Ireland supports Commission review of patent boxes

Is the patent box an unfair
way of saving on tax payments?

An article by Ciarán Hancock, which appears in The Irish Times, reverts to the vexed question of Ireland and the Patent Box. Readers of this weblog will recall that, in July, this blogger listed Ireland as a country that already had a patent box tax break, only to be told by a reader that the Emerald Isle had scrapped its patent box regime back in 2010.  Well, the topic appears to be back on the table again, this time within a wide European Union context, in the hope that some sort of consistency of approach can be achieved.  The article, in relevant part, reads as follows:

Review of patent tax regimes in EU has Irish support

Ireland supports the EU review of all patent box regimes – under which certain member states offer tax breaks for intellectual property – and has decided to take a “wait-and-see approach” on the issue until guidance is provided by the European Commission. This has emerged from briefing documents provided recently by the Department of Finance to its newly-appointed Minister of State Simon Harris.

A patent box is a special tax regime offering a rate that is lower than a country’s standard corporation tax rate. Questions have been raised as to whether it breaches state aid rules, with the UK’s scheme being closely scrutinised by the commission.

The Ecofin council of EU finance ministers recently requested that the commission carry out an assessment of all patent boxes by the end of 2014. It is examining schemes in the UK, Belgium, Cyprus, Spain, France, Hungary, Luxembourg, Malta, the Netherlands and Portugal.

The briefing note to Mr Harris states that 

“Ireland is supportive of the . . . decision to look at patent boxes. There has been a lack of clarity around the issue of patent boxes for some time, and therefore we believe there should be a thorough analysis of these measures. In particular, given the persistent calls on Ireland to introduce a patent box, it would be helpful to get guidance from the commission. Ireland can adopt a ‘wait-and-see’ approach on this issue.”

Harmful competition

The briefing note adds some EU countries consider the patent box to be a “form of harmful tax competition, with Germany’s finance minister Wolfgang Schäuble making comments to the effect that they are contrary to the European spirit”. ...

Our thanks go to Chris Torrero, for spotting this link.

Death of a Travelling Patent Box

Blogger Jeremy's recent report on the first birthday of the UK patent box system lead to one commentator noting that the Irish had given up their system. This blogger was intrigued by the report, since he knew that at least one patent aggregation entity had set up in Ireland and assumed that this was because of the favourable tax regime. Setting up in the UK was probably not an option since the UK's scheme contains a development condition and an active ownership condition that were designed to stop PAEs from exploiting the British system.

The abolition of the Irish patent royalty relief scheme was one of the conclusions of the Irish Commission on Taxation set up in 2008 to review the appropriateness of the Irish taxation system. The committee was tasked to consider how the Irish tax system can best support economic activity and promote employment and prosperity in the country. It seems therefore strange that the UK government is promoting the patent box as a means of promoting economic activity.

The Irish scheme was a great deal simpler than the UK scheme. Basically any royalty income derived from a "qualifying patent" was exempt from income tax and corporation tax. A qualifying patent was a patent made on an invention for which the R&D work was carried out in a country in the European Economic Area.

An individual was only entitled to the royalty income if he or she were an inventor or a co-inventor. An annual limit of EUR 5 million was placed on the relief.

Dividends paid by a company our of patent income were also tax exempt. The commission concluded that the relief had not resulted in any increase in R&D activity - although they provide no data to back up their statement. It was also noted some companies were using the scheme as a taxi avoidance device to remunerate employees.

Intriguingly the commission concluded that the patent income exemption is a "windfall gain" after a successful invention, and not an incentive to encourage research and development. This is definitely an interesting claim and it would be highly useful to have some statistics to back it up. It would also seem to contradict the view of the British government that the tax savings would put more money into the innovation ecosystem. The Commission did conclude that R&D tax credit incentivises research and development activity more directly than the patent royalty scheme.

So how much did the Irish government actually save by eliminating the tax exemption for patent royalties? A mere EUR 84 million per annum in 2006. Certainly nothing like the millions that the UK scheme is supposed to release for R&D. On the other hand the Irish corporation tax rate for trading income is 12.5%, which is not significantly higher than the 10% headline rate that patent box is supposed to bring - and in practice is higher because of the need to deduct marketing assets and routine returns.

