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April 9, 2012 no comments

The UK Patent Box: a welcome gift for small biotech as well as large pharma

Confirming the launch of the Patent Box tax break for innovative technologies from April 2013, the UK government has made one of the most far reaching changes to corporate tax structure in recent times.

The full implications of the new UK corporate tax regime are still being unraveled, but within days of the announcement global pharmaceutical companies were announcing massive new investments into the UK, such as GSK’s £500M expansion of its Ulverston and Montrose manufacturing facilities.

But the introduction of the patent box will have far wider effects (perhaps not all of which have been fully appreciated by the government), and some of those benefits extend to smaller biotechs too.  So what is this patent box, and how might it change your view of the UK as a location for starting a new biotech company?

Facts first: the patent box is a tax break for corporate income earned through the exploitation of a patented invention.  UK Income derived from the sale of a product or service which depends upon a patent owned or exclusively licensed by the seller will attract corporation tax at a preferential 10% rate, rather than the headline 22% rate that will apply in 2013.

The rules are very broadly drafted (the legislation itself runs to 40 or so pages, and the guidance from HMRC, the UK tax authority, something more than double that).  While there are a few key hurdles that must be met, the central principle that sales that depend on a patented invention will attract the lower rate applies more widely than you might imagine.

Make sure you understand the far-reaching consequences of this legislation for your business and exploit the opportunities it offers – while they last.

What are the limitations?  In a nutshell, only that the rights must be owned or exclusively licensed (though the exclusivity can be limited by territory or by field) by the product seller, who must also have been responsible for the development of the product.  This last point is important: IP holding companies not actively involved in development are expressly excluded from benefiting – entirely in line with the intended effect of the legislation: to promote technology development and manufacture in the UK.

But if you hold such rights, and you are involved in the active development of the product, then just about any income derived from selling products protected by the patents you hold will qualify for the beneficial tax treatment.

Critically, even if only a small part of the product is protected by a qualifying patent, the entire income derived from the sale would, as the legislation is currently drafted, qualify for the 10% tax treatment.  That’s right: if you build a car with, for example, patented software controlling the engine management system, then the entire sale value of the car can go into the patent box, even if the remainder of the product is unpatented.  The patented part might be less than 5% of the costs, but that has no relevance when it comes to calculating the tax.

What sort of patent qualifies?  Any patent granted by the UK patent office, or by the EPO covering the UK (as well, in fact, as patents granted by a number of selected EEA states that the UK government considers as having similarly strict patent examination rules as the UK).  Importantly, the patent doesn’t have to be in effect in the territory where sales are being generated – so if a company based in the UK for tax purposes books sales in Japan of a product covered by a UK patent, then that income can also qualify for patent box treatment.

Supplementary protection certificates (which extend the life of qualifying UK or European patents) and marketing authorizations in respect of veterinary and medicinal products, as well as plant-breeding rights, are also covered by the legislation.

Unlike other similar rules in other jurisdictions, patent box benefits cannot be claimed with respect of pending patents (rightly so, since it is too easy and cheap to file frivolous applications with no chance of eventual grant and keep them pending almost indefinitely).  Instead, the benefit accrues from the date of filing, but can only actually be claimed after grant.  If the patent is subsequently opposed or overturned, while any further benefits into the future would be lost, there will, apparently, be no attempt to reclaim past gains from the patent box (it would simply be too difficult in practice).

Any kind of transaction that leaves money in the company, becomes much more tolerable, even to shareholders domiciled in low tax havens, resulting in much increased flexibility on deal structures.

There are a couple of deductions that must be made from the qualifying income – in addition (quite obviously) to any income derived from non-patented products, profit attributable to ‘routine activities’ and ‘valuable marketing assets’ will need to be subtracted.  The size of these deductions will be critical to larger companies with complex activities (and their accountants will be pouring over the fine details of the calculations as we speak), but for smaller companies these deductions will scarcely, if at all, affect the calculated patent box profits.

There is nothing in the legislation to exclude either services or software from the new tax regime.   If your product depends on a patented process, or your company sells a service with a patented step in it, then the attributable profits will qualify for the lower tax rate (as long as the other conditions are met, relating to ownership and development, and the patent itself qualifies).

