How to maximise profits under the government's proposed Patent Box tax regime

This week the Government publishes draft legislation dubbed Patent Box to encourage UK innovation. Patent Box will reduce Corporation Tax on patent profits to 10 per cent. This makes the UK competitive with other European countries, including Ireland, Switzerland and Hungary, which have had similar systems in place for years.

Unlike in some other European countries, however, the UK system will not apply to copyright or brands. For multinationals to work the system effectively, sophisticated analysis of the pros and cons of the competing regimes will be necessary.

There are anomalies in the proposals. For example, profits from cloud computing services are to be excluded from the Patent Box, although they may involve a number of patented technologies. So-called "divisionalisation" – separating the company into different functional units for tax purposes – may be necessary to create internal licences on which royalties are charged, defining the profits falling within the regime.

For products, Patent Box relief can be claimed on licence profits or on patent sale or enforcement profits, as well as profits from products where patents are bundled with other licences.

In the consumer electronics field, where big-name companies have been engaged in high-profile patent disputes, each product incorporates thousands of patented features. Ironically, the number of patents embedded in a product is not directly taken into account in calculating Patent Box tax relief.

However, if significant R&D expenditure results in higher operating profits, it will increase the amount of Patent Box relief available.

Consumer electronics products are built in accordance with technical standards, and patents belonging to multiple competitors must be cross-licensed in order to achieve operability within the standard.

The "profit" from a company's patents may simply involve having to pay less in royalties to competitors that have more valuable patent piles. At the same time, tech patents tend to cover relatively small, incremental developments, and consumer value is derived to a large extent from brands and software that are not protected by patent rights. So it's not straightforward to identify a company's patent profits.

To overcome the relatively simplistic options in the Patent Box, companies need to develop a tax structure that will enhance the effect of the Patent Box by virtue of transfer pricing, using established standards for allocation of profits between group companies. This will help companies to maximise profits via internal revenue and cost allocations.

But implementation of such structures can take up to 18 months as board-level decisions are needed. Companies will need to act quickly if they are to review this and make changes before the law comes into force on 1 April 2013, to take full advantage of the rewards.

Jeremy Morton is a partner at CMS Cameron McKenna