Taxes and innovation — the patent box

Yesterday, President Obama held a jobs forum with business leaders and talked about “in-sourcing” jobs. In his remarks, the President said that “in the next few weeks, we’re also going to put forward new tax proposals that reward companies that choose to bring jobs home and invest in America.” According to a story in the Wall Street Journal, that package of tax incentives could include “lower tax rates for income derived from innovation produced in the U.S. or expanded breaks for domestic research or manufacturing.” Presumably, the latter reference to research means the Research and Experimentation Tax Credit (generally known as the R&D tax credit). The former reference by the Journal to income from probably refers to what is known as the “patent box.”
While the Administration has not said anything about supporting the concept of a patent box, the idea has been gaining support in Washington. As I noted in an earlier posting, I support the idea of a patent box. It would provide an incentive to keep intellectual property (IP) in the United States. However, it needs to be tied to the other side of the equation: the international taxation and transfer pricing system that helps companies move IP to low tax countries.
Just to recapitulate. The public policy goal here is to promote more innovation and the utilization of that innovation (via production using that innovation) in the United States. This creates jobs and economic growth. A secondary goal is to capture the revenues from the income generated by that innovation and production activity. Tax policy can be crafted to provide an incentive to undertake innovation and production in the United States while creating a disincentive to move that activity elsewhere. There are two interconnected issues: the rate at which income from intellectual property (such as patents) is taxed and the transfer of intellectual property from one (high-tax) location to another (low-tax) location.
In the United States, the income from patents and other intellectual property is generally taxed at the normal corporate or individual rate. In some countries, income from intellectual property are taxed a lower rate — commonly referred to as a “patent box”. The rate and what constitutes “qualifying income” vary from country to country. For example, some countries allow a lower rare for income from copyrights as well as patents.
In addition, the U.S. has a worldwide system of taxation, meaning that income is taxable by the Federal government regardless of where it is generate, as specified in Subpart F of the Internal Revenue Code. However, companies are allowed to defer U.S. taxes on “active” income until the revenue is brought back to the United States. This includes income from intellectual property.
The tax rate differential and the ability to not pay U.S. taxes on income until repatriated has resulted in some corporations transferring ownership of their patents (and thus the income) to subsidiaries in low patent tax countries. The price that the company sells or licenses the patent to the subsidiary is known as the transfer price. The transfer price is supposed to reflect the true market (“arms-length transaction”) value of the patent. However, market prices of patents are difficult to obtain. Thus, companies use appraised values. Critics, including the IRS, raise the issue that the transfer pricing process can become a loophole that companies exploit to avoid U.S. tax. (See stories in the New York Times and the Washington Post on the transfer issue.)
In our Intangible Asset Monetization report, I suggested that we should explore lowering the tax rate on intangible asset royalties, in conjunction with stricter regulations on international transfer-pricing mechanisms and cost-sharing arrangements and on passive investment companies:

Providing a more direct tax incentive to the licensing of intangibles by lowering the rate on intangible asset royalties, such as to the capital gains rate, is a more controversial proposal. This lower rate could be crafted to apply only to royalties for new licenses for a limited time, such as a sliding scale for three years. In crafting such an incentive, safeguards would need to be established to prevent the incentive from being used for simply transferring existing licenses to SPEs [special purpose entities] and to ensure that the incentive went to new licensing activities only.
In conjunction with such a tax incentive, the problem of tax havens should be addressed. Transfer pricing mechanisms and cost sharing arrangements need to prevent those transfers that, as the IRS describes, are “for inadequate consideration.” The issue (some would say the abuse) of “passive investment companies” should also be handled.
The notion of tax havens and loopholes is often a matter of perspective. One person’s loophole is another person’s incentive. However, there is a growing concern that the tax code has become overly complex and that rates could be lowered in conjunction with the elimination of certain specific provisions. Any such tax reform, including the possibility of closing loopholes currently applied to intangibles and lowering the tax rate on royalties, should be looked at very carefully in the context of the impact on the creation and utilization of intangible assets.

On the patent box side of the equation, probably the best version to look at is the Dutch “innovation box.” The Dutch innovation box is an expanded version of their earlier patent box to include credit for the outcome of research activities that have not yet resulted in a patent (referred to as a “technology intangible asset”). The tricky part is determining the amount of what income qualifies as income from a technology intangible asset. The Dutch use transfer pricing mechanisms negotiated with the tax authority. In their more limited patent box, Luxembourg uses a royalty approach assuming the income that the taxpayer would have earned if it had licensed the right to use the patent to a third party. The UK is using a “qualifying residual profit” formula for its new patent box. By the way, the UK took a year of consultations to come up with its method. And the methodology is so complicated that the UK is making their system optional – i.e. a company can elect to apply for the lower rate but are not required to go through the calculation if they don’t feel it is worth the effort.
On the transfer pricing issue, the Obama Administration has already twice put forward two proposals as part of their budget proposals (see earlier posting). One proposal would tax “certain excess income” from intangibles at the U.S. rate if the income comes from a low-rate country. The second proposal contains three related changes in the transfer pricing rules addressing several definitional and methodological issues that have arisen over the years: clarify the definition of intangible property to include workforce in place, goodwill and going concern value; clarify the IRS’s authority to value the intangible properties on an aggregate basis where multiple intangible properties are transferred; and clarify IRS’s authority to value intangible property using the realistic alternative principle.
Congressman Lloyd Doggett (TX-25) and Senator Jay Rockefeller (WV) have a more drastic proposal in H.R. 62 and S. 1373, The International Tax Competitiveness Act of 2011. Section 3 of that legislation would remove intangibles from the tax deferral completely. In other words, all royalty income from IP would be subject to U.S. taxation. It has been estimated by the group Business and Investors Against Tax Haven Abuse that this proposal would generate $10 billion a year in revenues. That estimate, of course, is based on current tax rates, not a new patent box rate.
In any event, a patent box would be expensive. With limited ability to come up with a budget offset, expanding and making the R&D tax credit permanent would still be my first on my priority list. But the transfer of IP to low-tax rate countries is an issue that needs to be addressed in and of itself. It could be part of a larger tax reform package (see my earlier posting on House Ways and Means Chair David Camp’s proposal.) Or it could be part of a more targeted package, such as it sounds like the President is going to propose. Either way, it should be dealt with.


2 thoughts on “Taxes and innovation — the patent box”

  1. The offshoring of IP – and finding ways to promote US growth

    Last week, the Senate Permanent Subcommittee on Investigations held a hearing on offshore tax avoidance issues – as part of a long running series of hearings on the subject. Part of last week’s hearing was on the offshoring IP, mostly…


  2. President’s FY2014 budget again includes intangible transfer tax proposals

    Right now, every policy wonk in Washington is focused on this morning’s release of President Obama’s FY 2014 budget. I will have more on the budget and investments in intangible assets later. But right now I would draw your attention…


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