"Patent Box" – What is it and who needs it?

These are attractive tax incentives, which have been established in the Benelux countries, but also in large EU countries such as the United Kingdom, and regionally in Switzerland. As of January 1, 2015, Italy also introduced a "Patent Box." In Germany — surprisingly to many experts — Federal Finance Minister Schäuble announced in fall 2014 German Patent Box rules, but they face resistance from the federal states.

1. Patent Box – What is it and how does it work?

Patent Box tax regimes have existed since the 1970s. These tax models have gained significant practical relevance in the context of technological change (keyword: digital networking) and intensified international tax competition. All models of a "Patent Box," "License Box," or "Innovation Box" (as it is called in the Netherlands) share the common feature that the national tax authorities largely exempt certain income from or related to the exploitation of specific intellectual property rights (patents, etc.) from taxation. This is intended to attract research-intensive companies, as their settlement is expected to bring economic benefits.

In detail, the models of individual countries differ. They can be distinguished based on
– which protected rights are considered (patents and/or other protected intangible rights? Unprotected intellectual property? Licenses?),
– whether the rights must be created themselves or can also be acquired (if so, also from related companies?),
– how high the effective tax burden ultimately is, and
– whether the tax incentive can be combined with other local tax incentives.

For example, Belgium and the Netherlands waive a large part of payroll taxes in the first years for newly established R&D activities. Additionally, some countries reward R&D activities by allowing costs to be deducted not only simply but with a factor of 1.5 or 2.0. The ingenuity of national tax legislators is considerable.

2. Criticism and current developments

The taxation of income within the framework of patent boxes generally ranges around 10% or less, depending on the model. In Luxembourg, for example, the effective tax burden on qualifying income from patent licensing, as well as rights to software, is about 5.8%. In the Netherlands, the tax burden is only about 5%, but the requirements for claiming the tax privilege are significantly stricter.

These developments have prompted the major industrialized countries and the EU Commission to take action. Countries like Germany fear — not entirely unjustly — that such incentives unfairly siphon off tax base from established industrial nations (base erosion) and are used to shift taxable profits to low-tax countries (profit shifting). Therefore, all patent box models are under review. A pioneering development may be the agreement negotiated between the UK and Germany in November 2014: According to this, the UK has committed to revise and restrict its patent box rules. In particular, preferential patent box taxation will only be possible in cases where the patents were actually created in the UK beforehand.

3. Recommendations for German companies

Currently, it is unlikely that the patent box models of individual countries will survive in their present form. Many models will be adjusted under tax policy pressure so that only intellectual property created locally (through R&D) benefits from the favorable taxation.

German tax law already sanctions the shifting of value creation, both for intellectual property and R&D activities, abroad. The relocation of such assets and activities is often treated as a sale of the respective assets, and a fictitious profit is taxed. This applies even in cases of "function shifting" when no protectable rights yet exist but are expected to do so in the future.

This does not mean that, in individual cases, utilizing corresponding tax advantages abroad is impossible, provided the German tax law requirements are also considered. This is especially true if a country (or countries) are already considered for expansion for non-tax reasons.

Author: Dr. Henning Frase is a specialist lawyer for tax law and a tax advisor