The Patent Box regime is a generous tax incentive introduced in 2013 to encourage innovation in the UK. The regime broadly offers an additional deduction in calculating taxable profits, with the effect that the relevant intellectual property profits are taxed at a reduced corporation tax rate of 10%. The relief was phased in over a period of four years, and so full relief on all Patent Box profits came into force in 2017.
The Patent Box rules are complex and the complexity increased when new Patent Box rules were introduced from 1 July 2016. The old regime will be grandfathered until 2021 for companies that elected into Patent Box before 1 July 2016 and for qualifying intellectual property (IP) that was in existence before 1 July 2016.
The new rules, that altered the development condition and introduced a “modified nexus approach” to ensure that substantive R&D activity is linked with a patent box deduction, is applicable to any company that elects into the regime after 1 July 2016 and for new patent applications after that date.
Who is eligible to elect into Patent Box?
To qualify for Patent Box, a company liable to UK corporation tax must make profits from exploiting qualifying patented inventions (or other certain medicinal or botanic innovation rights).
The company must either own qualifying patents or hold exclusive licences for the rights to those patents, which must have been granted by the UK Intellectual Property Office, the European Patent Office or certain European patent offices.
An exclusive licence needs to give the licensee an exclusive right to exploit the patent in one or more countries and the right to enforce the patent against any infringement of those rights. If the patent is held by a group company and the patent rights are conferred on another company in the group, then that company is to be treated as holding an exclusive licence.
A development condition must also be met. Under the new regime, the company claiming relief will need to be sufficiently involved in the development/innovation of the qualifying IP rights or products incorporating the patented invention. Managing the rights is no longer sufficient (as was the case under the old regime for group companies that held qualifying IP rights and allowed other group companies to develop the IP).
Which income is covered by Patent Box?
The main category is sales income from the patent or patent protected products. A product may only need one patented component for all its revenue to fall within the regime.
Income from the following sources may also qualify: patent licensing and royalties; patents used in processes or services; patent rights sold; damages and infringement income.
Although the identification of sales income from patented products should be relatively easy to determine, it may be less clear in the case of processes and services and it may be necessary to calculate a “notional royalty”.
Once the IP income has been identified, relevant expenses must be allocated appropriately. Under the new regime, this should be undertaken for each individual IP asset, product or product family. This stage determines the attributable profits for each IP sub-stream.
A series of calculations must then be carried out to strip out profits from routine or marketing activities to leave only profits relating to the underlying patented technology. For the new Patent Box regime, the calculations are as follows:
The routine return calculation aims to remove the ‘normal’ return from each IP sub-stream, ie the profit a business might be expected to make if it did not have access to IP or other intangible assets.
To compute routine return, a notional 10% of certain tax deductible operating expenses is taken for each IP sub-stream. It is then deducted from the relevant IP sub-stream profit to arrive at the qualifying residual profit (QRP).
Marketing asset return (MAR)
MAR aims to remove from each IP sub-stream the arm’s length element of profit that relates to the company’s brand and marketing assets, so that only profits generated from the exploitation of qualifying IP benefit from the Patent Box.
Calculating the MAR can be involved and costly, often requiring a transfer pricing exercise to calculate the notional marketing asset return, a necessary component of the MAR calculation.
Companies with total QRP of less than £1 million (divided by the number of 51% related companies) may alternatively elect to apply a simpler formulaic method, known as the Small Claims Treatment, to arrive at the amount of profit derived purely from each patent (or other IP right). This treatment allows a company to calculate the MAR at 25% of QRP. Whilst this treatment may be simpler, it may not be as beneficial given the alternative approach may result in a £nil MAR in some circumstances, thereby maximising the quantum of profits that are included in Patent Box.
R&D fraction ‘Nexus approach’
The new regime has introduced the Nexus approach, which effectively limits the level of profits eligible for the effective 10% regime.
For each stream of qualifying Patent Box profits, it is necessary to calculate an R&D faction and then apply this to the appropriate QRP.
