"The wait is over! Since Minister Noonan announced in Budget 2015 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’", says Damien Flanagan of KPMG's R&D Incentives Practice.
Budget 2016 announced that the rate of tax which will apply for income qualifying under the new KDB will be 6.25%. This was confirmed in the recent Finance Bill (published on 22nd October).
The objective of the KDB is to provide a highly attractive tax rate for income generated from commercialising R&D/intellectual property. 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%.
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’. In summary, the ‘Modified Nexus Approach” seeks to link the relief under the KDB to the proportion of qualifying R&D expenditure bring carried on by the company in Ireland, as a percentage of overall group expenditure including acquisition costs.
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 intellectual property qualifies for the KDB?
The Finance Bill sets out that certain patented inventions and copyrighted software will be considered intellectual property for the purposes of the qualifying asset definition. The definition also includes plant breeders’ rights, supplementary protection certificates for medicinal products and plant protection certificates. The intellectual property must be the result of R&D activities.
The KDB will therefore reward companies who invest the time and effort into legally protecting their IP. This is not always straightforward as many 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 “trade secret” etc.).
In this context, of particular interest to smaller companies (defined for this purpose as companies with a turnover of less than €50m and annual income from intellectual property not in excess of €7.5m) may be the expansion of the definition of intellectual property. For those companies, intellectual property 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 the time of writing.
In simple terms, 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.
The relief is given by way of a deduction of profits equal to 50% of the qualifying profit from this separate trade to give an effective tax rate of 6.25%. The qualifying profit is determined by reference to the following formula:
Qualifying expenditure on qualifying asset (Possible 30% uplift)
Overall expenditure on qualifying asset
Profit of the specified trade relevant to the qualifying asset
Qualifying profit taxed at 6.25% effective rate
What is qualifying expenditure?
For the purposes of the above formula, qualifying expenditure on the qualifying assets means expenditure incurred by a company wholly and exclusively in the carrying on by it of R&D activities, where such activities lead to the development, improvement or creation of the qualifying asset (i.e. the intellectual property as defined above). The definition of R&D mirrors the definition for the purposes of the R&D tax credit.
Specifically excluded from the definition of qualifying expenditure (but included in the definition of overall expenditure for the purposes of the formula) are any acquisition costs in relation to the qualifying asset. Payments to a related group member for the carrying on of R&D, including related-party cost-sharing arrangements (“group outsourcing costs”) are also excluded from qualifying expenditure, although outsourcing payments to non-related parties are considered to be qualifying expenditure for the purposes of the relief.
It is possible to receive an up-lift in the amount of qualifying expenditure, to include the lower of:
As a consequence of the restrictions on acquisition costs and group outsourcing costs, the potential relief available will be diluted where the intellectual property has been acquired by the company (from a third party or a group company) or where the company outsources R&D activities on the intellectual property to another group company. Conversely, where an Irish company does all of the R&D work in-house, the KDB could be of significant benefit.
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 intellectual property development:
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.
The definitions of “R&D” from a KDB perspective are the same as those already used under the R&D tax credit regime. Likewise, the definition of qualifying expenditure for the KDB is the same as that used for the R&D tax credit regime. It therefore makes sense for companies to start thinking of these two incentives under the same umbrella.
At the time of writing, the Finance Bill set out that taxpayers will be obliged to ‘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. However, we would expect that SMEs should be able to leverage the information already maintained for the purposes of claiming the R&D tax credit.
It is welcoming to see that SMEs will not be required to apply transfer pricing practices when it comes to determining the market value of the intellectual property, apportioning income to the qualifying asset, apportioning R&D activities and expenditure and so on. Instead, SMEs are required to apportion income on a “just and reasonable” basis. This should reduce the administration cost of claiming the KDB for SMEs.
It is also worth noting that similar to the R&D tax credit, Revenue will be able to consult with technical experts in relation to many aspects of the KDB regime. We would expect that one area Revenue will focus on is whether or not the qualifying asset arose as a result of R&D activities, thereby effectively conducting R&D tax credit and KDB audits simultaneously.
When will this relief be available?
Relief under the KDB will be available to companies for accounting periods which commence on or after 1 January 2016 and before 1 January 2021.
A claim must be made within 12 months of the end of the relevant accounting period. The claim should be made in the corporation tax return of the claimant company for the period.
The Department of Finance has determined (based on the information gathered as part of the 2013 Review of the R&D Tax Credit) that the total 2013 corporate tax liability of the companies claiming the R&D tax credit was €1.4bn.
However, further analysis has concluded that at least €1.2bn of this tax take was paid by the top 20 companies who are unlikely to be able to avail of the KDB (the reason being that, as alluded to above, the KDB may not be as attractive for many multinationals).
Much of the remaining €200m of corporation tax was paid by Irish indigenous companies and SMEs, and the Department of Finance has concluded that the annual cost of the KDB could be in the region of €50m. This is €50m that will be vitally important for local businesses. Yes, it comes with an administration burden, but aligning the KDB to your R&D tax credit claims should make the claim process more straightforward.
The KDB was first announced by Minister Noonan in Budget 2015 and the Department of Finance has consulted widely over the last 12 months to ensure that Ireland’s KDB is “best in class”.
Ensuring a “best in class” KDB while staying within the parameters of the Modified Nexus Approach is a delicate balancing act.
Time will tell if this has been achieved.