Patently Obvious – Australia's new 'patent box'

Nina:
Sanjay, thank you for joining me today. Firstly, can you give me a brief summary of what a patent box is?

Sanjay:
Yeah, no problems Nina. Look, a patent box is like a fancy tax term for a regime that allows a concessional tax treatment to apply to profits derived from eligible IP, usually in the form of a lower tax rate, or a percentage deduction applies to qualifying IP income. I actually did some research to find out where the name patent box derived from. And I found out that it actually, because the regime is usually elective, it arises because you tick a form on your tax return saying that you want to claim the patent box concession, so then that's the patent box. So it's one of those, I guess, nerdy tax things. That's where the name actually comes from.

Nina:
Right. So, what has been announced for Australia?

Sanjay:
So it was in the May 2021 federal budget speech, where the Treasurer announced that Australia will introduce a patent box, the corporate income associated with patented inventions in the medical and biotechnology sectors, commencing from one July 2022. There's also the possibility that the patent box might be extended to renewable energy. Budget announced that there would be a consultation process for the design of the regime. And that regime has just kicked off back in July with the release of a discussion paper by the treasury. And submissions and feedback on that discussion paper have been requested by the 16th of August. It's quite a short discussion paper, but there's a lot of questions, there's some, 20, nearly 30 questions in that discussion paper, dealing with a whole range of things from the design of the regime, what types of IP, the registration requirements around the patents and a whole range of different questions.

I mean, the broad policy aims of the regime, I guess it's sort of twofold. One, is that obviously the intention is to encourage companies to base their medical and biotechnology R&D operations in Australia, and commercialize that innovation in Australia. And to retain the ownership of eligible patented inventions in Australia. Now, from a tax perspective, I guess the ownership of IP is quite a big thing in the global tax landscape. And Australia is one of many countries that have been trying to combat the migration of valuable intellectual property rights outside of Australia. So they might be IP developed in Australia, but then multinational companies might seek to migrate outside of Australia to another jurisdiction. There is transfer pricing rules, there's been tax avoidance alerts published by the APO, and a range of other sort of measures that the OECD has tried to take to combat that kind of behavior. And this patent box regime is possibly a reason why people wouldn't try and migrate IP off shore, but would want to keep it in Australia. So that's sort of another policy reason that's underlying all of this as well.

Nina:
Absolutely. And I guess from a broad government perspective, having IP in Australia and research and development activities in Australia, also promotes jobs and the economy more generally, as well as promoting Australia as an innovative country on the world stage. And while the government has had that objective for a while, this patent box is quite new to Australia, we don't even have one yet. But there have been patent boxes abroad for some time. Is what's being proposed here, the regime going to be comparable with what we see overseas?

Sanjay:
Look, I think in some respects, yes, but in many respects, no. So as you say, patent boxes have been around for quite a while, in the UK, introduced their patent box regime back in 2013. And there are now around 20 countries in the world that have them. So we're pretty late to the party on this one. The regime that has been proposed is also, I mean, on its face, it looks pretty good. But there's a 17% concessional tax rate on the patent box profits, which compared to the Australia's corporate tax rate of between 25 and 30%, depending on the type of tax paying company you are, looks on its face pretty attractive. It's almost a 50% tax rate for some companies. But when you look at patent boxes around the world where you've got Ireland at 6.25% and the Netherlands at 9%, and the UK at 10%. It's not that attractive compared to those other jurisdictions.

So, where tax is a major factor being considered in business decisions as to where to locate R&D activities, the Australian regime is uncompetitive compared to those other regimes. Although it should be kept in mind, that if the G20 global minimum corporate tax rate of 15% is ultimately implemented, then we might see other jurisdictions having to raise their rates closer to the Australian rate.

