Income Tax 30 Jan,2020
Expansion of purview of tax incentives under the Indian “Patent Box Regime”
Sridhar RPartner – Grant Thornton India LLP

1. Background

In the current dynamic global economy, we are moving towards an information based world, which is clear from the fact that data and disruption (innovation) are considered as the new oil. In order to encourage these into the Country, it is necessary to incentivize investments within India and from abroad, into innovation and development of knowledge based resources including patents.

There is a direct nexus between investment and GDP growth of a country. This is evidenced by the fact that the low estimated GDP growth of 5% in the current fiscal is heavily correlated with the low Gross Fixed Capital Formation (also known as the investment rate) rate of 1%. An enriched Investment climate in the country is a pre-requisite to achieve the stated intent of the Government's USD 5 trillion-dollar economy mission.

The need of the hour is creating an investment friendly climate, specifically in the field of innovation and technological development, which would be an anchor for sustainable growth and development. The US-China Trade war had presented India a golden opportunity to project and showcase India as a technology development centric jurisdiction, as the trade war has technology development and protection in the heart of the issue.

India has taken lot of positive steps in this direction, with various initiatives such as 'Make in India', 'Startup Action Plan' and 'Digital India.' From a tax perspective, the patent box regime was introduced vide the Finance Act 2016, which seeks to tax income from worldwide exploitation of patents developed and registered in India at a concessional rate of 10%.

While these measures have played a significant role in India's growth story in the past few years, if India has to become a global superpower there is a need to bring out radical changes in the existing tax regime, with a special focus on incentivizing R&D. With the upcoming budget, the eyes of the entire world are on India, with an expectation that these changes are initiated. The current patent box regime needs to be spruced up to be able to achieve these objectives.

2. What is Patent Box Regime?

Patent box regimes or Intellectual Property ('IP') regimes provides for a lower effective tax rate on income derived from qualifying IP such as patents, software copyrights, etc. Depending on the regime, income derived from IP can include royalties, licensing fees, gains on the sale of IP, sales of goods and services based on the IP, etc. which are eligible for beneficial tax rates. The aim of patent boxes is generally to encourage and attract local R&D and incentivize businesses to house the IP in the jurisdiction.

Earlier, a common practice amongst inventors was to register the patents in tax havens, even though the R&D and related activities have been undertaken in a different country, thereby resulting in shifting of the profits from the country where it was developed. Many multinational companies used IP Based-Base Erosion & Profit Shifting tools such as Dutch Sandwich and Double Irish Structures, wherein royalty payment schemes and capital allowances for intangible assets scheme were used to shift significant profits to tax havens.

In order to protect the rights of the developing country and to promote indigenous R&D, many countries all the over the world came together to support a favorable treatment for income over the exploitation of intellectual property with adequate safeguards for preventing tax base erosion.

Consequently, various countries part of the Global 20 including India, were involved in the recommendation to OECD to recognize the fact that there was a misuse in the usage of the intellectual property rights and hence, the Modified Nexus Approach was introduced in the Base Erosion and Profit Sharing (BEPS) Action Plan 5: Agreement on Modified Nexus Approach for IP regimes in 2015. This Modified Nexus Approach limits the scope of qualifying IP assets and requires a clear connection between R&D expenditures, location of IP assets, and source of IP income to be established to be eligible for claiming the benefits under the IP regime.

Many countries to fall in line with this approach have either scrapped or amended their patent box regimes within the last few years, especially in Europe.

3. Patent Box Regime - Current Global Scenario

The European countries such as Ireland, Netherlands, France pioneered in bringing about the new tax regimes following the trails of the BEPS Action-5. The OECD report on Harmful Tax practices in a 2018 progress report classified the countries into various categories such as Harmful, Not Harmful on the extremes based on various factors. The tax rate adopted by such countries is summarized herein below:

Country Peer- Review status Tax Rate under the regime Tax rate that would otherwise apply Percentage of benefit available
Ireland Not harmful 6.25% 12.5% 50%
Netherlands Amended (Not harmful) 7% 20%-25% 65% -90%
Belgium Amended (Not harmful) 4.44% 29.58% 85%
China Not harmful 15% 25% 40%
France Harmful 15% 34.43% 56%
Singapore Not-harmful 5% or 10% depending on the investment 17% 35% - 60%
United Kingdom Amended (Not harmful) 10% 19% 47%
United States Under Review 13.13% 21% 37%

Most of the aforesaid Countries are BEPS Action 5 compliant countries, and therefore are similar in the way in which the taxation of patent regimes work (i.e. Modified Nexus approach).

