Category Archives: Money

Patent Box Regimes in Europe

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Patent box regimes (also referred to as intellectual property, or IP, regimes) provide lower effective tax rates on income derived from IP. Most commonly, eligible types of IP are patents and software copyrights. Depending on the patent box regime, income derived from IP can include royalties, licensing fees, gains on the sale of IP, sales of goods and services incorporating IP, and patent infringement damage awards.

The aim of patent boxes is generally to encourage and attract local research and development (R&D) and to incentivize businesses to locate IP in the country. However, patent boxes can introduce another level of complexity to a tax system, and some recent research questions whether patent boxes are actually effective in driving innovation.

As today’s map shows, patent box regimes are relatively widespread in Europe. Most have been implemented within the last two decades.

patent box regimes in Europe 2022 patent box Europe EU intellectual property tax regime IP

Currently, 13 of the 27 EU member states have a patent box regime in place. These are Belgium, Cyprus, France, Hungary, Ireland, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Slovakia, and Spain (federal, Basque Country, and Navarra). Non-EU countries Andorra, San Marino, Switzerland, Turkey, and the United Kingdom have also implemented patent box regimes.

The reduced tax rates provided under patent box regimes range from 0 percent in San Marino to 12.5 percent in Turkey.

Italy repealed its patent box in 2021 and instead introduced a deduction for 230 percent of costs related to research and development. This represents a transition from a benefit based on income (the patent box) to a benefit focused on investment or expenditure (the super-deduction).

Table 1. Patent Box Regimes in Europe, as of August 2022
  Qualifying IP Assets Tax Rate Under Patent Box Regime Statutory Corporate Income Tax Rate
Patents Software Other (a)
Andorra ✔ ✔   2% 10%
Belgium ✔ ✔   3.75% 25.00%
Cyprus ✔ ✔ ✔ 2.5% 12.5%
France ✔ ✔   10% 25.83%
Hungary ✔ ✔   4.50% 9%
Ireland ✔ ✔ ✔ 6.25% 12.50%
Lithuania ✔ ✔   5% 15%
Luxembourg ✔ ✔   4.99% 24.94%
Malta ✔ ✔   1.75% 35%
Netherlands ✔ ✔ ✔ 9% 25.8%
Poland ✔ ✔   5% 19%
Portugal ✔     10.5% 21%
San Marino (b) ✔ ✔   0% or 8.5% 17%
Slovakia ✔ ✔   10.5% 21%
Spain – federal (c) ✔ ✔   10% 25%
Spain – Basque Country ✔ ✔   7.2% 24%
Spain – Navarra ✔ ✔   8.4% 28%
Switzerland (d) ✔     Varies from canton to canton, up to a 90% exemption from corporate tax Varies from canton to canton; 11.9% to 21.6%
Turkey (e) ✔     11.5% 23%
United Kingdom ✔     10% 19%

Notes:

(a) “Other” refers to IP assets that are non-obvious, useful, and novel. These can only be applied to small and medium-size businesses.

(b) San Marino has two IP regimes. The “New companies regime provided by art. 73, law no. 166/2013” grants a tax rate of 8.5 percent. The “IP regime” grants a tax rate of 0 percent. Both apply to patents and software.

(c) The Spanish regions “Basque Country” and “Navarra” have separate corporate tax and therefore separate IP regimes.

(d) In 2020, Switzerland introduced a patent box regime at the cantonal level, which provides a maximum tax base reduction of 90 percent on income from patents and similar rights developed in Switzerland. Cantons can opt for a lower reduction.

(e) Turkey has a second IP regime which allows for a full tax deduction (0 percent effective tax rate) of qualified IP income resulting from R&D activities that were undertaken in Turkish Technology Development Zones.

Sources: OECD, “Dataset Intellectual Property Regimes”; Bloomberg Tax, “Country Guide”; PwC, “Tax Summaries”; EY, “Worldwide R&D Incentives Reference Guide 2022”; and OECD, “Tax Database: Table II.1. Statutory corporate income tax rate,” https://stats.oecd.org/Index.aspx?DataSetCode=TABLE_II1.

