The stated aim of the UK government is to provide the most competitive corporate tax system in the G20.

As part of this overall goal, the UK government has recognised that encouraging innovative business to invest in the UK will play a key role in supporting a strong and growing private sector economy.

This key theme of encouraging innovation was reflected in the 2011 UK Budget with the proposed introduction of a UK Patent Box regime. The Patent Box regime will tax income from patents, and certain other qualifying intellectual property (IP), at a lower effective tax rate – ultimately 10%.

The aim is to provide an additional incentive for companies to both retain/commercialise existing patents and to develop new innovative patented technologies in the UK, thereby encouraging companies to locate the high-value jobs associated with the development, manufacture and exploitation of patents in the UK.

The new rules will apply with effect from 1 April 2013 for those companies electing into the new regime.

The key features of the Patent Box regime are set out below.

Who will Benefit

Broadly speaking companies that hold qualifying patents and actively engage in the development and commercialisation of those patents will be eligible for the Patent Box.

The objective is to limit the Patent Box to companies which have been involved in the innovation lying behind the patents. As a result, simply acquiring the rights and marketing a fully developed patent or invention will not be sufficient.

However, the breadth of the qualifying criteria should mean that the Patent Box will have mainstream appeal across a broad range of industries.

Qualifying Criteria

The qualifying criteria broadly consists of 3 tests:

1. A holding test

The definition in respect of holding patents is drawn quite widely and includes legal ownership, beneficial ownership, an exclusive licence to exploit a patent in any given country as well as cost share agreements.

2. A qualifying patent test

Patents granted by either the UK's Intellectual Property (IP) Office or the EU Patent Office qualify under the rules. Both existing as well as new IP is included.

3. A development test

Companies will satisfy the development condition if the company, or a member of the company's group, carries out ‘qualifying development’.

For these purpose, ‘qualifying development’ is activity which creates or significantly contributes to the creation of the patent or performance of a significant amount of activity for the purposes of developing the patent or any product incorporating the patent.

Income Falling Within the Regime

Once a company is in the Patent Box (i.e. it has a qualifying IP right), the next step is the calculation of the relevant IP profits which are subject to the reduced rate. This follows a formulaic approach as outlined ?by HMRC.

While at first sight, the formulaic approach detailed below may not look very inviting, the majority of the components should be derived from existing information in the company, albeit not necessarily from statutory accounts.

The key features of the approach are set out below – see Appendix 1 for worked calculation.

Step 1: Calculate the total gross income of the trade for the accounting period

Total gross income is calculated by taking the company's trading revenues, adding any credits on realisation of relevant intangibles and deducting any finance income such as interest and dividends.

Step 2: Calculate the percentage of the company's total gross income of the trade that is relevant IP income

The relevant IP income is the aggregate income arising from the qualifying patents and includes product sales income, qualifying IP sales income and licence fees.

The percentage of the company's total gross income of the trade that is relevant IP income is then calculated.

Step 3: Apply that percentage to the total profits of the trade

The aim of this step is to apportion the taxable trading profits between activities related to the exploitation of qualifying IP rights.

Step 4: Deduct the routine return figure to obtain the qualifying residual profit

This step is designed to calculate the additional IP profit over and above a routine return which a company is expected to earn. The routine return is 10% of this base.

The percentage calculated at step 2 is applied to determine how much of that routine return is to be attributed to profits from the company's relevant IP income. The resulting number is then deducted from the profit calculated at step 3, to give the qualifying residual profit.

Step 5: Deduct from the qualifying residual profit calculated at step 4, an amount to be attributed to marketing assets

This requires companies to deduct the part of the residual profit that is associated with their brand.

It is important to note that not all companies will actually have to go through this brand profit elimination exercise. Companies with the features of B2B may benefit from a de minimis threshold where their brand profit is less than 10% of the qualifying residual profit.

Optional step for small claims – calculate the amount of the qualifying residual profit that is attributed to the qualifying IP rights

Companies may elect to apply the small claims treatment and follow a simplified procedure.

For companies with just one trade, the amount of relevant IP profits can be the lower of 75% of the qualifying residual profit or the small claims threshold (£1m pro rated for the number of associated companies also in the Patent Box regime).

This option should encourage the take up of the relief by more companies and is a welcome development.

Streaming – An Alternative Approach to Steps 1 to 3

In cases where the application of steps 1 to 3 gives rise to an inequitable amount companies can elect to apply the streaming provisions.

Streaming is also mandated in certain limited circumstances namely where a company's total gross income includes a substantial amount of licensing income that is not relevant IP income.

Those companies adopting streaming need to split their total gross income into two streams, a relevant IP income stream and all other income. Expenses then need to be allocated between those streams on a just and reasonable basis.

Companies then resume the main formula at step 4.

Streaming elections once made apply to all the company's trades and applies to subsequent accounting periods until such time that there is a change in circumstances.

Other Points of Note

• The legislation includes a number of anti-avoidance provisions.

For example, where a qualifying item is incorporated into a larger item with one of the main purposes being the extension of the Patent Box to the larger item, the planning will fail.

• Surplus Patent box losses must be offset against other group companies relevant IP profits in the current accounting period.

Any remaining losses are then carried forward to offset against future Patent Box profits of the company or, in certain circumstances, of other group companies.

• Companies who have elected to enter the Patent Box can revoke that election provided certain conditions are met.

However having done so they will not be allowed back in for 5 years.

• If a company has patent box losses in the first year, it is likely to be more beneficial for the company to delay its entry into the Patent Box regime.

Next Steps

Companies should now start to consider the potential impact of the Patent Box on their business. Collating the necessary underlying data may not be straightforward for all companies, especially for year 1. However, this challenge can be overcome in the vast majority of cases and the tax relief thus secured will be worth the additional work that may need to be undertaken.

The availability of the Patent Box reduced rate should encourage companies to genuinely incentivise innovative activity.

Appendix 1

Worked illustration – based on example provided in HMRC consultation document

• Company A has trading turnover of £1,000 (£700 of which results from the sale of qualifying patented products).
• Tax adjusted trading statement:

	£	£
Sales		1,000
Trading expenses:
R&D	100
Marketing	75
Other costs	600	775
Taxable trading profit		225

Step 1 – £1,000 (total gross income of the trade)

Step 2 – 70% (the percentage that is relevant IP income)

Step 3 – applying the percentage from Step 2 to the taxable profit figure gives £158 (i.e. £225 x 70%), being the profits related to IP rights.

Step 4 – calculation of routine return deduction using 10% mark up

	£	£
Total expenses	775
Total IP relevant expenses (£775 @ 70%)	543
Mark up rate	10%
Routine profit	54
Apportioned trading profit (Step 3)		158
Routine profit		(54)
Residual taxable profit attributed to IP income		104

Step 5 – elimination of profit attributable to marketing assets (Brand) via the application of an R&D / marketing spend ratio to allocate residual profit

	£	£
R&D	100
Marketing	75
Total	175
R&D as a% of R&D and marketing = 57%
Taxable IP profit after Step 4		104
Application of% to residual profit (i.e.£104 x 57%)		59

Overall result

£59 he tof taxable income of £225 will be taxed at the lower patent box rate.

Steven Stewart is a Tax Manager with Deloitte

Tele: Belfast +44 (0) 2890 322861

Email: stestewart@deloitte.co.uk

Website: http://www.deloitte.co.uk