Taxing Issues for Intellectual Property—A UK Debate

Where Should IP Be Held?

It goes without saying that the tax tail should not wag the commercial dog. The management of IP is a complex topic, but many companies will centralize their IP in a location which makes the most commercial sense—where there are strong laws to protect it, and the expertise available to do so, as well as employees with the capacity to manage and closely monitor the use of the IP.

In a multinational group, the company holding the IP will make charges to other subsidiaries which use the IP. Those charges should be calculated on an arm's length basis, i.e., the price which would be charged to an unconnected third party. For tax purposes, each group company is viewed as a separate entity, and determining an appropriate transfer pricing policy (and maintaining detailed documentation) is a major exercise which is outside the scope of this article.

IP Held in the UK

The UK tax system offers two key incentives for IP-rich companies. The first is during the development stage: the R&D Tax Credit. There are two separate systems, one for small and medium enterprises (SMEs) and the other for large businesses. An SME is a company with less than 500 staff, and a balance sheet total of less than €86 million or a turnover less than €100 million.

SMEs can deduct an extra 130% of their qualifying costs from their taxable profit, as well as the normal deduction of 100%—so costs of £1 million would lead to a total tax deduction of £2.3 million. If the company is loss-making, a tax credit of up to 14.5% of the loss can be claimed.

Qualifying costs must be part of a specific project to make an advance in science or technology. It will be necessary to explain how the project looked for an advance in science and technology, and how it overcame uncertainty which could not easily be worked out by a professional in the field.

Large companies, and smaller companies who do subcontracted work for larger companies, can claim a Research and Development Expenditure Credit (RDEC). This is an “above the line” credit, so is accounted for as a reduction in costs before tax, rather than as part of the tax charge. The amount was 11% of qualifying costs, but it is due to be increased to 12% with effect from January 1, 2018. Qualifying costs are defined in the same way as for the SME credit.

Once an invention has been patented, income may qualify for the Patent Box regime, which gives a 10% tax rate on certain income. This compares to the normal rate of corporation tax, which is currently 19% and is due to reduce to 17% on April 1, 2019. Where a company owns “qualifying IP” (broadly, UK and European patents), a proportion of the profits derived from licensing or selling products incorporating the IP will be taxed at 10%. However, the calculation of IP profits is complicated, as profits derived from routine manufacturing or marketing activities are excluded. Patent Box relief is only available where the company holding the IP has itself incurred the R&D expenditure, or has subcontracted it to an unconnected third party.

So, the UK tax regime for IP has some important advantages. The main rate of corporation tax is relatively low (19%, soon to be 17%); there are allowances for qualifying R&D spend, and some income from patents may qualify for a lower 10% rate of tax. Where IP is purchased, tax depreciation is given in line with the account's deprecation, and any profit on sale is taxed as ordinary income.

IP Held Outside the UK

However, multinational companies may choose to hold their IP in another country—perhaps another EU country such as the Netherlands, or a country with strong patent protection such as Switzerland, or (particularly in the case of a U.S. multinational company) in a low-tax jurisdiction. In this case, the UK group companies will not expect to be taxed on any IP profits, and will claim a deduction for any license fees or royalties paid for the use of IP.

The first requirement, from a UK perspective, is that the charge for the use of IP must be calculated on an arm's length basis. Frequently, tax authorities challenge whether transfer prices have been set appropriately, and disputes often arise. In some cases, the challenge may come on other grounds—the EU Commission has opened inquiries into a number of (mainly U.S.) multinational companies, on the grounds that tax rulings given by EU member states may constitute illegal state aid. Some of these investigations, such as the inquiries into Amazon and Starbucks, assert that royalties breach the arm's length principle.

Where IP is held in a foreign subsidiary of a UK group, dividends received by the UK parent will generally be exempt from tax. However, if the subsidiary is a pure passive IP-holding company, the UK's controlled foreign companies (CFC) regime will need to be considered. The CFC regime is anti-avoidance legislation, which imposes a charge to tax on the UK parent with respect to certain overseas profits.

