All companies claiming patent box relief are subject to the new nexus regime from 1 July 2021. Sarah Lord and Andy Jacott (Deloitte) explain how it works.
This article first appeared in Tax Journal on 8 July 2021. Reproduced with permission.
The UK patent box regime is a statutory tax incentive regime that enables companies to claim an effective 10% corporate tax rate on certain qualifying IP profits. The patent box regime is a valuable UK incentive and will become even more beneficial with the announced increase in the UK corporation tax rate to 25% from 1 April 2023. All companies claiming patent box relief are subject to the new nexus regime from 1 July 2021. These new rules require claimants to track their R&D expenditure in order to calculate a cumulative ‘nexus’ R&D fraction, between 0 and 1, and apply this to their relevant IP profits, which must now be calculated using a streaming methodology. In most cases, compliance with the nexus patent box regime needn’t be onerous. However, claimants will be expected to document their position and monitor it going forwards.
The UK patent box regime was originally introduced in 2013. It provides for a corporation tax rate of 10% on profits derived from the exploitation of qualifying patents. The stated aim of the patent box regime is to provide additional incentive for companies to:
Broadly, a company qualifies for the UK patent box regime if:
Assuming that a company qualifies, it must then elect into the patent box regime and undertake calculations that identify ‘relevant IP profits’; broadly, the company’s taxable profits allocable to the company’s exploitation of their qualifying IP, subject to a number of regime-specific adjustments. The taxable profits allocable to qualifying IP are taxed at an effective rate of 10%, rather than the main rate of corporation tax (currently 19%). The relief is given via a deduction from total taxable trading profits for a chargeable accounting period.
In 2017/18, the latest year for which HMRC published detailed statistics, 1,305 companies made UK patent box claims, with the total value of relief being £1,101m. More than half of the claimant entities were in the manufacturing sector (715 claimants), although the highest proportion of the aggregate relief was claimed by companies in the financial and insurance sector (34% of aggregate relief).
The nexus changes to the patent box regime were introduced from 1 July 2016 and applied to all new entrants from this date. For existing claimants, grandfathering provisions, are available until 30 June 2021. Following this date, all claimants are subject to the new rules.
The changes arose as a result of the OECD’s BEPS initiative (Action 5) and are intended to limit access to preferential intangibles regimes to companies that can demonstrate sufficient substance. Demonstration of sufficient substance is predicated on a link, or ‘nexus’, between R&D activity of the claimant company and the tax benefit derived from the preferential regime.
From a UK patent box perspective, the alignment of tax benefit and economic substance is achieved by linking the income generated by the exploitation of the relevant IP to the levels of R&D expenditure incurred to develop that IP. This is done through the calculation and application of a cumulative ‘R&D fraction’ to each identified sub-stream of relevant IP profits.
The nexus regime is largely based on the old patent box regime with the qualification requirements remaining largely unchanged. The two main changes are to the calculation of a company’s relevant IP profits. A high-level overview of the calculation methodology is detailed in the flowchart opposite. In summary, in step 2 (CTA 2010 s 357BF), the streaming of profits becomes mandatory (as opposed to being elective under the old regime) and at step 6 (CTA 2010 s 357BF), an R&D fraction is then applied to those profit streams.
The R&D fraction links the beneficial tax rate on income from a qualifying IP right to the research and development expenditure incurred by the company.
The following looks at each change in more detail.
Streaming requires a company to calculate patent box profits by ‘just and reasonably’ allocating costs to patented income sub-streams. Under the old regime the default approach was formulaic and used the percentage of patented turnover to total turnover to apportion profits. However, using a streaming methodology can be beneficial as it is not uncommon for a company’s patent income streams to command higher profit margins.
Where a company has historically undertaken all its own R&D such that its nexus fraction would be 1 for all income streams then it is only necessary to calculate one patented income sub-stream each year (as set out in HMRC’s guidance, at CIRD272000). However, in some cases it may be necessary to subdivide the patented income stream. This is outlined at s 357BF(2) and requires a company to identify all ‘relevant IP income sub-streams’, corresponding either to individual IP rights, products, or processes.
The legislation also permits sub-streams to be defined on a ‘product family’ basis (as defined at s 357BF(6)). This enables the grouping of IP item or IP process sub-streams, having regard to the purposes for which the IP items or IP processes are intended to be used or capable of being used).