So do the Irish regret scrapping their scheme? Maybe - a discussion recently featured in the pages of the Irish Times.

Low Valuations at the Heart of Tax Avoidance IP Schemes – An IP Solution?

Professor Andrew Blair-Stanek of the University of Marlyand, Francis King Carey School of Law, has published an article on SSRN titled, “Intellectual Property Law Solutions to Tax Avoidance” (forthcoming 62 U.C.L.A. Law Rev. __).  The article helpfully explains how transferring IP can result in substantial tax savings for IP owners and why initial low valuations of IP are at the heart of tax avoidance schemes.  He focuses his proposal on addressing tax avoidance schemes by using substantive IP law, as well as procedural rules involving IP cases, to incentivize IP owners to make initial valuations of IP closer to their “actual value.”  He provides a hypothetical example of the problem involving Google and licensing:

When Google’s California-based engineers develop a promising invention, Google owns the rights to all patents that can be obtained on the invention. Corporate ownership of employee-created IP is common practice.

Google then quickly licenses all the patent rights to a subsidiary in a tax haven like Ireland. Licensing allows the future profits from the patents to accrue to the Irish subsidiary, while the legal ownership remains with Google itself in the U.S., with its robust protection for IP owners.  This license is respected, since Google and its Irish subsidiary are separate corporate entities, and IP can be freely licensed.

U.S. tax law requires that Google receive “arm’s-length” royalties from its Irish subsidiary for the patent license.  The “arm’s-length” price is defined as the price that would have been charged if Google had instead been dealing with an unrelated party under the same circumstances.  The “arm’s-length” principle for cross-border transactions is deeply enmeshed in not only U.S. tax law, but also the numerous bilateral tax treaties that the U.S. has signed with its trading partners, including Ireland.  Google must pay U.S. corporate tax of 35% of these “arm’s-length” royalties.  

Herein lies the mischief. Google does not transfer its promising IP to unrelated parties, so there is no observable “arm’s-length” price. Valuing IP – particularly brand-new IP – is difficult and subjective. Unlike a mass-produced machine or a ton of aluminum, each piece of IP is unique and its economic potential is difficult to predict. Treasury regulations provide detailed econometric methods to estimate IP values, but these are extremely imprecise, often leading to a wide possible range of acceptable prices.

Google must hire appraisers (oftentimes economists) to ascertain an “arm’s-length” price for the transfer to Ireland, and to support that price with extensive contemporaneous documentation.  But Google chooses and pays these appraisers, who are inclined to err towards lower valuations. As a leading tax practitioner recently observed, “appraisers tend to agree with their paymasters on [valuation] questions.”

After the transfer to Google’s Irish subsidiary, the patented technology is incorporated into a new Google device.  The Irish subsidiary oversees a Chinese contract manufacturer’s building of the new devices.  The Irish subsidiary then sells the devices for a full markup that includes the value of the IP to Google distribution subsidiaries worldwide, who then sell them to consumers. The substantial profits from the IP remain in Ireland, typically not subject to Irish tax, and not subject to U.S. tax as long as the cash is not returned to the U.S.

He also discusses why meaningful change in tax laws is unlikely to happen which leads to his IP focused proposals.  Why is the solution unlikely to be based in tax law?  He provides, at least two reasons: nearly impossible coordination of tax law between many countries; and information asymmetries between multinationals and government tax authorities.  In describing the information asymmetry problem, he states that:

First, information asymmetry refers to the fact that the taxpayer inherently knows far more about the characteristics, potential, and value of its IP than does the IRS [U.S. Internal Revenue Service] (or any appraiser). For example, Google understands how its new invention could fit profitably into a new smartphone in a way that neither a team of IRS experts, nor a team of private appraisers, ever could. When the IRS challenges a low transfer price in court, the taxpayer has a depth of understanding of its own IP that gives it a large advantage in refuting the IRS challenge.

