On 29th February the Finance Minister in the Budget speech said, “Research is the driver of innovation and innovation provides a thrust to economic growth. I propose a special patent regime with 10% rate of tax on income from worldwide exploitation of patents developed and registered in India.”
The cue is clear that FM wants to promote domestic research and development and also make India a lucrative option for the Multi-National Enterprises (MNE’s) across the globe to base their R&D in India, which will accelerate employment opportunities, innovation, spur commercial and industrial growth. This will also arouse interest of high tech and life sciences corporates to engage in business in India. This would also help India boost the value of patents that are patented with the domestic patent law.
Before we discuss the newly introduced proposal in the Finance Bill, 2016, for royalty income the reader must be informed that the patent regime scheme of taxation has been in existence in various countries for some time now with respect to income from intellectual property (IP). Tax rates for Intellectual Property income under patent regimes vary between 0% (Malta) and 15% (France). A patent box regime, in simple words, provides lower tax rates on income from the exploitation of patent. Patent systems are competitively implemented by various countries to drive technology and innovations. Innovation plays a pivotal role in transforming a society and an economy as a whole. A number of nations believe that a beneficial regime for patents is essential to encourage R&D across sectors, which will foster and ensure the economic wellness of nations. The concept was first introduced in the year 2000 by the Irish and in 2001 by the French Government as a reduced rate of tax on revenue from IP licensing or the transfer of qualified intellectual property. Malta, Cyprus and Liechtenstein offer the lowest statutory IP Box tax rates.
Patent Regime and BEPS Project
Intellectual Property with its geographically mobile characteristics has been subject to aggressive tax planning by Multi-National Enterprises (MNE’s) keen on minimising their tax costs. By locating the intellectual property assets in low tax jurisdictions MNE’s have been able to lower their overall tax costs substantially to the disadvantage of nations where value is actually created. The Base Erosion & Profit Shifting (BEPS) project undertaken by OECD to address challenges faced in International tax administration by revenue authorities discusses patent regimes as part of its report in Action Plan – 5 of the BEPS Project Report. The Finance Ministry has been pragmatic in its approach to the BEPS Project and the BEPS Project recommendations feature prominently in the Finance Bill, 2016, in many places such as introduction of Country – by – Country reporting guidelines for transfer pricing, equalisation levy. The memorandum to the Finance Bill, 2016, while discussing the proposed patent regime makes a reference to Action Plan – 5 of the BEPS Project.
Operation of the proposed Patent Regime
The Patent Regime is proposed to be introduced by insertion of a new Sec. 115BBF in the Income-tax Act, 1961. The new section 115BBF provides that where the total income of the eligible assessee includes any income by way of royalty in respect of a patent developed and registered in India, then such royalty shall be taxable at the rate of ten per cent.
An eligible assessee would mean a person resident in India, who is the true and first inventor of the invention and whose name is entered on the patent register as the patentee in accordance with Patents Act, 1970 and includes every such person, being the true and the first inventor of the invention, where more than one person is registered as pantentee under Patents Act, 1970 in respect of that patent.
Illustration – 1
Assessment Year: 2017-18
XYZ Private Limited
|Particulars||(Amount in INR)|
|Royalty from patents||100|
|Expense incurred on patents||(30)|
|Copyright Software Revenue||100|
|Expense incurred on Copyright Software revenue||(50)|
|Other Business Revenue||100|
|Expense incurred on other business revenue||(50)|
|Particulars||Tax Calculation||(Amount in INR)|
|Copyright Software Income||(100-50)*30%||15|
|Other Business Income||(100-50)*30%||15|
|Total tax liability before Surcharge & Cess||40|
As seen in the above illustration, the new beneficial rate of 10% under the proposed Sec. 115BBF of the Income-tax Act, 1961 is applied on the gross royalty revenue. Also Intellectual Property income to qualify for such beneficial rate should be from a patent developed and registered in India. Developed in India has been defined to mean the expenditure incurred by the assessee for any invention in respect of which patent is granted under the Patents Act, 1970. The registration of the patent will have to be as per the provisions of the Patents Act, 1970 and Patent Rules, 2003.
Proposed Indian Patent Regime vs. Action Plan – 5
As discussed above the OECD BEPS Project as per its mandate has identified the significant challenges faced in International Tax Administration and has come out with recommendations in the form of 15 Action Plans which can be adopted by countries as best practices. Action Plan 5: Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, discusses Patent Regimes in Chapter – 4, and recognises the importance of Patent Regimes in fostering innovation while at the same time highlighting the fact on how Patent Regimes can lead to Base Erosion and Profit Shifting when abused by MNE’s. To counter the harmful effects of Base Erosion and Patent Shifting while at the same time maintaining the beneficial provisions of Patent Regimes, Action Plan – 5 recommends the “nexus approach” which can be incorporated in the tax codes of countries to align Patent Regimes with substance requirement.
