Patent Box Tech Note

________________________________________________

___________________________________________

The Patent Box: Technical Note and

Guide to the Finance Bill 2012 clauses

November 2012 Update; The new Patent Box guidance has now been

published in the HMRC Corporate Intangibles Research & Development

Manual starting at paragraph CIRD 200000.

Contents Page

Foreword:...................................................................................................................3

Update Note: Changes to the Legislation since 6 December 2011 ...........................4

Chapter 1 Introduction & Overview.......................................................................8

Chapter 2 Qualifying for and Giving Effect to the Patent Box ............................14

Chapter 3 Calculating Profits Eligible for the Patent Box Rate ...........................28

Chapter 4 Streaming .............................................................................................59

Chapter 5 Companies with relevant IP losses.......................................................69

Chapter 6 Anti avoidance ...................................................................................72

Chapter 7 Supplementary .....................................................................................75

Chapter 8 Amendments of other legislation .........................................................79

Chapter 9 Commencement and Transitional Provisions ......................................81

The Patent Box Legislation: An Outline Guide.......................................................83

2

Foreword:

Update at November 2012. The new Patent Box guidance has now been published in the Corporate Intangibles Research & Development Manual starting at paragraph CIRD 200000. This can be accessed on the HMRC website at http://www.hmrc.gov.uk/manuals/cirdmanual/CIRD200000.htm It replaces the information contained in this Technical Note .

This Technical Note accompanies the clauses in the Finance Bill 2012 published today, 29 March 2012, and the associated Explanatory Notes. It updates the Technical Note that was published on 6 December with draft Finance Bill clauses.

The aim of this Technical Note is to

give an outline of the Patent Box regime explain where and why Finance Bill clauses differ from the draft clauses

published in December

provide more detailed guidance about the legislation and how it is intended to operate.

This note starts with an outline of the main changes to the Patent Box as a result of comments on the draft legislation published in December (superseding the 6 December 2011 Tax Information and Impact Note). It then gives an overview of the current Patent Box rules, as revised.

The main section of the note then explains the legislation as it now stands section by

section to give more detailed guidance. At the end of the explanation of each section,

the note includes a summary of the changes made to the draft clauses published in

December.

We expect to update the explanations of the Patent Box regime set out in Technical

Note further as it gives rise to enquiries in practice. We will be providing detailed

guidance, based on this Note, in the Corporate Intangibles and Research and

Development manual during 2012. We will also in due course produce a simpler

practical guide to the Patent Box for smaller businesses.

Queries on the Finance Bill Clauses or this Technical Note should be emailed to:

[email protected]

Or addressed to

CT Reform

Corporate Tax Team

HM Treasury

1 Horse Guards Parade

London

SW1A 2HQ

3

Update Note: Changes to the Legislation since 6 December 2011

The Patent Box will apply a reduced rate of corporation tax to profits from patents and certain other forms of qualifying intellectual property from April 2013.

Legislation to implement the Patent Box is included in Finance Bill 2012, published today 29 March 2012, following three rounds of consultation:

November 2010 - The Taxation of Innovation and Intellectual Property: covering high level design principles;

June 2011 - Consultation on the Patent Box: covering more detailed policy design and implementation; and

December 2011 - Draft legislation and explanatory notes, Patent Box, response to consultation, and The Patent Box: Technical Note and Guide to the Draft Legislation: covering detailed technical aspects of the draft legislation.

The Government received 25 responses to the December 2011 consultation. Respondents welcomed the draft legislation, and made helpful suggestions for ways that it could be further improved. Changes to it to address the main points made, and to better meet the policy objectives set out in the consultation, are set out below.

Key Changes:

(i) Some consultation responses noted that the draft legislation did not encompass income from territorial licences of a patented invention if the qualifying patent does not cover the territory. The policy objective is to include worldwide income from exploitation of inventions which benefit from a qualifying patent. So the legislation is now amended to achieve this (357CC (6)(b)).

(ii) Several consultation responses asked for greater clarity about the types of expenditure on which the routine return exclusion from qualifying profits (particularly professional services) and considered that the expenditure should not include costs related to acquiring, maintaining or protecting patents. These rules have now been clarified accordingly (357CJ and 357CK).

(iii) Smaller claims can use a simplified calculation to avoid valuing the contribution of valuable brands, which is excluded from the Patent Box. There is a 1m limit to the profit that can benefit from the Patent Box as a result of this treatment. Consequently the small claims treatment ascribes increasing proportions of profit to brand value as profit subject to the treatment rises above 1.3m. But none the less, there may be some companies whose brand and volume of business drives total profits to well in excess of the small claims threshold, but whose patent derived profit is much less than 1m. To deal with this, in addition to having the threshold, small claims treatment is now limited to companies with profits (before excluding brand) of up to 3m (357CL).

4

(iv) The legislation now also specifies its extension to some patents granted by other EEA states (357BB (8)). The Government will make an order to include full patents granted by the national patent offices of Member States which have similar patentability and examination criteria to the UK. Utility patents, and any similar second tier rights, will not be included. Patents granted by the following states will be included:

Austria Bulgaria The Czech Republic Denmark

Estonia Finland Germany Hungary

Poland Portugal Romania Slovakia

Sweden

Other Changes:

Qualifying Conditions:

(v) The legislation now specifies the medicinal and plant protection marketing authorisation rights that can qualify for the Patent Box in the primary legislation, rather than as a statutory instrument. The rights that were included in the draft statutory order have been clarified (357BB), in response to comments about the scope of the draft order.

(vi) Several respondents thought that the condition requiring qualifying licences to be exclusive was unclear, particularly its reference to persons carrying on a similar description of trade. The legislation has been amended to remove this reference (357BA).

(vii) The development condition has been amended to, amongst other things, remove an unintended requirement for companies incorporating subsidiaries to continue undertaking development activity in order to maintain qualification for the Patent Box (357BC).

Relevant Intellectual Property Profit (RP) Calculation:

(viii) Finance Income excluded from the Patent Box calculation now includes credits on derivative contracts. The consultation documents made it clear that the Government intended to exclude all types of financial income from the Patent Box (357CB).

(ix) Income within the Patent Box has been extended to include compensation for loss of relevant IP income, wherever arising. This aligns the treatment of income from infringement claims and other forms of compensation such as insurance with that of the original income which would have been received if the infringement or insured event had not occurred (357CC).

5

(x) The rules that can reduce the Patent Box profit by deemed R&D expense in the first four years after electing into the regime have been revised. Excess actual expenditure in a year can now be carried forward to reduce any deemed amounts in later years, to help smooth variations in R&D expenditure (357CH).

(xi) The costs to be included in the calculation of the routine 10% return are now described as routine deductions rather than routine expenses. This ensures that all relevant tax deductible amounts are included, such as NICs and employee share schemes. The types of expenses which are not to be included in the mark-up are now listed separately. Specific R&Drelated deductions are excluded from the mark up even if they would otherwise be routine deductions (357CJ and 357CK).

(xii) Several comments were received on the notional marketing royalty rules which remove profits attributed to valuable brands from the Patent Box. Several respondents asked for greater clarity on how these rules would work in practice. The definition of marketing assets has been extended to ensure that it encompasses all relevant marketing assets in all relevant jurisdictions (357CO). This Note includes further initial guidance on the practical operation of the notional marketing royalty.

(xiii) A defect is corrected that would have prevented companies who use the small claims treatment from bringing pre-grant profits into the Patent Box when the patent is granted (357C (1) step 7 and 357CM).

Other Features:

(xiv) Where a company has to set-off a Patent Box loss (a Relevant IP Loss, or RIPL) against another group companys Patent Box profit, it may choose to make a payment to compensate the other company for the consequent restriction in its Patent Box profit. The legislation now ensures that the payment will not be taken into account for corporation tax purposes (357EF).

(xv) Participants in a qualifying cost-sharing arrangement who are entitled to rights over a qualifying patent as a result of the arrangement, rather than being entitled to income directly, will now be able to qualify for the Patent Box (357CG).

(xvi) A company receiving a substantial amount of patent licensing income from patent rights it itself licenses in will have to stream royalty or licence fees it pays for those rights against the income. This will prevent conduit arrangements from benefiting from the Patent Box (357DC).