The R&D fraction is based on the amount of qualifying in-house R&D expenditure incurred on the particular patent (or other qualifying IP right) plus third party sub-contracted R&D, relative to overall R&D expenditure (including connected party subcontracted R&D) and any relevant IP acquisition costs. This fraction is applied to each IP stream’s QRP (after deducting the appropriate MAR) to determine the amount of qualifying profits for each patent stream. In general terms, the more work undertaken in-house or sub-contracted to an unconnected third party, the more beneficial the Patent Box regime will be for a claimant.
The new Nexus approach requires the company to keep track of all expenditure incurred on qualifying R&D activities for each qualifying IP stream, as the R&D fraction uses the total R&D expenditure incurred from the appropriate relevant date (1 July 2013 for new entrants with accounting periods before 1 July 2021).
The final stage
The next stage of the calculations is to combine the results for all qualifying IP sub-streams (after applying the appropriate R&D fraction) in order to determine the total Patent Box profits or losses. For patents granted in the year, if pre-grant profits have been elected into the regime, then the appropriate profits should be included as relevant IP profits here (see patent pending section below for more on this).
For a company to obtain the effective 10% tax rate on Patent Box profits, an additional deduction to taxable trading profits is computed. This will either reduce a company’s taxable trading profits or it will create/ increase trading losses. If these losses cannot be used in the current period or carried back, they will be carried forward so the benefit can be obtained in a future accounting period.
For companies that have elected into Patent Box and have achieved a Patent Box loss, the rules ensure that such loss is offset against other patent profits in the current or future periods. For prospective entrants into the regime, care should therefore be taken to ensure that the election into the Patent Box regime is made at the most advantageous time.
If you have applied for a patent but it has not yet been granted, the benefit of Patent Box can still apply. Providing the company has elected into Patent Box and submitted a pre-grant election for a particular patent, the benefit accrues while the patent is pending, and is claimed in the period when the patent is granted.
The relief can be claimed on profits made up to six years prior to the grant, so long as the above-mentioned elections were in place for these accounting periods and providing this is after 1 April 2013.
Electing into Patent Box
A company must elect into Patent Box by giving notice to HM Revenue & Customs (HMRC). The notification is usually included within the company’s tax return/computations. A company has two years from the end of the accounting period in which to elect into the regime.
Once an election is made, the company will remain in Patent Box unless the election is subsequently revoked. It should be noted that once an election is revoked, a company will not be able to elect back into the Patent Box regime for a further five years.
Interaction with R&D tax relief
Patent Box complements the R&D tax relief regime. Any additional deduction obtained for making a claim for R&D tax relief is excluded from relevant taxable profits thus increasing the benefit of Patent Box. In addition, qualifying R&D expenditure together with any uplift and Research & Development Allowances (RDAs) are excluded from the calculation to identify routine expenses.
However, companies that outsource their R&D to fellow group companies may find the benefit of Patent Box reduced as the aim of the Nexus approach is to reward companies who undertake their R&D in-house or use unconnected third parties in R&D projects. Care should therefore be taken within groups to ensure, where possible, that the R&D tax relief and Patent Box claim are within the same company.
Unlike R&D tax credits, the Patent Box deduction cannot be exchanged for a cash repayment.
Whilst the Patent Box regime is complex, the benefits of claiming patent box can be significant and so those companies that meet the qualifying conditions should consider taking advantage of it.
How we can help
We can prepare a feasibility study to determine the potential benefit of electing into the regime. We can consider opportunities for improving the company’s position by evaluating different operational structures or ensuring that the R&D activities are in the same company as the Patent Box claimant.
We advise companies on the most advantageous time to elect into the regime to ensure that the benefit is maximised avoiding as far as possible Patent Box losses.
If you do not have patents but would like to discuss whether a patent application would be successful, we can put you in contact with patent attorneys.
Once a company is within Patent Box, we can assist with the detailed calculations to compute the total Patent Box relief. If appropriate, our specialist transfer pricing team can undertake a benchmarking exercise to determine the relevant marketing royalty to be used.
We often work with clients on both R&D and Patent Box. We review ways that will maximise the company’s R&D tax credit relief as well as the increase the benefit the Patent Box.
If you would like assistance with Patent Box, please get in touch with either your local partner or one of our specialists: Robert Langston, James Bramsdon or Justine Stalker.
This factsheet is based on law and HMRC practice at 1 July 2019.