex tax treaty networks and global business regulations.
By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The winds of change are swirling around the existing rules governing the allocation of income among the elements of offshore structures of U.S., and other, multinationals. At the moment, policymakers in the United States and overseas have as a principal focus of attention structures that have concentrated income arising from bearing risk and exploiting intangible property in an entrepreneur company subject to tax in a low-tax jurisdiction. The policy responses so far, and those which can be foreseen in the near future, have by and large been focused on trying to claw back some of that income from the principal company through increased taxation on entry into the structure (the German transfer of functions legislation or the U.S. 2009 revisions to the cost sharing regulations), adopting transfer pricing interpretations or other measures to increase the allocation of income to entities other than the central economic entrepreneur entity (the current draft revisions to Chapter VI of the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines regarding the taxation of intangibles or the Obama "excess returns" proposal), or perhaps even more radical proposals (report commissioned by the Ministry of Economy and Finance on proposals to reform taxation of the digital economy1). As a group, all of these initiatives can be regarded as separate manifestations of government concerns over "base erosion and profit shifting," which itself has given rise to a new acronym (BEPS) and the title to the newest OECD initiative in the area. The OECD warns that it may be necessary to "revisit dramatically" the current architecture of international tax.2 The report "Addressing Base Erosion and Profit Sharing" was released on Feb. 12.3
In an interesting countercurrent, however, some governments are actively courting enterprises to locate in their jurisdictions some of the same activities that have given rise to the anti-BEPS initiatives. In particular, this has been manifested in the proliferation of "IP box" regimes which have popped up in various European jurisdictions. At the moment, special European regimes for the taxation of certain income arising from the exploitation of patents or other specified intangible property exist in Belgium, the Netherlands, Luxembourg, the United Kingdom, Spain, the Canton of Nidwalden in Switzerland, and Hungary. (There may be others I have missed, or are still on the legislative drawing board.) These regimes differ among themselves in many major specifics, including the type of intangible property that is eligible for the incentive, the degree of local development or management that is required to qualify, the particulars of the treatment of acquisition costs for property acquired by the entity claiming the benefit, and the like. For example, qualification for the U.K. regime requires the taxpayer to satisfy either a development condition or an active management condition. But they are all focused on offering a low rate of tax in order to attract to the jurisdiction the sort of IP returns which for many groups have been a cornerstone of their international tax planning for some time, and which have caused the proponents of the anti-BEPS work to consider that "dramatic revisions" of the international tax law need to be considered.
It is not possible to predict what the end result of all the anti-BEPS initiatives will be, of course, but it seems to me that one consequence will be that many groups will explore using one of the IP box regimes as a more stable location for their offshore IP ownership in the future. That means that those jurisdictions that tailor their IP box regimes to offer the best set of incentives and protections to multinational groups have the potential to generate something of a windfall for themselves. For any group that decides to bring their IP onshore into an IP box regime, the effect of the anti-BEPS work will be to drive the IP returns away from certain entities in existing structures, and into the hands of those jurisdictions that are offering these incentives.
It also seems that the United Kingdom is particularly well positioned to reap a large part of that windfall. The U.K. legislation offers an attractive rate in patent box,4 10% when fully phased in effective April 1, 2017, which is competitive with the rates offered in the other competing European jurisdictions. It is interesting to note that this rate undercuts the best headline rate going in its Gaelic neighbor to its west (the 12.5% normal rate of corporate tax in the Republic of Ireland), and nestles exactly at the low end of the trigger for defining what low-taxed income could be picked up under some of the proposed Subpart F revisions that were circulated last year.5 The U.K. rate card seems to have been perfectly played; just high enough to avoid some possible U.S. anti-BEPS legislation, just low enough to be competitive in this area, and substantial enough to produce quite an increased tax revenue flow for HMRC if it becomes popular and attracts income that currently is reported outside of the United Kingdom.
