Patent Box: A worked example
A change in the calculation
Changes to the Patent Box scheme rules have affected the way in which the calculation is carried out. With the old rules companies had the option of using a simplified formulaic way of calculating the Patent Box profits, whereas the new rules have made it mandatory to calculate relevant Intellectual Property (IP) profits using a streaming method. This process involves separating the company’s income into income streams attributable to a particular IP right, product, or product family where one or more IP rights cover the product. The costs incurred by the company are then allocated against the different income streams.
Despite the new rules being introduced with transitional arrangements for IPs created before the 1st July 2016, the changes have made a fully reasoned Patent Box calculation a burden, so it’s recommended that you do seek specialist advice when making your claim.
A worked example
The new Patent Box rules were introduced with transitional arrangements for patents submitted before the 1st July 2016. These transitional arrangements are welcome but represent another area where skill and experience are important to ensure that mistakes are minimised, and benefit maximised. It’s recommended that you do seek specialist advice when making your claim.
Below we have outlined the steps and included a simplified calculation using the new rules, which may help you estimate the amount of saving in UK Corporation Tax you could expect.
The main aim of the Patent Box legislation is to reduce the profit on which Corporation Tax is payable. The relief is given by calculating a Patent Box deduction which is subtracted from the trading profits, therefore reducing the amount of taxable profit. Corporation Tax is then calculated at the main rate.
To calculate the Patent Box deduction, we use the formula given in the legislation; Relevant IP profits (RP) are multiplied by the main rate of Corporation Tax (MR) minus the special rate of Corporation Tax (IPR, ultimately 10%) divided by the main rate of Corporation Tax i.e.
RP x (MR – IPR) / MR
This relief has been phased in over 5 years meaning that only a percentage of the relevant IP profits will be included when calculating the Patent Box deduction.
The calculation required by the Patent Box legislation to determine the relevant IP profits is complicated however, below is an example that we have created to help you estimate the amount of Corporation Tax saving you can expect if you were to elect into the Patent Box regime.
There are normally 3 stages required to calculate the profit to which the Patent Box tax rate applies, i.e. the relevant profit.
- Identify the relevant income relating to qualifying IP rights.
- Removal of a routine return which gives the qualifying residual profit.
- Removal of a marketing assets return.
However, the calculation of relevant IP profits is now subject to an additional stage which applies a reduction to the Patent Box benefit if there has been substantial expenditure incurred in acquiring the IP and / or the R&D on the qualifying IP has been substantially carried out by group companies. This is known as the Nexus Fraction.
The legislation then further breaks these stages down into 8 steps to calculating relevant IP profit.
This example will follow the steps given under the new rules
ABC, a manufacturing company, have a trading turnover of £8,000,000 of which £5,000,000 has been generated from the sale of items that have a patent. ABC have 1 patent. It has tax deductible expenses of £5,000,000 which includes £1,500,000 for R&D, which qualifies for R&D tax credits.
If the company chose not to elect into the Patent Box scheme the Corporation Tax would be calculated as follows:
- Trading turnover £8,000,000
- Tax deductible trading expenses £5,000,000
- R&D tax credit additional deduction £1,950,000
- Taxable trading profit £1,050,000
- Corporation Tax payable (assuming 19%) without the Patent Box £199,500.
If they did elect the Patent Box calculation would be as follows:
All taxable income arising from the trade (excluding finance income) is divided into two “streams”. IP related income and Non-IP related income. The IP stream is then further split into separate sub-streams for each qualifying IP right / product or product family.
IP related income is therefore £5,000,000 and non-IP related income is £3,000,000. There is no need to further separate the IP income as there is only 1 patent in force.
Allocate all costs that are deducted when arriving at taxable trading profit, excluding loan relationship debits, i.e. bank interest, and any additional R&D deduction, to the relevant income stream on a just and reasonable basis. The aim here is to ensure that the costs associated with generating the IP income are allocated against that stream and those that are not incurred as part of the IP income are not allocated to that stream.
In our example, IP related costs are £3,000,000 and non-IP related costs are £2,000,000.
Deduct all the costs allocated against the IP income stream from that income.
Therefore, IP profit is £2,000,000 and non-IP profit is £1,000,000.
This step involves removing a routine profit (referred to the legislation as a ‘Routine Return’) from the result of step 3. This will then determine the Qualifying Residual Profit (QRP). A routine profit is the profit that a business might expect to make if they had no access to unique IP and other intangible assets. The company must apply a 10% routine return percentage to any routine returns deductions that have been allocated against the IP income stream. These deductions fall into 6 categories, which are, capital allowances, premises costs, personnel costs, plant & machinery costs, professional services, and miscellaneous expenses.