Largely as a result of this information asymmetry, the IRS has lost both high-profile IP transfer-pricing cases litigated in the past decade. A quote from one of those opinions encapsulates the problem: “Taxpayers are merely required to be compliant, not prescient.” Taxpayers can fully comply with the law by disclosing all facts to their appraisers who must determine the “arm’s-length” transfer price. Any outsider (including judges) will not be able to discern its profit potential. But the multinational can determine its profit potential, which materializes after the IP is safely in Ireland.

His proposals for change (or perhaps, in some cases, suggestions for interesting arguments) essentially focus on using the initial low valuation position taken by the IP owner against it later in litigation (when the relevant information is likely discoverable) and licensing.  For example, he states:

First, the defendant should argue that the artificially low price is evidence that the patent was obvious at the time of invention, and hence is invalid.  Patent law recognizes that non-technical “secondary considerations” such as commercial success and licensing success are evidence for or against the validity of a patent. The artificially low price fits nicely into this rubric, because it demonstrates with a hard figure that, immediately after the invention, Google did not see the patent as being a substantial innovation. Additionally, the expert documentation justifying the low price may include damaging language downplaying the patent’s innovativeness.

Second, the defendant should argue that, even if the patent is valid, it has a narrow scope. Courts give innovative patents a broad scope that allows finding infringement whenever the infringer uses a close equivalent to the claimed invention. By contrast, less-innovative patents are given a narrower scope. The low transfer price is evidence that Google did not perceive the patent as particularly innovative, and thus should receive a narrower scope. Again, the expert documentation justifying the low price will often include damaging language downplaying the innovation.

Third, even if the court finds the patent valid and infringed, the defendant should be able to point to the low transfer price as evidence that damages should be correspondingly low. After all, a patent’s price reflects its potential to generate profits and royalties, and patent damages replace the patentholder’s lost profits and royalties.

Fourth, patent plaintiffs typically request a preliminary injunction against infringement and, if they prevail on the merits, then request a permanent injunction. But a low price for the patent suggests that infringement is unlikely to cause Google “irreparable harm,” which is required for injunctions. The low price also suggests Google does not come out ahead on the “balance of hardships,” another requirement for injunctions. Additionally, as discussed earlier, the low transfer price is evidence of invalidity and narrower scope, both of which suggest Google has a lower “likelihood of success on the ultimate merits,” a requirement for a preliminary injunction.

Finally, even if the court finds Google’s patent valid and infringed, the defendant should be able to argue that Google’s tax avoidance was “patent misuse.” When a court finds that a patentholder used the patent in a way that violates public policy, it will refuse to award damages or injunctive relief, at least until the misuse has been remedied. Misuse does not require that the patentholder harmed the defendant, only that the patentholder used the IP in a way that violated public policy. If the court finds Google’s tax avoidance sufficiently egregious, it could refuse relief to Google until it has repaid the U.S. Treasury the taxes it improperly avoided.  

Professor Stanek also discusses how copyright and trademark law have similar doctrines, such as copyright fair use, strength of the mark and secondary meaning, and damages that could be used to incentivize valuations closer to “actual valuation” and how the theories underlying IP protection support his proposals.  Notably, he states that usage of the initial transfer valuation could be used to undermine the IP holders royalty negotiation position if his proposals are adopted.  Do readers know of situations where the initial transfer valuation has been used in negotiating royalties, arguing damages, or in arguments concerning the scope or validity of IP?  (Hat tip to Professor Paul L. Caron’s (Pepperdine University) Taxprof blog for a lead to the article). 

The (bad) luck of the Irish: patent tax exemption bites the dust

Back to the dark ages for Irish
patent royalty taxation?

IP Finance has just learned that, in the Summary of 2011 Budget Measures, (See p B7 here), delivered to the Irish Dail yesterday, the provision for tax exemption for patent royalties was removed. Until now, income derived from patents was exempt from taxation (up to a cap of €5 million). The statutory basis for this relief is Section 234 of the Taxes Consolidation Act 1997.

