How patent boxes became the new normal

Governments continue to assess the merits of various incentives available (and permissible) under IP box regimes

The OECD identified patent boxes as a harmful tax practice, since they allowed many companies to take advantage of extremely low effective tax rates, without actually supporting their IP with economic substance. To fix the issue, the guidelines for patent box regimes that the OECD released rely on the 'modified nexus approach' to make sure a low tax rate can only be secured with significant R&D activity in a jurisdiction.

Despite the OECD taking a dim view of patent box regimes, they have remained popular with countries looking to increase foreign direct investment (FDI). Countries like the UK and the Netherlands are adapting their existing regimes to comply with the OECD guidelines but other countries, such as Ireland and India, are using the guidelines as an opportunity to create 'compliant' regimes from scratch.

Standardisation prompts the question of whether, and to what extent, IP box regimes retain any attractiveness for multinationals, and whether the benefits for countries are still worthwhile. In spite of this, patent boxes have become the new normal; even with the 'sting' removed, patent boxes are more in demand than ever before.

The new OECD guidelines may have removed the harmful aspect of the regime; however, they have not dissuaded countries that IP tax regimes a strong way to attract FDI, as evidenced by the new proposals forwarded in Ireland, India and Switzerland.

There is an argument that by laying out the guidelines for patent boxes, the OECD has actually given countries the opportunity to implement regimes.

"The OECD has effectively told the world that these boxes are acceptable ones on modified nexus approach. I would argue if they hadn't done so, then many countries wouldn't have implemented them" said Gary Tobin, assistant secretary for tax policy at the Irish Department of Finance, at the Global Tax Conference hosted by the Irish Tax Institute at the beginning of March.

However, the benefits of patent boxes were already being scrutinised by countries before the release of the BEPS guidelines. It is undeniable that the UK was successful with its original patent box structure, with government statistics suggesting 639 companies had taken advantage of the system, and other countries were therefore keen to not be left behind.

"Even before BEPS was introduced, more and more countries without a patent box regime had realised that they were losing out on tax revenues on IP income due to favourable tax regimes provided by some other countries," said Maulik Doshi, partner at SKP in Mumbai. "BEPS, in a way, has highlighted the loss of tax revenues on account of the shifting of IPs by corporates, which in turn has encouraged countries like India to have IP regimes with the nexus based approach."

India's new IP regime was announced by Arun Jaitley, the finance minister, in the February 29 Indian Budget. It complies entirely with the OECD recommendations, making it the second patent box to do so since Ireland introduced its Knowledge Development Box in October 2015.

One of the newer box regimes introduced shows there remains appetite from some jurisdictions to take advantage of the pre-BEPS recommendation patent box provisions. Italy introduced its system in 2014, after the BEPS Project had started but before the Action 5 guidelines were released.

"It could be argued that Italy decided to introduce its IP regime before the end of the work on Action 5 of BEPS in order to put itself in the same condition as the other European countries that were already benefitting from IP regimes," says Stefano Simontacchi, managing partner at BonelliErede. "And that it would continue to take advantage of these regimes still for a while under the grandfathering rule provided by the Action 5 BEPS."

While countries continue to drive ahead with IP box regimes, the OECD's position on them remains outwardly negative, even with the introduction of the modified nexus approach. Pascal Saint-Amans, director of the centre for tax policy and administration at the OECD, has publicly spoken out against patent box regimes at many events.

"Patent boxes are a bad policy," says Saint-Amans. "If you decide to have a policy that is not smart, that is your sovereignty, but do it in a way that does not cause too much harm."

Scepticism of patent boxes has not solely come from the OECD. Valere Moutarlier, director of the Directorate General for Taxation and Customs at the European Commission, talking at the Irish Tax Institute event, took time to support Saint-Amans' comments.

Much of the push-back against the regimes was led by Germany, and it was the compromise reached between Germany and the UK on patent boxes that brought the modified nexus approach into the OECD guidelines. However, under this new style even Germany is reviewing the merits of creating a regime.