What makes the U.K. patent box particularly interesting for U.S. multinationals is that the United Kingdom has always been a logical base of foreign operations for U.S. groups. For example, the U.S. high-tech community has found the United Kingdom to be an attractive jurisdiction in which to locate regional management headquarters, and some English industrial parks look like they have been transported from Silicon Valley. Advertising-supported internet-based businesses are particularly attracted to the United Kingdom, as London remains the region's preeminent center of the advertising business.
So if the United Kingdom can get its patent box right, there is a real possibility that some U.S.-based internet and similarly situated businesses could see reasons to consolidate more activities in the United Kingdom, even making their U.K. group entities the central economic entrepreneur for their offshore structures. Given that these businesses today have generally regarded Ireland as their European headquarters of choice, Ireland could be at the losing end of this investment realignment.
As it stands now, however, the U.K. patent box legislation needs some refinement to turn it into a truly powerful incentive for many industries. In particular, the legislation in fact is narrowly focused on income from patents (in some circumstances, such as the sale of tangible products, income from unpatented technology can qualify for the low rate of tax as well as income from patented technology, but in other circumstances, such as the provision of services, only income from patented technology can qualify).6 I understand that the principal domestic proponents of the legislation were companies that heavily rely on patent protection for their IP. In that case, Parliament's focus on patents perhaps is understandable. In many industries, however, including in particular software and e-commerce enterprises, patents may form part of the company's IP portfolio, but other properties such as copyright, trademark, and confidential information are even more important. It is possible to create structures in the United Kingdom in which the patent box benefit is available for entities that extend a license to an operating entity and derive income arising from properties other than patents, but only if the income from the other property (such as a copyright) is derived from a license to the operating entity that either: (1) is a license of a "process" in respect of which the licensor holds a patent; or (2) is a license under which the other property is licensed for the "same purposes" as the patents.7 There is significant uncertainty at the moment as to how this principle can be applied to enterprises with IP more heavily weighted towards copyright. Also, the 10% rate applies to gain from the disposition of patents by the patent box entity, but not to gain from the disposition of any other property, including property that may have been licensed as part of a qualifying process or for the "same purposes" as qualifying patents. That gap in the capital gains coverage creates a serious trap for investors that may be faced with fully taxable capital gain arising on the disposition of a product line, or an internal reorganization that requires extracting IP from the patent box entity. Given the volatility of changes in international tax law and practice in jurisdictions around the world today, it is a brave investor that would bring offshore IP now situated in a low-tax environment into an incentive regime that could trap the appreciation forever at normal rates.
If these deficiencies can be addressed, however, the United Kingdom stands to offer a powerful combination of business and tax incentives to enterprises with significant offshore intangibles to bring them onshore to the United Kingdom. It can be envisioned that groups may combine that IP migration with increased investment into the U.K. entity as a regional sales or management company, thereby achieving one of the stated aims of the patent box legislation, which is to encourage companies to locate in the United Kingdom high-value jobs associated with the development and exploitation of patents. The United Kingdom, through prudent tax policy, has the potential to become a big winner here.
That is, of course, if U.S. multinationals can stomach the idea of investing in a jurisdiction where a respected Member of Parliament has called fully compliant companies "immoral."8
This commentary also will appear in the March 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Culbertson, Durst, and Bailey, 894 T.M., Transfer Pricing: OECD Transfer Pricing Guidelines, and Nias, Ross, Khvat and Morison, 989 T.M., Business Operations in the United Kingdom, and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers
5 See Technical Explanation of the Ways and Means Discussion Draft Provisions to Establish a Participation Exemption System for the Taxation of Foreign Income, at 32-34 (10/26/11); Ways and Means Discussion Draft, H.R. __, Part 2 - Prevention of Base Erosion, Sec. 331A [Option A] (Excess Income from Transfers of Intangibles to Low-Taxed Affiliates Treated as Subpart F Income) & Sec. 331B (Low-Taxed Cross-Border Foreign Income Treated as Subpart F Income) (10/26/11).
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to email@example.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to firstname.lastname@example.org.
Put me on standing order
Notify me when new releases are available (no standing order will be created)