2015-Issue 33—This past summer, you probably noticed a significant number of both business and tax publications discussing “patent boxes.” Your initial reactions were likely, “what is a patent box?” and “how would it impact my company?” Hopefully, this edition of Tax Advisor Weekly will give you a basic understanding of the patent box concept. This includes a summary of the major patent box legislative proposal presented in the U.S. House of Representatives, along with an idea of when and how a U.S. patent box might affect your company’s tax reporting requirements.
Patent Box Basics
A patent box tax regime allows a reduced tax rate on profits derived from intellectual property (IP). The concept was introduced a few years ago in Europe. It is now a common tax structure in a number of European countries. The expressed goal of patent boxes is to encourage businesses to maintain their IP in the country where it was developed by offering a reduced tax rate on profits generated by a company’s in-country IP. A patent box can be thought of as a “back end” incentive, as it activates at the end of the production cycle. In contrast, research tax credits are “front end” incentives, which stimulate investment during the development process before a product is ready for production. Patent boxes apply after technologies are fully developed by providing incentives on the sale and commercialization of existing IP assets. Both the patent box and research tax credit are founded in the belief that private investments in research and development cause the invention of technologies that are fundamental to a nation’s creation of jobs.
Patent Box Calculation
Although a patent box calculation seems relatively simple in theory, the devil is always in the details. At a high level, a patent box requires taxpayers to identify revenue streams generated by in-country IP. Cost of goods sold and other direct and indirect expenses are then identified for those revenue streams, and net income is calculated. A reduced patent box tax rate is applied against the IP net income, while the remaining income streams are taxed at the standard rate. The patent box calculation is similar to a Section 199 calculation, and anyone who has worked through even a “simple” Section 199 calculation knows that the guidance and details for that exercise can be numerous, contradictory and often ambiguous (additional adjectives include “frustrating,” “aggravating” and” infuriating,” etc.). Knowing the propensity of Congress to avoid simple, straightforward language when it comes to enacting new tax legislation, it’s debatable whether a U.S. patent box would be a welcome addition to the U.S. tax code or just another compliance nightmare for corporate tax departments. Identifying qualifying IP, properly identifying IP-generated gross receipts and properly allocating expenses are just a few of the issues that come to mind when envisioning the operation of a U.S. patent box regime. A patent box proposal presented this summer by two members of the House Ways and Means Committee provides some clues as to what a U.S. patent box would look like and how it would work.
Boustany and Neal Patent Box Proposal
In late July, House Ways and Means Committee members Charles Boustany, Jr. (R-La.) and Richard Neal (D-Mass) issued the Innovation Promotion Act of 2015 discussion draft. They also requested detailed feedback on their proposal, including its scope, costs and compliance burdens, and whether it would in fact help U.S. economic competitiveness. In general, the Boustany-Neal patent box would provide a deduction for “innovation box” (their name for a U.S. patent box) profit from the use of U.S. domestic innovations and provide incentives for transferring IP to the United States. The deduction would result in an effective tax rate of approximately 10 percent on innovation box profits and would be equal to 71 percent of the lesser of a taxpayer’s innovation box profits or taxable income. Further, the deduction could not create a net operating loss deduction. The proposal would also allow companies with overseas IP to bring such IP back into the U.S. in a nontaxable event. The Boustany-Neal proposal would leave the current research tax credit under Section 41 and the research expense deduction under Section 174 unchanged.
Under the proposal, innovation box profit equals the tentative innovation box profit multiplied by a fraction consisting of a numerator of five-year R&D expenditures performed in the United States, as determined under Section 174, and a denominator of the taxpayer's five-year total costs. Five-year total costs equal the excess of all costs paid over the taxpayer's cost of goods sold, interest and taxes. To determine tentative innovation box profit, cost of goods sold and other expenses, losses or deductions allocable to qualified gross receipts are subtracted from qualified gross receipts. Qualified gross receipts are the taxpayer's gross receipts derived from the sale, lease, license or other disposition of qualified property in the ordinary course of its U.S. trade or business. Generally, it does not include the sale of qualified property to a related person unless resold to an unrelated person. Income from services is not included either.
Qualified property includes patents, inventions, formulas, processes, designs, patterns, know-how, motion picture films or videotapes, or computer software.
The Boustany-Neal proposal also includes special rules for transfers of intangible property from controlled foreign corporations (CFCs) to U.S. shareholders. Taxpayers may distribute appreciated intangible property assets from a CFC to a domestic corporate parent that is a U.S. shareholder, under a qualified plan, without giving rise to taxable income if certain requirements are met. A qualified plan is a written plan filed with the Treasury secretary, in effect before the distribution, that describes the distribution or series of distributions that are made through intervening CFCs and completed within two years.
Will a Patent Box Lead to True Tax Reform or Cause Further Complexity for Taxpayers?
