Analysis

UK patent box: fair competition or

a harmful tax practice?
SPEED READ There is growing debate over whether

A
news item from The Wall Street Journal
(Europe) on 16 October 2013 carried the
headline ‘EU raps UK over “patent box”
scheme’, and says that the Commission had said ‘in
an opinion distributed to finance ministers that the
scheme violates several provisions of the EU’s code
of conduct on taxation’. The news article said it was
because the regime is not sufficiently linked to real
economic activity in the UK and that the formula
for determining how much profit is derived from
a particular patent is not in line with international
principles.
This follows on from several headline news items
over the summer. For example, on 9 July 2013, an
article in Reuters read: ‘Germany’s finance minister
[has] called for a ban on the so-called “patent box”
tax break offered by Britain, Netherlands and some
other bloc members which he says results in unfair
competition for foreign investment.’ These comments
seem to have been triggered, in part, by the
introduction of the UK patent box this year, under
which income from patented inventions is taxed at
10%, and possibly the UK’s new ‘open for business’
agenda, which is seeking to attract investment to
the UK through its fiscal policy. However, the UK
is arguably only catching up with many of the other
countries in Europe.
Innovation regimes in Europe
In recent years, many EU jurisdictions have
introduced preferential regimes for intellectual
property. The table below summarises the key
features of some of these regimes.
It is clear that there is a considerable variety in
the nature of the regimes, the breadth of intellectual
property included, and whether they provide a
specific low tax rate, partial exemption for income
or amortisation. In broad terms, all the regimes
result in some profits being taxed at a low effective
rate of tax. It would seem difficult to conclude from
this brief overview that the UK patent box regime is
particularly different or more competitive.
preferential innovation regimes represent harmful tax
practices. Whilst there are already many existing regimes
throughout Europe, both the newly introduced UK and
Cyprus patent boxes have been referred to the European
Council. The key question is whether they represent a
harmful tax measure under the European Code of Conduct
on Business Taxation (EU COC). Based on the information
currently available, it appears unlikely that any of the
potential challenges to the UK patent box will have a
significant impact on dissuading the UK government from
its continued desire to make the UK a highly competitive
location for innovation activities.
Kate Alexander is a tax partner at EY and has more
than 15 years’ experience of advising clients on
international tax matters. Kate leads EY's patent box
team and specialises in helping clients to design
and implement intangible assets strategies. Email:
kalexander@uk.ey.com; tel: 020 7951 8196.
Code of conduct on business taxation
(EU COC)
In the December 1997 meeting of the Council of
Economics and Finance Ministers (ECOFIN), it
was agreed that there was a need for coordinated
action at a European level to tackle harmful tax
competition. This led to the introduction of the
EU COC and, whilst not legally binding, member
states committed to:
! roll back existing tax measures that constitute
harmful tax competition; and
! refrain from introducing any such measures in
the future (‘standstill’).
When adopting the EU COC, the Council
acknowledged the positive impact of fair
competition. The EU COC was designed to
monitor measures which unduly affect the location
of business activity and a series of criteria was

Comparing key EU IP regimes

UK Belgium Ireland Luxembourg Netherlands Spain
Effective 1 April 2013 1 January 2007 8 May 2009 1 January 2008 Patents: 1 January 2008
date 1 January 2007.
Other qualifying
IP: 1 January 2008
Qualifying Patents Worldwide Broad range Worldwide patents, Worldwide patents Technological
IP registered in patents, additional of IP rights, software copyrights, and all other IP: patents,
the UK, EU protective including trademarks, intangibles from secret formulae
and certain certificates, patents, trade names, qualifying R&D or processes,
EEA states connected know- brands, domain names, activities and design and
how know-how designs and models breeder rights models
Effective 10% 6.8% (based on 12.5% 5.84% (based on 5% 15%
IP regime (phased in) 80% gross income 80% net income (based on 30%
rate exemption) exemption and tax rate on 50%
taxation of 20% at a income)
rate of 29.22%)

8 November 2013 ~ www.taxjournal.com 11

 Criteria for identifying harmful measures
1 A significantly lower level of effective
taxation than the general level of taxation
in the country concerned (a tax benefit).
Potential application to UK patent box
‘A significantly lower level of effective taxation’ is generally thought to be close
to zero, not 10%. The rate of 10% in a country with an expected headline rate
of 20% is not out of line with other European innovative regimes, and is not
unusually low compared with other European innovation regimes.

2 Tax benefits reserved for non-residents or Benefits are available to both residents and non-residents.
transactions with non-residents.

3 Tax benefits for activities which are
isolated from the domestic economy and
have no impact on the national tax base
(ring-fencing).
Tax incentives are integral to the domestic economy and HM Treasury has
calculated the cost of the relief at £1bn per year. The company making the
claim must be carrying on a trade in the UK. In addition, either R&D in relation
to IP or active management of its commercialisation must be undertaken by the
patent box company, both of which represent real economic activity.

4 Tax benefits granted despite the absence The patent box requires either R&D to be performed, or active management of
of any real economic activity (substance). the commercialisation of the IP, to be undertaken by the patent box company,
both of which represent real economic activity.

5 Departs from internationally accepted
rules (especially OECD) in setting the
basis of profit determination for companies
in a multinational group.
The regime was deliberately designed to be simple and, therefore, where a
product includes a patent, all the income from product sales falls within the
regime. It does not require consideration of the value of solely the patented
element, as is the case in some of the other European regimes. However, the
underlying profit is based on internationally accepted rules.
The 10% rate applies to all residual profit attributed to patents after
adjustment for routine return and, where relevant, a notional marketing royalty.
The latter specifically imports OECD methodologies. The routine return is
based on a prescribed 10% mark up on certain costs, rather than requiring a full
transfer pricing review.

6 Lack of transparency. The regime is totally transparent and enshrined in legislation rather than
bespoke rulings. The underlying profit of the trading company is based on
internationally accepted rules.

developed against which any potentially harmful
measures are to be tested.
In March 1998, ECOFIN confirmed the
establishment of a Code of Conduct Group (COC
Group), which reports regularly on measures
assessed and whose reports are forwarded to
ECOFIN for deliberation.
Rollback of original harmful tax
measures
Under the chairmanship of the then UK paymaster
general, Dawn Primarolo MP, the COC Group
issued a report in November 1999. This identified
66 ‘potentially harmful’ tax measures present
in a wide range of member states and covered a
broad range of tax policies from holding company
regimes and financing, to patent and research and
development incentives. Whilst holding company
regimes have since proliferated across Europe
and are generally not now considered harmful in
their own right, a number of member states made
changes to their domestic tax regimes, for example:
! Ireland recognised that its Dublin and Shannon
regimes were under scrutiny from both the EU
and the OECD, abolished both, and introduced
a general low tax rate regime of 12.5%,
establishing that a low general tax rate was
acceptable; and
! the Netherlands revoked its old style ruling
practices, and introduced advance pricing
agreements and advance taxation rulings
(confirming how particular legislation will
impact a particular transaction), reconfirming
that such rulings are acceptable.
Standstill: review of new measures
The process of review for new regimes is not
completely transparent, and certainly not all
results of recent reviews are available in the
public domain. Any member of the COC Group
can request that a new regime is reviewed and
it is understood that some have been discussed,
including Ireland’s research and technical
development regime which applied to patents,
the Netherland’s patent box, and the Belgian
regime. In the case of the Dutch patent box,
the Netherlands prepared a description of the
measures and it was agreed there was no need to
formally assess them. Some other regimes appear
to have been introduced and not questioned.
The report from COC Group to ECOFIN on
21 June 2013 states that the UK and Cyprus patent
boxes had been identified as regimes that require
further review. When such a request is made to
consider a particular regime, the Commission will
prepare a draft assessment (also known as a grid
evaluation) to the COC group to aid discussion.
This is meant to be a confidential document, but
this appears to have been leaked to the press on
16 October 2013.
Application to UK patent box
As noted above, the EU COC has developed a
series of criteria for identifying potentially harmful
measures. It is not necessary for all criteria to be
satisfied for a regime to be regarded as harmful.
These criteria are considered where there is a tax
benefit, i.e. a significantly lower level of effective
tax applies to the regime. The table above sets out
those criteria and how they may apply to the UK
patent box.
It is understood that the debate in the EU
COC Group meeting on 22 October 2013 focused
on whether the UK patent box requires any real
economic activity (substance) and whether the
calculation methodology is consistent with OECD
principles. Apparently, the discussion ended in
stalemate, which is somewhat surprising, especially
given the eligibility criteria for many of the other
existing EU regimes and that there needs to be
a trade in the UK alongside the development or
exploitation criterion.