The second thing that makes Australia's patent box regime potentially uncompetitive, is that it is quite limited. It's, as I said, limited to the medical and biotechnology sectors and potentially the clean energy sector, depending on how the consultation goes, but other regimes aren't anywhere near as restrictive as that. And so it's not apparent why Australia has necessarily decided to limit the patent box to just those very narrow sectors and hasn't gone for a broader approach comparable with other regimes. The other thing that will be very important in designing Australia's patent box regime is how that benefit will ultimately flow through to shareholders in companies. Because as you know, Australia is one of the few countries in the world that has an imputation regime where corporate tax... A credit for corporate tax is given to the shareholders, who ultimately then pay tax at their own marginal rates on corporate distributions. So, if what we're going to have is Australian companies paying tax at a 17% rate, which sounds good, but then the shareholders have to top up to their own [crosstalk 00:07:14]

Nina:
Yeah, that's fascinating thinking about how [crosstalk 00:07:18] the tax will flow on through Australia's quite unique corporate tax.

Sanjay:
[crosstalk 00:07:24] with Australian shareholders. [crosstalk 00:07:26].

Nina:
And I guess the tax office is obviously thinking about that, and we've had a discussion paper that's been released. And you mentioned that while it's quite short, there are certainly a number of questions in there, really looking at the design of the regime and the government is thankfully seeking to consult regarding what it should look like. Having said that, they haven't left us with a huge amount of time to respond. And so, really it will remain to be seen how many people are actually able to file submissions on this issue and given its importance, potentially there might be an extension, who knows? But it does seem from my review of the discussion paper, that there is a significant focus on what the requirements will be from a record keeping and compliance perspective, and trying to keep things simple. What is so difficult about all of this? (silence)

Sanjay:
Yeah. So I suppose that on its face, it sounds fairly straightforward, that you're really just trying to give a 17% tax rate to income derived from patents based on how much research and development has been carried out in Australia. So it all sounds very simple in concept, but I guess the thing to remember is that companies will... They're very complex carrying out R&D, they'll have all sorts of different revenue sources, all sorts of different R&D projects. So where it gets very difficult is trying to track and allocate income and expenses when different types of patented inventions, and other types of IP that don't necessarily qualify. So, on the expense side, there is a fairly, I would expect that taxpayers would generally have systems in place to track expenses for qualifying projects, because of the R&D tax offset. So people should already have those kinds of, I guess, record keeping systems in place.

And you can see in the discussion paper, there's a lot of focus on how much people will be able to use existing mechanisms for tracking expenses based on the R&D system, and trying to leverage off of that. Where I think it will get more difficult is on the income side, because there isn't really any mechanism for taxpayers to track income and allocate it to particular patented inventions. So I think that will be somewhat difficult. The other thing is that because a product can have multiple patents and multiple different types of IP embedded within it, some of which might have been developed in Australia, some of which might have been developed by a foreign affiliate, some of which might be licensed from a third party, and then you sell the product. You're going to need to have some mechanism to allocate the income, to be a patented invention that is qualified for the concession.

And then the idea also is that you're only supposed to qualify for the concession for the income from the patent, and not income that are generated from other things like brand, marketing, manufacturing, those kinds of things. So, you're going to have to have a mechanism for breaking down one income stream into a whole bunch of different income streams to allocate to the qualifying patent. I think that will be quite difficult and quite challenging. And that's what I think a lot of the focus of the discussion paper is about, is how are we going to do that? How is that going to be implemented in the way that is going to make compliance as straight forward as is possible? And then even when you've done that allocation, then you need to try and work out what is the qualifying component of that revenue stream.

So as I said, the idea is to only grant a concession for the patented IP, to the extent that the R&D had been carried out in Australia. So to the extent that you've acquired IP from offshore, or you've outsourced potentially a R&D activity to an offshore affiliate, you're going to have to try and come up with some formula to back out that part of the revenue, and to arrive at the actual amount of revenue that [crosstalk 00:12:32].

Nina:
Absolutely. And just looking at it from my IP perspective, without the tax element that you cover Sanjay, [crosstalk 00:12:42] I mean, there seems to be a number of challenges with the income analysis. [crosstalk 00:12:46] I mean, first the one you identified where there'll be a product which is comprised of many elements. Some which are patented and some which are not. So, if they do allow for clean energy, for example, if we look at a solar panel, there'll be technology to attract the sun, separate technology, which converts the rays to electricity. So there'll be another potential patentable invention, which describes how you would fix that solar panel to the roof, and even potentially some waterproofing technology. And it may be that one aspect of that product meets the requirements of a patent, that is inventive and it's new. But the remaining aspects don't qualify patent protection, maybe because they've been used in the industry for so many years, and they're all well-known. And in addition to those elements being not subject to patent protection, they'll also be the Goodwill for the brand, which will contribute to the income derived for that product.

