Patent box legislation introduced
The Australian government first proposed a patent box regime in the 2021-22 Federal budget released on 11 May 2021, and then on 10 February 2022 it introduced the Tax Concession for Australian Medical Innovations Bill. The bill still needs to pass in the House and Senate and may be subject to amendments during that process.
The proposed regime would effectively result in a concessional tax rate of 17% (instead of the standard corporate rate of 25% or 30%, depending on the taxpayer’s size) for ordinary and statutory income derived directly from medical or biotechnology patents for income years commencing on or after 1 July 2022.
To access the patent box regime, an entity must be an eligible “research and development (R&D) entity,” which includes Australian resident companies and branches of foreign corporations if there is an income tax treaty in place between Australia and the foreign corporation’s country of residence. The R&D entity must be undertaking eligible R&D activities associated with relevant patented invention/substance in Australia.
The patent box regime is intended to incentivise commercialisation of patents in Australia’s medical and biotechnology industry to allow for income to be directly generated from the patent.
What do Australian stakeholders think about the proposed regime so far?
There is currently no clear consensus regarding the effectiveness and benefits of the proposed regime, with some of the differing views summarised below.
Australia has already adopted schemes and tax incentives for R&D activities to encourage innovation. Its current R&D tax incentive program provides a tax benefit to companies that invest in eligible R&D activities regardless of whether they ultimately commercialise their research or not.
Under the proposed patent box scheme (which adds to the existing concessions), the taxpayer would be unable to claim the concessional tax rate if no income is generated (in other words, the product must be commercialised). Because not all R&D is patentable, there is a school of thought that argues the scheme may encourage companies to shift their focus to performing only activities that can be patented and would therefore be eligible for the tax benefits under the scheme and avoid performing R&D activities that cannot be patented. This incentive may therefore have the potential to negatively affect investment in research that, while valuable, cannot be patented.
The patent box scheme may also encourage additional opportunistic patent applications that would have otherwise remained unpatented, that may not be connected to real economic activity being performed in Australia.
The scheme is likely to incentivise companies to undertake more R&D activities in Australia and to keep the resulting IP here, as the cost of doing so is reduced due to tax concessions. However, the likely impact, particularly in the medical and biotechnology industry, is that only a handful of innovators (who, based on anecdotal evidence from other countries with similar regimes, are potentially larger market players) are likely to benefit, given the high barriers to entry in the industry. As such, it is likely that the benefit and uptake of the proposed regime will be limited, if it is not expanded to include other industries.
Finally, as with any patent box regime, and given the difficulties associated with accurately attributing revenue to a specific patent, there is a concern that the scheme could encourage multinational enterprises to artificially structure their arrangements to take advantage of the concessional tax rates.
It is therefore important that companies taking advantage of the regime be aware of both Australian and multinational tax anti-avoidance guidance and seek appropriate advice.
Implications for transfer pricing professionals
Companies that apply for the patent box scheme should be aware of several practical issues that will require the application of transfer pricing principles.
As the concession is applicable only to income attributable to R&D activities performed in Australia, the Australian taxpayer will be required to clearly identify Australian R&D-related expenditure that is directly connected to the relevant patent for purposes of the scheme.
Taxpayers also will be required to determine what portion of the income from the sale of a particular product is directly derived from the R&D patent itself. For example, there may be instances where income from sales is related to the marketing functions, brand name and the global distribution networks, as marketing activities and product branding can result in a valuable trademark and associated goodwill.
Unless there is a formula or a safe harbour approach to deal with the above concerns (both currently missing from the proposed legislation), an analysis consistent with the arm’s length principle will be required to establish the amount of revenue eligible for the concession. This would be a subjective exercise and therefore would need to be undertaken with sufficient rigour to mitigate the risk of subsequent challenge by the tax authorities.
If there are overseas operations in the value chain, additional transfer pricing compliance costs will arise in ensuring that the transactions between related entities are arm’s length. It would also be prudent for taxpayers to undertake a two-sided analysis to ensure that any revenue determined under the Australian transfer pricing rules as relevant to the R&D patent does not create potential transfer pricing issues in overseas jurisdictions.
Taxpayers will also need to consider the Australian Taxation Office’s (ATO’s) draft Practical Compliance Guidance (PCG) 2021/D4, which sets out the ATO’s compliance approach to international arrangements connected with the development, enhancement, maintenance, protection and exploitation of intangible assets and/or migration of intangibles. The PCG is intended to apply irrespective of the taxpayer’s size or the nature of the intangible arrangements and will need to be taken into account for all companies with IP-related transactions when finalised. The PCG prioritises contemporaneous documentation of these issues as one of the key elements of risk management.
Dealing with intangible assets such as patents involves inherent subjectivities and a heightened level of risk. Thus, it is crucial that multinationals planning to access the regime invest in robust analysis in support of their position that aligns with their transfer pricing documentation and relevant valuations.