Should the United States enact a patent box?

• Author: Jones, Cherie L.

International tax law is going through significant change as countries improve the competitiveness of their tax regimes by reducing their statutory corporate income tax rates, tightening anti-abuse regimes, and granting preferential treatment on special sources of expense or income such as from research and development (R&D) and intellectual property (IP). (1) IP is of particular relevance because it is highly mobile, and, as such, companies often relocate their research and innovation activities (and associated revenue) offshore to minimize tax. Many countries have felt the significant economic impact of losing high-tech companies to more attractive locations for their research and development.

Facing increased competition, several countries have implemented preferential tax systems called "patent boxes" over the last decade to bolster incentives to keep research and innovation activities onshore. (2) However, those regimes have not reached the United States; patent box legislation has been introduced by Congress several times but has not been enacted. This could soon change; in July 2015, Reps. Charles Boustany, R-La., and Richard Neal, D-Mass., introduced a discussion draft of the Innovation Promotion Act of 2015. Citing pressures introduced by the current economic climate, this act again aims to introduce a patent box to the Internal Revenue Code.

While a U.S. patent box could become an essential tool for reviving America's tax base, there are also risks. Congress must carefully design a patent box regime to avoid its becoming a proverbial curate's egg--good in parts but on the whole bad. This article examines the background of the patent box concept, how it works, and how it could benefit or disadvantage the United States.

The Patent Box

A patent box is a preferential tax system that allows companies to elect a reduced rate of corporate tax on income derived from qualifying IP assets. (3) The rationale behind a patent box is to benefit a country's local economy by ensuring economic activities will continue to be undertaken in the country. The economic theory behind this is based primarily on two factors: market failure and increasing global tax competition.

First, while the market is supposed to reward commercialization after IP development, market failure may still exist because competitors may reap the benefits of innovation without incurring the development costs. Despite the presence of R&D tax benefits, one firm's efforts bringing an innovation to market can create a spillover effect to firms that did not commit the investment in R&D. (4) Apple's iPad offers an example: Despite being protected by patents in the United States and Europe, once the device became popular, similar competing tablets quickly emerged, suggesting that Apple was not able to capture anywhere near all of the returns from its innovation. (5)

Patent boxes reduce the cost of this spillover by increasing the potential profit of innovating, and thus they increase the incentive to develop new products. As such, a patent box complements R&D tax credit systems by creating tax incentives to spur the commercialization of research outcomes. (6) As stated in a 2013 Organisation for Economic Co-operation and Development (OECD) report, "International cooperation should extend ... to ... statutory policies for supporting R&D through tax credits and patent boxes." (7)

Second, global tax competition is a major reason behind the implementation of patent boxes. As mentioned earlier, because IP is highly mobile, innovation takes place on an increasingly global scale. In fight of this, countries seek to prevent domestic firms from holding IP and its resulting profits in foreign low-tax jurisdictions to avoid taxation, and realize the need for competitive tax systems to counter these actions. (8)

However, tax system competition is of interest to governments not only because of a loss in tax revenue, but also because of its wider social and economic impact. Encouraging companies to hold patents locally, governments hope, will, in addition to reducing tax avoidance, establish and retain high-value development, manufacturing, and jobs. The government of the United Kingdom, for example, became concerned about the negative impact on employment, innovation, and national competitiveness after departures of multinationals with headquarters in the United Kingdom. (9)

A preferential tax regime such as a patent box thus is seen as one that complements other tax policies and improves the competitiveness of the national tax system to reduce tax evasion, increase innovation, and retain correspondingly high-value jobs and economic activity.

International Adoption

The European Union in 2000 developed a plan known as the Lisbon Strategy with the aim of making the economic bloc "the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion." (10) Subsequently, some EU states, such as France, the Netherlands, Belgium, Luxembourg, and Spain, introduced patent box policies. (11) Ireland, the United Kingdom, and Italy are among the most recent adopters. (12) These governments all saw the regime as a way to encourage investment in innovation activity within their countries.

BEPS

An important influence on the design of patent boxes was the resolution of the OECD's base erosion and profit shifting (BEPS) project. On Oct. 5, 2015, the OECD presented the final package of the 15-step Action Plan on Base Erosion and Profit Shifting. Among many other things, the Action Plan introduces new minimum standards on country-by-country reporting and rules to curb harmful tax practices, particularly in the area of intellectual property. (13)

For patent boxes, the agreed-upon "modified nexus" approach requires a direct nexus between the income receiving tax benefits and the activities producing the income, meaning that reduced tax rates can only apply where the actual R8dD activity is undertaken by the business itself. Patent box regimes must comply with these requirements starting July 1, 2016. Naturally, this will be an important influence on any patent box legislation in America, as the United States is a member of the BEPS project and has signed on to the new rules.

Patent Box Proposals in the United States

A patent box has been considered in the United States previously but has not been implemented. The Treasury first formally considered the concept in 2007, (14) when it was reported that American multinational corporations...