Other, more technical, drafting changes in the legislation are highlighted throughout this document.1

1 Note that some of the clause numbers have changed since 6 December 2011. This Note refers to clauses only by their new numbering.

6

Other consultation comments received, where no changes have been made:

(xvii) Some respondents felt that the anti-avoidance rules (357FA and 357FB) were too broad and may prevent some genuine claimants from benefiting from the regime. It is vital to the long term stability of the regime that effective anti-avoidance rules are included to prevent abuse. However, HMRC will not seek to apply these rules to practical and commercially appropriate transactions, even if they have the effect of creating or enhancing Patent Box benefits.

HMRC will also not seek to apply these rules where a group takes reasonable and commercially appropriate steps to restructure group arrangements in order to benefit fully from the Patent Box if current arrangements are accidentally disadvantageous. Further indicative guidance is included later in this note.

(xviii) Several respondents also requested extensions to the types of income or intellectual property included in the Patent Box, beyond the proposals set out in December. The Government is grateful for all comments and has taken these into account. However, the remit of this technical consultation was to deliver effective legislation based on the proposals set out in the December 2011 consultation document.

(xix) A few respondents felt that companies which use patents to provide services are particularly disadvantaged because they are required to use the notional royalty rules rather than being able to include all income from the services. As set out in the December 2011 consultation document, the Government does not consider that the approach used for product income is likely to consistently result in a reasonable proportion of profit being attributed to patents used in services. The notional royalty approach will allow the full economic benefit of the patent to the business to benefit from the Patent Box rate. Further guidance on this is included later in this note.

7

Patent ownership

requirements i

Rights ncluded c

Ao

Rexe

Deo

velopment ndition

IP Profit apportionment / income streaming r

nt

ctiwn

ve ership

ouptu

Profit calculation

Other features

Relevaincome

10% rate formula

Negative Patent Box amounts

tine enses rn

Anti avoidance rules

Marketing return / small claims election

Partnerships & cost contribution arrangements

Chapter 1 Introduction & Overview

Summary of the Patent Box

1.1. The Patent Box provides a reduced corporation tax rate for companies from April 2013. It will apply to companies exploiting patented inventions or certain other medicinal or botanic innovations.

1.2. The reduced rate applies to a proportion of the profits derived from:

licensing or sale of the patent rights; sales of the patented invention or products incorporating the

patented invention;

use of the patented invention in the companys trade; or infringement and compensation.

1.3. Profits attributed to routine manufacturing or development functions, and profits attributable to exploitation of marketing intangible assets, are excluded.

1.4. The Patent Box is an optional regime. Companies elect into it. If, exceptionally, a company has more than one trade, an election applies to all of them.

1.5. The reduced rate of tax is delivered through an additional deduction in the corporation tax computation.

1.6. To minimise administrative costs and compliance burden, Patent Box profits for many claims can be calculated using an approximate, largely formulaic, approach. Companies can instead however opt to identify the profit through a more bespoke calculation.

1.7. The main concepts of the Patent Box are shown in the diagram below and explained further in the next section of this introduction:

8

Overview of the Patent Box

(i) Qualifying Ownership Requirements

1.8. A company can elect into the Patent Box. It can then benefit from the regime if it owns or licenses-in patents granted by:

the UK Intellectual Property Office; the European Patent Office; or specified EEA countries.

1.9. There are two main conditions:

(i) the company must have undertaken qualifying development by making a significant contribution to:

the creation or development of the invention claimed in the patent; or a product incorporating this item.

(ii) if the company licenses-in patent rights, the licence must give it exclusivity for those rights. This must extend at least country-wide.

1.10. Some European Union plant breeder or variety rights and EU marketing authorisation rights of medicinal or plant protection products will also be in the Patent Box. Unless specified otherwise, this note should be read as including items that benefit from these rights.

1.11. If the company is a member of a group, then in some circumstances it can qualify if another group company has undertaken the qualifying development. But only if it takes a significant role in managing its portfolio of qualifying rights.

1.12. The company does not have to make all decisions concerning the portfolio. But it must undertake a significant amount of management activity: forming plans and making decisions about the portfolio.

(ii) Profits Benefiting from the Patent Box

1.13. The profits benefiting from the Patent Box are calculated as a proportion of the corporation tax profit of the companys trade.

Relevant IP income

1.14. The calculation starts by identifying how much of the companys total gross income includes relevant IP income (RIPI), which is income derived from its qualifying patents. Broadly, five specific types of income can qualify as RIPI.

9

1.15. But additionally companies who generate income outside these categories can treat a part of their turnover as relevant IP income if they use patented inventions in providing services, or in their business processes. This will be an arms length royalty rate for the qualifying patent.

1.16. RIPI includes:

(i) income from worldwide sales of the patented item, or an item incorporating it, including in territories where the item is not protected by a patent or whose patents would not themselves qualify for the Patent Box;

(ii) worldwide licence fees and royalties from:

rights that the company grants others out of its qualifying patents or over the patented item or process, including licences in territories outside the protection of the qualifying patents over the item or process; and

other non-patent rights granted for the same purpose as the patent rights;

(iii) income from the sale or disposal of UK or other qualifying EPO or national patent rights;

(iv) amounts received from others accused of infringing the qualifying patent; and

(v) other compensation, including damages, insurance proceeds and compensation for lost income that would have been relevant IP income. Again, this applies wherever the RIPI would have arisen worldwide.

1.17. For these purposes, finance income is not part of the companys gross income. Additionally, neither ring-fence oil extraction income nor income from exploiting non-exclusive patent rights can qualify.

Profit Apportionment/ Income Streaming 1.18. The company can normally choose one of two routes to calculate how much

of its profits derive from this qualifying income. Either:

(i) it can apportion its total profits according to the ratio of RIPI to total gross income; or

(ii) it can allocate its expenses on a just and reasonable basis to the two streams of income: RIPI and non-qualifying income, to arrive at an appropriate profit derived from its RIPI stream.

1.19. Profits apportioned or expenses attributed should exclude finance income and expenses. They should also exclude any additional deduction above actual cost for research & development costs under the R&D tax credits regime.

10

Removing a Routine Return 1.20. Two further stages are necessary in the calculation. The first is to remove a

routine return on certain specified expenses from the apportioned or streamed patent-derived profits. This leaves an amount called Qualifying Residual Profit (QRP).

1.21. The relevant costs include corporation tax deductions made in respect of personnel, premises (if tax-deductible), plant and machinery (including capital allowances) and miscellaneous services.

1.22. Expenditure qualifying for R&D tax credits or Research and Development or patent allowances is excluded. So are loan relationship and derivative contract debits.

1.23. The return is set at 10% of the relevant expenses and the profit is reduced by this amount.

Removing a Marketing Assets Return 1.24. The final stage is either:

to remove a return on marketing assets used to derive RIPI , by deducting a notional marketing royalty for use of the assets; or

provided the companys QRP are less than a maximum amount of 3m, to apply small claims treatment to the QRP. The small claims treatment removes 25% of QRP as a deemed marketing return, leaving the remaining 75%, (up to a maximum 1m small claims threshold) inside the Patent Box.

1.25. In either case the result is a profit figure called Relevant IP Profits (RP) which can then benefit from the Patent Box.

(iii) Applying the Patent Box to Relevant IP Profits (RP)

1.26. The Patent Box taxes RP at a reduced rate. This is effected by including an additional deduction in the companys corporation tax computation, calculated from the RP figure.

1.27. Although the resulting profits chargeable to corporation tax are then charged at the normal corporation tax rate, the extra deduction has the effect of reducing the rate.

1.28. If the Patent Box RP calculation produces a negative figure, then there is no change to the companys normal corporation tax computation. However, the negative amount of RP must reduce other RP of the company derived from a different trade, of other group companies, or future RP of the company or other group companies.

11

1.29. A company cannot benefit immediately from the Patent Box on profits from items pending patent approval. But, for up to six years before grant, the company can calculate what the relevant RP would have been had the patent been granted at that time. These amounts are aggregated over the six years, and then they can be added to the RP of the year in which the patent is granted when calculating the Patent Box deduction.