Following the identification of the sub-streams, step 6 prescribes the application of a cumulative, and individual, ‘R&D fraction’ to each sub-stream. This fraction takes a value between 0 and 1 and is defined (at CTA 2010 s 357BLA) as the lesser of 1 and:
(D + S1) x 1.3
D + S1 + S2 + A
The categories of expenditure within the R&D fraction are:
If the value of the R&D fraction is below 1 then only a portion of the patent box benefit will be available to the company. Consequently, it follows that if the fraction has a value of 0, then no benefit is available. For these purposes, the definitions of R&D expenditure align with the definition used by the research and development expenditure credit (RDEC) regime, as summarised in HMRC’s Guidance at CIRD82100.
Broadly speaking, if the company has historically undertaken all R&D activity in respect of its qualifying IP and has not acquired the qualifying IP, then the fraction is likely to be 1, as the company has only incurred ‘good’ expenditure (being categories ‘D’ and ‘S1’). If the company has acquired the IP or subcontracted the R&D work for the patented technology to a connected company then, to the extent that the acquisition costs or the subcontracted connected company expenditure exceeds the 30% uplift on ‘good’ expenditure undertaken in-house and sub-contracted to third parties, this could have a negative impact on the R&D fraction.
In order to calculate the R&D fraction it is necessary to track the relevant R&D expenditure. In some cases all of the data required to calculate the R&D fraction will already be collated for the purposes of preparing a company’s R&D claims.
As a minimum requirement, the R&D fraction is calculated cumulatively from 1 July 2016. Where an entity is a ‘new entrant’ and the accounting period begins before 1 July 2021, companies are required to track from 1 July 2013. However, according to HMRC’s guidance in its Corporate Intangibles Research and Development Manual at CIRD272200, as this date was before the date the legislation was enacted, HMRC acknowledges that companies may not have this information and therefore will accept 1 July 2016 as the start date for tracking. If helpful to a claimant’s position, a claimant can elect under s 357BLF(2)(b) to extend the relevant period for tracking and go back up to 20 years.
If the value of a company’s R&D fraction clearly takes a value of 1 by virtue of the fact that there is no ‘bad’ expenditure for the purposes of the R&D fraction, being ‘S2’ or ‘A’ expenditure, the claimant’s patent box claims should be unaffected by the nexus patent box rules. Furthermore, HMRC’s guidance (at CIRD272000) sets out that the claimant is not required to go into further detail in calculating its R&D fraction. Where this is the case, it is still recommended that companies monitor and retain their cumulative R&D expenditure from 1 July 2016 should the need to calculate the cumulative R&D fraction arise, for example if significant relevant subcontracted spend is incurred in later periods.
Example 1 illustrates this calculation.
The requirement to calculate the R&D fraction brings into the spotlight the distinction between expenditure on externally provided workers (EPWs) and expenditure on sub-contracted R&D.
For the purposes of the R&D fraction, expenditure on EPWs (either connected or not) is ‘D’ expenditure for the purposes of the fraction and therefore is ‘good’. Conversely, expenditure on connected sub-contracted R&D is ‘bad’ expenditure for the purposes of the R&D fraction, forming category ‘S2’. As such, whether expenditure is categorised as EPW expenditure as opposed to sub-contracted R&D can be of material importance to a patent box claim.
The definition of EPWs for these purposes is from the R&D legislation (CTA 2009 s 1128). The legislation sets out seven conditions (A to G) that need to be met for a person to be an EPW. Broadly speaking, the arrangement must be for the provision of individuals (from either a connected or unconnected party) who will operate as if they were staff of the claimant company but on a temporary basis - as opposed to an arrangement for the provision of some type of consultancy advice or subcontracting of the R&D activity. Typical characteristics of EPW provisions include but are not limited to:
The distinctions in this area can be very fine, and there is no substitute for reviewing the contractual arrangements and related documentation and actual practice to determine the position.
See example 2.
The patent box regime is a valuable UK incentive regime and will become even more beneficial with the announced increase in the rate of corporation tax to 25% from 1 April 2023.
It could be the case that a claimant’s R&D fraction will be demonstrably 1. Where this is the case and the company has previously used the default formulaic methodology, applying the required streaming methodology may increase the benefit where patented income profit margins are higher.
All claimants should consider the following points in relation to their claims: