The Chancellor of the Exchequer, George Osborne, yesterday confirmed that a Patent Box will be introduced in the UK in 2013. This policy will reduce the rate of corporation tax on the income derived from patents to 10%. Our analysis suggests that the policy will lead to a large reduction in UK tax receipts from the income derived from patents, is poorly targeted at promoting research, will add complexity to the tax system, and it is far from clear that any additional research resulting from the policy will take place in the UK.
The announcement of a UK Patent Box has been widely welcomed by the corporate sector and notably by a small number of large patenting firms for which the tax savings will be greatest. However, we are today publishing new research which simulates the impact of the introduction of a Patent Box and questions whether the UK will in fact benefit from such a policy.
In the document released yesterday, the Government suggests that the UK will benefit from the "additional tax on the consequential profits" associated with patents. However, we find that the introduction of a UK Patent Box would lead to a substantial reduction in government revenues: even though the UK would become a more attractive location for patents, the boost to revenue this would provide would be outweighed by the lower tax rate. The Government's own forecasts in the June 2010 Budget predicted a revenue loss of £1.1 billion a year. The largest share of the tax savings entailed in a UK Patent Box will accrue to a small number of firms that account for the majority of patents and are likely to generate large associated revenue streams.
There is a clear rationale for the government to enhance the incentives for firms to engage in research; some of the benefits of research accrue to third parties and because of this firms tend to under invest in research, especially basic research. But this rationale is currently explicitly recognised in the corporate tax system through R&D tax credits.
The Government has highlighted that the focus on patents, as opposed to other forms of intellectual property, is a result of patents having "a particularly strong link to ongoing high-tech R&D". However, a Patent Box is poorly targeted at research as the policy targets the income which results from patented technology, not the research itself. Once a patent is in place, a firm has a monopoly on the use of those ideas, and so can capture all of the returns and therefore faces the correct incentives to maximise the related income stream. In addition, to the extent that a Patent Box reduces the tax rate for activity that would have occurred in the absence of government intervention, the policy includes a large deadweight cost.
The Patent Box policy will also add complexity to the tax system and require policing to ensure that both income and costs are being appropriately assigned to patents. While the Patent Box may spur some new innovation and incentivise firms to create more patentable technologies, the time lags and uncertainty inherent in creating a patentable technology will likely mute these incentives. Moreover, it is not clear that any additional research resulting from a Patent Box will take place in the UK. Under European law, eligibility criteria for inclusion in the Patent Box could not include restrictions that patentable technologies be created in the UK. It would therefore be possible to hold patent income in the UK without co-locating any associated real activity. Indeed, while patent ownership is frequently co-located with research, there is an increasing trend towards holding intellectual property separately from real activity. Looking forward, firms may be more likely to separate income from real activity in the face of greater tax incentives for mobile income.
The UK will not be the first country to introduce a Patent Box; the Netherlands, Belgium, Luxembourg and Spain have recently introduced similar policies. The income from intellectual property is highly mobile and the presence of other Patent Boxes gives UK firms the incentive to locate patents offshore. But our research shows that the introduction of a UK Patent Box, accounting for the current Benelux Patent Boxes, would see UK revenue from patent income halved. In addition while a Patent Box may initially be successful in attracting or retaining firms' patent holdings, such gains can be quickly eroded if other countries introduce similar policies. That is, tax competition attempting to attract mobile patent income using Patent Box policies could amount to governments engaging in a race to the bottom in which related government revenues fall.
The UK Government faces the challenge of preventing firms from holding patents offshore for the sole purpose of avoiding tax. Indeed, the Government is consulting on reforms to the Controlled Foreign Companies (CFC) regime, which sets out the rules that determine how offshore mobile income is taxed, in relation to income from intellectual property. Our research highlights the potential interactions between Patent Boxes and CFC regimes. In particular, a UK CFC regime that effectively captured patent income held in Patent Box countries could reduce the incentive for UK firms to hold patents offshore and therefore mitigate some of the negative impact on revenues.