Initial tax commentator reactions to the Boustany-Neal proposal were generally unfavorable, given the complexities of the actual calculation. Many commentators believe that as written, the Boustany-Neal proposal would be difficult for the IRS to administer and would cause many of the same difficulties for taxpayers as the Section 199 deduction mechanics. The largest concern for taxpayers is the potential need to establish separate or parallel accounting procedures or ledgers in order to properly track the qualifying revenues.
On the other hand, many lawmakers welcome the Boustany-Neal proposal and view it as an initial step towards U.S. tax reform and as an effective method of keeping IP (and the related tax base) in the United States. Otherwise, it is feared that more U.S. IP will end up in European countries that already offer their own version of a patent box (and there are additional concerns that the patent box countries will eventually begin to require companies to move research jobs in order to qualify for the benefit). A Wall Street Journal article made it clear that House Ways and Means Committee Chairman Paul Ryan (R-Wi) supports a version of the Boustany-Neal Proposal and hopes to make it part of his comprehensive corporate tax reform proposal. (See “Lawmakers Unveil Tax Plan on Intellectual Property,” The Wall Street Journal, July 29, 2015.)
Many issues will have to be resolved before patent box legislation is enacted in the U.S., not the least of which is that the White House currently prefers the research credit as the most effective means of keeping IP and R&D jobs within the United States. The primary questions to be resolved are what types of IP should qualify and what IP-related revenue streams should qualify. And in answering these questions, can the calculation be kept relatively simple? Congress will have to determine how to replace the lost tax revenues resulting from the implementation of a patent box. Finally, it remains to be seen whether a patent box can be incorporated into meaningful corporate tax reform or if it will become just another complicated deduction mechanism that causes friction between taxpayers and the IRS and is seen by others as another example of corporate welfare.
Congressman Ryan has been quoted as wanting to introduce an international tax reform bill by October that would likely offset the cost of an innovation box provision by slowing the recovery of research expenses. Ryan's proposal would include an innovation box, similar to the Boustany-Neal proposal’s innovation box. The Ryan patent box's high cost would be offset by requiring companies to amortize research expenses over five years. Under Section 174, companies can currently elect to deduct research expenses when they are paid or incurred. (See “Ryan Eyeing Research Cost Recovery to Pay for Innovation Box,” Tax Notes Today 158-4, August 17, 2015.) Essentially, Ryan would be taking away “front end” research incentives in order to provide “back end” research incentives.
Alvarez & Marsal Taxand Says:
Fundamentally, Congress has to decide the how it wants to incentivize and reward research occurring in the United States. Does Congress want to incentivize research on the “front end,” “back end” or both? The Section 41 research tax credit has always been, at its root, a U.S. jobs incentive. This incentive is focused on rewarding companies as the research is occurring. Like the Section 174 deduction, the research credit is a “front end” incentive. Still, it isn’t perfect, as it isn’t refundable. Therefore, it incentivizes only profitable companies. Many companies preserve high-paying technical engineering and research jobs within the U.S. in order to take advantage of the research credit. Many of the same companies have significant IP overseas in order to take advantage of lower corporate tax rates on revenue generated from the sale of products produced by such IP. A number of U.S. entities have been acquired by foreign entities for the same reason.
Given the way a patent box is administered, companies that benefit the most are those with large manufacturing operations that are very profitable. A company spending a great deal on research that is short on investment with no present profits receives no tax assistance to help it arrive at the next great technology. Many companies would rather see the research credit made permanent and the credit rate increased than the addition of a complicated patent box regime.
In our opinion, a fair, relatively simple, clearly defined patent box regime would encourage companies to keep both research jobs and IP in the United States. This result would be a welcome addition to the U.S. tax code. It has the potential to spur U.S.-based innovation, increase the number of high-paying U.S.-based research jobs, and generate long-term U.S. economic growth. In its present form, we don’t believe that the Boustany-Neal proposal provides the correct patent box solution. The compliance burdens will likely outweigh the benefits.
As currently written, the Boustany-Neal proposal’s patent box calculation mechanics are very complicated. Much like the Section 199 deduction, we fear that if the Boustany-Neal patent box is enacted, U.S. companies would be required to establish separate or parallel accounting ledgers. Additionally, the ambiguity of many terms in the Boustany-Neal patent box provisions, such as “patents, inventions, formulas, processes, designs, patterns, know-how, motion picture films or videotapes, or computer software” will require extensive regulations (as we’ve seen with the research credit) and provide the opportunity for numerous and contentious taxpayer-IRS disputes (as we’ve seen for the Section 199 deduction and the research credit).
The proposal would also be costly to the Treasury. If a patent box proposal can be made part of a comprehensive corporate tax reform package that truly simplifies the U.S. tax code and provides a more competitive tax rate for U.S. companies, it could provide the U.S. with a more competitive tax landscape. However, it remains to be seen in today’s Washington D.C. political climate if this type of tax reform can be enacted. In the meantime, most companies would be satisfied in the short term if Congress would see fit to extend the research tax credit (along with the dozens of other extender tax provisions that expired on December 31, 2014) prior to the end of 2015.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.