(iv) Other Aspects of the Patent Box

1.30. There are a number of rules to determine how patented and non-patented items sold or licensed together, are taken into account in arriving at RIPI.

1.31. In some cases it may be obligatory for the company to stream its profits attributing expenses to RIPI and non-RIPI on a just and reasonable basis rather than on a pro-rata basis.

1.32. The Patent Box has an anti-avoidance rule to prevent unreasonable tax benefits arising from tax- motivated schemes which aim to create mismatches of income and expenditure or to avoid particular provisions of the Patent Box.

1.33. And there are anti-avoidance rules to stop commercially irrelevant patented items being included in or with a product or spurious exclusive rights being added to licence agreements solely to enable income to qualify.

1.34. There are rules enabling partnerships and cost-sharing arrangements to qualify for the Patent Box.

1.35. In some circumstances RP in the first four years for which a company qualifies for the Patent Box may be reduced by additional deemed R&D expenditure. This will be if the actual expenditure is less than 75% of the average R&D expenditure over the four years immediately prior to electing into the Patent Box.

1.36. The full benefits of the Patent Box are being phased in over five years from April 2013, with full benefits being available from April 2017.

12

Draft Legislative Structure of the Patent Box

1.37. The main Patent Box legislation is to be included as Part 8A of CTA 2010. It will fit between other parts that specify the corporation tax rules for profits from particular activities (oil and gas exploration and leasing of plant or machinery).

1.38. This primary legislation is set out in 7 chapters:

Chapter 1 provides an introduction; Chapter 2 sets out qualifying conditions for a company; Chapter 3 provides the main rules for calculating profits eligible for the

reduced rate (relevant IP profits);

Chapter 4 specifies a more bespoke alternative method of identifying these profits (streaming);

Chapter 5 provides rules for dealing with companies that have relevant IP losses in some periods (relevant IP losses);

Chapter 6 contains targeted anti-avoidance rules to prevent abuse of the regime; and

Chapter 7 sets out the rules regarding elections into the Patent Box regime, its application to partnerships and cost-sharing arrangements and provides definitions.

1.39. Additionally a Treasury Order will specify that certain other patents granted by particular EEA territories can qualify for the Patent Box.

1.40. The remainder of this Technical Note goes into more detail about the legislation, following the legislative structure described above.

1.41. An outline summary of the legislative structure is provided at the back of this Technical Note.

13

Chapter 2 Qualifying for and Giving Effect to the Patent Box

2.1 The structure of this part of the legislation is set out below:

357A Description of the Patent Box and formula for calculating its benefit

357B to Ownership/licensee conditions for a company 357BA to qualify for the Patent Box

What IP rights qualify

The development condition

The active ownership condition

357BB 357BC to BD 357BE

357A Election into the Patent Box

2.2 Companies that elect into the Patent Box alter the way that they calculate corporation tax profits of each accounting period when they are a qualifying company. In order to be a qualifying company the company must satisfy the conditions about ownership of patent rights. These are set out in sections 357B to BE.

2.3 Where the company has elected into the Patent Box, it is entitled to an additional trading deduction in computing its corporation tax profits for each accounting period in which it is a qualifying company. The deduction is the amount obtained from the formula set out in 357A(3).

2.4 This achieves the same result as charging the relevant IP profits of the company (which are the profits in the Patent Box) directly at 10%.

For example, if a company has trade corporation tax profits of 1000, which qualify in full for the Patent Box when the main rate of tax is 22%, then instead of arriving at a tax charge of 100 by multiplying 1000 by 10%, the calculation is as follows:

Profits of Companys trade chargeable to CT 1000 Patent Box Deduction 1000 x (22-10)/22 545 Profit Chargeable to corporation tax 455

Tax Payable 455 x 22% 100

This approach is used, rather than directly charging the relevant profits at 10%, to avoid complications if the company claims losses or other reliefs and to simplify the way the Patent Box will be administered on corporation tax returns.

14

2.5

2.6 The formula is the same for companies charged at the main rate of corporation tax and for companies is charged at the small profits rate, or at the main rate with marginal relief. This means that in some cases Patent Box profits may be charged at a little below 10%.

2.7 If, unusually, a company has more than one trade the Patent Box deduction is calculated for each trade separately. If any one trade produces a negative amount of relevant IP profit, referred to in the legislation as relevant IP losses, this will need to be deducted from the relevant IP profits of the other trades, under 375E to 375EE (chapter 5 below).

2.8 Full Patent Box benefits are being phased in over five years. See Chapter 9 of this Technical Note for how this affects the computation until 2017.

Summary of Changes to 357A

2.9 357A has not changed since the draft clauses were published on 6 December 2011.

357B - Qualifying company conditions

(holding, licensingin, developing and managing IP)

2.10 Patent holders may wish to license their invention for others to develop. The Patent Box is designed to benefit both the licensor and any licensee who has been given exclusive rights under which it develops and exploits the invention.

2.11 A company that has elected into the Patent Box is a qualifying company for

an accounting period if it holds, or licenses-in exclusively, IP rights of the

types specified under the legislation. This is so long as:

it satisfies the development condition in relation to those rights, so that the rights count as qualifying IP rights; and

if it is a member of a group, it satisfies the active ownership condition in relation to substantially all of its qualifying IP rights.

2.12 The meaning of an exclusive licence is set out in 357BA (explained below).

2.13 In the normal situation, a company that has elected in to the Patent Box will

be a qualifying company if it holds qualifying IP rights at any time in the

relevant accounting period. This is Condition A in 357B

2.14 To cater for situations:

where a company disposes of qualifying IP rights, but receives income from the disposal in a later period; and also

where income is received as a result of infringement of a patent, but not until after the expiry of that patent,

357B also allows a company to be a qualifying company for the Patent Box if it has previously elected into the Box, and is taxed in a current period on

15

income derived from an event at that earlier time concerning a then qualifying IP right. This is Condition B.

2.15 A company qualifies for the Patent Box throughout an accounting period, if it holds qualifying rights at any time during the accounting period. However, other than in the situation above, for income to qualify for the Patent Box the company must hold a qualifying IP right at the time that income is recognised. For example, income from stocks of patented goods produced before their patent expires but which are not sold until after expiry will not be relevant IP income

Summary of changes to 357B

2.16 The only change to 357B since the draft clauses were published on 6

December 2011 is the revised reference in subsection (5) to 357BE,

reflecting the new numbering of this section concerning active ownership.

357BA Meaning of exclusive licence

2.17 The key aim is that to qualify for the benefits of the Patent Box, a licensee must have some unique rights to develop, exploit and defend rights in the invention.

2.18 The rules recognise that a patent holder may grant licence rights in different fields of application or in different territories.

2.19 A licensee does not need to be given all rights in the patented invention, but must be given one or more rights to the exclusion of all other persons. A right in relation to a patent could be limited to a particular commercial field of use without falling outside 357BA.

2.20 However, a right will only be regarded as exclusive if, as a question of fact, it commercially excludes competitors operating in the same market from using the invention. In the absence of any commercial effect no real right will have been exclusively conferred by the licence.

2.21 The licence must also give the licensee exclusivity for its rights extending throughout an entire national territory at least. So a licence that gives sole rights to manufacture and sell an item within part of a country only, as opposed to the whole country, will not qualify as an exclusive licence for this regime.

2.22 Additionally the licensee must either:

be able to bring infringement proceedings to defend its rights in the patented invention, or (if the patent owner retains control over defence of the patent)

be entitled to most of the damages relating to its rights that would be awarded in successful proceedings.

2.23 Normally, between third parties, it is expected that it will be clear from the language of the licence whether it grants the necessary exclusivity, because it

16

is something that each of the parties will need to be able to rely on to protect their interests. More informal arrangements may exist within a group. Provided that it is clear from the group operations that the licence is exclusive, the test will be satisfied.

An inventor develops and patents a chemical compound, to be used on its own in a product that the inventor manufactures and sells. Recognising that other companies may wish to develop other applications by mixing the compound together with other chemical ingredients, it grants a licence to another company to develop such mixtures. But not the right to sell the unmixed compound.

