Since it was first trailed as part of the Finance Act 2012, the Patent Box has been a flagship policy of the government’s package of reliefs and reforms aimed at making Britain a hub of innovation and development.

Offering a 10% rate of tax (currently being phased in) for profits derived from patented intellectual property (IP), this attractive incentive has garnered significant media attention in recent years. However, in this era of international tax competitiveness and fair play, not all publicity is good publicity.

Member states of the EU questioned the objectivity of the regime in the context of the ongoing G20 OECD Base Erosion and Profit Shifting (BEPS) project. In the wake of this challenge, the Patent Box regime came under scrutiny from Brussels.

Some limited clarity came in October 2015, with the release of BEPS Action 5: Countering Harmful Tax Practices. This confirmed that from 1 July 2016 all preferential IP regimes, such as the Patent Box, must link the benefit derived to “substantial activities” being undertaken by the claimant company. In its release, the OCED recommended R&D activities as the proxy for these “substantial activities”.

Therefore, Action 5 did not fundamentally outlaw the Patent Box as some had feared and others had hoped for, but modifications were required to the regime.

The UK government sought to comply with these new guidelines through the release of draft legislation and a corresponding consultation document in October 2015. These outlined the proposed changes to the design of the patent box calculation to comply with BEPS; the fundamental modification of which is the application of the nexus fraction.

This is the distinguishing feature of the modified Patent Box regime, and is a computational requirement only which serves as an additional step to the original approach. The broader principles of the regime, including what qualifies as IP income, remain unchanged from the currently enacted legislation.

The nexus fraction

Under the original Patent Box rules, there is no requirement for the company receiving the patent box benefit to have undertaken the development that yielded the qualifying IP asset. As this directly opposes the spirit of BEPS Action 5, the nexus fraction has been introduced as a mechanism to align the benefit of the patent box regime to this underlying development.

The nexus fraction seeks to affiliate the patent box benefit to IP development by penalising the subcontracting of R&D activities to connected parties and the acquisition of qualifying IP assets rather than undertaking development in-house. The definitions used for the purposes of the enhanced R&D tax credit apply equivalently to the nexus fraction.

Notably the modified regime does not seek to comprehensively penalise all subcontract relationships. This restriction is limited in its application to connected parties only, and so the subcontracting of R&D activities to unconnected parties should result in no diminution of the patent box benefit. Furthermore, the fraction provides an allowance for up to 30% of qualifying expenditure to be subcontracted to related parties before any restriction is enforced.

That said, it should be highlighted that this connected subcontractor restriction does apply even in a scenario where the connected entities are both based in the UK. As a result, groups that operate entirely in the UK should not readily assume that they are by default shielded from any modifications to the patent box regime, and should reassess their subcontract relationships on the basis of the draft legislation.

Furthermore, as we move forward with the modified regime, groups that segregate R&D activities and IP ownership or that are active in the acquisition of IP assets must be mindful of these key features of the modified regime.

However, even within the modified regime there are circumstances where the full benefit of the current regime will still be available to patent companies when applying the nexus fraction. Where the IP is held in the same company that undertakes all R&D activities or less than 30% of expenditure is acquired or subcontracted to connected parties, the nexus fraction should have no power to impede the current benefit.

This serves to highlight that the modified regime can still provide a considerable benefit to qualifying companies.

However, given the direction of travel of the Patent Box modifications it should be noted that for companies which fall within the so-called grandfathering provisions outlined in the draft legislation, this modified regime may not apply to them for up to five years.

Grandfathering

Companies which have elected qualifying IP assets into the current regime before 30 June 2016 can ‘grandfather’ these assets with the effect of continuing to apply the current regime until 30 June 2021.

When considering the grandfathering of IP assets it is important to note that a company must elect qualifying IP assets into the regime. Therefore, only companies which do not hold any ‘new’ IP assets arising after 30 June 2016 are entirely grandfathered within the current regime. Consequently, companies that have elected into the existing regime but continue to develop, acquire or license new patents after 30 June 2016 will be required to apply both the current and modified regime concurrently.

While the nexus fraction may not curb the patent box benefit for certain companies, all those within the modified regime must calculate and apply the fraction as an additional step in the computation of the patent box deduction. All companies within the current and modified regimes are therefore united by a much more onerous administrative burden, in collecting and apportioning the relevant R&D expenditure data and attributable income.

Track and trace

Under the modified regime it will be necessary to divide qualifying patent box income into separate sub-streams to allocate costs to each on a just and reasonable basis. This is required to be carried out at the most granular level at which the costs can be mapped effectively. This may be at the level of the patent itself, a product which includes the patent (or patents), or a product family.

As a result, rather than calculating a single nexus fraction, this streaming approach requires the calculation of a separate nexus fraction for each patent sub-stream. These fractions are required to be cumulative and therefore the associated costs and income streams must be traced to the patent and tracked for up to 15 years.

Going forward, for most companies this data must be captured and retained from 1 July 2016 at the earliest. However, for companies entering into the modified regime before July 2021, the relevant date will be 1 July 2013 although special provisions have been made where a company has insufficient data for the period 2013 to 2016 to calculate the fraction.

This level of data capture is entirely new to the patent box regime, and therefore raises many questions and challenges for companies in identifying appropriate methodologies for tracking and tracing these sub-streams. Further complexity will be imposed on companies administering both the current and modified regime simultaneously, particularly when these patents are embedded in a single product.

Therefore even companies operating grandfathered schemes will be impacted by these reforms as they may be required to track and trace the relevant income and cost information immediately.

As a result of this increased subjectivity and complexity, HMRC anticipates a much higher level of interaction and collaborative effort in agreeing these methodologies with affected companies and their advisors.

Looking forward

While the draft legislation is still to be enacted, it has provided us with the greatest clarity to date on the future of the Patent Box. This seems to affirm that even within a modified framework the Patent Box has the potential to provide companies with a significant reduction in their corporate tax bill.

Even in the context of an 18% main rate of corporation tax or a still-to-be-enacted Northern Ireland rate, the Patent Box benefit remains highly lucrative. This is not simply on the basis that it undercuts both these rates but owing to the fact that it is enacted and available to qualifying companies immediately.

This benefit does however come with increased compliance burdens and much more rigorous record keeping which, even those grandfathered entirely into the current regime, will have to assess and implement as soon as possible.

In terms of immediate next steps, groups and standalone companies alike need to review the potential operational impact on both existing and potential future patent box elections as soon as possible.

Ian Edwards is a Director with EY

Email: iedwards@uk.ey.com

Website: http://www.ey.com/UK