Adding the patent box and intangible transfers to the tax debate

Earlier this week I posted an piece on Senator Baucus’ draft tax reform legislation. Interestingly the proposal does not contain a so-called “patent box” that would lower the tax on royalty income from patents. As I’ve noted before, the idea of a lower tax rate on patent royalties has gained acceptance in a number of countries. 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.
A recent OECD report on tax modernization (see earlier posting) highlighted the issues around intangible, although they did not address the patent box directly. They did warn that such “ringfencing” of specific forms of income could lead to a “race to the bottom.” Having said that, I still believe (as outlined in our our Intangible Asset Monetization report) 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. Tightening up the transfer pricing rules will help. But there will always be people trying to find ways around the rules. It may be that a carrot and stick approach is called for.
My recommendation is a version known as 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.
But I would also tie the lower tax rate to domestic production. This could be done through a domestic production bonus provision where an even lower tax rate is applied to companies where over 50% of the royalty income comes from products manufactured in the US. The rate could even be on a sliding scale depending on the amount of domestic production.
The reason for such a provision goes back to the underlying goal. 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 should be crafted to provide an incentive to undertake innovation and production in the United States while creating a disincentive to move that activity elsewhere. Tying a reduction in the tax rate on the fruits of innovation with a domestic production requirement and disincentives to harbor IP elsewhere would accomplish those goals.

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