Australia: Patent box legislation introduced to parliament

In brief

The Bill implementing Australia's highly anticipated patent box has been introduced into the Australian Parliament (the Treasury Laws Amendment (Tax Concession for Australian Medical Innovations) Bill 2022), following the Australian Government's announcement in the 2021-22 Budget (see our prior alert here). This comes on the heels of the beneficial changes to the R&D tax incentive and other recent announcements intended to make Australia a more attractive location for medical research and clinical trials.

Following extensive public consultation, the bill sets out the proposed design of the patent box which implements a concessional effective income tax rate of 17% for eligible income derived from medical and biotechnology patents with effect for income years starting on or after 1 July 2022. Australia's current corporate income tax rate is 30% or 25% for certain small business entities.


Contents

In welcome news, the Australian Government has adopted two of the key improvements raised by Baker McKenzie in our submission on the proposed regime and by a range of stakeholders:

  • The patent box applies to patents granted or issued after 11 May 2021, not just those patents applied for after 11 May 2021, recognising that the patent lifecycle involves long lead times from application to ultimate grant of a patent.
  • Eligibility for the patent box is no longer limited to owners of Australian patents, but has been extended to owners of utility patents issued by the United States Patent and Trademark Office and European patents granted under the Convention on the Grant of European Patents. The Government states that 97% of medical and biotech patents filed by Australian entities are filed in at least one of these three jurisdictions, and consequently almost all Australian medical or biotechnological inventions should be caught.

Although other suggestions made in consultation have not been implemented, the patent box is a welcome development in improving Australia's tax competitiveness for medical and biotechnology commercialisation decisions.

The key prerequisites companies must meet to take advantage of the patent box are summarised at a high level below:

Icon_CASE0792669     Incur expenditure on eligible R&D activities in Australia for the purposes of the R&D tax incentive.

Icon_CASE0792669     Patentee of an Australia, US or European patent.

Icon_CASE0792669     Make an irrevocable election to access the patent box by the time the income tax return is due for the first income year in which they wish to access the patent box.

Icon_CASE0792669     Patent linked to a therapeutic good that is on the Australian Register of Therapeutic Goods maintained by the Therapeutic Goods Administration.

Icon_CASE0792669     Derive income from the exploitation of the qualifying patent(s).

 

As the patent box relies on a combination of existing transfer pricing rules and the R&D tax incentive, it will be critical that taxpayers prepare robust transfer pricing documentation to support how eligible income has been calculated. Taxpayers should carefully consider the compliance work required and other tax impacts before opting in due to the irrevocable nature of the election. We provide a high level overview of the patent box design below.

In depth

Eligible taxpayers

  • Taxpayers must be a body corporate under Australian law or a foreign company that is either an Australian tax resident or carrying on business in Australia through a permanent establishment. Certain types of trust may be eligible. This mirrors the threshold eligibility provisions for the R&D tax incentive.
  • The regime is optional. Taxpayers must elect for the patent box to apply by notifying the Commissioner of Taxation by the time their income tax return is due for the income year of entry. The election (once made) is irrevocable and applies to all of a taxpayer's eligible patents on a prospective basis. 
  • Where income, such as milestone payments, is derived in an income year prior to the remaining conditions of the patent box being satisfied taxpayers may seek to amend their income tax return to claim the patent box concession in respect of that income once the conditions are satisfied - but importantly, the taxpayer must have made the patent box election with respect to that prior income year. Taxpayers in receipt of milestone payments with respect to an invention that may not yet be patented should therefore consider whether to make an election for the income year in which the payments are derived.

Eligible patents

  • The taxpayer must "hold" (within the meaning of the tax depreciation provisions) an eligible patent. An exclusive licensee of a patent will not meet this eligibility requirement. This is in contrast to other regimes such as the UK patent box, which extends to licensees of patents.
  • The patent must be linked to a therapeutic good that is registered on the Australian Register of Therapeutic Goods maintained by the Therapeutic Goods Administration. This confines the patent box regime to the medical and biotechnology industry and this approach should provide certainty as to which patents are eligible.
  • The Australian Government has not yet made any decision regarding the expansion of the patent box beyond medical and biotech innovations to low emissions and clean energy technologies.