So, there should certainly be some challenges in how you then divide up and determine, well exactly what amount of that income for that product is contributed to by the patented technology by itself. It seems to be a very artificial process to try to identify just that income. A second challenge that I could see arising in the case of pharmaceutical patents, is that there are often multiple patents on the same product. So firstly, you tend to have a compound patent for the pharmaceutical, that thing created itself. And that can be for 25 years in some circumstances, because of the patent extension regime we have here. And then there can be follow on patents. So usually we see at least a formulation patent for a particular tablet or capsule, or the best way of administering that pharmaceutical process patents for the way you make the pharmaceutical, as well as second medical use patents.

So once you've worked out that it can be used for one disease, then discovering it can also be used for other diseases, can give rise to patent protection. So each of these patents could last for 20 years and in some cases 25 years, but they all effectively relate to the same product in the same pharmaceutical. So I mean, one issue which will need to be addressed is whether you can keep claiming that lower income for the same product for longer than 20 years, because of the additional patents that have been granted. I imagine these will all be issues that will need to be addressed. And I guess one place to look for how we might address these, is overseas jurisdictions. I mean, how has this complexity been dealt with abroad and are there any lessons for Australia in these? (silence)

Sanjay:
Yeah, so obviously all these other jurisdictions have had to grapple with some of that complexity. And there are a couple of different methods that have been used in other jurisdictions to try and allocate income to particular patents. But I think the thing to also recognize is that because there is a very concessional regime here, it's one of those areas where the OECD as stepped in to put some parameters around what is able to be done and what's not able to be done. So that was I think, it's useful to look at the UK experience. So, the UK originally started with, I guess, a fairly, what was administratively in pool, in the sense that originally their patent box regime allowed patent box profits to be calculated using some approximations and largely formulaic approaches to apportioning profits based on simple ratios of relevant IP income to total income.

And that was done to deal with some of the administrative complexity and compliance burden that would arise from trying to get down to a very granular level of trying to track income attributable to particular patents or particular patented products. But more recently, they had had to move to what's called a streaming approach. And that does require a much more granular way of allocating income and expenses on a just and reasonable basis to particular income streams, which is where it gets its name of streaming. And that really has been driven by the OECD requirements to get down to a much more granular level of allocating income and expenses. So if I was to guess how Australia would go, as much as it would probably want to go down the least administratively burdensome approach as it possibly could, it's probably likely to have to go down this more complex streaming approach that the UK is now had to start using. And then, which is sort of the OECD preferred method of doing this. So, that's how I would expect Australia to implement their regime as well.

In terms of how you then go about backing out other types of profits that might be embedded in a particular income stream like brand and marketing and other profit elements, that will be interesting to see how that is done. The other jurisdictions have done it on a, again, on a fairly formulaic approach, based on what would be a routine return, to try and back out those elements to arrive at the profit that is attributable to the patent itself. And while others have obviously gone down, again, a more granular approach. So, I think that it'll be interesting to see which way Australia goes in that respect as well as to how they actually then remove from the particular income streams that have been identified the other profit elements.

And then as I said, the other aspect of it is trying to then allocate the profit to the R&D that's actually being carried out in Australia. Which I would imagine that, that's something that we should be able to implement relatively readily because of the R&D. We already do track R&D expenditure to particular patented products or particular R&D projects. So hopefully, calculating that fraction is something that can be implemented in a relatively straightforward manner. But you can see that there is a lot of complexity here, and it's interesting that reading some of the literature in other jurisdictions, that because there is so much upfront cost in designing and purchasing systems that enable you to track income and expenses and carry out the relevant calculations. And because the regimes elective, as I said, a lot of companies, particularly startup companies that don't have the money to be able to invest in these kinds of compliance mechanisms, have just decided to not elect into the pattern box regime, which is really interesting, because it is such a concessional rate.

But they view it as just not being something that they can spend the money on to set up all those expensive compliance tools. So I think anything we can do to keep these existing systems and processes and keep the compliance burden to a minimum, will be something that makes our regime comparatively more attractive than other regimes.

