A Patent/Innovation Box as a Tax Incentive for Domestic Research and Development

Summary

A patent box provides a lower tax rate on income from patents, and in some cases, from other intellectual property. A number of countries, including the U.K., France, the Netherlands, and China, have adopted a patent box. Rates generally range from 5% to 15%. Patent boxes are in some cases referred to as innovation boxes because they cover income from non-patented as well as patented intellectual property. Patent boxes can have narrow coverage (providing a lower tax rate on royalties and licenses from patents) or broadly cover income attributable to intellectual property, including that used directly by the firm in production. The purpose of a patent box is to encourage research and development, and, in some cases, to encourage the location of profits from intellectual property in the country.

Proposals for a patent box in the United States include a draft proposal by Representatives Boustany and Neal, the Innovation Promotion Act of 2015; proposed legislation in the 112th Congress by Senator Feinstein; and a bill introduced by Representative Schwartz in the 113th Congress (H.R. 2605). The Feinstein proposal provided a 15% tax rate on income from patents developed and used for manufacture in the United States, whereas the Boustany-Neal proposal and H.R. 2605 allowed a 71% deduction of income, which produces an effective 10% rate for corporations. The Boustany-Neal draft proposal would allocate profit between the ordinary tax rate (35% for corporations) and the patent box rate, based on the share of (research and development) R&D spending in total spending.

Current tax law contains incentives for investment in research and development. One is the option to expense certain R&D costs (deduct immediately) rather than deduct them over the life of the investment. Expensing is the equivalent of a zero effective tax rate on the return to investment. The tax code also contains a research tax credit. R&D subsidies are justified because the average company is likely to invest less in R&D than the amount warranted by the social returns from the investment. There may be disagreement over whether tax subsidies are the best method.

The expected effectiveness of a patent box on R&D depends on its design, and particularly whether it applies to net profit, where the tax rate on the up-front deductible cost is the new, lower patent box rate, or to gross investment, where the deductible cost is still valued at the higher regular statutory rate. The Boustany-Neal draft proposal applies to net profit, which means that lower statutory rate has no effect on the incentive to invest in R&D. The effective rate is still zero under expensing regardless of the statutory tax rate, and the credit is not driven by the tax rate. Moreover, if part of the revenue cost for the lower patent box rate is offset by slower recovery of costs, the effective tax rate rises. Similarly, the R&D credit, which was recently made permanent, is more valuable in reducing effective tax rates than a lower rate applied to net profit.

It is possible to design a patent box where the lower rate applies to gross rather than net profit. This approach would produce large subsidies for R&D that could lead to negative pre-tax returns, which might be justified depending on the size of R&D spillover effects.

A global economy also raises a number of policy issues. To the extent that a patent box has been adopted to discourage profit shifting to low-tax foreign jurisdictions, the Boustany-Neal patent box proposal may not be very effective. For an additional dollar of profit, the rate is a weighted average of the regular 35% rate and the 10% patent box rate; estimates suggest that the rate would still be relatively high. The effect of a patent box when part of profits are already shifted to a low-rate country is an increase in effective rate domestic R&D, for a patent box that applies the rate to net income rather than gross income.