09 April 2020 - Article
We previously have discussed a number of general tax considerations for implementing a global intellectual property structure. Now we will explore a specific tax incentive that often encourages such planning. We will also discuss developments related to this incentive that taxpayers should consider in light of their overall business objectives.
A popular strategy for reducing the effective tax rate on income derived from IP is to locate it in a country that offers a fairly common tax incentive known generally as an “innovation box.” As IP gained significance in the global economy, many countries erected programs meant to lure foreign corporations not only with lower overall income tax rates, but also with deeply discounted tax rates specifically applicable to income derived from IP.
However, rules governing many popular innovation-box regimes are likely to change soon as a result of final recommendations issued by the Organization for Economic Cooperation and Development (OECD). Companies enjoying the benefits of an existing innovation-box regime should consider these changes in light of existing and future tax and non-tax business objectives and determine whether the jurisdiction in which they hold their IP remains advantageous.
The United States, which is an OECD member country, does not offer an innovation box. However, legislators introduced a bill that would create the first ever U.S. innovation box.
‘Modified Nexus' Approach
The OECD issued a final report in October encouraging member countries to incorporate “modified nexus” components into their innovation-box regimes. In keeping with the OECD's general aim to align taxation with substance by preventing profits from being shifted away from countries in which companies create value, the modified-nexus standard conditions innovation-box benefits on threshold levels of research and development costs incurred in the countries offering benefits. That is in contrast to many existing innovation-box regimes that do not so require material economic activity to occur within their respective countries.
It is worth noting that the OECD's final report is not a legally binding instrument. However, there exists an expectation of cooperation among member countries.
Notwithstanding the absence of legal compulsion, a number of European countries have already taken steps to adopt the OECD's recommendations. The United Kingdom announced that its existing innovation-box regime would incorporate a modified-nexus component that will measure research and development expenditures within that country as a proxy for substantial economic activity and apportion benefits accordingly.
Luxembourg's finance minister announced the repeal of that country's innovation box regime but did not explain how it would implement the modified-nexus approach in any future offering. Ireland's finance minister announced that that country's first innovation box would contain a modified-nexus component in accordance with OECD recommendations. Similar announcements from more OECD member countries are expected.
A U.S. Innovation Box
Although innovation-box regimes are common in Europe, the United States does not yet have one. Due in large part to the availability of foreign innovation-box regimes and the high U.S. corporate income tax rate, studies show a strong correlation between rising profits attributable to IP and corporate expatriations. To combat that trend, U.S. legislators introduced draft legislation that would create the first U.S. innovation box.
Although the U.S. proposal was issued before the OECD's final recommendations, the latter was long in the works and by no means a surprise. Perhaps anticipating final OECD action, the U.S. proposal reveals a parallel concern over the potential harm of the modified-nexus approach to the U.S. tax base.
Companies carrying out research and development in the United States while sourcing IP profits to countries with existing innovation-box regimes that will soon condition benefits on economic nexus may be compelled to move those activities abroad. It seems the U.S. proposal aims to prevent that outcome by allowing U.S. companies with foreign IP to domesticate their IP tax-free and take advantage of the U.S. regime.
Along with announcements in the United Kingdom and Ireland concerning existing and newly formed innovation-box regimes, the U.S. proposal would measure economic nexus and dole out benefits accordingly. While the U.S. proposal was put forth before the OECD's final recommendations, its economic-nexus component was anticipated; existing U.S. “controlled foreign corporation” rules and supplementary “passive foreign investment company” rules are in many ways underpinned by a focus on economic substance.
Details regarding how the OECD's final recommendations concerning the modified-nexus approach will be implemented have been released only in the United Kingdom and Ireland thus far. However, the U.S. proposal's economic-nexus component substantively mirrors details put forth in the United Kingdom and Ireland and therefore serves as good guidance with respect to what can be expected in other OECD countries when those details are released.
Generally, the U.S. proposal calls for a reduced 10.15 percent tax rate on income attributable to IP by allowing companies to deduct from total gross income up to 71 percent of their IP income. The deduction's availability is directly tied to the level of economic nexus in the United States, measured as a function of a company's ratio of costs related to IP research and development to operational costs, like wages and rent. In most practical applications, the test for economic nexus will produce an effective tax rate higher than 10.15 percent but still lower than the general corporate income tax rate of 35 percent.
For the first time in history, the United States may offer a reduced corporate income tax rate for profits attributable to IP and provide a feasible alternative to foreign tax incentives for U.S. companies with such income. Notwithstanding catch-up efforts to attract global IP dollars, companies now enjoying foreign tax incentives that wish to maintain existing benefits need to reconsider their strategies in light of OECD economic nexus recommendations.
This article originally published on Inside Counsel on November 19, 2015
Reprinted with permission from “InsideCounsel”© 2015 ALM Media Properties, LLC. All rights reserved.