This exemption has been removed with immediate effect (in fact, if the Budget Measures document is to be believed, the exemption vanished two weeks ago, on 24 November). This is an extraordinary measure to introduce out of the blue and it lends no thought to companies (especially start-ups) which may have based some of their cash projections on their (already meagre) royalty incomes.  IP Finance's source, Andrew Waldron, comments:

"Perhaps it seemed like something easy to dispose of, but it is an especially curious measure given that the Irish Government's line over the last number of years has been to champion R+D and the creation of IP in the economy. Plus, I would have imagined that they should have maintained any measure that offered even a glimmer of the possibility of job creation".

Andrew would be curious to know readers' thoughts on this and he asks if we know of other such exemption schemes in other countries? Have they succeeded in fostering innovation/luring large R+D companies? Could the UK benefit from the removal of the Irish exemption?

The feeling of this blogger is that it is indeed extraordinary. I have no direct data, but I had imagined that the tax exemption for royalty income was a useful carrot to dangle in front of small businesses but not one which would often be nibbled, given the arduous task of turning innovations into patent-protected streams of royalty income.  Anyway, responses to Andrew's questions are very much welcome. Please post them below if possible.

Ireland: no change ... so far

From Naoise Gaffney (Tomkins & Co, Dublin) comes some reassuring news. For those enjoying a favourable tax position as recipients of income from patent royalties and other IP-favourable tax-breaks in Ireland, the position after yesterday's Irish Budget Speech -- delivered by my old student Brian Lenihan -- is one of "no change so far".

You can check the full budget speech via the Irish Times here. On IP taxation in Ireland see IP Finance here and here.

Irish make IP-friendly amendments to Finance Act

In "Tangible Tax Relief for Intangible Assets", written for International Law Office by Aoife Murphy and Robin Hayes (WhitneyMoore), the authors welcome changes in the Irish tax set-up that will benefit intellectual property rights owners.
They explain:

Right: Ireland is taking steps to improve the position of IP rights exploitation

* the Finance Act 2009 introduced wide-ranging tax relief on capital expenditure incurred by companies on the acquisition of intangible assets in order to enhance Ireland's appeal as a location for the development and exploitation of intellectual property; a wide range of IP now falls within the scope of Ireland's tax incentive regime for the acquisition of intangible assets, enabling companies previously not entitled to tax relief on intangible assets to avail themselves of a tax write-off.

* the definition of an 'intangible asset' which qualifies for the relief has been extended and now includes (i) patents and registered designs, design rights and inventions; (ii) trade marks, trade names, trade dress, brands, brand names, domain names, service marks and published titles; (iii) copyright and related rights within the meaning of the Copyright and Related Rights Act 2000; (iv) certain plant breeders' rights; (v) know-how generally related to manufacturing or processing; (vi) sale authorizations in relation to medicines or products of any design, formula, process or invention; (vii) rights derived from research prior to authorization, on the effects of items covered directly above; (viii) licences in respect of such intangible assets referred to above; (ix) any 'non-Irish' right similar to those outlined above; and (x) goodwill which is directly attributable to the items set out above.

The authors then detail how the relief works, explaining that where a specified intangible asset is held for more than 15 years and then sold, there is no clawback of capital allowances unless the asset is sold to a connected company which subsequently claims allowances in respect of the capital expenditure on the asset. They also mention new provisions relating to Stamp duty and the restrictions and (sadly necessary) anti-avoidance measures that seek to prevent abuse of the relief.

The authors' final word on the reforms is this:

"The absence of a wide-ranging tax relief for the acquisition of intellectual property (except for certain cases such as patents and software) was considered to be a problem for some years. It is anticipated that the changes to the tax regime will encourage more companies to develop and exploit intangible assets from an Irish base and should help to increase Ireland's portfolio of overseas investors".

Ireland's tax proposals for IP investment and transactions

Writing in the April 2009 issue of Dublin law firm Philip Lee's Media and IP E-Bulletin, Jonathan Kelly's "New Irish Tax Reliefs for Purchasing Intellectual Property" provides a succinct summary of the government's position regarding IP investment and taxation in general following the Irish Minister for Finance's emergency interim budget. In short,

"... the Government intends to introduce a new tax relief for capital expenditure incurred in the purchase of intellectual property assets. The precise details of the scheme ... will be outlined in the forthcoming Finance Bill ...