The licensee will be treated as having an exclusive licence provided that it is clear from the licence or arrangements attaching to the licence that only the licensee, or persons authorised by it, have or can have the right to exploit the compound as mixtures.

A licence that retains rights for the owner to licence others to sell the same mixture under a different brand name (or to do so itself) or with minor differences but to use for essentially the same application would not provide exclusive rights over the patented invention. The rights in relation to the invention would be substantially the same: to use the compound in a mixture with substantially the same outcomes.

2.24 Groups of companies may hold legal ownership of a portfolio of patents in one company. The legal owner may confer rights in particular patents on another group company to develop and exploit the patent and derive income from it. But it may retain some rights it needs to manage its portfolio. To accommodate this, 357BA(4) and (5) allow the other group company to elect into the Patent Box as if it held an exclusive licence, if it has all rights in the patented invention, or all rights apart from rights to enforce, assign or licence the patent.

2.25 Companies holding an exclusive licence over a patented invention must have the right to bring infringement proceedings, or else to benefit from any damages that would be awarded for successful proceedings.

2.26 However it may happen that the holder of a qualifying IP right is unsuccessful in an action against an alleged infringement of that right. Normally this will not affect entitlement of the Patent Box claimant their rights will be qualifying rights until such time as they cease to be protected (e.g. by a valid patent) or until a licensee no longer holds rights that grant the necessary degree of exclusivity. If losing an action results in either of these being the case, then it will not be necessary to make a retrospective adjustment to the Patent Box calculation if the Patent Box claimant reasonably believed that it did hold qualifying rights.

2.27 357F allows non commercial or unnecessary terms in a licence, included to secure Patent Box benefits, to be ignored for the Patent Box.

17

2.28 The holder of an exclusive licence over a qualifying IP right is still required to meet the development condition in 357BC and 357BD in respect of that right.

Summary of changes to 357BA

2.29 Two changes have been made to 357BA since the draft clauses were published on 6 December 2011:

the term protected item is replaced by principal right. This is to ensure that a licence of a process protected by a patent can be included.

However sales of products resulting from that patented process will not generate qualifying income (except to the extent of a notional royalty explained later) unless the patent includes a relevant product by process claim. The IPO and EPO allow a process patent to include a product by process claims where the claim is to a novel and inventive product defined by its method of production.

Reference to a principal right also ensures that a licence must confer exclusivity in relation to a qualifying patent rather than (as might have been inferred before) alternatively a non-qualifying patent over an invention that had a qualifying patent over it; and

the December 2011 draft clause required an exclusive licence to have conferred rights to the exclusion only of people carrying on a similar description of trade. Now the licence must confer rights to the exclusion of all others irrespective of the nature of their trade.

The change is because it is felt that rights given to people carrying on different trades are likely in any case to be substantively different rights and so reference to trade description is unnecessary.

357BB What patents and other rights can qualify

2.30 Patents granted by the UK Intellectual Property Office (IPO) under the Patents Act 1977 and patents granted by the European Patent Office can qualify for the Patent Box.

2.31 The Patent Box is also extended to other EEA states which have similar examination and patentability criteria as the UK. A list of qualifying patent jurisdictions (together with a description of the types of patents rights) will be published in an Order of the Treasury and are as follows:

Austria Bulgaria The Czech Republic Denmark

Estonia Finland Germany Hungary

Poland Portugal Romania Slovakia

Sweden

18

2.32 The scope of the Patent Box also extends to rights similar to patents. Section 357BB includes a list of such rights. This list was previously set out in an Order of the Treasury in the documents published on 6 December 2011.

2.33 The rights are:

Supplementary protection certificates

Supplementary protection certificates, (SPC) which are issued under Regulations (EC) 469/2009 and 1610/96 relating to medicinal and plant protection products respectively. This will also include any paediatric use extension: Article 36 of Regulation (EC) 1901/2006 extends the duration of an SPC issued under Regulation 426/2009 in respect of a paediatric use medicinal products for six months. Therefore where this is the case the company would continue to hold the SPC issued under Regulation 469/200 for an additional six months and hence continue to hold an IP right to which the Patent Box applies for that period.

Plant breeders and plant variety rights

Plant breeders rights granted in accordance with Part 1 of the Plant Variety Act 1977.

Community Plant Variety rights granted under Council Regulation (EC) No 2100/94.

Medicinal and Veterinary Products with Marketing authorisations and marketing or data protection

Companies granted marketing authorisation for reference medicinal products for human use under Regulation (EC) 726/2004 or Directive 2001/83/EC and who benefit from marketing protection by virtue of Article 14.11 of Regulation (EC) 726/2004 and Article 10.1 of Directive 2001/83/EC respectively will be treated as if they hold a right to which the Patent Box applies for the period of the marketing or data protection. This is ten years, extended by a further year in certain circumstances.

Companies granted marketing authorisation which benefits from one year of data exclusivity under Article 10.5 of Directive 2001/83/EC or an in-force one year prohibition on referring to the results of test or trials in relation to the product imposed by Article 74a of that directive will be treated as if they hold a right to which the Patent Box applies for those one year periods.

As set out in Article 38 of Regulation (EC) 1901/2006 paediatric use medicinal products are also granted marketing authorisations under Regulation (EC) 726/2004 or Directive 2001/83/EC. Therefore companies will also be treated as holding a right to which the Patent Box applies during the periods of marketing protection for such paediatric use medicinal products.

Medicinal products designated as orphan medicinal products under Regulation (EC) 141/2000 benefit from a period of marketing

19

exclusivity by virtue of Article 8.1 of Regulation (EC) 141/2000. Where this is the case a company will also be treated as holding a right to which the Patent Box applies for the ten year period of the marketing exclusivity. This period is extended to twelve years if the orphan medicinal product is also a paediatric use medicinal product that meets the requirements set out in Article 37 of Regulation (EC) 1901/2006. Therefore where this is the case the company would continue to benefit from marketing exclusivity under Regulation 141/2000 for an additional two years and hence continues to hold an IP right to which the Patent Box applies for that period.

As for medicinal products for human use, where a company is granted a marketing authorisation in respect of a veterinary medicinal product that benefits from marketing protection under Article 13.1 of Directive 2001/82/EC it will be treated as if it holds a right to which the Patent Box applies for the period of the marketing protection, i.e. ten years, extended by a further three years in certain circumstances. Where veterinary medicinal products are authorised in accordance with Regulation (EC) 726/2004 they also benefit from the from the provision of marketing protection under Article 13.1 of Directive 2001/82/EC and therefore will also be treated as if they hold a right to which the Patent Box applies for the marketing protection period referred to above.

As the Veterinary Medicines Regulations 2011 implement Directive 2001/82/EC then where a marketing protection or prohibition under paragraph 11 or 12 of Schedule 1 to these Regulations is in force, it will also be treated as if it holds a right to which the Patent Box applies for the period of the marketing protection/prohibition.

Plant Protection Products with Data Protection Benefits

Similarly plant protection products who benefit from a period of data protection under Article 59 of Regulation 1107/2009 will also be treated as holding a right to which the Patent Box applies for the period of ten to thirteen or thirteen to fifteen years as set out in that Article. However, a company will not be treated as holding a right to which this Patent Box applies if the only data protection afforded under Article 59 is in respect of a study that was necessary for the renewal or review of an authorisation.

2.34 Additionally if a patent is not granted by the UK IPO, on grounds of national security or public safety, then the applicant is to be treated as if it had been granted the patent. Such treatment, however, does not extend to cover secrecy granted by IP regimes other than the UK IPO because it would be extremely unlikely that equivalent evidence to confirm the position could be supplied to HMRC in support of the claim.

Summary of Changes to 357BB

2.35 Since the draft clauses were published on 6 December 2011, 357BB has been changed to:

20

incorporate specifically additional IP rights for supplementary protection certificates, medicinal, veterinary and plant protection products and plant varieties which were previously set out in secondary legislation; and

specifically give the power for an order to specify that certain rights granted by specific EEA states that are equivalent to UK or EPO patents will qualify.

