The debate surrounding U.S. corporate tax reform is very much alive, driven in large part by international events that signal an end to some forms of tax avoidance by U.S.-based multinational corporations. Undoubtedly, these corporations are currently considering the best moves to protect existing and future foreign earnings by reducing U.S. taxes. One of these moves is to encourage U.S. policymakers to adopt a patent box tax structure. Policymakers, however, should be wary of this option.
Right now, the international tax scene is fluid for U.S. multinationals. The Organisation for Economic Co-operation and Development, or OECD—in cooperation with the G-20—is rapidly developing concrete proposals to address corporate tax avoidance as part of its Base Erosion and Profit Shifting, or BEPS, initiative. The initiative will end in December, with follow-up efforts expected to encourage the adoption of proposed policies across OECD member countries.
U.S. multinationals seem to be at the center of many of these efforts. Although the United States taxes the worldwide income of U.S.-based corporations, companies do not have to pay U.S. tax on their foreign earnings until they are repatriated. U.S. parent companies get credit for foreign taxes already paid on repatriated income; nevertheless, they are holding huge amounts of untaxed foreign earnings offshore. In fact, they now hold more than $2 trillion in untaxed offshore earnings, much of which is from earnings on intangible assets and subject to little or no foreign or domestic tax. U.S. multinationals have become so adept at avoiding tax on foreign earnings that the European Union has lobbed harsh criticism at them. Further, it is aggressively pursuing serious fines in investigations of agreements between certain EU member states and U.S. multinationals.
Support for the patent box
As a means of addressing competition from U.S.-based and other multinationals, some foreign governments are turning to the patent box, which offers domestic companies a favorable tax structure for royalties and other income that flows from the patents they hold. Foreign governments hope this will lure international companies that invest in high-technology or science-based research to their shores, while retaining similar domestic companies. U.S. companies, particularly those in the pharmaceutical and technology sectors, can move patents developed in the United States to their foreign subsidiaries in patent box countries to take advantage of lower tax rates; however, that income theoretically is still subject to U.S. tax once it is repatriated. Enactment of a U.S. patent box law would enable companies to bring revenue home at a much lower tax rate—or encourage them to keep it here in the first place.
To some U.S. policymakers, the patent box could seem like a win-win concept. At a time when many U.S. companies are moving their domiciles out of the country, some lawmakers believe that a patent box could help keep science-based companies at home, where research and experimentation, or R&E, can have positive ripple effects on the economy. At the same time, they hope a patent box can be part of a partial tax reform bill later this year that would also include funding for infrastructure.
Reality of implementing the patent box
Theoretically, under a U.S. patent box law, a U.S. multinational company would report all of its patent-related income worldwide on its U.S. tax return each year and pay U.S. tax on those earnings even if they were not repatriated. The key attraction of this for companies is that income in the patent box is subject to what is usually a much lower tax rate. The United Kingdom, which adopted a patent box structure in 2013, applies a 10 percent tax rate to that income, well below its top business tax rate of 20 percent. Proponents of a U.S. patent box argue that this is necessary to discourage companies from moving offshore, where foreign companies receive much more favorable treatment of their patent-related income. A recent study confirmed that there is a strong association between U.S. corporate expatriations and the growth in revenue from intangibles such as patents. The same study also found that corporate expatriations have generated excess returns of about 225 percent above market returns, suggesting the magnitude of the international tax avoidance problem.
From a budget perspective, however, a U.S. patent box is too good to be true. Rep. Dave Camp (R-MI) included an expansive version of a patent box in his Tax Reform Act of 2014. The Congressional Joint Committee on Taxation scored that measure, along with some related changes, as raising $115 billion in federal revenue within the 10-year budget window that lawmakers use to assess tax proposals’ impact. Unfortunately, because it was included in a costly and much broader proposed reform of the taxation of foreign income, the estimate is not helpful in determining how much revenue, if any, a more typical patent box proposal would raise in the early years.
Nevertheless, it seems likely that a patent box provision would lose significant revenue in the long term, as earnings that would have been repatriated at a higher tax rate would instead be taxed at the much lower patent box rate. The majority chief tax counsel of the House Ways and Means Committee has implied that this would be the case, and as such, it would hamper later efforts to achieve a broader-based corporate tax rate cut. To be sure, the amount of revenue lost depends in part on whether the income would have been repatriated and on the specific tax rate lawmakers choose for the patent box income. But the long-term revenue loss could grow as companies find ways to include other income in the box, such as income related to a large product that includes one small patented part, a criticism raised over the U.K. patent box. Alternatively, companies could pressure policymakers to expand the definition of qualifying property to a wider range of patentable items. These could include computer programs and software, business methods, financial instruments, accounting systems or even tax strategies. Worse, lawmakers could expand the box to include unpatented forms of intellectual property, an approach referred to as an innovation box.
In the end, the patent box would reward many of the very companies that have taken the greatest advantage of this form of profit shifting to avoid paying their fair share of U.S. taxes. These companies already benefit from the strong legal protection the U.S. provides for patents. And many of them undoubtedly benefited from the R&E tax credit when developing their patented products. The R&E credit arguably provides incentives for innovation when it matters most—before ideas become commercially valuable and regardless of whether they do. Patent boxes, however, reward only innovation that proves itself to be commercially successful.
In their effort to find revenue to support other federal priorities, lawmakers should ensure that U.S. multinational corporations pay their fair share of taxes. A patent box with a low tax rate could end up being just another tax loophole for U.S. multinationals, further reducing these corporations’ tax bills while requiring others to endure higher taxes or program cuts to make up for it. Congress should avoid putting international patent income into such a budget sieve.
Alexandra Thornton is the Senior Director of Tax Policy on the Economic Policy team at the Center for American Progress.