Qualifying expenditure incurred to develop IP asset * overall income from IP Asset = Income receiving tax benefits
Overall expenditure incurred to develop IP Asset
Action Plan – 5 covers royalty income from IP assets which are in the nature of (i) patents defined broadly, (ii) copyrighted software, and (iii) other IP assets that are nonobvious, useful, and novel. However, Sec. 115BBF of the Income-tax Act, 1961, refers to only royalty income from patents while royalty income from copyrighted software and IP assets that are nonobvious, useful, and novel are not covered by the provisions of Sec.115BBF. Also Action Plan – 5 for the fulfilment of the substance requirement, has recommended a formula based approach as follows:
- A qualifying expenditure in the numerator includes all expenditure incurred by the tax payer himself but does not include interest, acquisition costs, building costs or costs that are incurred by a related party or costs that cannot be directly linked with the IP asset .
- Overall expenditure in the denominator includes qualifying expenditure, related party costs and acquisition costs.
- The overall income has been defined as the net income from the IP asset i.e. after deducting IP expenditures allocable to IP income; this is to ensure the fact that the whole of the IP income will not qualify for tax benefits when whole of the expenditure is not incurred by the tax payer.
Action Plan – 5 discusses each of the variables elaborately to give a clear picture of how to use the above formula. Para 48 of Action Plan – 5 while defining Overall IP income eligible for preferential rate of tax includes embedded income from the sale of products and the use of processes directly related to the IP asset. However, Explanation Clause (h) to the proposed Sec.115BBF of the Income-tax Act, 1961, clearly excludes such embedded incomes from the ambit of the preferential rate eligible to the scheme under section 115BBF of the Act.
The Finance Bill – 2016 explaining Sec. 115BBF of the Income-tax Act, 1961, makes a reference to the Action Plan – 5 which prescribes the ‘nexus approach’ so that income arising from exploitation of intellectual property should be attributed and taxed in the jurisdiction where substantial research and development activities are undertaken rather than jurisdiction of legal ownership only. In comparison the provisions of Sec. 115BBF are narrower in scope as can be observed from above.
Proposed patent regime vs. other provisions of the Income-tax Act, 1961
- 115BBF Income and MAT provisions
The MAT provisions are proposed to be amended to provide that the amount of income, by way of royalty in respect of patent chargeable to tax under sec 115BBF, shall be reduced from the book profit, if such amount is credited to the profit or loss account. Further, the book profit shall be increased by an amount of expenditure relatable to royalty in respect of patent chargeable to tax under sec 115BBF.
- Can an assessee choose to be governed by the normal provisions of the Act instead of adopting the scheme under section 115BBF of the Act
There could be situations where the scheme under section 115-BBF which is applicable on the gross royalty income is less advantageous to the assesse than the normal provisions of the Act. For Example: Income from Royalty is 100; Expenses in relation to the Royalty Revenue incurred amount to 90
Tax as per Sec. 115BBF: 100*10%= 10
Tax as per Normal Provisions of the Act: (100-90)*30%=3
Now the assessee opts to be governed by normal provisions of the Act.
- expenditure or allowance in respect of such royalty income shall be allowed under the Act. Therefore, the assessee earning royalty income in respect of patents developed and registered in India will be governed by the provisions of Sec. 115BBF. He has no choice to opt to be governed by the normal provisions of the Act.
- Set-Off of Losses
The Hon’ble Supreme Court in Dr T.A. Qureshi v. CIT 157 Taxman 514 (SC), has distinguished a ‘loss’ from an ‘expenditure’. Proposed clause (2) of Sec. 115BBF of the Income-tax Act, 1961, restricts claiming of expenditure or allowance only. It does not however, restrict set-off of losses unlike clause (2) of Sec. 115BBE of the Act where it is proposed to restrict set-off of losses specifically. In the absence of a provision restricting set off of losses in Sec. 115BBF it is inferred that losses are allowed to be set-off against the royalty income.
India from the times of Indus Valley civilisation has been a great contributor to the field of science. Today India is a preferred hub for global R&D, with MNE’s increasingly choosing India to establish research centres owing to the abundant supply of premium talent. However, owing to tax considerations MNE’s have normally capitalised India developed IP Assets in jurisdictions allowing favourable tax treatment for IP incomes. With the adoption of BEPS recommendations by majority of the nations where intellectual property assets cannot enjoy preferential tax treatment without fulfilling the substance requirement, the patent regime in India could not have been introduced at a better time, as MNE’s now can capitalise their IP Assets in India and still enjoy preferential tax treatment of IP income while fulfilling the substance requirement. This should in turn help in achieving our Prime Ministers vision of ‘Make in India’ and contribute to the growth of the nation.