Launched nearly a decade ago, Patent Box relief is one of the least accessed innovation incentives in the UK tax system.
This underutilisation may come as a surprise considering that claiming Patent Box could offset the recent increase (19%-25%) to Corporation Tax with an effective tax rate of 10% when applied to eligible profits.
One possible reason for this low take up is due to Patent Box changes that introduced complexities around the nexus fraction – essentially determining how a business’s income and expenditure map to its IP profits. In this article we take you through the nexus changes and how to calculate the nexus fraction.
What is Patent Box?
The UK Patent Box is a tax incentive that allows eligible businesses to pay a reduced rate of Corporation Tax on profits generated from their patented inventions and other qualifying IP rights.
The scheme is designed to encourage businesses to invest in innovation and to help them retain and exploit their IP rights in the UK. If a business is liable to UK Corporation Tax, holds or exclusively licenses-in a granted UK or European patent; and has undertaken qualifying R&D development on their patent they are eligible for Patent Box relief on related profits.
ForrestBrown, the UK’s leading innovation tax adviser, can help fully reward your IP investment by navigating this complex and sophisticated area.
Nexus changes: Patent Box evolves
The most impactful update to Patent Box relief came in its recent history. As of 1 July 2021, UK companies claiming Patent Box relief are subject to a modified nexus approach. The new nexus regime requires companies to demonstrate that they have undertaken the qualifying research and development (R&D) activity that led to the creation of their patented inventions or other qualifying IP rights.
The new nexus approach introduced a set of rules that require companies to demonstrate a direct link between the qualifying R&D activity that led to the creation of their patented inventions or other qualifying IP rights, and the profits that are eligible for Patent Box relief. This link is known as the “nexus”.
Patent Box Nexus Fraction
With the nexus changes, companies must now calculate the proportion of the profits that are eligible for Patent Box relief based on the proportion of the qualifying R&D activity that was undertaken by the company or a group entity. This is referred to as the nexus fraction, nexus R&D fraction or sometimes the nexus ratio.
The qualifying R&D activity must have been undertaken in the UK, or in a European Economic Area (EEA) state with which the UK has a double tax agreement that includes an exchange of information provision.
The new regime replaces the previous system, which allowed companies to claim Patent Box relief on profits generated from qualifying IP rights without having to demonstrate a direct link between the IP rights and the qualifying R&D activity.
Why were the nexus changes introduced?
The new nexus regime is intended to bring the UK in line with the international standards set by the Organisation for Economic Co-operation and Development (OECD) for the taxation of IP rights. The OECD has recommended that countries introduce a nexus requirement for the taxation of IP rights to prevent base erosion and profit shifting.
How the nexus fraction works in practice
To illustrate how the new nexus fraction works in practice, let’s consider an example.
ABC Ltd is a UK-based pharmaceutical company that has developed a new drug for the treatment of a rare disease. The company has obtained a patent for the drug and wishes to claim Patent Box relief on the profits generated from the sale of the drug.
To qualify for Patent Box relief, ABC Ltd must demonstrate that the profits generated from the sale of the drug are directly linked to the qualifying R&D activity that led to the development of the drug.
ABC Ltd undertook the qualifying R&D activity in the UK and spent £1 million on R&D in the year ended 31 December 2021. The company generated total profits of £10 million in the same year, of which £4 million are eligible for Patent Box relief.
To calculate the proportion of profits that are eligible for Patent Box relief, ABC Ltd must first determine the proportion of the R&D activity that was undertaken by the company or a related party.
This is achieved by tracking and tracing the above costs via the following calculation:
(D + S1) x 1.3
D + S1 + S2 + A
The expenditure categories within the R&D nexus fraction are:
- D: R&D eligible staff costs, consumables and externally provided workers (EPWs) incurred by the entity;
- S1: R&D costs sub-contracted to unconnected parties;
- S2: R&D costs sub-contracted to connected parties;
- A: acquisition costs of qualifying IP rights only.
In this case, ABC Ltd undertook all the qualifying R&D activity itself, so the proportion is 100%.
ABC Ltd can therefore claim Patent Box relief on 100% of the profits generated from the sale of the drug, which amounts to £4 million.
The value of Patent Box to your innovation
The increase to the CT rate will present some difficulties to UK businesses looking to compete internationally. Though, for businesses holding an exclusive license-in or legal ownership of UK/ EU granted patents, Patent Box relief can help to reduce this burden.
Patent Box rewards innovation by lowering a company’s CT rate on qualifying IP profits to an effective rate of 10%.
Prior to the Spring Budget 2023, the CT rate was 19%. Patent Box was already offering significant relief for innovative businesses. With the rate at 25%, its positive effect has increased dramatically.
The news is good even for those companies who are in the process of applying for a patent. Whilst this process is slow and drawn out – UK patent waits are currently among some of the longest in the world – businesses can elect into the relief even before a patent has been granted, ensuring qualifying profits which have been generated since the date of application are included. This accumulated relief (once a patent is granted) is claimed in your tax return for the year that your patent is awarded.
How ForrestBrown can help
As the UK’s leading specialist innovation tax adviser, ForrestBrown can provide expert guidance and support in all R&D intensive sectors. Our experienced team can quickly understand your underlying technology, products, projects, and processes to extract practical efficiencies and help your company grow.
We’re passionate about the transformative power of innovation incentives and the benefits they bring to both your business and the wider economy.
Our Patent Box team, composed of chartered tax advisers, lawyers, and technical experts, can help you get the most out of your patents, ensuring that your investment in intellectual property (IP) is rewarded.
Rewarding your IP investment
We help innovative business to grow by advising them on how to strategically access innovation tax incentives. ForrestBrown’s integrated services help to protect, commercialise and fully realise the benefits of your intellectual property through claiming Patent Box relief.
We’d love to learn more about your business and discuss how we might be able to help.