According to this nexus approach, a taxpayer would benefit from an IP regime to the extent that it can be demonstrated that the taxpayer incurred expenditures, such as R&D which gave rise to the IP income.

The computation formula proposed in the approach is as follows:

Qualified expenditures incurred to develop IP asset * Adjusted Net Qualifying Income from IP asset
Overall expenditure incurred to develop IP asset

In terms of net benefits accrued (i.e.) the difference between the ordinary tax rate and the tax rate under the regime (expressed as %), Belgium and Netherlands are topping the list. Further, in the case of Belgium and Netherlands the status is "Not harmful (amended)", which is one notch below the desirable status of "Not Harmful"

On the other hand, though the net benefits accrued in case of France is lower compared to Belgium and Netherlands, the status of France has been specified as "Harmful", as per the BEPS Action 5. This is on account of the fact that the regime adopted by the French does not meet certain grandfathering requirements. Therefore, this highlights the need for the jurisdiction take holistic approach considering various factors while implementing the IP regime.

The patent regime in India is considered as "Non-harmful", which reflects the fact that it is compliant with extant requirements of OECD to curb the harmful tax practices and does not require any amendments.

4. The Indian Context

In India, the Patent Box regime was introduced in 2016 through the introduction of Section 115BBF of the Income-tax Act, 1961 (Act), following the trails of Action 5 in OECD to curb the harmful tax practices which recommended the "Nexus approach". The Nexus approach prescribes attributing the income arising from exploitation of Intellectual Property (IP) to the jurisdiction where substantial Research & Development (R&D) activities are undertaken rather than the jurisdiction of legal ownership.

In India, the beneficial tax rate on royalty income is 10%, subject to satisfaction of following conditions:

  •  Person claiming the benefit should be a tax resident;

  •  At least 75% of the total R&D expenditure should have been incurred in India;

  •  Patent should be registered in India.

While the nexus approach has been followed in terms of the expenditure incurred criterion above, it is important to understand that the fundamentals behind the said approach is that the legal status of the patent is irrelevant to determine taxability.

The Indian provisions require patents to be registered in India, by following the stringent provisions of the Patent Law in India. It is pertinent to note that the patent protection mechanisms in India are in nascent stages and has a long way to go in development of effective mechanisms for patent protection. In view of the same, extending the IP Regime only to patents registered in India would be a deterrent for many multinationals to opt for the scheme in India. Relevant amendments to incorporate this scenario would result in significant investment flow into the country.

Creation of Composite Scheme with Reduction in Tax Rate: The existing rate of 10% can be more inclined towards the global average rate of 6.5% or 6%, this would be more critical considering that no deduction or allowance is available with respect to patent income and the effective tax savings is on the lower side, and there is scope for providing for a lower tax rate.

Alternatively, the Government could consider bringing in a more composite scheme wherein the R&D deductions under Section 35 of the Act and reduced tax rate on royalty income are consolidated to bring the effective tax rate down to the global average of 6% to 6.5%. Having a single basis of tax for such companies will also help in reducing time and effort in complying with two sets of rules.

Inclusion of Capital Gains from sale of IP/Income from goods and services incorporating IP: Royalty excludes income chargeable under Capital Gains and consideration from sale of products manufactured using the patented process. There are broadly three possible income streams arising to a royalty owner and user. Firstly, the regular royalty income and Capital gains from sale of the patent arising to the Royalty owner and profits from sale of products in the hands of the royalty user.

The aforesaid provisions cover only the first income stream. Many advanced jurisdictions have expanded the purview of IP income to include the above income streams and this has a gone a long way in substantially increasing the R&D inflow.

From an Indian perspective, the current provisions are highly restrictive and coverage of the balance two income streams would go a long way in improving the patent scenario in the country, since patent users would also be incentivized to be involved in the process.

5. Conclusion and way forward

As per the recent rankings conducted by Global Innovation Policy Centre (GIPC), which does an extensive analysis based on 45 indicators, India ranks 36th in the year 2019, up 8 places from the previous year. This improvement is not enough, in order to accelerate indigenous R&D, Indian government should consider the various proposals discussed above for improving the existing patent box regime to build a R&D ecosystem which would nurture significant investments into India.

The upcoming budget is a significant opportunity for the government to hit the right chords with the investor community and coax the multinationals to bring in significant investment into R&D facilities in India.

Sridhar R, Partner - Grant Thornton India LLP with inputs from CA Koushik Balaji and CA Pranaav Murali