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DZIUREK / SHUTTERSTOCK.COM
16 June 2015Big Pharma

Tax matters: A level playing field

You could say it worked well.

Soon after the UK government announced that it would introduce the patent box, a tax break for innovative companies, GlaxoSmithKline (GSK) and AstraZeneca, the country’s largest pharmaceutical companies, announced plans to expand their operations at home.

GSK reportedly poured £500 million ($771 million) into a manufacturing facility in the UK, created 1,000 new jobs and constructed a new factory, while AstraZeneca invested £120 million, also in a new factory.

By letting businesses pay a lower rate of tax on income from their patented inventions, the UK’s patent box, established in April 2013, sought to make the country a destination for high-tech companies large and small, while retaining existing innovative businesses.

But countries that use patent boxes to encourage innovation have been accused of skewing competition in the global field, and of artificially shifting profits between countries.

The Organisation for Economic Co-operation and Development’s (OECD) new proposal on these tax regimes—the Modified Nexus Approach—aims to level the playing field by requiring that companies claiming tax credits establish a stronger link between their research and development (R&D) activities and their income.

How will this approach affect the UK, the government of which is committed to creating the most competitive tax regime in the G20?

Building the box

Back in 2008, it looked as though the UK was losing its grip on home-grown life sciences companies, as Shire Pharmaceuticals announced it would be moving its tax headquarters from the UK to Ireland, which has a corporation tax rate of 12.5%, compared to the UK’s then 28%.

Allistair Booth, partner at law firm Pinsent Masons in London and a member of the BioIndustry Association’s finance and taxation advisory committee, says that this, coupled with other jurisdictions’ tax breaks for innovators, meant that the UK was under pressure to establish its own regime.

The resulting patent box provisions allowed companies to apply a 10% rate of corporation tax to profits earned from their patented inventions.

“The patent box represented yet another good element in a very supportive environment for innovative companies,” says Booth, referring to the UK’s existing tax credit regimes, which include the Enterprise Investment Scheme, which helps smaller innovative companies raise financing, and the R&D Relief scheme.

Jason Rutt, head of the patents group at law firm Rouse in London, called the patent box a generous scheme.

“It’s a great incentive to do research in the UK, but it’s also a great incentive to just locate your company here for the tax break.

“A great attraction of the attempted Pfizer takeover of AstraZeneca was based on the idea of the UK being a great place to list your company in terms of corporation tax.”

The Modified Nexus Approach

While UK life sciences companies were enjoying the benefits of the patent box, it soon started drawing criticism from Europe.

German finance minister Wolfgang Schäuble called for a ban on patent box regimes, arguing that they are unfair. News organisation Reuters quoted him as saying: “We have to look at this practice and discuss it in Europe … that’s no European spirit. You could get the idea they are doing it just to attract companies.”

German Chancellor Angela Merkel said that the scheme encourages artificial profit shifting between countries.

The UK’s financial secretary to the treasury David Gauke fought back, saying in a speech last October that the scheme “does not create an opportunity for businesses to reduce their taxes without increasing their value to the UK economy”.

In February, the OECD announced a solution for levelling the high-tech playing field among innovator countries, publishing its proposal on the Modified Nexus Approach for intellectual property regimes such as the patent box.

The consensus, which built on a proposal drawn up by Germany and the UK last November, said that taxpayers should benefit from IP regimes only “to the extent that the taxpayer can show that its employees incurred expenditures, such as R&D, which gave rise to IP income”.

Booth explains: “The OECD is seeking to address BEPS (base erosion and profit shifting) to make it easier for countries to collect tax revenue on income earned by companies in that country.”

To reach its consensus, the OECD considered a number of countries with patent boxes, including Luxembourg, Belgium, and the Netherlands.

How will it change things?

The OECD’s proposed approach won’t necessarily make life worse for companies operating within the UK, but would make it a bit different, says Rutt.

“The big change is that the amount of tax credit a company can claim is linked to the costs of the R&D associated with that IP and done within that company.”

This would affect the model where small biotechs or medium-sized businesses sell their late-stage research projects to big pharmaceutical companies, Rutt says.

“Before, all the IP costs of an acquisition could be set against corporation tax. Now they can’t and there’s a maximum tax break of 30% of the acquirer’s qualifying income. So if a larger pharmaceutical company is acquiring a smaller biotech, and is going to absorb that biotech’s projects and products, the tax break is no longer as generous as it was previously.”

"If a larger pharmaceutical company is acquiring a smaller biotech, and is going to absorb that biotech’s projects and products, the tax break is no longer as generous as it was previously.”

Booth also notes a few concerns that UK-based businesses may have about the proposed Modified Nexus Approach. Generally speaking, he says, those concerns will depend on a company’s size.

“It is a broad generalisation, but the bigger you get, the more complicated it is,” he says.

Small biotechs that develop IP within the UK and commercialise it from a UK base will probably be unaffected, he says, as the “nexus between the R&D expenditure and the qualifying incomes is there, and has always been there”.

However, larger companies with IP holding units that license the development of those technologies to their subsidiaries and offshore may face challenges.

Many of those businesses outsource certain development projects to subsidiary companies located in centres of expertise domiciled outside the UK, Booth adds.

“That makes perfect scientific and business sense, and we need to see how the UK’s tax office is going to consider that.”

Rutt adds that companies that subcontract their R&D may find it more difficult to claim tax credits.

“Those smaller companies might move from a model of outsourcing all the R&D they can to trying to source some R&D in-house again,” he says.

Innovative companies seeking to benefit from the patent box’s tax breaks under the OECD’s new approach will have to ensure good systems are in place for allowing them to track and trace their R&D expenditure, which given the volume and complexity of transactions that take place throughout a new product’s development, could be challenging.

“It is not the case that there’s a very simplistic delineation from a company’s expenditure on drug A to your expenditure on drug B—it just isn’t accounted for within the big pharma companies in that manner,” Booth says.

Rutt adds: “At an early stage you might have a biologist running assays on thousands of compounds. Do you pay for him or do you pay for the fraction of his time where he was working on that one compound?

“Companies will have to put a lot of work into showing how the R&D investment was made, what was spent, and for what purpose. It’ll be the accountant’s job to ensure all those costs are brought through.”

A sensible approach

The OECD has acknowledged that guidance on how companies can implement a practical way of tracking and tracing R&D expenditure is required, and it aims to deliver some by June this year.

“You would hope there would be some level of pragmatism,” Booth says, adding that the UK’s tax office, HM Revenue and Customs (HMRC), must also do its part to ease the transition.

“The OECD isn’t going to get prescriptive about the legislation so once it comes down to national interpretation, we would be looking for some level of acknowledgement of the complexity from HMRC.”

The OECD has said that countries that have tax regimes like patent boxes must bring the rules for them in line with the new Modified Nexus Approach, and that any legislative processes needed to make those changes must start this year.

Companies enjoying the current patent box set-up can do so until June 2021, when the old tax regimes will be phased out completely.

The benefits of the new approach are clear, but will implementing it in the UK make the country a less attractive place for innovative life sciences companies to do business?

“The UK’s patent box regime was incredibly generous,” Rutt says. “The OECD’s current proposals are still good, and will certainly work to guard your R&D base, as they offer great incentives to carry on doing R&D.

“But they do make it marginally less attractive to relocate here or just to buy a company in the UK and list here for the corporation tax break.”

However, Booth says, with its other tax incentives for innovative companies, the UK is still a great place to set up.

“The biotechnology sector is probably in the rudest health that I’ve seen it for a long time,” he says.

Whether the UK can stay competitive in the life sciences sector without stepping on too many toes will be a fine balancing act.