... the Government has committed to increasing R&D spend to 2½% of GNP by 2013. This is designed to supplement the Government’s measures over the last ten years of having trebled its R&D spend, to a current level of approximately €2.5 billion per annum. ...

[These] measures are a welcome addition to Ireland’s existing tax incentives for intellectual property creation and exploitation. In addition to the Ireland low corporation tax rate of 12.5% for IP exploitation activities which are carried on as an Irish trade, other taxation measures which already form part of Ireland’s intellectual property regime include the following:

Patent Income Exemption
In general, profits or gains arising from a patent (whether received in the form of royalties or as a capital sum) are taxed as income. However, Irish legislation provides a tax exemption (limited to €5 million per annum) for income derived from “qualifying patents” when received by an individual or company resident in Ireland.

A “qualifying patent” is defined as a patent in relation to which the research, planning, processing, experimenting, testing, devising, designing, developing or similar activity leading to the relevant invention was carried out in the European Economic Area. It is not necessary that the patent itself be registered in Ireland or indeed in another country of the EEA. However, the recipient of the royalty income must be Irish resident.

The exemption is generally available from the date on which the patent is granted. A retrospective exemption may be available for income arising in the period between the date of filing of the final patent specification and the date on which the patent is granted.

Where the patent holder is a company, Irish legislation also provides for a tax exemption in respect of dividends paid by a company which is in receipt of tax-free patent income, subject to certain restrictions where the royalty income is received from a related company.

... As there is no requirement that the patent royalty be payable in respect of an invention used for an activity located in Ireland, this exemption has been traditionally very attractive to large international groups, making Ireland a popular location for IP holding companies.

Stamp Duty Exemption
Irish tax law also provides an exemption from stamp duty on the sale, transfer or other disposition of intellectual property, including patents, trade marks, copyright, designs, inventions, domain names, supplementary protection certificates and plant breeder's rights. Goodwill is also expressly included in the exemption to the extent that it is directly attributable to IP. This represents a huge tax saving for companies engaged in the licensing of IP or other hi-tech business and therefore acts as a further incentive to locate IP rights in Ireland.

Research and Development Tax Credits
Tax credits are available on research and development on up to 25% of qualifying expenditure. The credits can be carried back one year as well as forward. Where a company has insufficient corporation tax to absorb the credits, they can instead be set off against payroll taxes over three years ...".

All of this may be compared with Alastair Darling's UK budget proposals yesterday, where -- with the exception of some comforting words for the green innovation sector -- there was not much cheer for prospective investors in IP innovation or the acquisition and commercialisation of existing rights.

The Malign and the Benign of the Transfer of Know-How

There are various ways to view trade secrets and know-how. From the strict IP vantage point, we like to juxtapose trade secrets with patents on the basis of their largely diametrically opposed characteristics. The one is open, fully disclosed, subject to examination and registration good against the world, limited in time and governed by various international treaties. The other is unexamined, unregistered, disclosed, if it all, on the basis of personal undertakings based on mutual trust, unlimited in time but always vulnerable to public disclosure that reduces its value to first mover advantage, if at all.

From the vantage point of policy and trade, patents are researched from multiple angles, focusing on the role of patents in enabling innovation, and calculating the national winners and losers in the patent registration race. On the contrary, trade secrets are accorded far less research attention. Hand over heart, how many of us have read articles discussing the role of trade secrets in innovation, much less any consideration about one even goes about setting out a a score card for national winners and losers in the trade secret arena. (That is not quite right: there is, of course, the one well-known exception attributed to the OECD, which is reported to have concluded that more technology is due to trade secrets than to patents.)

Against this backdrop, I was struck by two brief passages that appeared in two articles, one right after the other, in the March 21st issue of The Economist . In the first, a three-page Briefing entitled "China and the West", it was observed, citing an article in a Chinese publication (Economic Reference), that the current economic troubles offered China a unique opportunity to expand its strategic influence. One way was for China to purchase U.S. companies with the explicit purpose of acquiring "sophisticated know how". If the Americans resist, China can use its dollar holdings to force the Americans to comply.