Let’s say that of our IP allocated costs of £3,000,000, £2,000,000 fall into the routine return categories. Therefore, our routine return deduction would be £200,000.
Then the Quantifying Residual Profit is calculated as the amount of step 3 minus the routine return: (£2,000,000 – £200,000) = £1,800,000.
Make a small claims election with regards to the Marketing Assets Return (MAR) if applicable. The reason for the MAR is to remove the profit associated with marketing assets from the relevant IP profits. This focuses the benefit derived from the Patent Box on the technology covered by the IP rights. The nature of the business will indicate whether the marketing activities are likely to make a significant contribution to the generation of profit and of course may believe that they do not in reality exploit any marketing assets. If the company can demonstrate that this is so, it may choose not to elect for small claims treatment and make no deduction for MAR at all.
These elections should be made each year showing proof that the criteria are still met. They should be included in the corporation tax computation to which they apply.
If step 5 is not used, then the MAR figure will need to be calculated using the formula given in the legislation;
( NMR – AMR )
Where NMR is the Notional Marketing Royalty and AMR is the Actual Marketing Royalty.
If the AMR is greater than the NMR the MAR return figure will be Nil. This will also be the case where the difference is less than 10% of the QRP. This is intended to avoid the further reduction of patent box profits where marketing assets only make a small contribution to overall profits.
Each case should be considered on its own facts.
For our example we will assume that the MAR is 20%.
(£1,800,000 × 80%)= £1,440,000.
Step 7: Apply the Nexus Fraction
The fraction links the beneficial tax rate on relevant IP income to the research and development expenditure incurred by the company. A separate R&D fraction is calculated for each sub- stream.
The fraction is created by dividing any relevant R&D expenditure directly undertaken by the company plus any relevant R&D expenditure subcontracted to an unconnected third party for each sub-stream. Divided by the total relevant R&D expenditure for each sub-stream which includes the above plus relevant connected party R&D subcontracting expenditure and acquisition costs relating to the qualifying IP rights within the sub-stream from the relevant period.
This fraction is the lower than 1 and ((D+S1) x 1.3)/(D+S1+S2+A) where the following applies:
D = qualifying direct expenditure on in-house R&D relevant to the income stream.
S1 = the company’s qualifying expenditure on relevant R&D sub-contracted to unconnected persons. That is the amount incurred by the company for R&D purposes in the relevant period in respect of unconnected subcontractor payments.
S2 = is the company’s qualifying expenditure on relevant R&D sub-contracted to connected persons. That is the amount incurred by the company for R&D purposes in the relevant period in respect of connected subcontractor payments.
A = expenditure on acquisition of qualifying IP rights
If we assume that half of the relevant R&D expenditure of £1,500,000 incurred in the relevant period (up to 20 years) is for sub-contractor costs (20% unconnected 3rd party, 80% connected party) and £100,000 was spent on relevant IP acquisitions, the nexus fraction can be calculated as:
(£750,000 + £150,000) x 1.3 / (£750,000 + £150,000) + £600,000 + £100,000=1,170,000 / 1,600,000 = 0.73
Using the previously calculated (RP) of £1,440,000 we apply the R&D fraction of 0.73 giving us £1,051,200
If all relevant R&D expenditure is spent on in house R&D and / or on 3rd party subcontracted R&D, or if there is only a small fraction of the R&D expenditure on connected party sub-contracted R&D. It’s likely that the nexus fraction will be near 1 and therefore the Corporation Tax savings would be the same under both the pre and post Patent Box rules.
Step 8: Include relevant profits accruing from patent pending periods
This is the final step in determining the Relevant IP Profit (RIPP)
In our example there are no relevant profits in previous periods and therefore the RIPP is £1,051,200.
Now we have determined the RIPP we can insert this figure into the formula to calculate the Patent Box deduction.
The patent box deduction is calculated as £497,937 (£1,051,200 *(19-10)/19))
Assuming a 10% Patent Box rate and Corporation Tax rate of 19%.
In this case the full rate of Corporation Tax is payable on the taxable trading profit (£1,050,000) minus the Patent Box deduction (£497,937) = £552,063.
At a Corporation Tax rate of 19%, Corporation Tax of £104,892 would be payable with the Patent Box, compared to £199,500 without.
A tax saving of £94,608
Irrespective of which patent box approach is being applied, the calculation requires certain figures that may not be readily available within existing accounting procedures. Therefore, we include the necessary forensic accounting in our Patent Box claim process, which is essential to identifying relevant and non-relevant IP income. This is a complex task for companies with multiple sources of income. With the application of the streaming calculation, a detailed understanding of the income and costs and how they are attributable between various income streams is required. Our team of experts will audit the income streams to determine the relevant IP income and calculate the routine deductions / costs relevant to calculating the return.