✔In 2015, OECD countries agreed on a so-called Modified Nexus Approach for IP regimes as part of Action 5 of the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan. This Modified Nexus Approach limits the scope of qualifying IP assets and requires a geographic link among R&D expenditures, IP assets, and IP income. To be in line with this approach, previously noncompliant countries have either abolished or amended their patent box regimes within the last few years.

Many European countries offer additional R&D incentives, such as direct government support, R&D tax credits, or accelerated depreciation on R&D assets. The effective tax rates on IP income can therefore be lower than the ones stated in the respective patent box regimes.

Arkansas’s Rate Reduction Acceleration

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With passage of SB1 in the General Assembly’s third special session, Arkansas last week became the 13th state to authorize an individual income tax rate reduction this year. This round of Arkansas income tax cuts effectively accelerated reforms policymakers enacted eight months ago.

The December 2021 changes set the state on course to lower its top individual and corporate income tax rates from 5.9 percent and 6.2 percent, respectively, to 4.9 percent and 5.3 percent as early as 2025. However, the state’s $1.6 billion surplus in fiscal year 2022 made it possible to advance the timeline by three years for the individual tax and two years for the corporate income tax.

The passage of SB1 marks the fifth round of reforms spearheaded by Governor Asa Hutchinson (R) since 2015 that have primarily dealt with rate reductions. Nested inside the past two reform bills, however, have been seemingly minor policy changes that, while less headline grabbing, actually make Arkansas’s tax structure significantly more neutral and competitive. It is these somewhat less intuitive reforms that Arkansas policymakers should prioritize in the future. Rates are important, but even more are how those rates interact with the rest of the code.

During the special session of December 2021, the legislature designed tax reforms to include immediate individual income tax cuts supported by well-designed corporate income tax reform, revenue triggers, and inflation indexing. The state was in the enviable position of having a $946 million surplus from FY 2021, a projected $263 million budget surplus in FY 2022, a $1.2 billion reserve, and full funding of essential obligations under the state’s Revenue Stabilization Act.

The incremental, revenue-based approach allowed Arkansas to chart a responsible path to regional competitiveness while guarding against unforeseen economic downturns or inflation-related costs. In accordance with the 2021 reform package, provided the state did not draw on its Catastrophic Reserve Fund between July 1, 2022 and January 1, 2025, the top individual rate would have decreased to 4.9 percent at the beginning of 2025.

The Department of Finance and Administration (DFA) projected that if fully implemented by FY 2026, the 2021 rate cuts would cost the state approximately $1.9 billion in forgone revenue over the period, costing $523 million per year by FY 2026. The state had been projecting a $263 million surplus in FY 2022, but the DFA noted that the income tax reforms would likely result in a $135.2 million general revenue reduction the same fiscal year, effectively cutting the anticipated surplus in half.

In stark contrast to the projection, Arkansas ended FY 2022 with a $1.6 billion surplus—roughly six times larger than expected. Relatedly, the scored revenue costs for 2023 have been all but imperceptible in the revenue reports released since the cuts were enacted. After accounting for the FY 2021 and FY 2022 surpluses, the entire amount of the estimated forgone revenue can be paid for immediately, with $300 million remaining. The surpluses alone should go a long way to alleviating concerns over the long-term stability of the rate cuts. But just as important is the point that the revenue department’s estimates were not dynamic and thus did not account for the effects the tax savings would have on the economy.

It is well established that marginal rate cuts lower economic barriers to productivity. As workers and business owners consider the impact of taxation on their next dollar of income, they consider the extensive and intensive effects of taxation (that is, whether to work/invest and how much to work/invest). Thus, lowering the individual income tax rate from 5.9 percent to 4.9 percent should promote in-migration on the margin and increase employment.

The accelerated rate cuts are also likely to influence the amount of work people choose to perform. When workers can take more of their next dollar home, it will, on the margin, incentivize those already employed to work an additional term (hour, week, full time vs. part time).

All this is not to suggest that the tax cuts alone would have paid for themselves. They would not. But it would be incomplete to propose that lower rates, inflation-adjusted brackets, and $1.9 billion of additional discretionary spending amongst individuals, small businesses, and corporations will not feed back into the state’s general fund to a significant degree in the form of new revenue from additional purchases, larger wages and salaries, and higher employment levels on the extensive and intensive margins.