Calculation of of eligible income

  • Only a proportion of income derived from exploiting an eligible patent (a patent box income stream) is subject to concessional tax treatment. 
  • Patent box income streams are limited to certain specifically defined forms of income: broadly, sales or rental income, royalties or license fees, balancing adjustments derived from proceeds of sale that are received, or damages and compensation derived for an infringement of the taxpayer’s patent.
  • Notably, income from manufacturing remains excluded from the scope of the patent box.
  • Taxpayers will need to work out the proportion by undertaking the following steps:
  1. Identify all eligible patents underlying the patent box income stream;
  2. Determine a reasonable apportionment of the income arising from the patent box income stream that is attributable to those patents by undertaking a full transfer pricing analysis consistent with OECD principles; and
  3. Reduce that amount to reflect the extent of the taxpayer's Australian R&D activities, using an R&D fraction formula which is consistent with the formula set down by the OECD in the BEPS Action 5 Report on Harmful Tax Practices. The R&D fraction is capped at 1.
  • A portion of that amount is then deemed to be non-assessable and non-exempt income ("NANE income") to achieve an effective tax rate of 17%.
  • Importantly, the effect of making a portion of the patent box income stream NANE income is that the taxpayer will no longer be entitled to claim deductions to the extent that their losses or outgoings are incurred in gaining or producing that NANE income. Taxpayers will need to ensure that expenses are apportioned on a reasonable basis.
  • This approach is consistent with the OECD's recommendations to ensure that deductions are claimed at the same rate as income. However, it introduces additional complexity as partial loss of deductions may have flow-on effects for the overall tax position, particularly for taxpayers with loss-making products. Taxpayers should carefully consider these impacts before opting in to the regime.

R&D fraction

  • The R&D fraction acts as a measure of the taxpayer's involvement in the R&D conducted to develop the eligible patent. Consistent with OECD requirements, this ensures a link between the benefits of the concessional patent box regime and the R&D activities undertaken in Australia.
  • The fraction is applied for each patent box income stream (following the reasonable apportionment in step 2) to limit the income that can benefit under the patent box.  
  • Very broadly, the fraction is equal to the taxpayer's R&D expenditure with respect to the eligible patent as a proportion of the taxpayer's total expenditure with respect to the eligible patent, including expenditure on R&D activities conducted outside Australia by the taxpayer's associates, with certain adjustments. A 30% uplift is then applied to the fraction to ensure taxpayers are not excessively disadvantaged for acquiring intellectual property or outsourcing activities overseas to related parties.
  • "R&D expenditure" is defined by reference to the R&D tax incentive and consequently only captures the R&D expenditure incurred by the taxpayer for R&D activities undertaken in Australia. A taxpayer who solely undertook the R&D themselves in Australia to develop the patent would have an R&D fraction of 1.
  • Conversely, a taxpayer who outsourced the R&D activities to a related party overseas (even if those activities qualified for an Overseas Finding under the R&D tax incentive), or acquired intellectual property developed by another party, would have an R&D fraction of less than 1.  As such, outsourcing clinical trials to a related party overseas may reduce the patent box income that qualifies for concessional tax treatment.   
  • Only R&D expenditure incurred for the purposes of actual R&D activities (as defined in the R&D tax incentive) in the development of an eligible patent can constitute qualifying expenditure for the purposes of the R&D fraction. This link to the R&D tax incentive means that taxpayers accessing the patent box are already subject to existing record-keeping obligations to substantiate their R&D expenditure and R&D activities.

Next steps

  • The second reading of the Bill took place on 10 February and to date no amendments have been proposed. The Bill will need to pass the House of Representatives and the Senate to become law. With an upcoming Federal Election (likely in May 2022) and limited sitting days, and based on our understanding that the Bill has bipartisan support at this stage, it is hoped that the Bill will be prioritised.
  • Taxpayers in the medical and biotechnology field should monitor the Bill carefully and, if passed in its current form, consider whether to opt into the patent box by the time their tax return is due for the first applicable income year.   

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