United States: Innovation Box Regime Proposed For US Tax Code

Keywords: US tax code, patent box regime, innovation box profits

US Congressman Charles W. Boustany Jr. (R-La) and Congressman Richard Neal (D-Mass), both senior members of the Ways and Means Committee, released draft legislation that would create an "innovation box regime" in the US tax code. The release of the legislation follows a recommendation by bipartisan Senators for the creation of a US patent box regime. The Congressmen have requested that interested stakeholders provide feedback and comments on their legislative proposal.

Summary of Proposal

The legislation would:

  • Provide a 71 percent deduction on the lesser of qualified innovation box profits or total taxable income.

    • Innovation box profits are determined by qualified gross receipts less qualified expenses.
    • Qualified or "innovation" receipts are those from the sale, lease, license or disposition of (i) a patent, invention, formula, process, design, pattern or know-how; (ii) motion picture film or video tape; (iii) computer software; or (iv) any product produced using any of the property described in category (i) above.
    • Qualified expenses are those allocable to the receipts described above.
  • The 71 percent deduction is further limited by applying a ratio equal to a corporation's five-year US R&D expenses over its total five year costs. Total costs are the excess of all costs over the sum of (i) cost of goods sold and (ii) interest and taxes paid or accrued. For purposes of this calculation, costs incurred by foreign branches of the US corporation are included in the corporation's total costs (denominator of the ratio) but non-US R&D expenses of the foreign branches are not included in the R&D expenses (numerator of the ratio), with the additional exception that R&D conducted in a US possession is eligible for inclusion. This ratio is multiplied by the corporation's innovation profits to determine the amount of income eligible for the 71 percent deduction.
  • Income not eligible for the 71 percent deduction is subject to otherwise generally applicable tax rules.
  • Additionally, income associated from the sale or disposition of property to a related party is not eligible for the deduction except in the case of property sold to a related person outside the United States if such property is subsequently sold to an unrelated party outside the United States.
  • Lastly, the proposal allows a controlled foreign corporation ("CFC") to distribute intangible property to the US parent without triggering US tax liability by (i) deeming the fair market value of the property as equal to the CFC's tax basis in the property; (ii) providing an additional dividends received deduction in excess of what would otherwise be available under Section 245; or (iii) providing for additional CFC stock basis if the distribution otherwise would result in gain recognition at the shareholder level. The distribution could trigger foreign taxes; no foreign tax credit would be allowed in respect of the distribution, however. Such a distribution must take place through a qualified plan filed with the US Treasury and such transfer must be completed within two years.

Simplified Example: US corporation has $100 in software sales in 2015. All of that income is qualified "innovation" receipts. In 2015, the corporation has $50 in qualified expenses. Thus, the corporation has $50 in profits. Absent the innovation box regime the corporation would be subject to corporate income tax at a rate of 35 percent on that $50 for a total of $17.50 in tax liability (for simplicity, this example ignores the impact of the R&D credit or other credits and deductions).

Between 2011 and 2015, the US corporation incurred $20 in R&D expenses and $80 in total costs (the excess of all costs over cost of goods sold, interest and taxes.) Thus, the ratio applied to the $50 in innovation box profits is 25 percent ($20/$80). As a result, the corporation has $12.50 in innovation box profits which are eligible for the 71 percent deduction. The deduction therefore is equal to $8.88 (($50 * 25 percent) * 71 percent) which is subtracted from the $50 in income subject to the 35 percent rate and the corporation's tax liability is reduced from $17.50 to $14.39. As a result, the corporation's effective tax rate is reduced from 35 percent to 28.8 percent.

Comparison to Other Innovation Box Regimes

A number of countries maintain innovation or patent box regimes. These regimes cover a wide array of different forms of intellectual property and provide a variety of reductions in tax liability for qualifying intellectual property. Innovation box regimes in such countries as Malta, Hungary and Cyprus, in which copyrights and trademarks qualify for innovation box treatment, may be more expansive than the US proposal. However, the scope of this proposal may be more expansive than regimes in the United Kingdom, Belgium and France.

It appears that in most cases the tax advantage provided to qualifying income is greater in foreign innovation box regimes. Tax rates on qualifying profits range from zero in Malta to 15 percent in France and countries with these regimes generally have lower statutory corporate tax rates than the United States. In the case of this proposal, only when the ratio applied to the qualifying innovation income is 100 percent is the effective tax rate on the innovation box profits 10.15 percent. When the ratio is less than 100 percent, some percentage of the income will not qualify as innovation box profits and therefore will be taxed at a rate of 35 percent, which raises the effective tax rate to something greater than 10.15 percent.

Relationship to OECD BEPS Recommendations

Generally, this proposal appears to reflect a variation on the "nexus approach" of the September 2014 OECD report on BEPS Action 5. This proposal and the OECD-consensus approach both seek to condition the benefits of the regime based on the local performance of R&D activities, using an R&D expenditure ratio as a proxy for measuring the level of R&D activities performed locally. However, there are notable differences in the calculation. For example, the proposal uses a denominator based on the US taxpayer's "total costs" while the nexus approach uses a denominator based on the total development costs incurred by the taxpayer and other parties. In this proposal, the R&D expenditure ratio would conclusively limit benefits, while the September 2014 report suggests that the limitation based on the ratio could be a rebuttable presumption.

Further, in February 2015, OECD member countries reached a consensus for IP regimes based on a proposal by the UK and German governments for a "modified nexus approach" that potentially allows more income to qualify by permitting up to a 30 percent "uplift" to be applied to qualifying expenditures in certain circumstances (generally, where the taxpayer incurs otherwise non-qualifying IP acquisition and outsourcing costs). This current proposal does not allow for the uplift contemplated by the modified nexus approach.

Moreover, the February 2015 consensus position allows for limited grandfathering of IP regimes that do not comport with the "modified nexus approach," including current patent box regimes that allow the preferential rate to apply to all qualifying IP income. Specifically, new entrants would generally be able to join these existing regimes through June 30, 2016, and these regimes would be permitted to remain in place through June 30, 2021. The continued short-term viability of less restrictive foreign regimes, combined with generally lower effective rates allowed by these regimes, may limit the attractiveness of this proposal in the short term.

However, in other respects this proposal appears more favorable than the OECD consensus position. Notably, the type of IP coverable is broader than in the OECD consensus, which currently (and subject to future guidance) calls for patent box regimes to be limited to patents and patent equivalents. Further, by allowing all the income from the sale of property that contains qualifying intellectual property (as opposed to only the share of the income related to the value of the intellectual property) this proposal may trigger the same concerns about existing patent box regimes that gave rise to the OECD's proposals in this area.

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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