In 2015, the UK introduced a major new anti-avoidance regime, called Diverted Profits Tax (DPT). This applies where profits have been “diverted” from the UK, under arrangements which “lack economic substance,” and where it is reasonable to assume that the arrangements were designed to secure a lower tax rate. DPT is charged at a higher rate of 25%, rather than the normal corporation tax rate of 19%.

A group that holds its IP in the best commercial location, with real substance, might assume that DPT would not be relevant. However, the “insufficient economic substance” test in the DPT legislation does not test the actual substance of the arrangements, but instead applies an artificial comparison between the non-tax savings of the structure and the tax reduction achieved. So, where a group decides that it makes commercial sense to hold its IP in, say, Switzerland, and estimates that there will be pre-tax savings of £1 million but tax savings of £1.5 million, there is a risk of DPT applying.

Experience to date has been that HM Revenue and Customs (HMRC, the UK tax authority) is using DPT more widely than first expected, and in particular, is using it to force groups to amend their transfer pricing policies, since a transfer pricing adjustment will be charged at 19% rather than the DPT rate of 25%. Since transfer pricing is never an exact science, this is likely to lead to a level of over-compliance in the UK, with the risk of challenge by other tax authorities who may consider that the revised intercompany charge to the UK is too low. Any group with IP held in a jurisdiction with an effective tax rate less than 80% of the UK rate (i.e., below 15.2%) should carefully consider its DPT position, and consider making a precautionary notification to HMRC. Notification must be made within three months of the year end to protect a group against potential penalties and to reduce the time limit for HMRC to issue a DPT notice from four years to two years.

Payments of royalties made from the UK may also be subject to withholding tax, although the rate is generally zero for payments within the EU (under the EU Royalties Directive), and many other UK tax treaties also exempt UK royalty payments from withholding. However, the anti-avoidance rules are becoming ever stricter, and new proposals in the Autumn Budget 2017 may result in the withholding tax rules applying to payments made outside the UK as well as to payments made directly by UK companies.

In order to benefit from a reduced rate of withholding tax, payments must be made to a company resident in a country where the UK has an appropriate tax treaty, and where the recipient is the “beneficial owner” of the royalty. Where a company is merely a conduit (so that the royalty is ultimately paid on to a low-tax country) the reduced rate will not be available, and tax should be withheld at 20%. In addition, new anti-avoidance rules are being introduced into a large number of tax treaties, which provide that treaty benefits will not be available where the “principal purpose” of the arrangement is to reduce tax by using the tax treaty. These rules are not yet in force, but are likely to cause increased uncertainty for many companies.

The new proposal in the Autumn Budget 2017 is that payments made outside the UK, but which are calculated by reference to UK sales, should also be subject to UK tax at 20%. This is primarily aimed at digital tech companies (particularly U.S. multinationals), but it could have wider impacts, depending on the final version of the legislation. In particular, where the new rules apply, any UK company in the group will become jointly and severally liable for any tax due by the worldwide group. The proposals are currently out for consultation, and are expected to be introduced on April 1, 2019.

What Should Biotech Groups Do?

From a UK perspective, the tax regime for holding IP in the UK is relatively benign, with a main tax rate of 19% and incentives available for R&D and patents. Where IP is held outside the UK, it will be important to be able to demonstrate that transfer prices have been set on a commercial basis, and that there is real substance in the company which holds the IP.

Many other countries have similar incentives and pitfalls. Where a group is considering where to hold its IP, commercial considerations should be the main driver, but the detailed tax rules should also be taken into account.

In particular, groups should be aware that anti-avoidance rules are changing rapidly, not only in the UK but throughout the Organisation for Economic Co-operation and Development (OECD). It is important to clearly document the commercial reasons for decisions, and the basis on which transfer prices have been set.