Innovation boxes are not sound tax policy and are difficult to construct properly. Nevertheless, these schemes to offer preferential tax rates to certain types of income are becoming increasingly popular. Countries, including the U.S., would be better served pursuing lower business tax rates for all businesses.
What is an innovation box?
An innovation box, often called a patent box in Europe, offers lower tax on certain types of income derived from intellectual property (IP). Income from things such as patents, trademarks, copyrights, know-how, brands, business processes and formulas, designs, logos, customer lists, and other types of IP, are eligible for inclusion in the box in some combination in the countries that have them. If a business has income that fits the definition of the box, it can put that income in the box, and pay lower taxes either through a lower rate on the income, or by claiming a large exemption of the income from tax, and thus exposing a small remaining portion of the income to the country’s business tax rate.
IP is generally highly mobile, which means that businesses can sell it to subsidiaries in low-tax jurisdictions without moving plant, equipment, and employees. Contrary to common perception, businesses must have a business or economic reason for selling the IP to a subsidiary in another country, such as the subsidiary is utilizing the IP there. Businesses cannot move IP solely for tax benefits without conflicting with transfer pricing laws.
If businesses are able to price the IP low enough and still adhere to applicable transfer pricing laws, they will reap tax savings as long as the IP generates income. There is inherent risk in such a transaction, however. IP is volatile and, in a short period of time, can shift from being profitable to being valueless. If IP does lose its value, the business in question could end up worse off due to the transaction. Nevertheless, the potential tax savings creates an incentive for businesses to sell their IP to subsidiaries in low-tax countries.
The motivation for countries that have higher tax rates to create innovation boxes is to encourage businesses not to move their IP to those low-tax locations. Retaining this IP helps maintain the country’s tax base, which, in turn, allows them to raise more tax revenue. A secondary justification is that it encourages job creation by businesses in innovative industries that create the IP that usually qualifies for inclusion in the box1 – a highly arguable proposition.
Many countries in Europe have innovation boxes that they have established in recent years.
The United Kingdom was the latest to create one. Other countries that have them include Belgium, France, Hungary, Italy, Luxembourg, The Netherlands, and Spain.
Each of these boxes is unique to the country that offers it. The countries offer different rates on qualifying income, define the qualifying income differently, and have different rules for administering the boxes.2
Innovation boxes are not sound policy
Despite their current global popularity, innovation boxes are not sound policy. The biggest reason for skepticism is that they pick winners and losers. All business income should be taxed at the same rate. An innovation box would break this vital factor for maintaining tax neutrality. Those businesses that earn income that qualifies for the box will see their profitability and competitiveness increase sharply because their taxes will fall. Businesses that do not earn such income will see no benefits and therefore suffer in comparison. It is unfair to force those businesses left out of the box to pay an uncompetitive amount of tax while allowing businesses that happen to be in a government-favored industry to enjoy the benefits of lower taxes.
It is not only unfair, but such favoritism distorts the economy by shifting resources to industries that benefit from the box. Such distortions make the economy less productive, which reduces output and wages compared to the ideal system that taxes all income alike.
Furthermore, because they only apply to some forms of income, many businesses still face a higher tax rate on all their income. Hence, an innovation box is no substitute for a lower rate.
Many questions need answering before enacting an innovation box
Innovation boxes are also complicated to construct. As such, the law creating one needs to explicate the types of income that will qualify for the box, and the rules regarding the box’s use need to be well defined. The U.K., the last major country to create a box, took several years to fully establish its system.3
Without question, the creation of an innovation box is poor policy. If, however, a country decided to pursue such an unsound policy, below are just a few of the policy questions that need to be answered (there are several additional technical questions that would have to answered as well).
What type of income would qualify for the box?
This is the most pressing question as pertains to establishing an innovation box. Assuming it limited the box to IP, governments need to determine what types of IP it would allow to qualify for inclusion. There is a multitude of types of IP and those that they would want to qualify would tie directly to what they want to accomplish by creating the box. Presumably, they would intend for the box to incentivize, at least partly, innovation for high-tech fields under the pretext that such innovation would create jobs in their country. This would undoubtedly lead to cronyism, as businesses would fight to make sure their IP qualified and their competitors’ did not.
How would it define the qualifying IP and allocate income to the IP?
By its nature, IP defies a fixed definition. Yet, governments need to define, in explicit detail, the guidelines that IP would have to meet to qualify for the box. Even if they were able to provide such a definition, their revenue agencies would be under constant strain, as businesses try to make their IP fit the parameters of the box. An onslaught of litigation would likely follow.