357BC and BD The development condition

2.36 The key aim of the development condition is to limit the Patent Box to companies and groups which have been properly involved in the innovation lying behind the patent or the application of the patented invention.

2.37 The definition of qualifying development set out in 357BD(1) requires:

creating, or significantly contributing to the creation of, the patented invention; or

performing a significant amount of activity to develop the patented invention, any product incorporating the patented invention, or any process incorporating the patented invention.

2.38 Whether activity is significant will be determined in the light of all the relevant circumstances. Simply applying for a patent in respect of acquired rights, or acquiring rights to and marketing a fully developed patent or invention, or product incorporating the invention, will not be sufficient.

2.39 However there may be a number of ways in which activity could be significant. For example it could be coming up with the breakthrough idea. Or it could be work to test or enhance the viability or usefulness of the idea. In addition, qualifying development includes developing a new application for an item for instance, establishing a new therapeutic indication for a medicinal product.

2.40 A contribution could be significant by virtue of the costs, time or effort incurred. Alternatively it could be significant due to the value or impact of the contribution.

2.41 In certain circumstances a company may acquire fully developed qualifying IP as part of a wider project. For this reason the development condition can be met if the development activity took place before or after acquisition of or licensing-in the qualifying IP.

For example, a company conducts a project to develop a more efficient light bulb and undertakes a significant amount of research and development. But then the project discovers that the design of the light source they intended to use is already the subject of a third party patent which the company then acquires.

The development activity will satisfy the development test, even though it took place before acquiring the patent.

21

2.42 By way of contrast, if the companys only activity in relation to the development of the patented invention relates to commercialisation of a product or process that is otherwise fully developed, then this will not satisfy the test of contributing to significant development of the item. The same will apply where activities are limited to other commercial and legal matters such as the negotiation of a licence, the challenging or defending of a patent.

For example, a company specialises in finding customers for innovative technological products, researching the market and bringing together inventor and potential customers. It is sometimes rewarded for this by way of a share of future royalties from licensing of the patented technology.

The commercial development activity that the company performs in return for an interest in the patent will not satisfy the development test.

2.43 Qualifying development may include the commissioning of external research to develop a patented invention, for example clinical trials of a substance by a Clinical Research Organisation.

2.44 There are four ways that a company can pass the development condition. Two (conditions A and B) apply when the company has undertaken the development itself. The other two (C and D) allow a company to qualify if another group company has undertaken the significant development.

2.45 Condition A deals with the case where the Patent Box company has undertaken the development itself and does not join or leave a group after carrying out the development on the patented invention. Condition C deals with the case where the development was done by another company while it was a member of the group of which the Patent Box company is currently a member. Conditions B and D set out additional requirements if a company that has performed qualifying development joins or leaves a group after the development has been carried out.

Condition A

2.46 Condition A is met where a company has itself carried out the qualifying development activity and since that time has not ceased to be, or become, a controlled member of a group.

2.47 Group is defined in section 357GD as a company (company A), and every company with which company A is associated. Company A is associated with another company if any one of five tests is met. The three main tests are:

the financial results of company A and the other company are fully consolidated into a single set of financial statements;

company A and the other company are connected. Sections 466 to 471 of CTA 2009 apply for this purpose; or

22

company A has a major interest in the other company or vice versa. Major interest has the same meaning as in section 473 and 474 of CTA 2009.

Ceasing to be a controlled member of a group

2.48 For the purposes of conditions A (and B, described below) a company ceases to be a controlled member of a group if every other member of that group that controlled it, or held a major interest in it, ceases to do so and as a result the company ceases to be associated with any of those companies.

2.49 This means that a company that leaves a group as a singleton company, or as the holding company of a subgroup ceases to be a member of a group. Where, at the time it ceases to be a member of a group, the company continues to control or hold a major interest in any other company, then the other company is also treated as ceasing to be a member of a group at that time. So where a group disposes of a subgroup all of the companies that comprise the subgroup cease to be members of that group.

2.50 The companies that remain in the old group do not cease to be (or become) members of a group. This applies even if the old group now consists of just a singleton company.

Becoming a controlled member of a group

2.51 A company becomes a controlled member of a group if another company (P) becomes the holder of a major interest in it or begins to control it and immediately before that time the company was not associated with P or any company associated with P.

2.52 This means that a company becomes a member of a group when a new parent company not initially associated with it begins to control or hold a major interest in it. For example where an existing group, or an existing singleton company, acquires ownership of the company. However, this will not apply where, for instance, a companys ownership is transferred within a group, or where a new company is formed within a group to which ownership of the company is immediately transferred.

Condition B

2.53 Condition B deals with changes of ownership. It allows a company that has performed qualifying development as a member of one group to qualify following a change of ownership provided it continues to perform development activity of the same description (although not necessarily on the same invention) for at least 12 months after a change of ownership.

2.54 The intention behind condition B is two-fold. Firstly, it prevents a group which acquires a patent complete with the shell of the company which developed the patent from benefiting from the Patent Box where there is no further development of the patented invention. However, it does allow the Patent Box to apply where the group acquires a company with a patent that requires no further development so long as that company continues to be

23

engaged in the activities that led to the creation of the patented invention for at least 12 months after it is acquired.

2.55 357BC(11) ensures that condition B can be satisfied during the relevant 12 month period.

For example, in 2009 a company which manufactures metal widgets developed and patented a new process that allows stronger widgets to be produced.

It exploits the patent in the UK market and has licensed the process to widget manufacturers in a number of overseas territories. In 2013 it is acquired by a larger group, after which it no longer carries out any development activity on the patented process.

It is still engaged in manufacturing widgets throughout the following 12 months, and is actively engaged in researching new manufacturing techniques for lighter and stronger metal products.

It still receives licence fees from other manufacturers. All its relevant IP income, including the licence income, qualifies for the Patent Box after it joins the new group.

Condition C

2.56 The development condition is extended further in group situations by condition C. A company within a group satisfying the ownership requirements can qualify if another company in the group has carried out the qualifying development activity.

2.57 This accommodates arrangements within groups where for example one group company carries out R&D activity, but the IP arising out of that activity is owned by, or transferred to, another group company which holds the groups intangible assets. In this context it is worth bearing in mind that the Patent Box definition of a group in section 357GD is wider than for many other tax purposes, so that development activity carried out by a company that is a CFC, for example, would be regarded as carried out by a member of the group.

2.58 A company may qualify under condition C even if it was not a member of the group at the time that the qualifying development was performed. All that is required is that the qualifying development was performed within the group of which the Patent Box company is currently a member.

Condition D

2.59 Condition D extends condition B to allow a group which acquires a company which developed the patent to transfer the qualifying IP to another company in the group. Activity done in the acquired company before acquisition can satisfy the development condition if the acquired company continues with the

24

same description of qualifying development for at least 12 months after acquisition.

2.60 Condition D also allows an acquiring group to transfer the qualifying IP to another company in the group and transfer the trade of the acquired company also, either to the same company which acquires the qualifying IP or to another group company which for example might be the entity in which the acquiring group habitually locates its R&D work.

2.61 This will cater for situations where one group acquires another group. In such cases the larger group might wish to rationalise its structure and either centralise its R&D activities in one company and/or consolidate its IP holdings in a different company. Without condition D the larger group might be forced to mothball the activities of the acquired companies before beginning any reorganisation. However condition D will allow the acquired IP and R&D functions to be separated provided that the group as a whole continues qualifying development of the same description as that which led to the development of the qualifying IP for a period of at least 12 months following the original acquisition/merger.

2.62 As for condition B, 357BC(11) ensures that condition D can be satisfied during the relevant 12 month period.

Summary of Changes to 357BC and BD

2.63 There have been a number of changes since the draft clauses were published on 6 December 2011:

the definition of significant development has been separated into a new section. The term protected item has been replaced by invention, which is defined in 357GE.

This is part of a wider replacement of the term within the legislation, designed to emphasise that worldwide income from an item can qualify for the Patent Box even if the item is not protected by a qualifying patent in every territory where that income arises: provided that the invention is protected in at least one territory by a qualifying patent; and

the conditions for a company to continue to qualify for the Patent Box on the inception, change or cessation of group membership have been rewritten to put beyond doubt that companies do not cease to qualify if they begin or cease to hold subsidiaries.

