United States: US Congress Considers Domestic Patent Box Regime – Should You Reevaluate Your Global Structure?

Patent box regimes typically apply deeply discounted tax rates to income derived from intellectual property. Recently unveiled draft legislation may pave the way for a US patent box regime and incentivize taxpayers to reevaluate their global structures.

Introduction

The US imposes the highest corporate income tax rate (35%) in the developed world and the third highest rate among all countries, surpassed only by Chad and the United Arab Emirates. US corporations have clear incentives for moving business operations offshore, where corporate income tax rates well below the US federal rate are available.

Owners of intellectual property (‘IP’) are uniquely well positioned to take advantage of low corporate income tax rates in foreign jurisdictions. Many countries have successfully lured US corporations to their borders not only with lower overall corporate income tax rates, but also with deeply discounted rates specifically applicable to income derived from IP. These efforts have come to be known collectively as ‘patent box’ or ‘royalty box’ regimes.

IP plays a significant part in today’s global economy. In fact, studies in the US show a strong correlation between corporate expatriations and rising profits derived from IP. However, it is not always easy for US companies to select appropriate foreign jurisdictions during preliminary expatriation planning. The appeal of lower tax rates is diminished if the local workforce and infrastructure is incompatible with a company’s operational needs, for instance. Legal, governmental and tax system stability are also important factors to consider when moving abroad.

With proper planning, US companies can benefit greatly under existing law by moving IP and other assets offshore. Every dollar saved on US taxes can be reinvested into research and development, IP development, capital expenditures, sales and marketing, talent acquisition, manufacturing, etc. Moreover, every dollar saved on US taxes is one less dollar that needs to be raised from investors.
US Patent Box Regime – Will Moving Offshore No Longer Be Necessary?

While patent box regimes are very common in Europe, the US has yet to implement a version of its own. With domestic corporate tax competitiveness at an all-time low, Congress now hopes to reverse the tide of expatriating companies by enacting into law a US patent box regime. Members of the House Ways and Means Committee recently unveiled the Innovation Promotion Act of 2015 (the ‘Act’). If enacted, the proposed patent box regime may provide adequate incentives for domestic companies to keep IP stateside and may create a viable route for US technology companies to move IP to the US. While the Act is only applicable to domestic IP, companies with foreign-based IP may also benefit. Notably, the Act allows US companies with foreign-based IP to move property to the US without paying any federal taxes on the transfer, so that the domesticated IP would be eligible for the US patent box regime.

Generally, the Act provides a reduced 10.15% tax rate for income derived from expenditures on IP development by allowing companies to deduct from total gross income 71% of income attributable to IP (‘IP Income’). The advertised 10.15% rate is somewhat misleading, however, because it assumes that a company’s research and development (‘R&D’) costs will always equal its total operational costs (e.g., wages, rent, etc.).

The deduction is calculated as a function of the ratio between costs related to IP R&D over total operational costs. A company’s effective tax rate will be 10.15% only when those two variables are equal. To illustrate, suppose a company earns $2B of IP Income and incurs $1B of costs related to IP R&D and $1B of total operational costs. Since the company’s ratio between costs related to IP R&D over total operational costs would be 100%, the company’s deductible IP Income would be $2B (all of its IP income) and its effective tax rate on total IP Income would be 10.15%.

Now imagine that company earned the same amount of IP Income and incurred the same amount of costs related to IP R&D, but that its total operational costs doubled to $2B. The company’s deductible IP Income would then be $1B, since the ratio between costs related to IP R&D over total operational costs would now be 50%, not 100%, as before. The company’s effective tax rate would be 22.58%.

Clearly, the objective is to reward expenditures on R&D; the higher that figure, relative to total operational costs, the higher one’s deductible IP Income. While unclear now, perhaps future versions of the Act or even regulations issued after the Act’s passage will clarify whether a company’s deductible IP Income may exceed its overall income derived from IP in cases where R&D costs exceed total operational costs (i.e., cases where the relevant ratio exceeds 100%). The Act does make clear though that excess deductions will not be taken into account in computing net operating losses or the amount of any operating loss carrybacks or carryforwards.
Considerations Going Forward

Taxpayers should pay close attention to the Act’s movement through Congress. A recent Organization for Economic Co-operation and Development (OECD) proposal related to patent box regimes may be responsible for renewed vigor for patent box legislation in the US. The proposal would attach a ‘nexus’ component to patent box benefits offered by member countries, which would effectively condition patent box benefits on a threshold level of research and development costs associated with income derived from IP being incurred in the country offering the patent box benefits. If the OECD proposal is adopted by member countries, companies conducting research and development activities in the US but paying taxes in lower-tax jurisdictions may feel compelled to move their research and development activities to those lower-tax jurisdictions in order to preserve patent box benefits.

The Act is also receiving significant support from influential congressional representatives. Republican Representative Paul Ryan, Chairman of the House Ways and Means Committee, publicly endorsed the Act and even expressed intent to incorporate a similar provision into his broader tax reform proposal. Democratic Senator Charles Schumer swiftly endorsed the Act after its unveiling and recommended a patent box in a bipartisan report to the Senate Finance Committee on international tax reform.