Furthermore, determining how much of a business’s income is generated by qualifying IP would be extremely difficult. Armies of lawyers, accountants, and economists would be employed making these determinations and quarreling with tax authorities.
The situation would be analogous to that which plagues transfer pricing, income sourcing and expense allocation rules that guide inter-company transactions today. Transfer pricing works well when businesses sell tangible items to their subsidiaries for which there is an established market. It becomes significantly more complicated when they sell IP because defining the income associated with particular IP is difficult. There are rarely markets in which an arm’s-length price for the IP can be determined, which means calculating the income IP earns is fraught with uncertainty. It is impossible, even in principle, to determine what the correct price is. Rules for determining how much income IP placed in an innovation box earns would experience the identical complication.
Isolating the income that IP placed inside an innovation box earns would be the most troublesome challenge with which countries would have to deal.
How would it apply a lower rate?
Innovation boxes in different countries apply lower taxes to the qualifying income either by lowering the rate at which they tax the income, or by allowing businesses to exempt a sizeable portion of the income from tax and applying the business tax rate to the remaining income. A country would need to decide which system it would use, although both result in the same outcome: lower taxes for the qualifying income.
Would expenses still be deductible (tax gross or net income)?
An innovation box would substantially lower tax on qualifying income. Depending on how a government allowed businesses to deduct concurring expenses, it would substantially affect the size of the tax cut. Some countries disallow, or reduce, the expenses businesses can claim against income that qualifies for the box. Others allow full deductions for those expenses. If a country reduces the expenses businesses can claim it reduces the size of the tax cut.
Depending on how an innovation box treats the expenses incurred from the income that qualifies, it would likely create an incentive for businesses to allocate expenses to income that does not fit inside the box. This would further reduce their taxes because it would reduce higher-taxed forms of income. Allocating how much of certain expenses are incurred with certain forms of income is as difficult as determining the income that IP earns and would require extensive rules.
How would it treat losses associated with the IP in the box?
A country would also have to determine what options are available to businesses that experience losses on IP they previously put in the box. If it allows businesses to claim losses on the IP outside the box, it would create an even larger benefit. Furthermore, would it allow businesses to carry forward or back losses on IP in an innovation box to offset further taxes paid when their IP was profitable?
Does a business have to participate directly in the creation of the IP for it to qualify for the box?
Businesses acquire IP in numerous ways. For example:
- They can fund research and development (R&D) that leads to its creation within their business;
- They can fund the R&D efforts of subsidiaries and then own fully or partially the resulting IP;
- They can hire a contract R&D business to create IP for them; or
- They can buy IP from another business that created it.
A country would need to detail which acquisition methods would allow IP to gain entry to the box. This is a highly important question for it to resolve because what it decides will have a significant impact on how the box functions.
The country would also need to determine if IP funded or acquired outside its borders would be eligible for the box. And does the business have to be actively engaged in the IP’s creation, or if it can only fund it?
Would only new IP be eligible?
Or would previously developed IP qualify as well? How a country decides this question will largely be determined by what it wants the box to accomplish. For instance, if it sees the box as a way to encourage more innovation, it would restrict the box to new IP created after its enactment. If it sees the box as a way to reduce the harm of the high corporate tax rate, it would allow old IP into the box, resulting in large windfall gain to owners of existing IP.
Innovation boxes are not sound policy and are difficult to construct well if a country decides to implement one. Instead, countries should focus on lower rates for all business income and avoid picking winners and losers.
- Robert D. Atkinson and Scott Andes, “Patent Boxes: Innovation in Tax Policy and Tax Policy for Innovation,” The Information and Technology Foundation, October 2011, http://www.itif.org/files/2011-patent-box-final.pdf (accessed July 27, 2015).
- Peter Merrill et. al., “Is It Time for the United States to Consider the Patent Box?” PricewaterhouseCoopers, March 26, 2012, p. 1665, http://www.pwc.com/us/en/washington-national-tax/publications/tax-patent-box.jhtml (accessed July 21, 2015).
- Merrill et. al., “Is It Time for the United States to Consider the Patent Box?” and W. Wesley Hill and J. Sims Rhyne, “Opening Pandora’s Patent Box: Global Intellectual Property Tax Incentives and Their Implications for the United States,” University of New Hampshire: Intellectual Property Law Review, Vol. 53, No. 3 (May 2013), p. 385, http://law.unh.edu/assets/images/uploads/publications/idea-vol53-no3-hill-rhyne.pdf (accessed July 23, 2015).