This week, Representatives Charles Boustany (R-LA) and Richard Neal (D-MA) introduced a discussion draft on the “Innovation Promotion Act of 2015.” This act would introduce what is called an “innovation box,” or 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. to the U.S. 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. code.
Simply put, a patent box provides a lower tax rate on income related to intellectual property. Its stated goal is to promote research and development in the United States.
How Would the Patent Box Work?
The Patent box would work by providing a (71 percent) deduction for patent income. For example, if a company had $100 of patent income, only $29 of that income would be taxed at the 35 percent 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. rate. The company’s effective tax rate on that $100 patent income would be 10.15 percent. Non-patent income would still be taxed at 35 percent.
Under this plan, there is a broad definition of income that qualifies for the 71 percent deduction:
- Licensing fees. If a corporation licenses the right to use a patent and receives licensing fees, those payments qualify.
- The sale of a product related to a patent. If a corporation invents a new product, the profit related to the sale of that product qualifies for the deduction. This also applies to income derived from selling products to related foreign corporations that then sell the product overseas.
However, the total amount of profit related to this income does not qualify for the patent box. Instead, only a share of that income gets the deduction. The share is based on the qualifying research and development expenses related to the product that occurred over the past five years.
For example, a company may receive $500 of revenue from the sale of a newly invented toaster. The total costs associated with those sales are $400, leaving the company with a $100 profit. Of those $400 of costs, 50 percent or $200 were qualifying research and development costs. The patent box would require that a company multiply its $100 of profits attributed to the new toaster by 50 percent (the share of research and development costs to total costs attributed to the toaster).
This means that only 50 percent, or $50 would receive the 71 percent deduction and face a 10.15 percent tax rate. The remaining income would be treated as ordinary income and be taxed at 35 percent.
This provision also allows companies that currently have patents outside of the United States to transfer those patents back to the United States without the risk of taxation.
What do Patent Boxes Try to Accomplish?
The push for a patent box is three-fold:
First, the U.S. tax code has become increasingly uncompetitive. The U.S.’s top marginal corporate income tax rate is 35 percent (39 percent if you include state and local income taxes). This is the highest rate among the 34 most developed nations in the world. The average among these counties has declined rapidly in the past decade and is currently 25 percent. This has led companies to place their patents and related income overseas where they face lower tax rates. The argument is that reducing the rate on patent income here will bring some of that income back where it would generate U.S. tax revenue.
Second, lawmakers are concerned that under the BEPS project, U.S. companies will be pressured to move related R&D to foreign countries to satisfy new foreign tax laws.
Third, lawmakers want to encourage the creation of more research and development and the related jobs in the United States by providing a lower rate on its income.
What Other Countries have Patent Boxes?
A U.S. patent box would not be the first in the world. Several developed countries already have patent boxes that provide low tax rates on income derived from intellectual property. There are currently 11 developed counties that have some form of patent box regime or plan to enact one.
OECD Member Countries With Patent Box Regimes
*There is no Federal Patent Box, but Cantons may offer one.
Does the U.S. Need a Patent Box?
The underlying argument for a patent box comes from the idea that many inventions or patents are public goods. When a company invents something new, or figures out a new way of doing something in order to make a profit, it isn’t long until someone copies it, or slightly modifies it and takes some of those profits from the first mover. As a result, companies have less of an incentive to invent new things because they know they won’t get the full payoff. Thus, there are fewer than the optimal number of inventions. People argue that the government must step in to subsidize “new ideas” to fix this market failure.
However, the U.S. federal tax code already has a provision that provides a subsidy for research and development: the R&D credit. The R&D credit gives companies an up-front subsidy for research and development expenditures. Theoretically, this is identical to giving a reduced rate to a company after a product has been developed. If lawmakers believe that the current R&D credit is not doing a good enough job, then perhaps they should look to improving that policy before attempting to add on another provision.
It is also a concern that the patent box may end up looking a lot like the current manufacturing deduction (Section 199). When the 9 percent deduction for manufacturing income was passed, it was meant to give a preferential tax rate to income attributed to manufacturing. At first, the definition of income was narrow, only allowing certain manufacturing companies to take advantage. However, as time went on, the definition of manufacturing income broadened so much that even restaurants now earn income that qualifies for the deduction. This could happen to the patent box: companies may bend over backwards to define some portion of their income as patent income. This defeats the purpose of having a targeted rate for one type of income.
Lawmakers would be been better off focusing on the underlying issues with the corporate income tax. As stated before, the U.S. has the highest top marginal corporate income tax rate in the developed world and is one of only six countries that tax the worldwide profits of its corporations (Chart, below). A reduction in the corporate income tax rate across the board and a move to a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. would fix a lot of the problems that lawmakers want to address with the patent box. Not only would it encourage more companies to locate patents and their profits in the U.S, it would also increase the size of the U.S. economy in the long term. We estimate that a reduction in the corporate rate to 25 percent would increase the size of the economy by about 2.2 percent.