The United States has a rich history of encouraging and safeguarding research and development (R&D) activities. In 1981, for example, we became the first nation to realize the importance of spurring R&D through the implementation of a tax credit applied toward such activity.
As a result, the country experienced an R&D “stimulus,” leading to robust innovation and growth in sectors across the economy such as computing, healthcare, and agriculture.
Regrettably, America’s standing as a global leader in innovation has diminished in the decades since, because of an overly uncertain and complex tax code. In 2015, a record 160,000 patent applications were filed in Europe, a 5% increase over the 152,700 applications in 2014; in contrast, in the United States the number of patent applications and grants of a foreign origin is gradually and consistently increasing.
Taxes surely play a role: Prior to the U.S. Research and Development tax credit being made permanent last year, it was estimated that the United States ranked 27th out of 42 countries in terms of R&D tax incentive generosity, down from 23rd just five years ago. It’s no mystery, therefore, why U.S. firms increasingly choose to “invert” and move their headquarters abroad to receive more favorable tax treatment of their intellectual property and associated profits.
In response to this flight of R&D and profits abroad, a broad range of academics, business leaders, and policymakers have proposed a “patent box” regime in the United States, whereby intellectual property (IP) would receive favorable tax treatment in exchange for remaining under U.S. jurisdiction.
On balance, that would be a step in the right direction. It would prevent the flight of research abroad. It would be far better, however, if the patent box regime were accompanied by comprehensive corporate tax reform.
Consider the experience of other developed countries that have bought into patent box solutions. In both Ireland and the United Kingdom, patent boxes have complemented, rather than substituted for, a business-friendly taxation system. For instance, the corporate tax rate sits at 12.5% in Ireland and 20% in the U.K., versus an OECD-leading 35% rate in the United States. Without a reduction in corporate taxes, a patent box would be a Band-Aid for the bigger reasons companies choose to move abroad.
Moreover, countries that already have patent box regimes have designed them to be neutral from a business implementation and process standpoint. In Hungary and the Netherlands, for example, it makes no difference whether IP is developed or acquired by an existing company, or is placed in a company newly formed to exclusively hold only that IP.
In other words, it is left to businesses to decide how to structure the development or acquisition of IP, rather than according to the dictates of an overly restrictive tax code.
There also remains a need for profound analysis on how much and what types of IP would be kept in the United States as a result of the enactment of a patent box. Currently, the U.S. R&D tax credit (Section 41 of the Internal Revenue Code) incentivizes the “front end” of the innovation — the ideation phase, consisting of innovative activity and research. In contrast, a patent box typically strengthens the “back end,” or the tangible results of those activities from which a company can derive profits.
Enacting a patent box regime without addressing these issues might lead to distortions in the allocation of investment capital. Companies would naturally channel capital into innovation that would succeed, thereby paying off in terms of tax benefits, but also moving capital away from innovation that is least likely to result in patentable IP.
That would be to their benefit — in the short term. But what about the long term? The fact is, even research that doesn’t result in a successful product or advance often lays the groundwork for future innovations and research, which very well may turn out more profitable. Companies need to start somewhere.
Having said all that, comprehensive tax reform realistically isn’t going to happen anytime soon. In my opinion, a patent box would still have a net positive effect, especially now that the R&D tax credit is permanent.
Currently, the R&D credit covers ideation — the actual research being conducted. So, many companies prefer to keep high-paying scientific and engineering jobs in the United States in order to take advantage of the research credit. Once a product is commercialized, however, it often makes more sense to relocate IP abroad (typically in Europe) because of the lower tax rates. Keeping both jobs and developed IP in the United States would encourage companies to keep innovation in the United States.
While a patent box/tax credit regime wouldn’t remove all the other incentives companies have to move offshore, it would be a good start.
A patent box regime would also need to conform to broader international tax reform efforts. A U.S. regime could not be a mere pass-through, but rather would need to ensure that substantial R&D is occurring here, in line with the OECD’s Base Erosion and Profit Shifting “Action #5” proposal.
In that proposal, the OECD recommends that member and associate countries adopt a “nexus” approach in the design or modification of their IP incentive regimes in order to ensure that such regimes do not produce harmful tax practices. This approach links IP ownership to the location where substantial innovation activity occurs. IP incentive regimes must require IP owners to demonstrate nexus as a condition for qualifying for the benefits of such regimes — a key aspect to consider in designing a U.S. patent box solution.
In the long run, if the patent box lives up to its goal of stimulating successful IP innovation activity in the United States, expanding the tax base, and creating new businesses and job opportunities, it would be a net positive.
Many failed R&D initiatives later provide the building blocks for truly transformative technologies and applications. If the United States wants to remain a leader in that regard, we should be prepared to incentivize corporations to conduct the research, and keep it close to home.
Yair Holtzman is a partner at accounting firm Anchin, Block & Anchin in New York. He is practice leader of the firm’s R&D tax credits group, life sciences industry group, and chemicals and energy industry group.