An introduction to the UK’s Patent Box

Overview of the regime

The UK Patent Box is an optional regime is designed to incentivise UK innovation and the development and retention of certain IP rights in the UK. Broadly, the regime allows qualifying companies to elect to apply a lower corporation tax rate on all profits attributable to qualifying patents, whether paid as royalties or embedded in the price of the products. The relief provides an effective tax rate of 10% on worldwide profits attributable to qualifying patents and similar IP rights. Given that the main UK corporation tax rate is 25%, access to the Patent Box can provide valuable tax relief to qualifying companies.

Eligibility under the regime is based on the “modified nexus” approach, which considers the jurisdiction where the R&D in developing the patent or product is undertaken. By requiring the eligibility of tax relief to be directly connected to R&D expenditure, the UK’s Patent Box has been designed to ensure that substantial economic activities relating to the development of the IP are undertaken in the UK.

Tax relief under the Patent Box may still be available where R&D activities are subcontracted to an unconnected third party. Where R&D is undertaken collaboratively by two or more companies under a "cost sharing arrangement", the companies involved are treated neutrally so that neither is disadvantaged or advantaged by the arrangement. Detailed record keeping is required so that companies can provide evidence of income and expenditure for each patent.

IP acquisition costs and R&D subcontracted to connected companies can still qualify for the Patent Box if they do not amount to more than 30% of the aggregate of the total R&D spent by the company itself and the R&D subcontracted to unconnected third parties. R&D subcontracted to a connected company - even another UK company - or costs incurred in acquiring the IP may result in a restriction in relief under the Patent Box. Groups may need to restructure to ensure that the IP is held by the company incurring the expenditure.

Qualifying IP rights

IP rights qualifying for the UK’s Patent Box include:

• Patents granted by the UK Intellectual Property Office (IPO);
• Patents granted by the European Patent Convention (by the European Patent Office);
• Patents issued by other specified EEA national countries including: Austria, Bulgaria, Czech Republic, Denmark, Estonia, Finland, Germany, Hungary, Poland, Portugal, Romania, Slovakia and Sweden;
• Supplementary protection certificates relating to medical or plant protection products granted by the UK IPO or issued by other authorities under relevant EU regulations;
• UK plant breeders and European plant variety rights; and
• Certain UK and European data or marketing regulatory exclusivity rights for medicinal, veterinary or plant products.

Unlike patent box regimes in other countries, the UK has not extended the definition of qualifying IP rights to include copyright software.

A patent which has been granted and subsequently found to be void under patent law ceases to be qualifying IP for the purposes of the UK Patent Box at the date that it is declared void.

Which profits qualify?

Broadly, the Patent Box rate applies to a proportion of a company's profits derived from:

• licensing or selling qualifying IP rights,
• selling products incorporating a patented invention,
• using a patented invention elsewhere in the course of the company's trade, or
• compensation received for infringement of a qualifying IP right.

Profits derived from a company's routine manufacturing or development functions, or marketing activities, are excluded.

Profits are calculated using the streaming method, whereby income and expenditure is allocated to two streams: one for all IP income and the other for all non-IP income. There has to be a separate sub-stream for every individual IP right or, where this is not reasonably practicable, for each patented product or product family. This individual streaming requirement means that companies need to have comprehensive systems in place to track and allocate expenditure and income to the relevant stream.

Development condition

Companies can only elect into the Patent Box regime where they meet the development condition, which prescribes the extent to which companies should be involved in the development of the qualifying IP. Simply owning a patent is not enough to qualify for tax relief under the Patent Box regime. A company only needs to satisfy the development condition in relation to the IP rights for which it seeks Patent Box tax relief.

Broadly, under the development condition a company must:

• create (or significantly contribute to the creation of) the invention underlying the qualifying IP right; or
• perform a significant amount of activity for the purposes of developing that invention or any item or process incorporating that invention.

Whether an activity is significant is determined considering all relevant circumstances. HMRC’s guidance confirms that “simply applying for a patent in respect of acquired rights to and marketing a fully developed patent or invention, or product incorporating the invention will not be sufficient.” 

Reform of the Patent Box regime

The Patent Box regime was overhauled in 2016 to comply with recommendations of the Organisation for Economic Cooperation and Development (OECD) as part of its base erosion and profit shifting (BEPS) project to reduce international tax avoidance by multinationals. The OECD was concerned that preferential tax regimes, such as the patent box, could be used for profit shifting, unless the availability of the regime was linked to economic substance in the relevant country.