The development and exploitation of IP is the key for most contemporary businesses. Throughout a company’s lifetime, IP is an asset that the entity uses for the provision of products and services. Due to the important value derived out of IP and its high mobility, it is a crucial asset used for tax planning structures to reduce tax liabilities. The increasing reliance of cross-border businesses on intangible assets such as software or algorithms leads to difficulty regarding the taxation of IP and its valuation. While obtaining huge profits from IP rights, companies usually move this mobile asset easily around to avoid taxation of IP-driven profits in an effective way.
Competitive advantages of different jurisdictions and a highly globalized economy help the MNEs to increase their IP-driven profit and avoid effective taxation of such income. Global competition and operations encourage MNEs to locate each part of the value chain in a different jurisdiction. As a consequence of such dispersed business structures, it is repeatedly witnessed that entities involved in a business structure have fewer functions, risks, and hold little or no IP.
In certain structures, the effective tax rate was reduced at the group level, which was the direct result of moving functions, assets, and risks from high-tax jurisdictions to low-risk jurisdictions. This CIT efficiency, along with operating expenses efficiency, has led to the abuse of IP as profit shifting and base erosion instrument. In general, these structures have a simple logic behind them. They benefit from the deduction of royalty for the payer who is a resident of high-tax jurisdiction to an IP holding company resident of a favorable tax jurisdiction or an IP box regime. Moreover, the case of internally developed intangibles is even more relevant from a CIT perspective because while all R&D expenses are immediately deductible, these intangibles are not recognized in the balance sheet and as a result, they are not taxed sometimes.
As a result of all the base erosion and profit shifting activities, OECD and EU have enacted BEPS actions and ATAD legislations, respectively to force MNEs to pay their fair share. At the scale of EU, these legislations are supposed to neutralize IP ATP structures by introducing anti-tax avoidance measures however some opt-outs and carve-outs are granted to protect genuine economic activities. Aside from the fact that carve-outs are inevitable in order to exclude genuine economic activities from the scope of the anti-tax avoidance rules, some of the opt-outs and carve-outs may still leave room for either tax avoidance or harmful tax competition.
BEPS Action 5
According to BEPS action 5, the solution to patent boxes lies in requiring a nexus between preferential tax treatment and R&D expenses incurred by the taxpayer. To tackle the nexus problem between IP income and IP tax incentives, the OECD and G-20 developed Action Plan 5 on harmful tax practices. The latter practice is also considered as harmful tax competition according to the Code of Conduct for Business Taxation, which is adopted back in 1997 by the Council of Economics and Finance Ministers (ECOFIN). This Code is not a legally binding instrument, but it has always been considered by European institutions as having a certain “political force”.
The adoption of such a document implies the intention of MSs to reverse the existing tax measures that constitute harmful tax competition and refrain from introducing any such measures in the future. This soft law was specifically arranged with the intention to detect only such measures which unduly affect the location of business activity in the European Community (now EU).
According to the CCBT document, the criteria specified for recognizing a tax practice as harmful include but is not limited to: an ETR significantly lower than the general level of taxation in the relevant jurisdiction, tax benefits reserved for non-residents; tax incentives for activities that are isolated from the domestic economy and therefore have no impact on the national tax base; granting of tax advantages even in the absence of any real economic activity; determination of the basis of profit for companies in a multinational group departing from internationally accepted rules; e.g. transfer pricing guidelines and lack of transparency. Patent boxes are mainly regarded as a means of attracting highly mobile capital and relocating corporate income rather than promoting innovation. Therefore, in some IP ATP structures, there is no real research activity to earn the exemption granted by patent boxes.
Action 5 of the OECD and G20 BEPS project specifically suggests that there should be “substantial research activity” effectively and actually carried on in order to access the preferential patent box regimes. This contributes to one of the main ideas behind the BEPS, namely, to align substance, and therefore income, with its relevant taxation, ensuring that taxable profits can no longer be artificially shifted away from the jurisdiction in which the value is originally created in favor of jurisdictions offering a preferential tax regime. In this action plan, the OECD encourages jurisdictions to modify their patent boxes according to the so-called modified nexus approach (MNA) to align fiscal advantages with substantial R&D activity.
