EC challenges UK Patent Box

Posted on 29 Oct 2013

In a report prepared by the European Commission in advance of last week's meeting of the EU's Code of Conduct Group on business taxation, the EC concluded that the UK Patent Box regime amounts to harmful tax competition.

What has the EC determined?

Paul Rutherford, Tax Partner at DLA Piper, writes.

The Code of Conduct for business taxation is intended to discourage EU Member States from introducing tax measures that constitute harmful tax competition. The Code is not legally binding but, having been adopted by Member States, carries political force.

The Code sets out criteria by reference to which potentially harmful tax measures are tested. The EC has determined that the patent box offends two of the five criteria.

The patent box requires significant involvement in the development of the innovation to which qualifying IP rights relate and in the case of corporate groups, qualifying rights must also be actively managed. The EC has concluded that these conditions can be satisfied without there being any real economic activity or business substance in the UK. This offends the Code criterion relating to the granting of tax advantages in the absence of any real economic activity in the country concerned.

The UK patent box also contains prescriptive rules for determining patent box profits. The EC considers that in certain respects, these rules depart from internationally accepted principles, in particular those approved by the OECD.

The EC has found that the development of qualifying IP rights outside the UK (but which can nevertheless be eligible for the patent box within the UK) is harmful. This is something of a paradox, since a restriction in the patent box regime to qualifying Rights developed in the UK might be contrary to the fundamental freedoms enshrined in European law.

Further, while there is some basis for the EC’s finding that the patent box deviates from international standards for determining profits (because it computes an enhanced tax deduction by reference to a statutory formula), such a deviation is necessary to the functioning of any special tax regime which seeks to target a specific area.

Although there has been no official response from the UK Government, sectors of the press have reported that HM Treasury disagrees with the EC’s findings. Those same reports suggest that HM Treasury considers the UK patent box to impose tougher eligibility criteria than similar regimes in France, Spain and the Benelux countries. The effective rate of tax under the UK patent box (10%) is also higher than the rates afforded by the regimes in Belgium (7%), Luxembourg (6%) and The Netherlands (5%).

The introduction of the UK patent box was seen by the UK Government as an important part of the UK’s strategy to foster innovation and to create the most competitive tax system among G-20 nations. Given the initial reaction of HM Treasury, it seems likely that the UK Government will staunchly defend the current regime. To the extent that changes are required to meet any concerns, one might therefore expect minor changes to the rules, rather than a wholesale re-write.