Since tax reforms in Arkansas began in earnest in 2015, most of the attention and energy has been focused on increasing the competitiveness of the state’s individual and corporate income tax rates—and with good reason. As we have previously written, Arkansas’s rates were rapidly becoming regionally uncompetitive. In 2021, even after three earlier rounds of rate reductions, each of Arkansas’s border states, with the exception of Louisiana, had a top individual income tax rate that was at least 0.5 percentage points lower and at most 5.9 percentage points lower than that of the Natural State.

With the state’s top individual and corporate rates now set at 4.9 percent and 5.3 percent, respectively, Arkansas’s rates are the regional median. And while a state’s rates are important, just as important are how those rates interact with the less headline grabbing components of a state’s tax code. Perhaps significant tax pyramiding occurs in the sales tax base, or firms are unable to deduct operating losses and capital investment due to the absence of well-designed net operating loss and expensing provisions, for instance. A state may have very low or even no individual income tax but still be unable to generate sufficient economic activity due to other tax policies that are incompatible with a healthy business climate.

Recently, Arkansas policymakers have taken important steps toward a more neutral and stable tax code that do not rely on rate reductions alone. The state had earlier indexed its individual tax brackets to inflation, and during the December 2021 special session it indexed the standard deduction and consolidated its two lower income tax tables into one. Although the headline of the most recent special session was rate reduction acceleration, an equally important but less-publicized component will conform the state treatment of capital investments to Internal Revenue Code provisions that allow for the immediate expensing of capital investments in the year the investments were made.

Consider how our State Business Tax Climate Index scored the impact of SB1 on the state’s tax competitiveness. Prior to the most recent special session, Arkansas’s tax structure ranked 43rd out of 50 in overall structural competitiveness. Its corporate income tax (CIT) and individual income tax (PIT) ranked 30th and 37th, respectively. If the rate acceleration were factored in alone, the state would improve one place, to 42nd, its CIT would improve marginally to 29th, and its PIT would remain unchanged.

When Arkansas’s conformity of capital investment treatment to IRC Sections 168 and 179 is included, the state’s rankings rise appreciably. This less dramatic, below-the-fold structural change, combined with the rate reductions, propels the state to 38th overall, to 22nd for the CIT, and to 34th for the PIT, reflecting that allowing companies to immediately expense capital investment in the year it was made has an outsize impact on economic growth.

As policymakers in Little Rock discuss how to leverage future tax reforms to facilitate greater economic activity, they should look beyond rates and focus on a broader range of policy changes—on elements that may be tucked away in the inner folds of the code. These policies may be less well-known among the public, but businesses are intimately aware of them. They are integral to every competitive tax system, and they are often significantly cheaper to implement than broad base rate cuts.

At the top of the list of reforms for future discussion could be the redesign of the state’s treatment of net operating losses—a change that would remove barriers to entrepreneurship, reduce income volatility, and remove conditions that disadvantage low-margin industries. A second reform may include the elimination of the state’s throwback rule—a policy that risks double taxation and incentivizes relocation outside the state. Third, policymakers could repeal the franchise tax (also known as a capital stock tax), which acts as a tax on business wealth and disincentivizes investment. Many of these reform options and other ways to stabilize revenue can be found in the Tax Foundation’s Arkansas tax reform guide.

In the meantime, Arkansans have reason to be encouraged by the recent, accelerated tax reforms coming out of Little Rock. Annual, incremental tax changes have played a significant role in the economic and population gains many states have realized over the past decade—states that include Arizona, Indiana, North Carolina, and Utah just to name a few. There are many reasons for residency and relocation, but of the variables state governments can affect, tax policies are among the most influential.

 

Tax Foundation Response to OECD Consultation on Amount A of Pillar One

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Tax Foundation has engaged constructively in the OECD Pillar One and Pillar Two process since it was launched in 2019. The consultation on the Progress Report on Pillar One provides another opportunity for that. However, at this point it is challenging to be constructive when the policy seems designed to fail.

The Progress Report reveals that the ongoing technical work has continued to increase the complexity of the policy.

OECD Pillar One Amount A is meant to reallocate taxable profits of large multinationals, mitigate double taxation of profits, and avoid a harmful tax and trade war.