In the second article ("Ireland's Economy: The Party is Definitely Over"), the report noted that first phase of the Irish economic miracle, which ended in 2002, was "led by exports and direct foreign investment", primarily American, whereby Ireland was provided with "bags of capital and know how." In exchange, Ireland offered a combination of educated and youthful workforce, at reasonable wage, plus tax benefits, state grants and EU membership. The property bubble came later, and I seem to recall that Dell, one of the early entrants into Ireland, has recently pulled out in favor of Eastern Europe (although this is not mentioned in the article).

What is striking here is the difference in the strategic treatment of approach to know how, as set out in the two articles. In the first article, know-how is treated as a strategic asset, to be prised from its owner by financial force, if necessary. Lurking behind this characterization, it seems to me, is the issue of how know-how shared with Chinese partners can still be protected from unauthorized use and exploitation. There is a view out there that the sharing of know-how via direct investment into China is subject to material risk in this regard, with the result that some valuable know-how is still not shared.

The acquisition of U.S. companies, and the concomitant threat of the dollar weapon, is a means to presumably provide a solution for this problem. There is a sinister, almost Ludlum-like character to the role of know-how in China-U.S. relations. Whether all know-how can be so lumped in this regard, and how about the acquisition of U.S. companies can achieve this presumed goal (as opposed to targeted direct foreign investment and technology transfer), is left for another day and perhaps another article.

When Ludlum meets trade secrets and know how

In contrast, the treatment of know-how in the article on Ireland is, at least superficially, more benign. American know-how (and capital) were transferred to Ireland, factories, plants, and the like, were built, but time marches on (and indeed some of the facilities are going elsewhere). In the meantime, labor costs, retail spending, and a property bubble conspired to halt the Celtic Tiger in its tracks.

In this later phase, the issue of the transfer of know-how seems to have disappeared. This is so, both because inflation and labor costs made the exploitation of the know-how less attractive economically, and presumably because the ultimate ownership of the know-how remained in foreign hands, such that the transfer did not lead to a significant development of more broadly based local Irish technology based on the know-how. It would be interesting to know more about the role of know-how in Irish development, then and now. but here as well, this is left for another day and perhaps another article.

Find the know-how

Irish film and TV programme makers get tax boost

From the most recent Media & IP Newsletter of Dublin solicitors Philip Lee comes news of what it terms "Dramatic enhancements to Ireland's Film Tax incentive". The news item reads as follows:

"Ireland’s film and television industry has received a welcome boost from the Minister for Arts, Sport and Tourism, Martin Cullen. In a press release issued on 8 December 2008, the Minister outlined significant enhancements to the Section 481 relief for investment in film and television projects. The enhancements will be brought about by the Finance Bill (No. 2) 2008 that is currently being considered by Ireland’s houses of parliament.

Section 481 is a tax relief available to Irish investors who buy shares in a special purpose film or television production company (“SPV”). Under the current scheme, each individual tax-payer may invest up to €31,750 annually in qualifying projects, 80% of which can be written off for tax purposes.

Up to 80% of a film or television project’s budget can be raised using Section 481 investments, subject to a maximum of €50 million per project. However, in order to access the investor funds it is usually necessary for the producer to set aside (using a banking mechanism known as “defeasance”) an agreed minimum return which is to be paid to the SPV on completion, delivery and acceptance of the project and which is ultimately returned to Section 481 investors. Therefore in practice the typical “net benefit” to the producer is currently about 20% of the total Section 481 funds raised.

The proposed changes will result in an increase to €50,000 in the annual investment limit for each individual tax-payer and, crucially, an increase from 80% to 100% in the amount of the investment that can be written off for tax purposes. This means that for each investor the available tax relief in cash terms will nearly double from
€10,414 to €20,500.

The net effect of the proposed changes is expected to be a large increase in the producer’s net benefit. Initial indications are that a net benefit of around 28% should be achievable in some cases, depending on various factors including project scale.

The planned enhancements require “state aid” approval from the European Commission. Once implemented, they should re-establish Ireland as one of the most attractive global locations for film and television production and are to be warmly welcomed by producers in Ireland and abroad".