Intellectual property taxation in post BEPS era
On 5th October 2015, the OECD released its final reports setting out the action plan on Base Erosion and Profit Shifting (BEPS) project, thus concluding the two year project which started at the behest of G20 countries in 2013. The reports are aimed at suggesting the measures to reform the current international tax rules which have remained unchanged for several decades so as to tackle the cross-border tax avoidance strategies of multinational companies.
Over the years, the tax authorities have viewed intellectual property (IP) rights as a tool used by taxpayers to shift income from one jurisdiction to another. Such shifting may happen through cross border intragroup transactions between two or more associated enterprises involving payment of royalty for use/exploitation of IP rights or transfer fee for sale of IP rights.
Unlike goods, the IP rights do not have physical existence and hence, can be easily transferred. Also valuing IP is extremely difficult and such valuation is mainly driven by perception of valuer.
Remarkably, not only taxpayers but also governments have been using IP rights as a tool in their tax policy in order to increase the investment attractiveness of their jurisdictions leading to harmful tax competition. Harmful tax competition can be described as a race to the bottom whereby each country artificially reduces its tax rates by introduction of special preferential regimes in order to attract higher amount of investments in their jurisdictions relative to other countries. Tax havens which impose low or no tax rates on income earned by the taxpayers also are the bigger promoters of harmful tax competition.
Several countries, prominently in Europe (the UK, Netherlands, Italy, Spain etc.), have “patent box” regimes in their tax laws. These countries impose tax at extremely low rate on income derived in the form of royalties or sale of products, services and processes which have at least one patented component that is either owned or exclusively licensed by the taxpayer.
Further, under these patent regimes there is no requirement that the underlying Research and Development (R&D) activity which led to creation of patent have to be undertaken in patent box jurisdiction. Taxpayers are eligible to obtain benefits of patent box regimes of a particular jurisdiction if they can just demonstrate that active management of the patents has taken place in such jurisdiction.
Hence, in the majority of cases, the taxpayers based in patent box jurisdictions outsource their R&D activities to their associated enterprises in low cost jurisdictions abroad, while retaining legal ownership of patents and therefore the right to receive the income from IP exploitation. This situation often leads to severe market distortions.
Final deliverable report on Action 5 of OECD’s BEPS Project reads: ‘Countering harmful tax practices taking into account transparency and substance’ aims to address the issue of harmful tax regimes which needs to be phased out. The report advocates existence healthy tax competition among countries by introducing the substantial activity requirement in relation to IP/patent box regimes by presenting the “nexus approach” as the agreed approach to be adopted by countries going forward.
The nexus approach requires taxpayer to itself perform R&D activity and thus incur related expenditure in the jurisdiction where it avails the benefit of preferential regime. Thus, it is based on principle that, a taxpayer claiming the benefits of IP/patent box regime should actually have economic substance connected to the IP which is undertaking the R&D activity for development of such IP. However, the report does not deal with scenario whereby the R&D activity is outsourced by the taxpayer to the associated enterprise in the same jurisdiction, as in this case there is no cross border shift of income or tax avoidance and economic activity is undertaken in the patent box/IP regime jurisdiction itself.
The Action 5 report has identified 16 existing IP regimes in countries like the UK, Netherlands, Spain, Switzerland, Italy etc. as potentially harmful and recommends that, going forward all the countries should modify such regimes or introduce new IP regimes which are based on such nexus approach.
In its working paper no. 57 – 2015 titled Patent Boxes Design, Patents Location, and Local R&D, the European Commission has expressed its support to the nexus approach proposed by the OECD. Accordingly, countries such as Spain and the UK have proposed modifications to their existing patent box/IP regimes. Countries like Italy, US and Ireland are looking at introducing new patent box/IP regimes which would be consistent with BEPS report recommendations.
With several countries changing their IP/patent box regimes to bring them in line with nexus approach, the recommendations given by BEPS report would act as game changer for companies as they would directly affect the way they actually structure their IP transactions. Also, with new IP regimes being proposed (e.g.Ireland etc.), the taxpayers would have opportunities to restructure their existing operations while taking benefits of low tax rate and at the same time complying with substance requirements.