Bottom line: there are few if any technically complex products that are not (or, with appropriate actions from the company that developed them, could not become) qualified for patent box treatment.

This has some far-reaching consequences.  Most obviously, the intended consequence is to drive development and manufacture of technically innovative products to the UK.   Signs are that it will be at least modestly successful in this aim (as the GSK announcement, the timing of which was no coincidence, was intended to demonstrate).   The limitations on the UK scheme are less onerous, particularly for larger companies, than most similar schemes adopted by other countries, providing a real impetus to locate hi-tech activities in the UK.

But will the resulting economic growth (enlarging the overall base on which tax revenues can be collected) outweigh the reduction in revenue that comes from reducing the effective tax rate on swathes of income from hi-tech products?  That depends on how imaginative companies are at diverting income into the patent box.  And given the powerful incentive one imagines they will be exceptionally creative.

The potential for creativity comes from the relative ease in gaining protection for narrow claims from the UK patent office.  If the task is not to exclude competition, but simply to cover a commercially-relevant part of your product, then there are numerous opportunities to secure the patent that will trigger patent box benefits.  A small improvement to the software, the embedded electronics or even the packaging is all that’s required.  And as long as its novel, inventive and industrially applicable the golden goose will lay the egg: granted claims covering your product and a halving of the effective tax rate on the profits generated.

Critically, even if only a small part of the product is protected by a qualifying patent, almost the entire profit derived from worldwide sales would qualify for the 10% tax treatment

If, as seems likely, swathes of UK industry adopt such a strategy, the drop in tax revenues could easily exceed the growth in the taxable base.  And there will be a  second unintended consequence: the UK patent office will be inundated with new filings.  It wouldn’t be hard to imagine a doubling of the rate of new applications if, for every broad application intended to gain a genuine monopoly, there was a very narrow, focused application intended to gain patent box status at the earliest possible opportunity.  At the very least, priority applications filed in the UK are more likely to be prosecuted to grant rather than allowed to lapse in favour of a PCT route that would likely take three of four more years to reach the same point.

Patent offices worldwide are already creaking under the demands of inventors, with a process from application to grant that typically lasts years rather than months, and can often stretch out to five or more years.   Any measure that dramatically increases the workload can only increase these delays.  And the delays matter: pending applications are an impediment to innovation.  They can be skillfully used as smokescreens and the lack of clarity about what will eventually be granted holds back the competition.  The European Patent Office recognized the problem, and with their “Raising the Bar” initiative took steps to counter this trend – so any reversal resulting from the introduction of the UK Patent Box legislation would be a retrograde step.

One thing is for sure, there is one group who will be rubbing their hands: the patent lawyers.  Demand for their services will surely increase significantly over the next few years.  And the best strategists are sure to be in such demand that fees will rise too.

Its easy to see how all this will benefit manufacturers and sellers of products, like the global pharmaceutical companies.  But what about the smaller biotechs?  Companies with no sales, who make a loss, who pay no corporation tax anywhere.  Even for them, the patent box may change they way they do business for the better.

Selling assets, rather than the whole company, becomes much more tax efficient.  In short, any kind of transaction that leaves money in the company, rather than returned directly to shareholders, becomes much more tolerable – even to shareholders domiciled in low tax havens.   The result is much increased flexibility on deal structures.

And Universities, and other inventor owners of innovative technology like TCP Innovations, will also benefit.  As long as they meet the active development criteria, they can sell or license their technology and pay tax at patent box rates on the upfront, milestones and royalties that ensue.

There are few, if any, technically complex products that cannot be qualified for patent box treatment

With improved R&D tax credits and very favourable EIS and SEIS schemes for angel investors, the patent box is another reason why the UK has become a favoured spot for biotech start-ups.  With a world-class University in the vicinity, world-class infrastructure like the Babraham Research Campus where TCP Innovations are based, and now a friendly tax environment, the Cambridge biotech cluster is set for a golden age.

Its already clear that the UK government’s version of the patent box is going to achieve its intended objective: significantly increasing the size of the UK tech economy.  It’s a bold step, though, and the unintended consequences may yet out-weigh the benefits, if total tax revenues fall and the UK patent office is overwhelmed with new applications.  But for now, all you can do is make sure you understand the far-reaching consequences of this legislation for your business and exploit the opportunities it offers – while they last.

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