BONUS CONTENT: Patent Boxes

Patent boxes arose around the same time that personal computers did. And just like PCs, they’ve changed a lot in the years since.

In their purest form, patent boxes grant low or zero taxation to profits derived from patents, or all types of intellectual property including valuable copyrights and trademarks. By offering this benefit, they create an enticing incentive for companies to move those valuable intangible assets to that jurisdiction–which, most of the time, isn’t the jurisdiction where they were initially developed.

They are hardly the only way that tech companies could shield their income from taxation. Many used more elaborate structures to place intangible income in jurisdictions with no taxation at all, regardless of its form. Nevertheless, they became viewed as one of the most pernicious tax benefits offered to companies that hardly needed it, as well as a symbol of how the global tax system as a whole–whether by design or accident–disproportionately rewards companies whose income is tied to intangibles.

But that was then. Following the Organization for Economic Cooperation and Development’s 2015 Base Erosion and Profit-Shifting project, new international standards place new requirements on all patent box regimes, making them much harder to use for mobile income. Presumably, these rules–which are voluntary, but which nearly all countries have adopted to ensure against retaliatory actions–have moved patent boxes towards what they were originally meant to be, an incentive for companies to engage in more research and development than they otherwise would.

It’s not altogether clear that they have. But they’re clearly no longer the center of the global tax system. In a weird way, though, the concept of the patent box still has outsized influence, having changed the system in a fundamental way.

Because they’re a “back-end” tax benefit–the value of the benefit increases based on the amount of qualifying profits–economists have always been dubious of patent boxes’ capacity to encourage more R&D activity than would have happened otherwise. Rather than reward innovation, patent box regimes end up rewarding those who already own valuable intangible assets, often known as the collectors of “rents” in economic parlance.

This is in contrast to expenditure-based tax incentives like the U.S. R&D credit, which increase in proportion to the amount that the taxpayer has spent on activity that is likely to create new technologies or businesses. Those incentives are akin to the government becoming a silent partner on a new venture, whereas patent boxes are more like a sweetheart deal between a tax authority and an entity with an already-established income stream.

The OECD ultimately decided on a “nexus”-based approach, based on an agreement struck between Germany and the United Kingdom over the latter's patent box. The rule uses expenditures as a proxy for R&D activity. According to the OECD’s 2015 report, the requirement is based on the principle that “because IP regimes are designed to encourage R&D activities and to foster growth and employment, a substantial activity requirement should ensure that taxpayers benefiting from these regimes did in fact engage in such activities and did incur actual expenditures on such activities.”

In the years since, the OECD has conducted annual peer reviews, and they’ve shown that almost all of the patent box regimes have been changed to be compliant. Ireland, for instance, now has a “knowledge development box” which includes substance requirements.

There is one notable exception, at least on paper–the United States. Formally, the U.S. has never had an outright patent box, probably because it never needed one. While countries like Ireland were building their economies from scratch, the U.S. has always had a thriving tech sector going back to WWII. And its valuable R&D credit subsidizes tech spending to the tune of billions of dollars annually.

However, it has had a problem with valuable IP migrating from Silicon Valley, Seattle or New York to low-tax jurisdictions, including those with patent boxes. While U.S. lawmakers have tossed around the idea of enacting one from time to time, they ultimately opted for a sort of patent-box-by-proxy–the deduction for foreign-derived intangible income, a.k.a. FDII. This enabled a lower tax rate on income from intangible assets, determined by a formula based on tangible property, that is sold for use abroad. It pairs with the tax on global intangible low-taxed income, a similar provision that applies to foreign intangible income.

Notably, FDII doesn’t include any requirement for real R&D activity in the U.S. (In fact, the deduction is more valuable the less in physical assets the taxpayer holds domestically). It has documentation requirements, but those are to determine whether the products it covers really were sold or used abroad. If Congress gave the OECD standards any thought (which they may not have), they probably claimed they wouldn’t apply to FDII, since FDII isn’t literally tied to intangible assets.

Nevertheless, countries have already petitioned the OECD to declare FDII to be a noncompliant regime, which could become the basis for retaliatory actions. So far, the organization has delayed action, noting that the Biden Administration has called for FDII to be repealed. (Whether that will change when Trump takes office is an interesting question.)

It would be exceedingly rare that a corporation would shift IP developed outside the U.S. into the country, just to take advantage of the FDII deduction. FDII has been enough of an incentive to entice U.S. companies to bring IP home, but it’s not that valuable. (Many U.S. companies are opting to keep their structures in place, despite the TCJA incentives.) It’s a bit questionable whether there’s a real tax policy issue at stake here, or if it’s just arguing about technicalities. For that reason, the OECD may try to indefinitely defer making any sort of judgment here–but given the rocky diplomatic waters ahead, avoidance may be tricky.

The GILTI/FDII pairing highlights an interesting duality between patent boxes and anti-abuse rules that have developed. In theory, the policies should be total opposites, one granting a benefit and one strong disincentive. But in practice they can end up looking identical. In tandem, they ensure that IP is covered by taxation no matter where it is located. It ensures that the IP income has a lower tax rate, but at least it’s not taxed at zero.

Contact the author at amparkerdc@gmail.com.