The ability of acquired IP to enjoy preferential tax treatment is very limited according to the modified nexus approach; therefore, there will be far less motivation for separating the R&D jurisdiction from the patent box jurisdiction. Forty of the forty-four OECD MSs voted for the MNA, according to which the benefits of the patent box regime should be directly linked to the number of expenditures for R&D activities incurred by the taxpayer in developing and generating intangible assets.
To this date, Belgium, Hungary, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, France, The Swiss Canton of Nidwalden, and the United Kingdom have amended their patent box regimes in accordance with the MNA. This approach limits to some degree the harmful aspect of patent boxes by establishing a direct substantive link between preferential tax regimes for IP-derived income and R&D activities.
However, as the currently available research on this topic has revealed, this approach does not eliminate all the opportunities for income shifting. The reason for this is that the MNA focuses on the entity that undertakes R&D activity rather than the jurisdiction where the innovative activity is undertaken, and this implies that MNEs could still shift at least part of their income to another jurisdiction for example, the third jurisdiction with a patent box regime that does not apply MNA.
If MNA is at the scale of all EU MSs practiced and they change the patent boxes according to BEPS action 5, the possibility of IP ATP structures that develop IP in an R&D tax incentives jurisdiction and then transfer the developed IP to another EU MS with the patent box is seriously distorted as acquired IP may enjoy preferential tax regime to the extent of the ratio of its qualifying R&D expenses to total IP income, and therefore there exists far less motivation to separate the R&D jurisdiction from IP holding jurisdiction. The new nexus rules require the centralization of R&D and IP holding companies.
To avoid taxation on IP-driven profits effectively, companies often transfer this mobile asset between jurisdictions. This practice, combined with the competitive advantages of different jurisdictions and a highly globalized economy, allows multinational enterprises (MNEs) to increase their IP-driven profits while minimizing tax obligations. As a result, business structures are often designed with dispersed functions, assets, and risks across different jurisdictions, leading to reduced effective tax rates at the group level.
These strategies, which exploit IP as a profit shifting and base erosion instrument, have prompted international efforts to address tax avoidance. The OECD and the EU have enacted measures such as the Base Erosion and Profit Shifting (BEPS) actions and the Anti-Tax Avoidance Directive (ATAD) to ensure that MNEs pay their fair share of taxes. BEPS Action 5 focuses on patent boxes, aiming to establish a nexus between preferential tax treatment and research and development (R&D) expenses. The adoption of this approach seeks to align income and substance with their relevant taxation, preventing artificial shifting of taxable profits to jurisdictions with preferential tax regimes.
While some countries have amended their patent box regimes to align with the modified nexus approach, which links the benefits of the regime to R&D expenditures, there are still opportunities for income shifting. The focus on the entity undertaking R&D activity rather than the jurisdiction where the innovation occurs allows MNEs to potentially shift income to other jurisdictions with patent box regimes that do not apply the modified nexus approach.
If all EU member states implement the modified nexus approach on a broad scale and amend their patent box regimes accordingly, the possibility of IP-driven profit shifting through R&D tax incentives and subsequent transfer to another EU member state would be significantly reduced. Centralizing R&D and IP holding companies would become necessary to comply with the new nexus rules.
In conclusion, the development of IP as a key asset for businesses has led to complex tax planning structures and profit shifting practices. International efforts to address these challenges, such as the BEPS actions and ATAD legislations, aim to create fair taxation systems that align income with substance and discourage artificial shifting of profits. Implementing the modified nexus approach in patent box regimes can help mitigate the harmful aspects of IP-driven profit shifting, but further measures may be necessary to ensure comprehensive and effective taxation of IP-related income in a globalized economy.
For advice on sustainable IP and tax strategy and structures, contact one of our professionals.
Author: Roya Rezaiee, Junior Associate, TPA Global