"The major goal of the German government is a successful closing of the OECD/G20 BEPS Project. The general German 'anti-patent box mood' might be seen as second-tier with regards to this agreement," says Xaver Ditz, partner at Flick Gocke Schaumburg.

"Generally, the enormous impact of the BEPS Project worldwide, and more specifically, the increasing number of patent box regimes, enhances the pressure on countries without such an IP-system. The German Federal Ministry of Finance is monitoring this development attentively."

The drive for countries to use a patent box regime is powered by the desire for greater FDI. But, where all countries aim for the same revenue stream, competition begins. The OECD-standardised system for patent boxes makes individual regimes less useful for that competition. Instead, it creates a need for all countries to have the system, as the new base level.

"A standardised system of patent boxes does not cancel out the advantages of having one; in fact, having a patent box regime in today's integrated global economy ensures that countries are not losing out on tax revenues from IP income even when substantial R&D was done in their land," says Doshi. "Standardised patent box regimes create a level playing field for all countries."

It is this notion that is drawing more and more countries into discussing the need for a national patent box regime, including Germany and the US.

"When the US has to do something to change its system and be more competitive with the rest of the countries globally, all ideas are out there being discussed and patent boxes have got more momentum at least on the US side," says Robert Russell, international tax attorney at Alliantgroup.

The US introduced a draft Bill to discuss the implementation of a patent box regime in 2015, after politicians were inspired by what they saw in Europe, says Russell. However, public comments on the draft proposal revealed a belief that there may be better ways to compete with Europe.

"Why does the US need to compete in exactly the same way as Europe?" says Russell. "There were a lot of comments from the public in the US about whether a patent box is really sound tax policy. Or are there much better ways to get at what you're trying to do?"

Ireland's introduction of its Knowledge Development Box was to fill the gap in tax policy from where the OECD had forced it to close the option for companies to use the 'double Irish' structuring mechanism. The competitive edge it has brought to its patent box is in the form of an effective 6.25% tax rate, significantly lower than the UK's 10%.

"There is an argument that by laying out the guidelines for patent boxes, the OECD has actually given countries the opportunity to implement such regimes"

Even this extremely low rate, however, may not be the critical factor that brings FDI to Ireland. The combination of the much narrower breadth of what is covered by the patent box system and the complicated documentation necessary to benefit from the regime, may prompt multinationals to avail of other incentives when assessing where to base their R&D activities.

"What we're seeing from an Irish perspective is a lot of clients are looking back at Ireland's standard 12.5% tax rate, which isn't from a special regime, so isn't bound by the modified nexus type-rules. Instead it applies classic transfer pricing rules," says Joe Duffy, partner at Matheson in Dublin.

"I think when companies are looking at the simplicity and transparency of that sort of system, and they look at the 12.5%, compared to the 10% in the UK's patent box, which they may or may not qualify for, or similarly any other regime in other countries, then 12.5% can be a more attractive alternative."

Persuading multinationals to move all their R&D activity to a jurisdiction simply to take advantage of a patent box is unlikely to be a fruitful pursuit.

"The unfortunate thing about the patent box, given the political sensitivity, is that while they will benefit certain companies I think it will be hard for them to drive any major investment decisions," says Duffy.

The OECD intended, through the publication of new guidelines, to protect the tax base of countries which already hosted significant amounts of multinational R&D activity. While a greater degree of standardisation of patent boxes does make them the competition aspect less potent as a fiscal policy tool, it has not removed the need to compete entirely.

Patent boxes are becoming the necessary base level for countries to host any R&D activity, but it does not mean countries will stop reaching for FDI with other measures.

"Patent box is just going to be one part of the competition for mobile FDI," says Duffy. "The patent box is only one part of the tax regime which is only one part of the overall offering, so yes you've got to think about a competitive tax rate but also simplicity, transparency and ease of actually working in that regime."