To accomplish those goals, though, the policy needs to be attractive for governments to adopt it, simple enough for agencies to administer it, and clear enough for companies to comply.

The cover note suggests that a multilateral convention to implement Amount A will have the force of law “only upon ratification by a critical mass of countries, which will include the residence jurisdictions of the ultimate parent entities of a substantial majority of the in-scope companies whose profits will be subject to the Amount A taxing right, as well as the key additional jurisdictions that will be allocated the obligation to eliminate double taxation otherwise arising as a result of the Amount A tax.”

The United States would need to ratify for the “substantial majority” phrase in the quote above to be satisfied. Ratification of such a tax agreement would need a two-thirds majority in the United States Senate—an extremely unlikely outcome.

The OECD Secretariat has clearly made progress in developing a policy that works in theory and may have a slight chance to work in practice. However, progress has not been made in developing a policy that achieves the goals of the project while making it possible that elected representatives in governments would be willing to adopt it.

These rules point toward bureaucracy and complexity rather than simplicity and transparency.

Early in the process one key criticism was that attempting to build a new structure on top of the existing set of international tax rules could create a frail superstructure. The frailty of the potential superstructure has not been resolved as more details of Amount A have come into focus.

It seems likely that rather than resolving challenges created by the current system, Amount A would introduce many new areas for disputes. The tax certainty processes and procedures become necessary and critical because this policy could cause disputes to increase. Despite attempting to use a formulary approach to allocate taxes and eliminate double taxation, the design lends itself to interpretations that will be disputed.

The complexity of the proposal is not lost on the authors of the document. Footnote 4 shows a small window into the challenges of policy. Referring to Title 5 Article 9: Allocation of the obligation to eliminate double taxation with respect to Amount A Profit, the footnote states, “Work is on-going to review and if necessary remove any logical inconsistency from the elimination framework.”

Logical inconsistency is thinking that this complicated policy can be readily adopted by governments across the globe.

Because the general policy is complex, it requires shortcuts for defining the scope of the tax base, sourcing revenues, and identifying the tax base that is being surrendered. But those simplifications themselves will lead to questionable (if not disputable) outcomes.

The process to identify an in-scope segment should include a measure of overall company profitability to avoid having a company that in general is in a loss position to calculate and pay Amount A.

When identifying the tax base, a formula is used to identify excess profits and then yet another formula to determine domestic profits that should be excluded. The formula seeks to identify excess returns. Excess returns are usually those above a normal return to an investment and that normal return being a profit above what the time value of money and inflation would provide.

As inflation has crept up across the globe, it has increased the importance of evaluating whether the metrics in Amount A should be referring to profitability margins after excluding a measure of inflation. A company that makes 15 percent profit where inflation is 2 percent should not be treated the same way as a company that makes a 15 percent profit when inflation is 10 percent.

Inflation adjustments should be widely applied throughout the proposal.

The safe harbor makes a critical error in not including withholding taxes in the calculation of what taxes have already been paid in a market jurisdiction. This could lead directly to double taxation and misses an opportunity to incentivize jurisdictions to adjust their approaches to source-based taxation.

The revenue sourcing approach provides multiple allocation keys, but it remains unclear whether the allocation keys are for general use or if the transaction-by-transaction approach is still preferred in most cases. As Tax Foundation has published before, the global allocation key for revenue sourcing seems more consistent with identifying large economies rather than indicators specifically related to cross-border trade.

The process of eliminating double taxation relies on formulas that appear to be without clear rationale other than providing a level of convenience for identifying which jurisdictions should be surrendering profits.

In summary, the rules reflect a high level of complexity alongside a handful of shortcuts that either reflect rough approximations or show weaknesses in the plan. This sounds not unlike the current system for allocating profits across borders.

New policies that will generate disputes are being developed and therefore new dispute resolution mechanisms are being designed.

It seems unlikely that this design will be an acceptable solution to governments as an alternative to existing complexity and disputes.

There may be an opportunity to salvage some of the project that is most likely to deliver more certainty and avoid disputes; perhaps Amount B, which could provide an agreed-upon benchmark for profits attributable to certain defined activities, would make that cut. However, a successful salvage effort would require keen attention to designing a package that would be acceptable to the governments that would have to administer and enforce the rules.