In an increasingly interconnected world, national tax laws haven’t always kept pace with global corporations, fluid movement of capital and the rise of the digital economy, leaving gaps and mismatches that can be exploited to generate double nontaxation. This can undermine the fairness and integrity of tax systems.
Base erosion and profit shifting (BEPS) is the act of using tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax liability. BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises (MNE).
Patent box regimes fall under Action 5 of the Organisation for Economic Co-operation and Development’s (OECD) BEPS Action Plan.
The patent box originated in the early 1970s, when the Irish government granted full tax relief for royalties and other income generated from licenses patented in Ireland. Various foreign governments have enacted patent box regimes with the following objectives:
- Retaining income from the creation of intellectual property (IP) within their home countries
- Retaining and attracting engineers and other high-tech talent from around the world
Patent box regime rates vary as follows: France allows companies paying the French corporate tax rate of
33 percent to pay 15 percent on income from patents and royalties. In the Netherlands, the regime applies a
5 percent rate to patent income, while the U.K. rate is 10 percent, Hungary’s is 8 percent, Belgium’s is 6.3 percent and Luxembourg’s is 5.76 percent.
The initial Action 5 report follows a three-pronged, question-based approach to assess whether a preferential IP (or Patent Box) regime is harmful:
- Is activity shifted from one country to another country due to a preferential tax regime rather than generation of a significant new activity?
- Is the presence and level of activities in the host country commensurate with the amount of investment or income derived in the host country?
- Is the regime’s primary motivation the location of an activity or the location of the income?
In November 2014, the U.K. and German governments proposed changes to the OECD’s Forum on Harmful Tax Practices by adding a “modified nexus approach” requirement to preferential IP regimes under the Action 5 initiative. Under the new “OECD Action 5 Model,” countries with existing IP regimes would have to enter into informal consultation with the OECD to agree on ways to modify their existing regimes. They also would have to close these regimes to new IP by June 30, 2016, and abolish them by June 30, 2021. After they’re abolished, new regimes would be required to conform to the final OECD Action 5 model.
The modified nexus approach would require an IP regime to adopt the following limits:
- The regime is limited only to patents and other similar assets.
- The benefit of the regime is limited to the percentage of actual research and development (R&D) expenses incurred by the entity seeking benefits to worldwide R&D costs. This includes an “uplift” of 30 percent on additional outsourced contract R&D activities, including acquisition costs, and an assessment of the functions, assets and risks of the entity claiming benefits.
- The regime isn’t permitted to engage in related-party outsourcing beyond the 30 percent limit noted above, regardless of whether the R&D activity was performed in the same country where the entity is formed.
- The regime isn’t permitted to classify acquisition costs as a qualified expenditure, except when the cost falls within the 30 percent uplift exception noted above; this eliminates the benefit of a “buy-in” payment.
The modified nexus approach would further require taxpayers to track and trace their expenditures; the country hosting the IP regime would remain responsible for verifying the benefits upon audit. Enforcement of the new rules would rest with the Forum on Harmful Tax Practices, which consists of government representatives from participating countries operating in complete secrecy.
Given the forum’s confidential nature and the IP system’s “self-monitoring” model, questions have arisen regarding accountability and compliance under the OECD’s Action 5 plan.
While the OECD’s approach to the patent box is based on the concept of creating fairness among tax regimes, the real goal of the initiative is to force companies to send more development resources from their current locations, i.e., inside the U.S., to the location where the actual patent box benefits are being granted.
Given potential for the loss of these tax benefits, if the U.S. remains on the sidelines, it could experience even more loss of high-tech and engineering jobs to other global locations. U.S. multinationals simply wouldn’t want to lose the benefit of their R&D expenses.
The U.S. response to these new OECD guidelines likely would follow one of two paths: an IP patent box regime would be enacted in the U.S. along with overall tax reform (that would potentially include moving to a territorial tax system), or moving IP offshore from U.S. locations would be made more difficult through stiffer penalties and tax enforcement.
Given the likelihood that U.S. corporations would suffer under stiffer IP migration rules, it’s more likely the U.S. would consider an IP patent box regime as part of an overall tax reform plan—or perhaps on its own, before such a larger reform plan could be adopted. MNEs should stay up to date on the latest developments in this area.
For more information, contact your BKD advisor.