UK patent box changes
Following complaints by Germany to the EU Commission and a report by the OECD’s Forum on Harmful Tax Practices (FHTP), HM Treasury announced that the UK patent box would be amended. The FHTP identified the patent box as potentially harmful and the general consensus seemed to be that it was insufficiently targeted and had inadequate links with the R&D activity that eventually resulted in profits being generated. It was argued that it was a ‘harmful’ measure designed to attract business to the UK rather than a legitimate reward for innovation.
The government also confirmed that it would make the patent box BEPS-compliant (i.e. to satisfy the requirements of the reports on Base Erosion and Profit Shifting produced by the OECD) by making the low (10%) tax rate dependent on, and proportional to, the extent of R&D expenditure incurred by the company claiming the relief. This change came into effect on 1 July 2016.
The new regime is based on the OECD’s “modified nexus approach” (MNA) – this approach seeks to ensure that preferential IP regimes require substantial economic activities to be undertaken in the jurisdiction in which the regime exists and that tax benefits are connected directly to R&D expenditure.
The amendments closed the existing UK regime to new entrants (products and patents) in June 2016 and the existing regime will be abolished by June 2021. To allow transition to the new regime, IP within the existing regime will retain the benefits of that regime until June 2021.
The amendments to the regime also make ‘streaming’ mandatory. This is a process by which the profits that relate solely to a particular patent are isolated from the total profits made by a company. Previously it was possible to do this on a company-wide basis, but now it must be done on a patent-by-patent or product-by-product basis, which for some companies will make the compliance process considerably more onerous.
UK withholding tax changes
Budget 2016 brought a number of unexpected tax changes. One change that could have an impact on the life sciences sector is a proposed change to the UK withholding tax regime on royalties.
Withholding tax is UK tax that the royalty payer (licensee) must withhold from its payment to the royalty recipient (licensor) and pay to HMRC as a sort of ‘down payment’ on the licensor’s UK tax liability on the royalty. Most countries operate a similar regime. It is levied at 20% in the UK on royalties for patents (and also for other IP rights such as copyright and design rights in certain situations). With effect from Royal Assent to the Finance Bill (which occurred in mid-September 2016 and created the Finance Act 2016), withholding tax will also apply to royalties for trade marks and trade names.
The change will not affect current patent licences (unless they include a trade mark licence), but it could affect licences for branded non-patent protected items (such as a branded, off-patent drug). Currently, payment of a royalty for a trade mark licence for an off-patent drug would not be subject to withholding tax in the UK, but this is changed by the Finance Act 2016.
The Finance Act 2016 also prohibits group companies (or other connected parties) from accessing the benefits of double tax treaties (which can reduce or eliminate withholding tax) if trying to access those benefits forms part of a tax avoidance arrangement.
The practical consequence of these measures is that parties to licences of (or which include) trade marks or trade names where there is a UK licensee will need to think more carefully about the withholding tax position and make sure their licences include withholding tax provisions, if they do not already. This is to ensure that each party knows what the result of a withholding might be (for example, the UK licensee might be required to gross-up the payment to counteract the effect of the withholding) and whether any relevant double tax treaty between the UK and the jurisdiction of the licensor can be used to alleviate the situation (for example, by reducing or eliminating the requirement to withhold).
Tax issues arising from Brexit
In the short term, the result of the referendum is unlikely to have a material impact on UK tax rules. It had already been announced, prior to the referendum, that the corporation tax rate was to be reduced to 17% by 2020 and the Chancellor has subsequently confirmed this in the Autumn Statement. Beyond that there are a number of ways that the UK tax regime could change as a result of no longer being bound by the EU Treaty.
Thinking about issues affecting the life sciences sector, the biggest hurdle for a number of tax reliefs is the rules on State Aid (i.e. where the provision of a tax relief is regarded as being an anti-competitive advantage to certain taxpayers over others). One of the many tax reliefs that requires notification for possible State Aid is research and development tax credit. Without the constraints of State Aid, the Government would, in theory, be able to provide much more generous tax reliefs and incentives to particular taxpayers or industry sectors.
VAT can also be a cost, or at least a material cash-flow issue, for many businesses in transactions. The rules on VAT are set out in an EU Directive, but once the UK is outside of the EU VAT Directive, it would, in principle, be free to create new zero-rated supplies (i.e. those supplies which allow the supplier to recover the VAT incurred in making the supply, but without having to charge any VAT to their customers). It could even abolish VAT altogether if it wanted to, although, given the revenue raising power that VAT has, this is pretty unlikely.
In the longer term, the UK may seek to promote itself as a jurisdiction with low taxes (but not an ‘offshore’ jurisdiction) in order to attract new investment. We might see further cuts in the rate of corporation tax (suggestions of a rate of 15% have already been floated, but it is not clear how serious they were) or more generous tax reliefs for R&D.
However, it will not all be plain sailing. Many of the changes that have been made to UK tax rules in the recent past have been as a result of the work of the OECD countries, and the UK’s membership of that organisation is not affected by Brexit. UK tax issues that were a concern for the EU were also a concern for the OECD (the patent box being a good example). The fact that the UK is free of the rules of one organisation does not mean that it can abandon the commitments it has made to other international organisations. This may have a significant restraining effect on the extent to which tax policy can evolve. Also, as is the answer to so many Brexit-related questions: we shall have to wait to see what ‘Brexit’ actually looks like to gain a better idea of what the future might hold for UK tax for the life sciences sector.