This has required further consequential changes to ensure the legislation still delivers the policy aim that the company (or another company) must do further significant development work if it changes group or must for at least 12 months continue to carry on development activity sufficiently similar to that which constituted the original development.

25

357BE The active ownership condition

2.64 The key aim of the active ownership condition is to ensure that the company qualifying for the Patent Box is not a passive IP holding company, but must either have developed the IP itself or be actively managing it. If the company does not meet the active ownership condition for its portfolio of qualifying IP rights then it will not be a qualifying company.

2.65 Only qualifying IP rights (i.e. rights of a type listed and for which the company meets the development condition) are considered when determining whether the active ownership condition is met. The amount of development or management activity carried out in relation to any other IP rights is irrelevant.

2.66 The test does not apply for singleton companies outside a group, because the company will itself have to meet the development condition outlined above. If it does so it will have to have undertaken significant activity and so will not be passive.

2.67 However, a company which satisfies the development condition only because of the activity of a fellow group company must show that it plays an active role in managing the qualifying IP rights it holds. This means it must be involved in the planning and decision making activities associated with developing or exploiting substantially all of its qualifying IP portfolio.

2.68 Activities such as deciding on whether to maintain protection in particular jurisdictions, grant licences, research alternative applications for the innovation or licensing others to do so count as management activity.

2.69 Similarly, where the rights are being exploited by incorporating the item into products, activities such as deciding on which products will go to market, what features those products will have and how and where they will be sold will also count as management activity.

2.70 Whether what is done is a significant amount of management activity is to be determined in the light of all the relevant circumstances, given:

the resources the company employs; the breadth of its responsibilities for the IP; and the significance and impact of the decisions and plans it, as opposed to

other group companies, makes in relation to that IP.

2.71 It is hoped that normally it will reasonably clear in practice whether the companys activity is significant.

2.72 The company does not necessarily have to take all decisions relating to the IPs management, particularly if normal group governance requires reference to the parent Board. But it must be actively involved in whatever activity is necessary in terms of making plans and decisions and have clear substantive responsibilities. Neither does there have to be activity in each accounting period in relation to each right, if this is commercially unnecessary for the

26

groups holding of that right. A minimal amount of activity could then be significant in relation to the right.

Summary of Changes to 357BE

2.73 357BE is unchanged from the version included the 6 December 2011 draft legislation.

27

Chapter 3 Calculating Profits Eligible for the Patent Box Rate

3.1 None of the rules in Chapter 2 of the legislation determine whether any profits of the qualifying company in an accounting period qualify for the reduced rate.

3.2 This is achieved by Chapter 3. It provides rules to calculate the part of its profit that will be eligible for the Patent Box rate.

3.3 The structure of this part of the legislation is set out below:

357C Outlines the steps in the calculation, starting from the relevant IP income generated from the companys patents or patented inventions and the taxable profits of the companys trade

Steps 1 to 3 357CG & 357CH 357CC to 357CF

Apportions profits of the trade, pro-rata to the proportion of:

relevant income from

Specifies that trade profits are before net finance costs and any enhanced R&D expenses

Defines relevant IP Income, including (amongst others) income from sales of items and notional royalties patents / total gross

trade income Reduces profits for the first four years in the Patent Box by earlier R&D expenditure in some instances

Excludes certain income & apportions mixed income sources.

Note: 357D to DC provides an alternative calculation

See paragraphs 3.4 to 3.95 of this Technical Note

Deducts a routine return figure from the amount obtained from steps 1 to 3 above to give qualifying residual profit (QRP)

Step 4 357CI to 357CK

Sets routine return at 10% of prescribed deductions, excluding R&D


Step 5 and 357CL-M Steps 6 & 7 and 357CN-Q

calculates the small claims amount to be 75% of QRP if

QRP is below the relevant maximum &

Deducts an arms length marketing assets return from QRP,

less any actual payment made for the relevant marketing assets

the company elects, up to a maximum limit of 1m

in the year of patent grant, on election, adds up to 6 years post-application profits to the result of step 6 or the small claims amount


28

357C Calculation of relevant IP profits

3.4 In the normal course, there are three stages to calculate the profit to which the Patent Box tax rate applies. These are broken down in the legislation into six steps.

3.5 Additionally, a seventh step may apply if profits were made previously from inventions awaiting grant of a patent if the patent is awarded in the accounting period. This is dealt with later in this Technical Note.

3.6 The first stage is steps 1 to 3 in 357C. This:

starts with the total gross income of the trade, which includes revenue receipts; and any profits from the realisation of trade intangibles or patent rights, but excludes any finance income;

works out the proportion of RIPI (relevant IP income that forms part of total gross income) to the total gross income of the trade; then

attributes the same proportion of the profits of the trade (adjusted by excluding finance returns and costs, and R&D additional deductions) to the RIPI.

3.7 The second stage is the removal of a routine return on certain costs described at step 4 in the legislation, from the attributed profits to get a figure of Qualifying Residual Profit (QRP).

3.8 The third stage, steps 5 and 6 in 357C, removes a marketing assets return from QRP, or 25% of the QRP figure in small claims cases. The remainder is then the Relevant IP Profits (RP) which are subject to the reduced rate.

3.9 Note that as an alternative, the company can allocate profits to RIPI using the streaming rules set out in Chapter 4 of the legislation. And in some circumstances the company has to use this approach.

Summary of Changes to 357C 3.10 Since the draft clauses were published on 6 December 2011, the only

changes to 357C have been:

to ensure in steps 5 and 7 that pre-patent grant profits under 357CQ can be added to RP calculated using the small claims treatment, which erroneously was not the case before in the draft clauses; and

to clarify that in step 3 a loss is calculated as a negative figure so that deducting sums in subsequent steps increases, not decreases, this figure.

29

357 CA to 357 CH - Steps 1 to 3 of 357C:

3.11 Key aspects to steps 1 to 3 are:

the definition of total gross income; the classes of income that are RIPI, and the types of income that are

excluded from being RIPI. Specifying this includes defining items whose sale generates the relevant IP income;

the concept of notional royalties. This enables some part of otherwise non-qualifying types of income to be treated as qualifying income. An example is income from services and processes that are carried out using patented inventions; and

adjustments which need to be made to taxable profits before apportionment. In the first four years after electing into the Patent Box this may include adjustments which take earlier R&D costs into account if actual R&D expenditure has fallen to 75% or less of its level before the election.

357CA Total gross income of a trade

3.12 The total gross income of the trade is the aggregate of amounts within five Heads of income. In essence, these Heads encompass taxable amounts recognised as revenues (turnover) in the accounts plus other receipts which may be recognised elsewhere in the accounts. But finance income (as defined in 357CB) is excluded:

Head 1 is amounts that are recognised as revenue under Generally Accepted Accounting Practice (GAAP) and taken into account as credits in calculating the corporation tax profits of the trade in an accounting period. IAS 18 defines revenue as the gross inflow of economic benefits such as sales of goods and royalties.

Where a company does not draw up accounts for an accounting period in accordance with GAAP, then they are required to include in Head 1 any amounts that would have had to be recognised as revenue were their accounts compiled in accordance with GAAP principles.

Head 2 is any damages, insurance proceeds or other compensation received of any nature which have been brought into account in calculating the profits of the trade but have not, for whatever reason, been included in Head 1 above.

Head 3 is any amounts brought into account as receipts under section 181 CTA 2009 in calculating the profits of the trade in an accounting period on a change of accounting basis, so far as these are not recognised in revenues under GAAP.

30

An example of this is:

A company with a 31 December year end succeeds in principle in an action to obtain infringement damages on 1 November 2013 but whose quantum is still in dispute until they are set at 1m on 1 April 2014.

In the year to 31 December 2013 it uses a GAAP accounting basis which (for the sake of this example) will not allow recognition of this 1m income in the profit and loss account until the year of quantification. But it changes its accounting basis in the next year to one that requires recognition in the year in which the action in principle succeeds: the year to 31 December 2013.