Nina:
Absolutely. And I'm sure the government is wanting to promote startups and the new technology in Australia, and so would be keen to avoid companies electing out of the regime because of its complexity. But besides the difficulty in setting up ways of attributing costs to the ultimate income, are there any other reasons why a company might not elect into the regime?

Sanjay:
Yeah, so there's probably a few that I've mentioned, but one that I've already mentioned is the franking credits, that for Australian companies... A lot of Australian companies like to pay fully franked dividends to their shareholders. Whereas if effectively, they're only paying tax at 17% rate, and that rate is then required to be topped up at the shareholder level, because the companies aren't paying fully franked dividends. And I think that may be something that's not particularly attractive to Australian companies which are owned by Australian shareholders, which is, again, fairly counter-intuitive, if the idea is to encourage Australian investment and profits to essentially remain in Australia. There are a couple of other things that I think will be interesting to see how the government designs this, particularly with respect to startup companies, I think. So, one of the other major attractive policies that the government has for research and development at the moment is the research and development tax offset, which generates tax offsets, which in many cases are refundable tax offsets, meaning immediate cashflow for the business generated from the offset.

And that offset is currently pegged to the corporate tax rate at 25 to 30%, depending on what type of taxpayer you are. So, it's not clear whether the offset will then change if you were let into the patent box regime to be pegged to the 17% patent box rate. And if it is, then that does raise a real question for some companies, particularly startups who might benefit from the higher extra cash flow from a refundable offset pegged at the higher rate. So would you rather have immediate cash flow from a higher refundable tax offset, or would you rather have, I guess, a lower refundable tax offset with the prospect of having your income taxed in the future at a lower and a lower tax rate? And that's something I'd be really interested to hear from union on, later on about, how long is this lead time to actually getting a patent?

Because if there's a heap is a really long delay between doing the R&D and generating the income, then maybe you'd prefer to have R&D credits at a higher rate. The other thing is tax losses. So, in other jurisdictions, what we're seeing is that tax losses from patent box activities are quarantined against income from patent box activities. So again, obviously in a startup phase, when you're doing research and development, you're incurring losses. Again, there'll be a real question about, if the company has income from other projects, would you prefer to use those losses immediately at a 25 or 30% rate, or hold on to those losses, and pay income tax on your other profits. Again, in the hope of using them against patent box income, and then paying tax in the longer term at a 17% rate on your patent box income.

So, there are a few questions I think, about how this regime interacts with all those other things as to whether you would prefer to have access to other offsets or losses at effectively, a higher effective tax rate now, than wait into the future to get that, I guess, the 17% tax rate in the future, which could be many years out. And then that's certainly something which I'd like to hear from you with your experience, about how long might companies have to actually wait to be able to get the benefit of this regime?

Nina:
Well, it can certainly be several years Sanjay, and it's several uncertain years too. I mean, if a patent is filed, for example, through the PCT process, which is an international treaty which allows you to file patents, which then delays the time you then have to prosecute those patents in the various jurisdictions around the world. You have 30 months before you even have to enter the examination got to examination, we've waited a few years. And the reasons they're doing that, is because often you need to file a patent so early in the research and development process, before you actually know whether it's going to be a product or a process that you're going to be able to, or that you're going to want to commercialize.

And that is because in order for patents to be granted, the invention needs to be new and inventive, and often people need to do extensive study so that they can confirm that it is going to be a successful product. But you'll need to file your patents before you do the study to avoid somehow invalidating your patents though publication of the results, or even conduct of your study, so that means that you can be several years before you even enter patent examination.

And then once you get into the examination process, that can also be another several years of you go back and forth with the patent office, you might amend your claims several times, there might be opposition proceedings where a third party comes along and says, we don't think that this invention is entitled to a patent until finally, it will be granted in some form, potentially with the claims being quite different, and the scope of the patent being quite different to what you originally had in your patent application. So really, the patent process is lengthy and is uncertain. But one aspect that I'm interested in, is what about where a patent is granted, but is ultimately challenged? There are revocation proceedings before the court. What are the challenges with defining that income, where it would qualify for the regime for the period before revocation proceedings? Is there a clawing back process if the patent is successfully challenged and ultimately revoked?

