By Lorraine Smyth and Nicola Quinn

Part 2

This article is the second in a series of two articles on the subject.

As Ireland Inc seeks to position itself for future economic growth, there continues to be much commentary about the need to build a “smart economy” and to encourage innovative enterprises. Tax incentives have a key part to play in encouraging innovation. Tax incentives can and should be used both to attract foreign direct investment and to encourage home grown innovation.

In this article (the second of a two part series looking at tax incentives for innovation) we will consider two further tax incentives; (i) the tax exemption for patent royalties and (ii) the tax deduction for capital expenditure on scientific research. We will also consider briefly the new intellectual property tax deduction.

We mentioned in part one of this series (published in the May issue of tax.point), that the Innovation Taskforce Report made a number of recommendations in relation to improving existing tax provisions including the R&D tax credit, the tax exemption for patent royalties and the tax deduction for intellectual property. We will consider the comments of the Taskforce further below.

Tax Exemption for Patent Royalties

The Taxes Acts provide for an exemption from income tax and corporation tax for royalty income derived from a qualifying patent. Furthermore dividends paid by a company out of this exempt income are also exempt from tax subject to certain conditions.

The legislation in relation to these exemptions has been significantly amended and the exemptions restricted somewhat over the past number of years. However these incentives continue to be very attractive incentives for companies and individuals.

The main features of the exemption are:

• A royalty or other sum paid in respect of the invention to which a qualifying patent relates is disregarded for the purposes of income or corporation tax. With effect from 1 January 2008, the amount of disregarded income may not exceed €5m in a twelve month period. Any amount in excess of €5m is subject to tax.
• A royalty paid between connected parties must be arm's length and any excessive royalty amount paid will not qualify for the exemption.
• A qualifying patent is a patent in respect of which the work leading to the invention which is the subject of the patent was carried out in an EEA state (for patents developed before 1 August 2008, the work leading to the invention had to be carried out in Ireland). It is not essential that the patent be an Irish one and income from any foreign patent is covered as long as the work leading to the invention was carried out in an EEA state.
• Where the royalty or other sum is paid by a connected party, it will only qualify for tax exemption if the patent is used in manufacturing activities.
• Distributions made be a company from specified income in respect of a qualifying patent are disregarded for tax purposes in the hands of the recipient subject to meeting certain conditions.
• One of the main conditions is that the distribution does not exceed the amount of R&D spend by the company in the State in that accounting period and the previous two accounting periods. Where a company is a member of a group, it is the group R&D expenditure that is relevant.
• The R&D spend restriction does not apply where the invention which is the subject of the patent involves “radical innovation”. Radical innovation essentially involves creating something which is completely new and in practice we understand that few patents meet the radical innovation criteria.
• The exemption from income tax for income from patents is subject to the restrictions applicable to high net worth individuals introduced with effect from tax year 2007 onwards and restricted further in Finance act 2010.

The benefits of the patent income exemption are twofold. The effective rate of corporation tax for a company or group of companies is reduced because of the tax exemption for qualifying patent income. In addition the entrepreneur of the company can be rewarded through the payment of tax exempt dividends.

What Next?

The tax exemption for patent royalties was considered by the Commission on Taxation in their report (published in September 2009). The Commission was of the view that the relief had not resulted to any great extent in companies carrying out R&D. The Commission recommended that the tax exemption should be discontinued.

The Report of the Innovative Taskforce on the other hand recommended that the patent income exemption be retained. In the view of the Taskforce, the patent income exemption has played an important role in developing Ireland's smart economy to date. The exemption has already been significantly curtailed and it would in the view of the Task force be counter-productive to remove the exemption.

The effective tax rate in many European countries is being reduced in order to attract inward investment. In that context, it would seem that now is not the time to discontinue an incentive which can reduce the effective rate for companies and which has been through the rigorous EU approval process. In terms of the exemption for patent dividends paid to individuals, the Finance Act 2010 changes have restricted the benefit of the relief and in the current climate it is appropriate to limit the amount of tax free income that individuals can obtain. However, it is an important exemption in incentivising and rewarding the entrepreneur and for that reason should be retained.

Capital Expenditure on Scientific Research

A trading company which incurs capital expenditure on scientific research is entitled to a capital allowance equal to 100% of that expenditure against the profits of its trade. Scientific research is defined as meaning any activities in the fields of natural or applied science for the extension of knowledge. The scientific research allowance does not however apply to any expenditure incurred in the acquisition of rights in or arising out of scientific research.

The allowance is also available to persons who incur capital expenditure on scientific research although that research is not related to their trade.

What Next?

The Commission on Taxation in their September 2009 report recommended continuing this tax deduction as they believe it complements the R&D tax credit.

There would appear to be limited knowledge of this relief among companies and in practice we understand that it is not claimed by very many companies. There may be merit in reviewing the definitions and revamping the provision to encourage increased uptake of the deduction.

Intellectual Property

Finance Act 2009 introduced a new intellectual property (IP) tax regime which provides for a tax deduction for the cost of acquisition of qualifying IP assets. The regime was updated and made more internationally competitive in Finance Act 2010. This relief is a cornerstone of the Government's smart economy initiative.

A detailed review of this regime is outside the scope of this article but a summary of the main provisions are as follows:

• The deduction takes the form of capital allowances and is available for capital expenditure incurred after 7 May 2009 on the acquisition of qualifying IP assets.
• The deduction is equal to the amortisation or depreciation charge included in the accounts or alternatively the cost spread over 15 years.
• IP is widely defined and includes the acquisition of or the licence to use patents and registered designs, trademarks and brand names, know how, domain names and copyrights as well as goodwill directly related to these assets.
• The tax deduction is available for offset against income generated from exploiting IP assets or as a result of the sale of goods or services, where the use of IP assets contributes to the value of such goods or services.
• The tax deduction in a given year may not exceed 80% of the relevant profits of the company (meaning effectively a tax rate of 2.5% applies to income generated from qualifying IP assets). Any excess deductions can be carried forward for use in future years, subject to the noted restrictions.
• Where an asset is impaired in an accounting period, Finance Act 2010 confirmed that tax relief will be available for any such impairment charge.
• In order to avoid a clawback of the allowances, the qualifying assets must be used in the trade for a period of 10 years (formerly 15 years but amended in Finance Act 2010).

What Next?

The Innovation Taskforce while commending the enhancements to the regime contained in Finance Act 2010, have recommended further changes to make the deduction more attractive internationally. The Taskforce has recommended reducing the clawback period to 5 years and simplifying the calculation of the relief available.

One thing that is for certain is that the IP deduction will be retained and will continue to form an important part of Ireland Inc's package to attract investment. It is likely that we will see further refinement and amendment to the deduction over the next couple of Finance Acts as practical implementation issues come to light.

Conclusion

There is a clear recognition at Government level that tax incentives for innovation have a significant part to play in attracting investment into Ireland and encouraging entrepreneurship within Ireland. The changes made in Finance (No. 2) Act 2008 to the R&D tax credit regime are supportive of the efforts to enhance investment in research and development but as outlined in part one of the series further updating of the credit is required to make it internationally competitive. The patent royalty exemption should not be discontinued but is unlikely to be enhanced. The tax deduction for scientific research should be continued. The new IP regime is here to stay and is essential to attract inward investment.

The recommendations of the Innovation Taskforce in relation to tax are to be commended and it is hoped that these recommendations are reflected in future Finance Acts.

Lorraine Smyth is Head of Group Tax with Bank of Ireland

Nicola Quinn is Divisional Tax Manager Retail with Bank of Ireland.

Email: lorraine.smyth@boimail.com or nicola_m_quinn@boimail.com