This is the third article in a 4-part series on tax avoidance in Ireland.
US technology and pharmaceutical giants in the Irish state have benefited from varioustax credits, incentives and loopholes specifically relating to intellectual property and research and development, in addition to the low Irish corporation tax rate. But very little actual R&D is carried out in Ireland as a result of FDI, with US MNCs preferring to base R&D centres in Israel, China and India.
R&D tax credits against corporation tax were introduced in 2004 and expanded in Budget 2015 as the news that the Double Irish was to be phased out was announced. A 25 per cent tax credit is available on all qualifying R&D expenditure in addition to a 12.5 per cent tax deduction – so, a total of a 37.5 per cent tax deduction on such expenditure, or in other words, a corporate tax rate on R&D activity of around 3.3 per cent. Any company which trades in the Irish state and carries out R&D activities in Ireland or in the European Economic Area and incurs expenditure is eligible.
Before 2015, a base year of 2003 was in place – ie, a company could only claim credit for expenditure over and above what it incurred in 2003. This was to be a rolling base year in order to incentivise companies to spend more but the year didn’t change, and the base year was abolished altogether in Budget 2015. Under a Freedom of Information request, the Irish Times found in January 2015 that Department of Finance officials “expressed concern that changes to tax breaks in Budget 2015 would cost at least €50 million in foregone taxes annually and reward a relatively small number of companies” – just 15 firms, in fact, including one that would benefit by €14 million. The names of the companies were blacked out in the FOI release, but according to the Irish Times, “records indicate many of the firms that stood to benefit lobbied in favour of the move”.
There were no audits carried out on the tax credit scheme for the first decade of its existence. It was reported in September 2015 that 200 audits carried out in 2013 found “several multinational firms have been found to be aggressively and improperly claiming tax credits for research and development to lower their corporation tax bills” and resulted in firms being made to repay €21 million in back taxes. Revenue has identified the tax credit as a “significant risk” and used scientists and technical experts in its audits to determine if the companies were genuinely carrying out R&D.
The OECD modified-nexus regime
Also announced in Budget 2015 (with the phasing out of the Double Irish), and introduced in Budget 2016, was the Knowledge Development Box, a corporate tax rate of 6.25 per cent for profits arising from certain forms of IP. Ireland had already introduced the first “patent box”, a lower rate of tax on IP-related profits, in 2000 before the introduction of the 12.5 per cent corporate tax rate. A British patent box with a rate of 10 per cent from British and/or European patents was introduced in 2013. Luxembourg, the Netherlands, Cyprus, Spain, France, Portugal, Belgium and Malta have all introduced special low tax rates for profits from patents.
Patent boxes have been described as mechanisms for tax avoidance. The OECD-BEPS project proposed action to reduce the potential for profit-shifting abuse through patent boxes by ensuring there was a genuine link, or nexus, between the lower tax rate and R&D that was initially developed in the home state. A German-British compromise in November 2014 resulted in the so-called modified nexus approach being adopted by the OECD, which retained requirements for genuine local initial IP development but added concessions for Britain including a transition period and a 30 per cent “uplift” in what counts as qualifying expenditure to reflect outsourced intra-group research activities and costs.
While the Irish government initially opposed the modified nexus approach publicly during the German-British negotiations, and actively sought the advice of US MNCs in drafting its own legislation, Finance Minister Michael Noonan clearly saw the writing on the wall. Part of the OECD agreement was that all new entrants into existing patent box schemes that did not comply with the modified nexus approach would have to cease by 30 June 2016 and be abolished by 2021. When introducing the KDB in Budget 2016, Noonan stated that it would be the first and only patent box in the world to be fully compliant with the OECD’s modified nexus approach. Following the adoption of the German-British modified nexus approach, the European Commission withdrew its investigation into patent boxes.
