While some businesses rely heavily on physical capital such as machinery and buildings, others rely more on intellectual property (IP) such as patents, software, or proprietary production processes. Many taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. jurisdictions have specialized treatment for income derived from IP, with some providing more favorable tax treatment than others.
Imagine a German manufacturing company holding patents on several of its products. This company sells its patented products and additionally licenses the right to use its patents to other businesses and receives licensing fees in payment. Germany doesn’t provide preferential tax treatment of IP income, and so the income derived from the patents would be subject to the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. . (The combined corporate tax rate in Germany is 29.8 percent.)
The Invention of Patent BoxA patent box—also referred to as intellectual property (IP) regime—taxes business income earned from IP at a rate below the statutory corporate income tax rate, aiming to encourage local research and development. Many patent boxes around the world have undergone substantial reforms due to profit shifting concerns. es
In an effort to encourage and attract innovation, a number of countries have implemented so-called patent boxes (also referred to as “innovation boxes,” “IP boxes,” or “knowledge boxes”) in the last two decades. In essence, a patent box provides a lower effective tax rate on income derived from IP. Most commonly, eligible types of IP are patents (including supplementary protection certificates and related rights) and software copyrights. Some IP regimes also include trademarks, copyrights, formulas, and industrial designs. Depending on the patent box, income derived from IP can include royalties, licensing fees, gains on the sale of IP, sales of goods and services incorporating IP, and patent infringement damage awards.
The stated goals of patent boxes are to encourage local research and development (R&D), to incentivize businesses to locate IP in the country, and to increase a tax code’s international competitiveness. R&D tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s are another form of tax break to incentivize R&D. The main difference is that R&D credits effectively reduce the cost of R&D, while patent boxes reduce the taxes on profits resulting from R&D.
To avoid paying Germany’s relatively high corporate income tax rate, the German manufacturing company might decide to move its patents into a holding company in a country that offers a patent box regime, such as Luxembourg. In Luxembourg, income derived from patents is taxed at a rate of 5.2 percent, 24.6 percentage-points lower than the combined corporate rate in Germany. Until recently, this was relatively easy to do, especially because intellectual property is very mobile and some countries, such as Luxembourg, did not require any underlying R&D activity by the taxpaying company. So the manufacturer’s R&D division could stay in Germany while the resulting patents could be moved.
Changing the Game: The Modified Nexus Approach
Over the last decade, patent boxes attracting intellectual property from foreign businesses without R&D activity requirements, such as in the case of our German manufacturer, became part of a bigger debate about global tax practices. The OECD and the European Union voiced concerns about patent boxes being used as a tool for profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. . As a result, in 2015, OECD countries agreed on a so-called Modified Nexus Approach for IP regimes as part of Action 5 of the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan.
This Modified Nexus Approach requires a link among R&D expenditures, IP assets, and IP income. More precisely, the tax benefit for income derived from IP should be proportional to the IP owner’s own R&D expenditures. Tax benefits from IP acquisitions and outsourced R&D can also be claimed but are limited to a combined 30 percent of the IP owner’s own R&D expenditures. Marketing-related IP assets, such as trademarks, are excluded from receiving tax benefits. No new entrants are allowed into old IP regimes and all old IP regimes should be abolished by 2021. R&D does not have to be undertaken domestically as this would have violated EU law. According to the 2018 OECD Progress Report on Preferential Regimes, as of January 2019, “all IP regimes are, with one exception [France, but measures were taken in the meantime], now either abolished or amended to comply with the nexus approach.”
With this Modified Nexus Approach, the German manufacturing company could only take full advantage of the lower Luxembourg tax rate on IP if its R&D expenses occur within its Luxembourg holding company, requiring relocating its R&D division. The other option would be to bring the patents back to Germany. In any case, some costly restructuring of IP activities will be necessary for some businesses. These impacts depend on factors such as the mobility of R&D activity and the effective tax rates on patents (including the deductibility of R&D expenses) and whether it makes economically more sense to relocate the R&D division or to bring the patents back.
From an economic perspective, the Modified Nexus Approach has significantly altered the incentive scheme for R&D activity and can pose substantial restructuring costs for some businesses. As with every change in tax policy, businesses respond to new incentives. Depending on what businesses see as the optimal restructuring response, either R&D activity or IP assets get relocated and tax jurisdictions either gain or lose tax revenue.
The Economics of Patent Boxes
As the Modified Nexus Approach for IP regimes has just recently been introduced, not enough time has passed for a thorough analysis of its economic effects. So far, research has focused on the effects of patent boxes prior to the implementation of the Modified Nexus Approach.
A 2014 study by Rachel Griffith, Helen Miller, and Martin O’Connell published in the Journal of Public Economics found that businesses are more likely to locate patents in countries offering relatively lower effective tax rates on income derived from patents than in countries with higher rates. All else equal, businesses prefer countries where they have associated real innovative activity. Their estimates also show that while patent boxes do attract IP from foreign countries, the tax revenue loss due to the lower preferential tax rate tends to exceed the revenue gains from additional patents, resulting in a net revenue loss.
A 2015 paper by Annette Alstadsater, Salvador Barrios, Gaetan Nicodeme, Agnieszka Maria Skonieczna, and Antonio Vezzani published by the European Commission also found that patent registration is responsive to lower tax rates provided through patent boxes. Also, patents tend to be relocated without the underlying R&D activities. Surprisingly, their results show that the size of the preferential tax treatment is negatively correlated with local R&D activity. However, R&D development conditions for income derived from IP tend to encourage local R&D activity.
It’s Time to be Patient
Now, while the implementation of BEPS Action 5 regarding IP regimes is still under review and businesses are still responding to the new rules, there is an ongoing debate about whether current rules allow for the right taxation of profits earned by multinationals. But before moving forward with new proposals, policymakers should allow for some time to let the economic effects of the Modified Nexus Approach unfold.
As with every change in tax policy, there are trade-offs. The Modified Nexus Approach adds an additional layer of complexity to the already complex issue of taxing IP income. Linking tax breaks for IP income to its associated R&D activity has changed the game and will likely result in some businesses restructuring and relocating their IP assets and R&D activity. Effective tax rates on IP income will likely play an important role in determining optimal locations, giving measures such as R&D credits more importance. Whether this new approach to IP taxation will impact profit shifting and which countries will be the winners and losers is yet to be seen.
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