Sanjay:
No, I think that'll be a really important design feature as to whether that will be the case. Because I can imagine that having the possibility of a patent being challenged, possibly for many years, many years that risk will still be there. But that will be unacceptable where a company that has had their patent granted by the patent office, and has been claiming the lower tax rate. And then for years on end is exposed to an additional 13% tax rate, assuming it's a 30% tax payer, if the pattern is successfully challenged, I just feel that, that doesn't give you any real certainty of your tax position. But I think the government will need to have some mechanism to, I guess, to not have any claw back. Obviously, if the patent is successfully challenged, you would then stop claiming the concessional rate.

But up until it is successfully challenged, you would hope that the government won't seek to claw back the benefit, because I could just say that being an unacceptable risk to companies that can... You just can't be exposed to that. And I think in other jurisdictions, I think the UK doesn't have any explicit claw back mechanisms, but the concession stops being about a little after. That's obviously if the patent is successfully challenged. The other thing that the UK has done to deal with this lengthy patent approval process, is to allow profits from the patent pending stage to qualify for the concession, but not during the period while the patent is pending. But once the patent is granted, then you can sort of go back and look at all the profits that were accruing while the patent was pending and fold that into future years to claim the benefit on those profits.

Because the way the UK does their patent box, it's not actually granting a 17% tax rate, or a 10% tax rate on the income. They actually do it by way of a deduction from the income to arrive at an effective tax rate of 10% on the patent box income. So the way they do it is, they do in effect allow the profits from the patent pending stage to get the benefit. So I think, again, that'll be an important design feature of our regime as to how they do, and hopefully they do grant the concession for profits which are accruing while patents are pending.

I think the other thing that is quite interesting with respect to the regime is that, when I was reading the discussion paper, it looks like the government wants to only grant this concession to patents which either are registered in Australia or would be registered as patents in Australia, under Australian patent law, or rather than just allowing patents which are registered anywhere in the world necessarily to qualify for the regime. And I'm wondering what the rationale for that might be, and whether that's an easy... I guess, if an Australian company were to register a patent in say the UK or France or the USA, how easy for them would it be to work out that, yes, this pattern would also be registered in Australia, and therefore I can get the benefit of the concession for my patent.

Nina:
I certainly don't think that would be an easy inquiry. I mean, the nature of patent law is that every jurisdiction has its own application of the principles and its own precedents. And while in the past we might've said, well, confidently, a patent that's been granted in the UK is likely to be granted here. That position has certainly changed since Britain became part of Europe. And maybe it'll go back to changing now that we've had Brexit, and Britain's not so bound to follow the European decisions. But there are certainly very different principles of patent law in countries like the US and France, and even the UK now. So, you'd need to get legal advice as to the scope of your claims and the nature of your patent specification and whether or not that patent would be granted here. And what we typically see is that patents applied for all over the world, and the scope of the claim are different in every country when they're granted, because they're amended during that examination process, so as to be compliant with the law in the particular jurisdiction.

So I think practically speaking, that would not be an easy task to achieve. But I think if one of the requirements that I understand is a requirement, is that you have to have done the research and development in Australia. Hopefully, that analysis would not be necessary, because you would expect that the company would then apply for a patent in Australia, and therefore either be granted or not granted the patent in Australia. So, you wouldn't have the situation where you're relying on a foreign patent in order to claim the deduction here. But I think if we're talking about research and development in Australia, or if manufacturing is happening in Australia, or there's any intention to exploit the invention in Australia, then the company would definitely at least consider, and should definitely apply for a patent in Australia itself, so that there's no need to rely on that foreign patent.

Sanjay:
Okay.

Nina:
And so I understand Sanjay, that there has been an approach abroad to deal with this issue, so that there is no kind of separate analysis of the scope of the claims. Is that correct?