The company makes an adjustment to reserves to reflect the change to the opening balances arising from the deemed adjustment to the prior period. However the 1m is not reflected in the profit and loss account for either period.

Tax rules therefore require an adjustment to be made on the first day of the period of account in which the new basis is first adopted. The 1m is therefore to be treated for tax purposes as income of the APE 31 December 2014, even though it will not be treated as a receipt under GAAP for that year. It will fall into Head 3 in this year.

Head 4 is any credits brought into account for tax purposes on realisation of intangible assets under the intangible fixed assets rules in chapter 4 of Part 8 of CTA 2009 (sales proceeds less allowable asset costs if any), so far as these are not recognised in revenues under GAAP; and

Head 5 is any profits from the sale of pre-2002 patent rights charged to tax in the accounting period under section 912 of CTA 2009. The company can choose to bring those profits into charge over six years. If so, total gross income each year will include the amounts charged in each accounting period.

Summary of Changes to 357CA

3.13 Since publication of the draft clauses on 6 December 2011:

357CA has expanded by inclusion of receipts taxable on a change of accounting basis; compensation or damages etc not recognised as revenue; and by dealing with accounts that are not drawn up in accordance with GAAP. Classifying Total Gross Income under different Heads is intended to make 357CA clearer; and

As the definition of finance income has also expanded since December 2011, it has been separated out into a new section 357CB, again for clarity.

31

357CB Finance Income

3.14 Finance income is excluded from the Patent Box. Any trading loan relationships credits are therefore excluded from total income for the Patent Box calculation. Finance income also includes:

any amounts that GAAP treats as arising from a financial asset (such as dividends or the sale of shares);

any return that is economically equivalent to interest (using definitions set out in s486B CTA 2009 (disguised interest)); and

credits in respect of a companys derivative contracts. 3.15 Including credits in respect of a companys derivative contracts, such as

swaps, forward contracts and options etc, means, for instance, that exchange gains on an instrument that is used to hedge foreign currency exposure on a trade debt will not constitute total gross income of the trade. This ensures symmetry of the treatment with any exchange loss on the money debt itself since these have to be added back under section 357CG in calculating the profits of the trade to which Step 3 of section 357C is applied.

Summary of Changes to 357CB

3.16 Since the draft clauses were published on 6 December 2011, credits in relation to derivative contracts have been added. This corrects their previous omission. The only other change is that the definition of finance income has been moved from section 357CA to its own section.

357CC Relevant IP income (RIPI)

3.17 Relevant IP income is defined in 357CC. In many cases RIPI and relevant IP income will be synonymous. However RIPI is defined in 357C(1) and in order for relevant IP income to be RIPI it must be included in the total gross income of the trade.

3.18 Therefore, finance income cannot be RIPI, as it is excluded from total gross income. Similarly any non-taxable income cannot be RIPI.

3.19 There are five different categories of relevant IP income arising from different ways of exploiting IP rights.

3.20 Additionally if the company derives some of its total gross income from the exploitation of the patented invention but the income does not fall into any of these heads, it may be able to deem some of that income to be RIPI as a notional royalty for the patented item (see 357CD). An example of this is may be where the company uses the patented invention to provide a service to customers.

32

3.21 The five categories of relevant IP income are:

Head 1: Income from sale of qualifying items etc.

3.22 Head 1 is income from the sale by the company of:

qualifying items; items incorporating a qualifying item, (or designed to incorporate a

qualifying item, if sold together with that item as a single unit and at a single price); and

items wholly or mainly designed to be incorporated into a qualifying item or an item incorporating a qualifying item.

3.23 357CC (12) ensures that a company is regarded as holding a qualifying IP right if it holds an exclusive licence of the right.

3.24 A qualifying item is an item in respect of which a qualifying IP right held by the company has been granted.

3.25 For a patent, the qualifying item will be the invention specified in the patent.

3.26 This description is intended to ensure that worldwide sales income can be treated as relevant IP income provided that it is received by a qualifying company.

3.27 Qualifying IP rights are likely to protect at most only European sales. For example an EPO patent will not prevent a competitor from manufacturing and selling the invention in a jurisdiction outside those to which that EPO patent relates. However worldwide sales of that item will still fall within Head 1: an item does not need to be protected by the qualifying IP right in the jurisdiction of sale. A qualifying item for the purposes of Head 1 is defined simply as an item in respect of which the qualifying IP right is granted.

3.28 Sales of products that are a direct result of a patented process will not fall within Head 1 unless the product is protected by a relevant product by process claim in the process patent (see 357BA above).

3.29 As well as sales of the invention itself, the Patent Box is intended to extend to income from the sale of items that include the patented invention and to spare parts.

3.30 To achieve this, the legislation uses the concepts of items incorporating a qualifying item and items designed to be incorporated into a qualifying item.

3.31 To be incorporated, the item must be physically part of the larger item and intended to be so for its operating life. Examples of what this might mean in practice are below:

33

A patented printer cartridge is designed to be inserted in a printer and once installed not to be removed until empty, at which point it will be replaced. The printer cartridge will be incorporated in the printer. Income from the sale of a printer including the printer cartridge (whether the cartridge is installed or included separately in the box with the printer as part of a single package) can therefore qualify as RIPI, even if there were no patent over the printer itself.

Conversely, if the printer includes a patented invention and the printer cartridge does not, then sales of the cartridges on their own will qualify as items wholly or mainly designed to be incorporated into the printer.

In contrast a patented DVD may be designed to work with a wide variety of DVD players and after each use is intended to be removed. So it is not incorporated in the DVD player, or designed to be incorporated.

So unless the DVD player is patented or includes a patented invention; including a patented DVD with it in a sale will not qualify the income from the player as RIPI. And similarly, if the DVD player is patented and DVDs are not, sales of the DVDs will not produce RIPI.

3.32 The reason for including items wholly or mainly designed to be incorporated into qualifying items, or products including qualifying items, is to encompass sales of a variety of bespoke spare parts etc. The company must hold the qualifying IP rights in the item the spare parts are designed for.

Containers and packaging

3.33 The contents of a container will not normally be incorporated in that container, as they will be intended to be removed from it for use. But, to avoid doubt, 357CC specifically defines packaging and its contents to be separate items, unless the packaging performs a function other than just the normal function of packaging: to contain, protect, facilitate delivery or handling of an item or to enable the item to be presented in a particular way. The reason for this is primarily to deal with cases where a non-patented product is sold in a patented container or packaging.

3.34 Packaging may in some instances however be an integral part of the product throughout its operating life, if it has a particular function aside from its packaging function. To deal with this, the draft legislation allows packaging to be regarded as incorporated with its contents if it performs a function that is essential to allow its contents to be used in the particular way they are intended to be used. An example is below:

A medical inhaler may include a sleeve, a canister and the active ingredient plus gas and other contents inside the canister to ensure an effective and measured dose of the active ingredient is administered.

It may be that each of these items: the sleeve, the canister and the contents of the canister are patented. But even if this is not the case, income from sale of the sleeve, canister and contents together will be within Head 1 if any one of the components is patented. The packaging rule will not exclude either the sleeve or the canister, because they fulfil an essential function in the proper administration of the drug.

34

3.35 Where the packaging is not patented but the contents are, there will generally be no need in practice to distinguish income from packaging separately. 357CF (6), explained later in this Technical Note, in most instances will allow the packaging to be ignored and all income to be treated as arising from the contents.

3.36 Note also that if packaging is patented, and materially contributes to the sale value of a non-patented product, then 357CF will allow the income that is reasonably attributable to the packaging to qualify as RIPI.

Head 2 Licence fees or royalties for granting rights over qualifying IP rights

3.37 Head 2 consists of licence fees or royalties received. The receipts must derive from an agreement that grants any of the rights set out below; but only these rights. An agreement that also grants other rights is a mixed agreement, to which 357CF will apply.

3.38 As for Head 1 income, 357(12) ensures that a company holding an exclusive licence is treated as holding the qualifying IP right.

3.39 The rights giving rise to Head 2 income are:

a right in respect of any qualifying IP right held by the company (the qualifying patent). This includes for example a licence (exclusive or non-exclusive) in the UK of a UK patent;

a right in respect of a qualifying item or process. This covers the situations when for instance:

(i) a company has a number of patents worldwide over an invention and licenses these worldwide rights (exclusively or non-exclusively) to one or more other companies.