12 www.taxjournal.com ~ 8 November 2013

 The next step is for ECOFIN to consider
the position at its meeting in December. It is
understood that the UK patent box will be debated
in the context of IP and R&D incentives more
generally and there would need to be unanimous
consent for such incentives to be found to be
harmful
In the Financial Times on 16 October, the
UK Treasury stated that: ‘The government is
confident that the UK’s patent box regime does not
breach the EU Code of Conduct Group’s criteria;
it is more tightly defined and imposes tougher
eligibility criteria than other similar measures in
operation that have previously been considered
by the Code Group, for example those in France,
Spain, Belgium and the Netherlands.’
Implications of being found harmful
To the extent that a regime is found to be
harmful, a member state would come under
pressure only to change the so-determined
harmful element and not to abandon its regime.
Based on the number of existing innovation
regimes within Europe that are similar to the UK
patent box, any determination that the UK patent
box is harmful is, therefore, unlikely to lead to
major amendments or a significant rewrite.
It is of course possible that the current focus
on the UK and Cypriot patent boxes could trigger
a rethink of the criteria for identifying harmful
measures. However, this would seem to me to
require a change to the terms of the EU COC itself
and require unanimous agreement of EU member
states. Ultimately, it would have to review the
position of other existing innovation regimes and
not solely the new ones.
Other potential challenges
For completeness, it is necessary to consider
the other features of the evolving global tax
landscape which could impact the UK patent box
regime.
Action plan on BEPS – harmful practices: The
recently published BEPS action plan includes
an action to counter harmful tax practices more
effectively, taking into account transparency
and substance (action 5), whilst acknowledging
that taxation remains at the core of a country’s
sovereignty.
At its heart, the action plan seeks to ensure
that there is alignment between taxation and the
relevant substance that creates economic value,
but recognises that preferential regimes continue
to be a key pressure area. The OECD’s work
to date on harmful tax competition has so far
focused on transparency (between member tax
authorities) and substance (on the principle that
tax competition should incentivise real economic
activity). It may be that the OECD will refocus on
the EU concepts. However, it would seem unlikely
that any regime approved under the COC would
be found to be harmful under any new OECD
principles founded on this basis.
8 November 2013 ~ www.taxjournal.com
State aid: Another key hurdle is whether a beneficial
measure constitutes state aid, essentially the giving
of assistance by a government to a business which
results in that business having an advantage over its
competitors. The rules are contained in the Treaty
on the Functioning of the European Union (TFEU),
which declares that certain state aid is incompatible
with the common market and, therefore, illegal
(certain types of state aid may be approved by the
EC as acceptable).
It is understood that the UK government did not
refer its patent box regime to the EC, on the basis that
it does not constitute state aid. However, other fiscal
authorities have taken a different approach, actively
seeking out authorisation. For example, the Spanish
patent box regime was authorised on 13 February
2008. Either way, such regimes appear in general to
have not constituted illegal state aid.
Common consolidated corporate tax base
(CCCTB): The proposed CCCTB could have an
impact on the attribution of profit to countries
with preferential regimes for intellectual property,
although it currently appears that groups may have
the choice of whether they elect into this or not. It
is also possible that the CCCTB will be introduced
by a group of EU countries, and not by the UK,
in which case there should be no real impact as
transactions between companies within a CCCTB
regime and those outside would continue to be
looked at under current principles.
Unilateral action: Finally, fiscal authorities that
regard innovation regimes as harmful could
consider unilateral action. For example, CFC
rules could be amended to specifically include
profits from territories which offer preferential
regimes. This would pose an interesting question
in the context of Europe, where CFC rules have
more recently generally been relaxed in relation to
operations in other member states.
For related
Where does this leave us? reading, visit
In my view, based on the position taken by the www.taxjournal.com
EU COC in the past, the UK patent box regime, Adviser Q&A: Is
together with the other innovative regimes I have the UK’s patent box
referred to, are examples of fair tax competition. ‘harmful’? (Carmen
In the event that the final European conclusion is Aquerreta, 1.11.13)
that the UK regime is harmful, there is a possibility
that the COC Group will re-examine all the other FA 2012 analysis:
innovative regimes across Europe, to outline with Patent box (Pete
more granularity what they consider constitutes a Miller, 6.9.12)
harmful tax practice, and to consider whether this
Ask an expert:
is a change to the tax package that was originally
Claiming patent box
agreed by member states. This would however need relief (Pete Miller,
unanimous consent and therefore would appear an 12.7.13)
unlikely outcome.
Overall, based on the information currently Patent box and SMEs
available, none of the potential challenges to the (John Endacott &
UK patent box seem likely to dissuade the UK Helen Lewis, 9.11.12)
government from its continued desire to make the
UK a highly competitive location for innovative The patent box and
software companies
activities. ! (Olivia Johansson &
The views expressed in this article are the author’s Sarah Lord, 11.1.13)
own and do not necessarily represent the views of EY.
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