Ireland’s Knowledge Development Box
The Irish KDB took effect on January 1 this year. It will apply a 50% allowance in tax relief to “qualifying profits”, resulting in a 6.25% tax rate. Qualifying profits arise from specified trade in “qualifying assets”, being intellectual property resulting from research and development carried out in Ireland or an EU member state. The intellectual property forms that can be qualifying assets are defined as being copyrighted computer software, inventions protected by patents and supplementary protection certificates, and plant breeders’ rights. The formula for calculating the qualifying profits under the KBD is below:
Qualifying Expenditure + 30% Uplift Expenditure x Qualifying Asset = Qualifying Profit
Qualifying expenditure is expenditure incurred in R&D activities that lead to the development, improvement or creation of the qualifying asset. Cost-sharing agreements where costs are outsourced to intra-group parties are excluded, but such intra-group expenditure and acquisition costs can be added as uplift expenditure up to 30 per cent. The overall expenditure is the full amount of costs incurred in the R&D and acquisition of the IP, so the qualifying expenditure is measured as a proportion of this. The qualifying asset is the profits made by the specified trade in the IP product and can include any royalty or other sum received in respect of the use of that qualifying asset – including sales income attributed to the qualifying asset on a “just and reasonable basis”.
The specified trade in the qualifying asset can include:
– the managing, developing, maintaining, protecting, enhancing, or exploiting of the IP;
– the researching, planning, processing, experimenting, testing, devising, developing or other similar activity leading to an invention or creation of intellectual property; or
– the sale of goods or the supply of services that derive part of their value from the activities described above.
KBD open to abuse
The corporate lobby initially expressed disappointment about the government’s use of the modified nexus approach, with one lobbyist saying: “What the Government could have done is waited longer to produce it. If they waited a few years more the temperature could have dropped and there would have been less focus on international tax, and they may have been able to pick up ideas from other countries… It has certainly impacted on how effective the KDB will be for the future in terms of an incentivisation vehicle.”
The Big Four accountancy firms and some corporate law firms have been more optimistic – while they have criticised the “onerous” tracking and tracing provisions that require a separate profitability stream to be accounted for each asset, they have nevertheless welcomed the KBD as a means to reduce tax bills that will specifically benefit the technology and pharmaceutical MNCs provided they jump through a few extra hoops. For example, the pharmaceutical sector generally uses “serialisation” features that correspond with the tracking and tracing provisions, but these would need to be developed in the technology sector.
Deloitte stated: “In our view, the introduction of the Irish KDB regime is welcome, although the narrow scope of IP assets that will qualify for the regime ultimately will result in limited uptake [ie, not trademarks] outside of the pharmaceutical and technology sectors.” William Fry law firm has said: “Overall, the KDB is to be welcomed as it bolsters Ireland’s competitive tax regime and complements existing tax benefits for IP such as research and development relief and the capital allowances available in relation to intangible assets. Given the limitations where research and development is carried out by group companies, in the first instance, the KDB relief may be more beneficial to indigenous companies. However, with proper planning, the relief may also prove to be of benefit to multinational enterprises.”
There is no doubt that the KBD will benefit MNCs disproportionately and that the KBD is wide open to abuse. The definition of R&D activities is identical to the definition in the R&D tax credit legislation, and it too can be self-reported by corporations when filing their accounts. The hugely problematic nature of measuring the value of intangible assets remains. The weak existing transfer pricing regulations on the arm’s length principle from the 2010 legislation will be applied. There is a right for Revenue to consult with experts on the R&D being claimed if it wishes to, as under the R&D tax credit regime, but a corporation can appeal against such consultation on the grounds that disclosure would be prejudicial to its business.
Put simply, there is nothing in the KBD legislation to prevent it from being used to concentrate profits offshore. The Double Irish system where all non-US sales pass through Irish subsidiaries to dramatically reduce the tax bill can continue but in a simplified way, with both Irish subsidiaries being tax-resident in Ireland, with one that can collect sales profits and another that holds IP rights and receives royalties that are taxed at the 6.25 per cent rate.
Inevitable profit-shifting – a theoretical example
Here is just one theoretical example of how the KBD can be exploited: a technology MNC, Pear Inc, is headquartered in Silicon Valley where 90 per cent of its overall R&D is carried out. It has two subsidiaries in Ireland called Pear Ireland Ltd and Pear Ireland Holdings. Pear Inc develops a software programme, called iThing, with 100 per cent of the R&D carried out in San Francisco. Pear Ireland Ltd then works on the next generation of the product – iThing 2.0.
