A growing number of countries, particularly in Western Europe, are allowing multinational companies to use “patent and innovation boxes” to provide them with tax breaks on their intellectual property and shield more of their profits from U.S. taxes. U.S.-based corporations are weighing tax incentives such as these against the competing tax reform proposals advanced by the Obama administration and Republicans in Congress.
During a conference last Tuesday sponsored by KPMG and the New York University School of Law, tax executives from IBM and Johnson & Johnson talked about how they view the corporate tax reform proposals circulating in Washington. They also explained how patent boxes operate in countries such as the Netherlands, Belgium, Luxembourg and the United Kingdom in comparison to each other.
“Coming from a corporation, the thing that we hear most importantly from our bosses and management is that they like to have a predictable situation when it comes to tax,” said Bruce Lassman, vice president of international tax at IBM. “They would like to be able to have the same sustainable tax rate every quarter, every year, and so one of the pressures we have has to do with all this legislative uncertainty.”
Among the concerns for IBM is that the research and development tax credit has expired. “We’re about to release our first-quarter earnings next week, and because there’s no R&D credit, our tax rate is going to be higher in the first quarter than it would otherwise be with the R&D credit. Now what’s happened traditionally every year is that in the fourth quarter or maybe even beyond the fourth quarter, the R&D credit is enacted and we have to then figure out the deduction for the whole year’s credit. So that’s kind of a nerve-wracking thing. It’s difficult to manage your affairs when you have a legislative situation like that.”
He noted that the under the Obama administration’s corporate tax reform proposals, the top income tax rate would be reduced from 35 to 28 percent, while under the proposal advanced by House Ways and Means Committee chairman Dave Camp, R-Mich., the top rate would go down to 25 percent. But Lassman noted that there are different approaches to how the rate reduction would be paid for under the two competing proposals.
Under the Camp proposal, the money might come out of ending tax credits such as the R&D credit or the domestic manufacturing deduction, but that has yet to be determined.
“We don’t have really great detail there,” said KPMG principal Sean Foley, the firm’s global leader of its Global Transfer Pricing Services practice. “Camp left that open. One of the things that we’re struggling with here is that we have a certain amount of information, and some of it we don’t.”
IBM is trying to fill in some of those blanks in its tax planning by constructing various models of how Washington might be able to get corporate tax rates down to 25 percent. “Notably the rate reduction would be paid for by domestic-type issues, and at the same time the Camp proposal puts forward a territorial system, which has a lot of attractions to a number of companies, particularly those which have cash outside the U.S. that they would like to bring back,” said Lassman. “But then the pay-for with the territorial system are these base erosion proposals.”
Under the Obama administration proposals, there would be some base broadening, along with a permanent R&D credit, domestic manufacturing deduction and incentives. There is no territorial tax system under the Obama proposal.
“As a multinational, we have to take very seriously both the Camp proposal and the Obama proposal as a framework and recognize that base erosion is important,” said Lassman. “It’s very noteworthy that the Republican chairman of the House Ways and Means Committee also has several base erosion proposals, recognizing that there needs to be some tightening there.”
IBM needs to consider how much it will need to pay in taxes should either scenario come to fruition. Because of the various tax breaks available to multinationals, and the ability to move money across international borders, the answers aren’t as simple as either 25 or 28 percent.
“We get questions from our CFO about what’s our tax rate going to be if the Obama framework is passed,” said Lassman. “We get constant questions on that. Literally the day it came out, we needed to run the numbers and say what is this going to cost us? At a high level, you have to take each piece by itself.”
Lassman believes that there is wide support for a territorial tax system among multinationals. “I think most companies have now come around to the notion that territorial seems to be the right way forward,” he said.
More companies are also favoring the idea of a “patent box” for protecting their intellectual property. “The carrot is this notion of a patent box so that with any royalties that come back to the U.S., you’d be entitled to a 40 percent deduction,” said Lassman. “It could be quite a significant incentive.”
Louise Weingrod, vice president and tax counsel at Johnson & Johnson, also sees advantages in patent boxes. “We’re aware that the idea of the patent box is not universally familiar to U.S. taxpayers,” she said. “Johnson & Johnson has quite a bit of experience with patent boxes in Belgium and the Netherlands.” The U.K. is also expected to enact a patent box incentive regime about a year from now.
With a patent box, an incentive is offered to stimulate innovation, she explained, through investment in intellectual property development. “The way it works is, to the extent that the taxpayer opts to take advantage of the regime, they’re entitled to a lower rate of tax on some part of the income associated with the resulting intellectual property,” she said. “The concept of a box is interesting because, as I understand it, you take your intellectual property and put it in the box. What’s in the box is subject to these other sets of rules that are incentives offered by the local country.”
Patent boxes have been offered by a growing number of Western European countries, especially since 2007, when Belgium, the Netherlands and Spain adopted them, Weingrod added. Since 2007, Luxembourg, Ireland and one of the cantons in Switzerland have also adopted them. The U.K. is still in consultation with taxpayers, but it is expected to adopt patent boxes in about a year.
“That is not to say that patent boxes sprung out of Zeus’s head in 2007,” she noted. “Back in the early 1990s, France adopted them, and in the mid-1990s Hungary, but I don’t think there is one now. They present an interesting opportunity for a country to incentivize job creation in the R&D sector because ordinarily they involve either development of IP, or at a minimum some management of IP, locally, and also R&D and investment locally, so they’re part of an system of incentives a country might offer to retain these types of jobs or this type of economic opportunity. Patent boxes will go hand in hand with an R&D credit, or R&D deductions, not as an alternative. If you’re a pharmaceutical company, you will typically spend six to 12 years developing a new product, and you’re also sensitive to the benefit you get on investment in addition to the benefit you might get on the resulting intellectual property.”
Lassman noted that in a business like IBM’s, the development time is often shorter. “In our businesses, our products are developed quickly, and become obsolete quickly,” he said. “We like having R&D credits, but we would like the patent box better.”
Weingrod noted that there are some risks with patent boxes, however. While they can attract more economic activity to a country, they can also lead to an erosion in the tax base. “It’s quite generous to the taxpayer, but it does lead to base erosion concerns to the government unless you have something to make up the difference,” she acknowledged. For example, in Belgium, the patent box could potentially reduce a company’s tax rate from 34 percent to 6.8 percent, so while the benefits might be significant, the risks of an audit could also be significant.