Sanjay:
Yes. Yeah, that's right. So for example, in the UK, they have white listed particular countries where the UK would just accept that a patent registered in one of those white listed countries is sufficiently comparable to the UK regime for the UK patent law regime, for the UK to grant their patent box concession. And that's actually a pretty common thing that's done in the tax law in other areas, where we have rules, which say that, look, these tax systems are sufficiently comparable to Australia's tax system that we'll recognize it as being efficiently comparable to attract other concessional treatments. I was wondering if that kind of white list approach might also work here. So Australia was at list, particular countries like our friends in New Zealand or the UK, or the USA. We would be happy for patents registered in those countries to qualify without needing to do that extra analysis that you were talking about

Nina:
That would certainly provide more clarity, and would shortcut the process if there was such an acceptable list. I think the challenge for Australia will be determining what countries fall on that white list. Because of the differences with our patent laws, and those which exist abroad. But surely the government could do that analysis and decide some countries that we might follow. For example, the UK might be one, particularly now that Brexit has happened, that would be on such a white list, and adding New Zealand equally could fall on that list. But it'll be interesting to see if the US made that list, because they do have very different laws to us on a number of the patent validity issues.

Sanjay:
Yeah. And the other thing I think that we've spoken about already is that currently, I guess the government's announcement is to restrict the regime to medical and biotech and potentially clean energy, which obviously are particularly hot areas, I guess, at the moment where of research and development. But as far as I'm aware, other jurisdictions don't their patent boxes in quite the same way that we're proposing to. Do you have any insights as to why the government might've decided to choose medical and biotech and potentially clean energy particularly, and not to expand it to other areas?

Nina:
I think it's interesting that they have limited in its way. The Australian government is certainly trying to increase innovation in the country and research and development happening onshore, and to avoid the loss of talent abroad to places such as the US and the UK. But the medical and biotech area, we already have a strong industry, particularly in medical devices. We've got some really strong homegrown companies, as well as some of the big international players that do research and development here. But it's also an industry that really benefits from patents. I mean, we see the med and biotech companies really rely on patent as part of their commercialization strategies, and so really is a key way of rewarding those companies. Equally, ClaimTECH will utilize patents, potentially not to the same extent that they're relied on in the medical and biotechnology space.

And I think the government really explained in a discussion paper that they have these Paris targets that they're seeking to achieve in the renewable energy space. And so they need to boost innovation in this area as a way to kind of achieve those targets. I think another kind of area we see Australia really trying to put itself on the map, is in the FinTech space, but there are real challenges with getting patents in the financial services' area, and the intersection between finance and technology. And a lot of those patents are ultimately found to be invalid. Either those patents aren't granted, because they're objected to in the examination process, or they're ultimately revoked. So perhaps the government's a bit wary of including FinTech at this stage, because perhaps patents aren't really the right vehicle to promote innovation in that area.

Sanjay:
Yeah. And I can imagine also that, given the state of the budget as well at the moment, that the government is keen to try and target the patent box to those areas where they think that they can get the most bang for their buck without weakening the budget anymore. So I imagine that, even that decision to expand it to the clean energy sectors, which as you said, it is an area which uses patents, I imagine that any decision to do that will also need to have regard to the current state of the budget.

Nina:
Absolutely, that makes sense. And so I think what we really wanted to ask here Sanjay, is of our clients and our listeners is, what are your thoughts on this discussion paper? And in particular, the issues we've discussed today. Should it be limited to medical biotechnology and life sciences? Should plane energy also be included, or are there any other areas where Australia should be promoting itself and encouraging innovation through a patent box regime? And we're also really interested to hear about existing systems and record keeping, and how they'll cope with tracking eligible expenses and income. And finally, the time taken to prepare for a start date. And finally, whether there'll be enough time to prepare for a start date for the regime, which is 1 July 2022, will there be the necessary record-keeping in place in order to achieve what needs to be achieved by July next year?

Sanjay:
Yeah, thanks. Thanks Nina. There's one other thing that I did want to ask our clients for as well. And that is particularly in relation to, I guess, the R&D credits and the tax losses and the franking credits. What sort of design features would be really important for our clients to make this regime attractive when you take into account those other, I guess, those other concessions and those other tax rules that are already in place? And the fact that, whether you actually ultimately benefit from a patent and get it registered is inherently uncertain. How can the government design a regime which links all of those different things together in such a way that it's going to be attractive for you to actually elect into this regime, rather than continue with what you already have.

Nina:
Fabulous. Well, thank you very much Sanjay for your time. It's been great to talk with you.

Sanjay:
Yeah, thanks Nina. I really enjoyed hearing about the patent process as well. That was really interesting and enlightening to get an understanding of all of that.