04 March 2021 - Article
Intellectual property ('IP') box regimes typically apply reduced tax rates to income from intellectual property as an incentive to locate IP-related work in a jurisdiction. Recently unveiled draft legislation may pave the way for a US IP box regime and incentivize taxpayers to reevaluate their global structures.
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. The potential rate differential gives US companies an incentive to locate business operations in jurisdictions with more attractive tax rates, particularly if the activities are geographically mobile. Of course, companies also require a local workforce with the necessary education and expertise, a reliable legal and tax system, political stability and appropriate infrastructure.
IP plays a significant part in today's global economy and may be more geographically mobile than many business operations. Further, US studies show a strong correlation between rising profits from IP and the recent increased trend in corporate 'expatriations', or inversions of US companies into non-US jurisdictions. Inversions are a particularly politically sensitive topic in the US currently and a number of anti-inversion measures have been proposed.
Companies whose businesses are based in significant part on IP may be particularly well positioned to consider locating those operations in jurisdictions with IP incentive tax regimes. Many countries (including the UK, the Netherlands and Luxembourg) have both maintained competitive corporate income tax rates and successfully implemented IP box regimes of various types. Congress may hope that the proposed US IP box will encourage US (and non-US companies) to locate IP-related activities in the US and potentially act as a 'carrot' to stem the tide of recent inversions.
US IP BOX REGIME – WILL LOCATING IP OUTSIDE THE US NO LONGER BE NECESSARY?
While IP box regimes are more common in Europe, the US has yet to implement its own version. With US corporate tax competitiveness at an all-time low, members of the House Ways and Means Committee recently unveiled the Innovation Promotion Act of 2015 (the 'Act'). If enacted, the Act could incentivize US companies to keep their IP in the US and non-US companies to base their IP and IP-related activities in the US.
It could also incentivize US companies with existing non-US technology subsidiaries to relocate their IP-related activities to the US, as the Act permits US companies with non-US subsidiaries holding foreign IP to move that IP to the US without paying US federal income tax on the transfer (subject of course to the tax rules of the jurisdiction in which the subsidiary is located). After the IP is relocated to the US, it would then qualify for the IP box regime under the Act.
Generally, the Act provides a reduced 10.15% tax rate for a portion of income attributable to IP ('IP Income') by allowing companies to deduct from total gross income 71% of their IP Income. The definition of IP for this purpose is quite broad, and includes patents, copyrights, software, film, videos, and many other categories of IP. However, the advertised 10.15% rate is somewhat misleading because in order to qualify for this rate, a company's research and development ('R&D') costs must equal its total operational costs (e.g., wages, rent, etc.).
This is the case because the deduction is calculated as a function of the ratio of (i) costs related to IP R&D to (ii) total operational costs. A company's effective tax rate will be 10.15% only when those two cost 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 of costs related to IP R&D to total operational costs would be 100%, the company's deductible IP Income would be $2B. Therefore, the company could deduct 71% of its IP income of $2B (or $1.42B) and would pay 35% tax on the remaining $580M, resulting in an effective tax rate of 10.15%.
Alternatively, suppose the company earned the same amount of IP Income and incurred the same amount of IP R&D related costs, but that its total operational costs were $2B. In this case, the company's deductible IP Income would be $1B, since the ratio of costs related to IP R&D to total operational costs would be 50%, not 100%. Therefore, the company could deduct 71% of $1B (or $710M) and would be taxed at 35% on the balance of $1.29B, resulting in an effective tax rate of 22.58%.
CONSIDERATIONS GOING FORWARD
The Act's objective clearly is to reward R&D expenditures. A company's IP R&D and total operational costs are aggregated over a 5-year period for purposes of determining its allowable deduction. Although the Act would be effective as of the date of passage, IP R&D costs incurred in prior periods would be included in the calculation of the allowable deduction. Therefore, existing structures should be reconsidered now as some companies may benefit from early-stage planning that would maximize benefits available under the Act once it is enacted into law.
Taxpayers should pay close attention to the Act's progress through Congress, particularly as a recent Organization for Economic Co-operation and Development (OECD) proposal related to IP box regimes may be responsible for renewed interest in a US IP box. The OECD proposal would impose a “nexus” component on IP box benefits offered by adopting countries, which may condition those benefits on a company incurring a threshold level of R&D costs in the jurisdiction offering the benefits and could require companies to move their R&D activities to those jurisdictions to preserve the benefits. If those companies currently have R&D activities in the US, a US IP box could incentivize them to keep those activities in the US.
Withers LLP and Withers Bergman LLP are particularly well-placed to advise on the optimum operating structures for global businesses through our 17 international offices. For further information about the proposed legislation and potential planning opportunities described in this alert, please feel free to get in touch with your regular Withers contact or any of the lawyers listed below.