In a bid to encourage more companies retain and commercialise their patents in India, the Finance Act, 2016 includes a new scheme of taxation for incomes from patents. We are discussing the proposed “patent box” regime and what it entails.
Under the new law, an eligible taxpayer who earns royalty income from a patent developed and registered in India, can be taxed at a concessional tax rate of 10%, on the gross amount of ‘royalty’ received. There will also be no Minimum Alternate Tax.
This benefit will be available only to an Indian tax resident, who is a “true and the first inventor” of the invention and registered as the patent holder(s) under Patents Act, 1970. ‘Royalty’ means consideration for (i) transfer of all or any rights (including license); or (ii) imparting any information concerning the working of, or use of, a patent; or (iii) use of any patent; or (iv) rendering of any connected services. The definition of “developed” has been linked to 75% expenditure being incurred in India. Unfortunately, income from copyrights, trademarks, design and other intellectual property are excluded.
Royalty from sale of products using the registered patent is also excluded from the beneficial tax rate. There’s no denying that developing new patents and its registration are expensive. Often, it may be years before a registered patent fetches actual profits, after offsetting all initial expenditure. But under the “patent box” for e.g., a pharmaceutical company which develops a patented drug cannot claim the lower tax rate if it sells the drug and earns income. Despite incurring huge expenditure developing the patent, to enjoy the fruits of its efforts, the company will be taxed at the lower rate only if it earns a fee for licensing the patented drug to another entity. Incidentally, outright sale of patent too will not fetch the beneficial rate since “royalty” excludes capital gains income.
Opening the patent box …
Under extant tax laws, expense deductions and additional weighted deductions are available to taxpayers for R&D expenditure. Unfortunately, despite requisite approvals and incurring genuine expenditure, taxpayers engaged in R&D activities run the risk of being disallowed the expenditure. Revenue authorities routinely disallowed such expenditure, alleging that it was not incurred for business purposes or that the expenditure was of enduring benefit that ought to be capitalised.
Further, the Government has proposed to reduce all types of weighted deductions for R&D expenditure to 100% by FY 2019-20. Thus, the tax framework will no longer provide any tax incentives for capital intensive patent development. The rationale behind linking the beneficial tax rate to 75% expenditure being incurred in India was interestingly, to ensure that the Indian exchequer will not lose any tax revenue despite allowing “tax incentives” towards developing the patent, if the taxpayer moved the patent revenue abroad. In fact, the patent box regime is being fêted in the context of BEPS, for ostensibly preventing flight of capital. Many multinationals have drawn flak for locating IP in favourable tax jurisdictions, with strong IP protection laws.
The appropriate transfer pricing model ensures that group revenues pour into an IP holding company, thereby reducing the group’s effective tax rate. This, along with the possibility of ring-fencing the IP from any creditor claims against the patent developer company, also encourages entities to keep patents outside India. Invaluable IP also finds its way abroad due to better valuations they fetch, if registered outside India. However, in the absence of any tax incentive during the R&D period when a patent is being developed (including, in some cases genuine expenditure) it is unclear what tax revenue the government would have lost, even if the tax benefit had not been linked to expenditure incurred in India.
….and finding Pandora’s Box
India has a dubious distinction in patent protection and enforcement since the country is also not perceived as the best jurisdiction for IP protection. Often multinational corporations especially, are hesitant to undertake sensitive IP related research or innovation activity in India for fear of poor patent protection.
Moreover, poor infrastructure and limited resources at the patent office results in a huge backlog, which further dents India’s image as an ideal IP destination. Added to this, there is also a large backlog in patent enforcement, due to delay in concluding litigation proceedings. Needless to say, aggressive revenue authorities who unleash weapons of mass disallowance on R&D expenditure too can be an unsavoury experience towards patent development in India. As against this, some jurisdictions like Singapore and UK not only offer beneficial tax rates for patent income, but are also renowned for their ability to provide protection against infringement, with an efficient judicial system.
While the Government is trying to project an image of being business friendly, half hearted measures in the name of tax incentives may neither achieve desired objectives nor support taxpayer initiatives. It may be useful to expand the ambit of the beneficial tax rate to other IP as well like copyrights, designs etc. Allowing lower tax rates to incomes from in-licensed patents and outright sale too may contribute to IP being housed in India. Larger legal/enforcement and commercial concerns too need to be addressed, before the “patent box” can become a treasure box of innovation.