Since Minister Noonan announced in October 2014 that Ireland would introduce a “best-in-class” Knowledge Development Box (“KDB” ), there has been a lot of speculation about ‘how low would he go’. Budget 2016 announced that the rate of tax which will apply for income qualifying under the new KDB will be 6.25%. The relief is available to companies for accounting periods beginning on or after 1 January 2016.
The objective of the KDB is to provide a preferential tax rate for income generated from commercialising R&D / Intellectual Property (“IP” ). While new to Ireland, “patent box” measures have existed for many years in other countries, with, for example, the UK having a Patent Box rate of 10%.
Anyone that has been following international tax developments in recent times will be well aware of the increasing pressure being applied by the OECD to ‘counter harmful tax practices’. With the final packages of measures to address Base Erosion and Profit Shifting (“BEPS” ) published on 5th October, the OECD has firmly set out its stall on how patent boxes and their equivalents should operate. According to Minister Noonan, Ireland’s KDB will be the “first OECD compliant KDB in the world”, which means that it will be in line with new international guidelines, e.g. the Modified Nexus Approach. It is likely that other jurisdictions who would seek to compete with Ireland as a location for conducting R&D or developing IP will in the long run also need to follow the Modified Nexus Approach.
In summary, the Modified Nexus Approach limits the application of the 6.25% KDB rate by reference to a company’s R&D spend in Ireland and in the EU. This is on the basis that the R&D activity produces, for example, patented or copyrighted software assets which generate income eligible for the reduced tax rate. Therefore, for Irish indigenous businesses and SMEs who undertake the majority of their R&D in Ireland, the KDB could be very attractive. Perhaps less so for multinational companies where the generation of the qualifying assets is the result of R&D activity conducted in countries outside Ireland and the EU.
What assets qualify?
While we had hoped that the KDB would apply to a broad range of assets, Finance Bill 2015 has provided that the breadth of assets to be included in the KDB is primarily restricted to patented inventions, copyrighted computer software and protection for certain medicinal products. However, an extra measure of relief has been brought in for SMEs with an annual income from IP not in excess of €7.5 million, where the definition of qualifying assets is broader. This should prove to be particularly advantageous to the SME sector.
The KDB should therefore reward companies who invest the time and effort into legally protecting their IP. This is not always straightforward as many larger Irish businesses may not protect their IP for lots of good commercial reasons (e.g. risk of exploitation, high costs associated with registering patents, lack of effective enforcement, preference to keep knowledge as a “trade secret” etc ). Companies will need to balance the KDB rewards against the time and cost of protecting their IP.
In essence, the higher the proportion of R&D that takes place in the Irish entity, the greater the proportion of income that may qualify for the KDB rate. Only income derived directly from the qualifying asset will qualify for the reduced tax rate. Once a claim is made, it remains within the regime until the asset is disposed of or ceases to be used.
By way of example, let’s assume that an Irish SME generates taxable profits of €1m from a patented asset and that all of the R&D work that went into generating the asset was undertaken by the SME in Ireland. Under normal rules (and ignoring any other reliefs etc. available ) the corporation tax payable on this income would be €125,000 (i.e. €1m x 12.5% ). However, if this income qualifies under the KDB, then the tax payable would be €62,500, 50% of the normal applicable rate.
KDB and the R&D Tax Credit
The KDB is designed to complement the other innovation tax incentives in Ireland, targeting different stages of a company’s IP development:
the R&D tax credit is intended to support firms at the time they are undertaking the actual R&D and reduces the net costs of undertaking this activity;
the Intangible Assets relief reduces the after tax cost to companies who are investing in and exploiting certain intangible assets and using them in respect of their Irish trade; and
the KDB is aimed at the future income that is generated from the results of the R&D activity (namely the income arising from the IP that is developed by the R&D ).
The KDB will be granted only where the qualifying assets are the result of qualifying R&D activities that have been carried out by the entity claiming the tax benefit. Therefore, claiming the KDB should be a natural extension for those companies already claiming the R&D tax credit on an annual basis. The R&D tax credit already allows a 25% tax credit (available also as a cash refund for non-tax paying companies ) on qualifying R&D expenditure.
As anticipated, the definitions of “R&D” from a KDB perspective are similar to those already used under the R&D tax credit regime. Likewise, the type of expenditure that qualifies under the R&D tax credit regime will be similar to what qualifies under the KDB. It therefore makes sense for companies to start thinking of these two incentives under the same umbrella.
Are there documentation requirements?
The Finance Bill provides that taxpayers availing of the KDB will be obliged to keep detailed records, that taxpayers can ‘track and trace’ and provide documentary evidence of expenditure incurred, income generated from the IP assets, and activity undertaken to generate the IP assets. Obviously, larger and more sophisticated organisations are better resourced to track and trace than some SMEs. As the KDB will be very important to Ireland’s SME sector, it will be essential that the track and trace regulations build upon the information already maintained under the diverse range of record keeping and cost control processes in place for the R&D tax credit and do not place additional administrative burdens on potential claimants in the SME sector.
Impact for Multinational Companies
The KDB is seen as forming a core part of Ireland’s international tax offering in attracting foreign direct investment in conjunction with the R&D tax credit regime, allowances for acquired IP and the bedrock of the 12.5% corporate tax rate. Notwithstanding this, the benefit of the KDB may be limited for multinational groups who typically undertake R&D activities globally on a joint and collaborative basis by and between development teams located in a number of jurisdictions, in relation to a number of assets, products and business lines. In such cases, the qualifying R&D activity undertaken by the Irish company in relation to an asset may only equal a small percentage of the overall expenditure on that specific IP asset, resulting in a reduced percentage of income from that IP being eligible for the reduced effective tax rate.
Impact for indigenous SMEs
While the benefit of the KDB may not be substantial for multinational companies, domestic SMEs may be in prime position to avail of the reduced tax rate on qualifying profits. Given the mechanics of the relief, where a company undertakes all, or a substantial portion, of its R&D activities in Ireland, it may find that a significant portion of qualifying income from its IP assets qualifies for the effective 6.25% rate.
Of particular interest to SME’s may be the expansion of the definition of IP for companies with annual income from IP not in excess of €7.5 million. For those companies, IP also includes inventions that are certified as being novel, non-obvious, and useful. However, the definition used in the Finance Bill appears to be a unique definition not referenced in relevant patent law, and its intention is therefore unclear at this point.
Overall, the KDB should prove to be extremely beneficial for companies operating in Ireland, particularly SMEs, and has the potential to build on the solid foundations laid by the R&D tax credit in recent years by encouraging even more investment in R&D.
This article was compiled by Terri Treacy and Darragh Bolton of the KPMG Galway Tax Team, Dockgate, Dock Road, Galway, Tel: 091-534600