In this situation, only the UK, EPO or certain other patents will be qualifying rights. But provided that the other licences are in respect of the same item or process as specified in the qualifying patent, income from these other licences will also be relevant IP income; or

(ii) a company has only, say, a UK (or EPO, or qualifying national) patent but licenses use of the invention worldwide; or

(iii) a company licenses a subsidiary to manufacture and sell an item patented in the UK and in an overseas territory whose patents do not qualify for the Patent Box. If the subsidiary sells only in that overseas territory, the company might grant a licence to the subsidiary only to exploit the patent of that overseas territory and not the UK patent. The rule makes clear that the licence income still qualifies;

fees or royalties received in respect of a qualifying process. A qualifying process is a process in respect of which a company holds a qualifying IP

35

right. As for qualifying items, fees or royalties in respect of non UK/EPO patents held over that qualifying process also will fall within Head 2; and

rights over non-patented items if the purpose of granting of those rights is the same as for the rights over the qualifying IP.

Where a licence grants multiple rights which are required to produce or sell a single product, these rights will generally have been granted for the same purpose.

However, enabling the sale or manufacture of multiple products, even where those products are part of a single product line or portfolio, is not a single purpose.

Where a single licence grants rights used in more than one product, and only some rights are qualifying, then it may be necessary to use the mixed income rules in 357CF to subdivide the licence income between qualifying and non-qualifying products.

For example:

Example 1 The owner of the patent rights over a silicon chip licenses others to

manufacture and sell products containing the chip. At the same time it licenses them to use designs, trademarks, know how and technical information to allow them to manufacture and market those products effectively.

These other rights granted are not themselves in respect of qualifying IP rights. But they will be other rights licensed for the same purpose as the licence over the qualifying IP right. Fees and royalties in respect of these other rights will therefore be relevant IP income in the same way as fees and royalties received in respect of the right to exploit the patented invention.

Example 2 The owner of the IP rights over a range of pharmaceutical products

licences all of their rights to another entity for manufacture and sale. The licence includes the rights to use qualifying patents, but also includes the rights to use know-how and technical information for products which are no longer covered by any patent.

Income from this licence will not all qualify as RIPI. Instead the company must apportion income between qualifying and non-qualifying products on a just and reasonable basis.

Head 3 Proceeds of realisation of a qualifying IP right

3.40 Head 3 is the income from the sale or other disposal of a qualifying IP right or exclusive licence.

36

3.41 RIPI under this Head will be the amounts included in total gross income.

3.42 So for post-2002 IP, RIPI will therefore normally be the taxable credit equal to the excess of proceeds of realisation over the accounts carrying value of the qualifying IP right, as set out in sections 735 and 736 CTA 2009.

3.43 And for disposals of pre-2002 patents, where the company chooses to spread the profit on a disposal for tax over a six year period, RIPI will be the part brought into charge to tax in the relevant year.

3.44 Note that this Head does not include sales or other disposals of non-qualifying IP rights, even if they are:

over inventions that the company also protects by qualifying IP rights; or

sold or disposed of in the same transaction as those qualifying IP rights. 3.45 This is because there can be significant differences between the claims

covered by different patents, even within a patent family. Allowing the sale of non-qualifying patents to qualify would therefore risk including substantial amounts of income from the sale of overseas rights that would not be patentable under the Patent Act 1977, European Patent Convention or in the specified EEA states.

Head 4 Infringement income

3.46 Head 4 is income payable to the company from an infringement or alleged infringement of the companys qualifying IP rights.

3.47 The company can qualify (condition B of 357B) and the income can be relevant IP income, even if it is received after expiry or sale of the relevant patent right, provided that the infringement took place when the right was a qualifying IP right and the company was then elected into the Patent Box.

3.48 Where a company receives an amount falling under this Head, or under Head 5, which relates partly to a period when both the company and the rights were qualifying, and partly to a period when one or both these were not qualifying, then a reasonable apportionment of the receipt should be made.

3.49 A reasonable apportionment will also need to be made for any receipt that relates to a period when the company was not elected into the Patent Box, including any period before 1 April 2013.

Head 5 Damages, insurance and other compensation receipts

3.50 Head 5 is income that is received by way of insurance, compensation or other damages which, although not falling under Head 4 as receipts for a direct infringement of qualifying IP rights, is nonetheless to be treated as relevant IP income. Such receipts must either be in respect of qualifying items etc whose sale would produce income falling within Head 1, or be an amount in

37

respect of lost income which, if it had been received, would have represented relevant IP income.

For example:

A UK company discovers that a rival has been manufacturing and selling products in the UK and the US using a process which is protected by patents in both countries which it owns.

It takes action in the courts in each jurisdiction alleging that its patents have been infringed and agrees an out of court settlement under which it receives 10 million compensating for lost sales in both countries.

All of the damages will be RIPI. The UK element will qualify under Head 4 and the US element under Head 5. There will be no need to determine the proportion attributable to each Head separately.

Leasing Income

3.51 HMRCs understanding is that it is usual for a manufacturer holding a patent to dispose of any products is wishes to offer on lease terms to a separate leasing company which will then arrange lease terms with end users. In these circumstances RIPI will be the price paid by the leasing company to the manufacturer provided it is on arms length terms, and the lease arrangements between the leasing company and the end user will be a financing arrangement that will fall outside the regime.

3.52 Operating leases where the lessor retains ownership of the leased item will not give rise to relevant IP income under any of the 5 Heads above. However, provided the lessor satisfies the necessary conditions, it will normally be able to compute a notional royalty under 357CD (see below), subject to the condition of not exceeding the amounts of the receipts included in total gross income.

Summary of Changes to 357CC

3.53 The changes to 357CC since 6 December 2011 are:

extension of Head 2 and inclusion of Head 5, to bring worldwide licensing and compensation income into the scope of relevant IP income;

removal of a separate subsection (subsection (6)) requiring a company to hold the qualifying IP right for sales of spare parts to qualify, and clarification in subsection (2) that a company is required to hold the qualifying IP right for the sale of any items to qualify; and

creation of a new subsection (10) for Head 4s restriction to income from infringement occurring when the company qualifies and has elected into the Patent Box; the consequent removal of this restriction from subsection (8); and the application of it also to the new Head 5.

38

357CD Notional royalties

3.54 The key aim of the notional royalty provisions is to deliver Patent Box benefits to a company that uses its patented invention in a way that does not generate relevant IP income under section 357CC, but does result in the company deriving income and profits (termed IP-derived income).

3.55 In particular, this is expected to cover patents used in processes that create non-patented products or to provide services.

3.56 Examples might be:

A patented tool is used in the manufacturing process of non-patented items which are sold by the company.

An airline company may develop a flight simulator using one or more patented components. The simulator is used both to train its own pilots, and also generates income by providing a training facility to pilots of other airlines. The airlines own ticket sales and the direct income from training facility provision are both non-RIPI income that for the purposes of the notional royalty provision will be IP- derived income.

3.57 357CD applies only to patents: it is not thought that qualifying data exclusivity and plant variety rights will be used in a way that generates income that is not RIPI.

3.58 The draft legislation allows part of the IP-derived income to be treated as RIPI. This is an amount equal to the royalty that would be paid to an independent owner of the qualifying IP rights for the companys exclusive use of those rights to generate the IP-derived income.

3.59 The notional royalty must be calculated in according with Article 9 of the July 2010 OECD Model Tax Convention and the OECDs Transfer Pricing Guidelines, or any successor documents.

3.60 It should be noted that the nature of the notional counterparty to the transaction, (termed P in the legislation), is not prescribed. This is because the notional royalty is intended to capture the full economic value of the patent to the business.

3.61 The royalty calculated under this clause should therefore be the full amount that the company would be willing to pay to be able to use the patent in an arms length situation. The company is not required to determine the price at which any particular counterparty would be willing to sell, and consideration of the relative bargaining positions of the two parties is not required. However, all other provisio

Documents

Patent Box Tech Note