The Rules: Patent Box changes will create increased red tape for UK businesses

AFTER the recent government consultation on the UK’s Patent Box scheme, businesses will find it a challenge to comply with the proposed new rules.

The changes will mean that businesses must now track and trace all of their research and development (R&D) expenditure if they want to continue to benefit from future tax relief, which is a significant administrative burden that may deter businesses away.

A (short) history

In April 2013 the UK Government’s Patent Box scheme came into effect. Patent Box allows UK companies to pay a reduced rate of corporation tax on profits generated from their patented technology. The scheme was introduced in order to encourage businesses to focus more on research and development and to “turn Britain into Europe’s technology centre”.

At the time UK corporation tax was 23% and the Patent Box rate of 10% was very attractive. However, news of this favourable regime spread overseas and attracted criticism from some foreign governments, who were concerned about erosion to their own tax revenues. Leading this opposition was the German finance minister, Wolfgang Schäuble, who called for a ban on the UK’s scheme.

International concerns about aggressive tax practices in general and the UK’s Patent Box regime in particular forced the government to reassess the scheme. Despite publicly and robustly defending the scheme as late as October 2014, the government eventually capitulated and, together with Germany, released a joint statement in November 2014 about the future of such preferential regimes for intellectual property. In that statement it was announced that existing schemes, including the UK’s, would be closed to new entrants by the end of June 2016 and cut off entirely by 30 June 2021.

Things moved slowly in 2015, with work mainly focused on the Organisation for Economic Cooperation and Development (OECD). Then in October the government launched a consultation on the proposed changes, followed swiftly in December with the publication of draft legislation, with the intention to become law by July 2016.
So how will these changes affect UK businesses and what will they need to do to benefit from the scheme?

Benefit follows effort

The underlying principal laid down by the OECD is that preferential IP regimes should follow the so-called ‘modified nexus approach’. This requires substantial economic activities to be undertaken in the jurisdiction in which the preferential regime exists, in other words tax benefits are connected directly to research and development expenditures.

Although UK SMEs who undertake their R&D work in the UK are compliant with this methodology, and will not be worse off under the new scheme, they nevertheless face an increased bureaucratic burden as they will have to track and trace their R&D spend on a patent or product basis. This will include for some historic projects too.

In addition to this challenge, larger companies will face further difficulties, particularly where a company has a complex corporate structure and where work is undertaken by more than one entity. This is because the benefit under the old scheme is to be reduced by what will be known-as the ‘R&D fraction’, having a value of one or less.

For example, where a company sub-contracts some of its R&D work to another group company, this will reduce the R&D fraction. This makes sense where the other group company is outside the UK, since the tax gain must follow the R&D pain. Logic would dictate that where both group companies are in the UK this should not prejudice the Patent Box benefit claimed. However, due to the stringencies of EU law, the second UK company cannot be given privileges over a non-UK EU company, which means that the government is prevented from allowing two UK group companies to collaborate in this way.

This change in particular is forcing large companies to reassess their corporate structure in order to squeeze into the new scheme. Conversely, when R&D work is sub-contracted to non-related third parties this will not reduce the R&D fraction, which perversely may cause companies to sub-contract to overseas non-related companies in preference to related UK companies.

In addition, the R&D fraction is reduced where patent rights are bought in by a company, with the cost of IP acquired contributing to the denominator of the R&D fraction. For example, where company A buys patents from company B, company A’s tax benefit will be reduced as a result of the acquisition. However, if company A buys company B outright, the proposed legislation encourages company A to keep company B separate and not to incorporate the organisation into its own structure.

This is clearly contrary to current best practice and will not engender a positive morale amongst its employees. Similarly, where a company or university spins-out a new start-up, the value of the initial IP transferred to the new company will pair back its Patent Box benefit.

Time to be heard

The new Patent Box scheme will be a significant administrative challenge for businesses, particularly those with more complex operating structures and where R&D activity is carried out across multiple companies, whether in the UK or overseas. The changes are intended to block profit shifting. However, they could also catch out some larger companies if they fail to take steps to restructure and document all related expenditure in order to evidence the fact that activity is substantively taking place in the UK.

Businesses should now be informing the government of the specific challenges they are facing in order to raise awareness of the extent of the complications. With the current take up of the UK Patent Box scheme already below expectations, the government should be concerned that these new changes could deter businesses further.

Michael Jaeger is a patent attorney at intellectual property firm, Withers & Rogers