It could claim to spend 70 per cent of the relatively small amount of R&D expenditure needed to make a few changes or improvements to the original iThing programme in Ireland, resulting in the creation of iThing 2.0. The new programme would not need to be patented with the Irish Patent Office because computer programmes are generally excluded from patentability but are specifically included in the qualifying asset IP definition in the KBD.
Because the new variation of the programme is in itself a qualifying asset, the overall expenditure does not necessarily need to include the original expenditure incurred in San Francisco, only the 30 per cent of expenditure not attributed to Ireland. As intra-group cost-sharing agreements are not allowed under the KBD, Pear Ireland Ltd can under certain circumstances add 30 per cent uplift, equaling 100 per cent of overall expenditure.
To be sure, Pear Ireland Ltd can simply obtain an advanced opinion from the compliant Irish Revenue to affirm its calculation that it incurred 70 per cent of the R&D costs, as the track and trace provisions are only required to be checked by the home state. Pear Ireland Ltd then licenses the IP to Pear Ireland Holdings, which collects all of the non-US sales profits from iThing 2.0 but reduces its taxable income through paying royalties and/or licensing fees to Pear Ireland Ltd under the clearly ineffective existing arm’s length legislation.
Then 100 per cent of the royalties and licensing fees received are attributable to the R&D expenditure carried out in Ireland, calculated as qualifying profit under the KBD and taxed at 6.25 per cent (this is on top of the 37.5 per cent tax deduction available for R&D expenditure through the combined R&D tax credit and the 12.5 per cent R&D tax deduction). This is an extremely simplistic example of a structure but it could obviously be improved in terms of tax avoidance through the more creative use of royalty payments and subsidiaries around the world including in tax havens.
No evidence that patent boxes stimulate R&D
There is little evidence that patent boxes do anything to increase genuine R&D or attract FDI in the productive economy in the states they exist in. Speaking in Dublin in March this year, the head of the OECD’s centre for tax policy Pascal Saint-Amans, said the development of knowledge or patent boxes does little to actually foster innovation and the creation of intellectual property.
This was followed by an OECD report in June this year which said Ireland’s public financial support to R&D businesses was “skewed” towards R&D tax credits that benefited MNCs, and explicitly called for public resources to be redirected away from MNCs to local SMEs, where there was little growth, in order to develop indigenous enterprise and increase productivity. Despite more than a decade of generous R&D tax credits and other tax incentives to promote FDI, less than one-third of IDA Ireland companies invest in R&D at all.
But despite its limitations and potential for abuse, a system of R&D tax credits, targeted towards SMEs and indigenous enterprise, has a broader economic and social value if implemented correctly – whereas there is no such corresponding social and economic benefits arising from a patent box regime. A research paper on patent boxes in 2014 argued: “Tax incentives for R&D expenditure reward firms for the societal benefits from innovation that they themselves are unable to appropriate. It is hard to make the argument that a patent box serves the same purpose: patent boxes introduce a preferential rate for income from innovations that are already protected by Intellectual Property Rights (IPRs). IPRs enable firms to capture a large part of the societal benefits, such that the need for a tax incentive for protected innovations becomes unclear.”
The supposedly limited opportunities the modified-nexus compliant KBD presents for US MNCs to reduce their tax bills makes it all the more likely that it has been introduced in the full knowledge that it will be exploited, while the government will turn a blind eye. Based on the form of successive Irish governments in relation to tax avoidance, we can guess that the government had two goals with introducing the KBD: to send a political message to US MNCs that the Irish government remained committed to ensuring the Irish state could continue to be used as a conduit for tax avoidance despite the phasing out of the Double Irish; and to introduce yet another mechanism that is wide open to abuse in order to please MNCs.
In the context of the phasing out of the Double Irish and an international crackdown on the use of offshore tax havens, the Irish KBD is an attractive mechanism for creative “onshore” tax avoidance. Matheson law firm advises its clients that offshore tax havens such as Bermuda and the Cayman Islands don’t have “the necessary economic infrastructure to which value and ultimately profits can justifiably be attributed”, whereas Ireland on the other hand can construct “profit-generating centres defensible by reference to functions, risks and tangible assets of the Irish operation,” advice that has become all the more relevant in the post-BEPS context.