Abolition of the Patent Income Deduction and Introduction of a Transition Period

In view of the increasing popularity of patent box regimes, the OECD's Committee on Fiscal Affairs believes that a common approach should be adopted which guarantees genuine innovative activity in the country in which the taxpayer is seeking the benefit, in order to avoid harmful tax competition between countries. This approach, known as the nexus approach, provides that preferential tax treatment should be proportionate to the taxpayer's investments in R&D, so that companies only qualify for the tax benefit to the extent they actually invest in research and development activities.

As none of the fourteen IP box regimes in the EU were deemed to meet the requirements of the nexus approach and given the absence of tax harmonisation in the EU, Member States with an IP box regime were asked to review their legislation.

To this end, the Belgian government adopted the Act of 3 August 2016, which abolished the patent income deduction effective 1 July 2016, subject to a transition period of five years. During this transition period, taxpayers must choose if they wish to continue to benefit from the patent income deduction or apply the new deduction for innovation income. It is important to note that once the taxpayer opts to apply the new rules, its choice is irrevocable. Therefore, it is important to study carefully the differences between the two sets of rules.

The purpose of the transition period is to ensure that the patent income deduction can still be requested for patent income received until 30 June 2021 from patents (i) for which an application was submitted before 1 July 2016 or (ii) acquired from another party before 1 July 2016. Moreover, a general anti-abuse measure has been introduced, designed to prevent group entities which no longer qualify for the patent income deduction from shifting their intellectual property rights to other group members that still benefit from a similar (transitional) regime. Therefore, patents acquired directly or indirectly as of 1 January 2016 from an associated company are excluded from the transitional regime if they did not qualify for the patent income deduction or a similar foreign regime in the hands of the transferor.

New Regime: Deduction for Innovation Income

Below we discuss the most important changes introduced by the draft bill submitted to the federal Parliament on 21 December 2016 and adopted on 2 February 2017.

The most important change is introduced by the nexus approach which imposes a new calculation method based on an expense ratio. The purpose is to ensure a correlation between the taxpayer's IP income, which qualifies for a lower tax rate, and eligible investments, using a formula that compares the qualifying expenditures[2] to the overall expenditures[3] (see formula below). Pursuant to the formula, the income qualifying for a lower tax rate will be deemed equal to total net IP revenue only if the qualifying expenditures are equal to the overall expenditures. This means that tax incentives will only be granted to businesses that have a sufficient level of activity ("substance") in the state awarding the benefit. In other words, the taxpayer must actually incur research and development expenses or bear the cost of outsourcing such activities to independent parties. Consequently, a company that acquires intellectual property rights from a third party or outsources R&D activities to associated (affiliated) companies will not qualify for the tax incentive. It appears that many companies will thus have to change their strategy and ensure that their qualifying expenses are as high as possible if they wish to continue to benefit from the Belgian tax deduction. Since such a change in strategy can be costly, the OECD allows states to apply a 30% uplift to qualifying expenditures, but with a maximum of the overall expenditures. It is up to each state to decide whether it wishes to do so. It should be noted that Belgium has decided to apply the uplift.

The second important change is the replacement of the gross approach with the net approach. Under the net approach, it is necessary to first deduct professional R&D expenses before applying the deduction. This change in the calculation method will significantly affect the level of the tax benefit. Belgium had no choice in this regard as the OECD clearly abolished the gross approach in the context of its BEPS project.

Moreover, the scope of the new regime is much broader than the patent income deduction as it also covers income from copyright-protected software, plant breeders' rights, plant protection products qualifying for data or market exclusivity, and orphan drug designations. This explains why the term "patent income" has been replaced by "innovation income". Furthermore, the deduction has been raised to 85% from the currently applicable 80%, with the possibility to carry forward any excess to future accounting years. This also implies that, if a taxpayer has in a taxable year no income from IP assets to apply the deduction on, the deduction can be used in future taxable years to reduce the tax base.

Consequently, the deduction is calculated in accordance with the following formula:

The definition of qualifying income has also been expanded. In addition to qualifying innovation income, the new regime also covers compensation awarded for the infringement of qualifying intellectual property rights and capital gains realised on the sale of intellectual property rights. However, the latter will only be considered qualifying income if certain strict conditions are fulfilled, including reinvestment of the capital gains within five years in research for other intellectual property rights. Besides, questions had been raised about the applicability of the deduction in the context of corporate restructurings. The law confirms that the deduction can still be applied even if even mergers or divisions occur within the company. The same holds true for the patent income deduction during the transition period.

It should be noted that tracking and tracing the income and expenses related to IP assets will be very important as a number of evidentiary requirements must be fulfilled in order to qualify for the new deduction.

Moreover, the new rules allow the unused portion of the deduction to be carried forward to subsequent tax years. Under the former patent income deduction, carry-forward was prohibited.

Finally, another important advantage of the new regime is that as from the time a patent application is submitted, a portion of the company's profits is temporarily exempt from tax. This temporary exemption is granted through the establishment of a tax-exempt reserve pending approval and grant of the intellectual property right. Once the IP right is granted, the reserve becomes definitively exempt from tax.

To conclude, it must be noted that the foregoing regime is only applicable in the Belgian corporate income tax. This means that only Belgian companies and Belgian branches of foreign companies can benefit from this regime. Nonetheless, Belgian tax law also foresees a favorable tax regime for Belgian residents - natural persons (i.e. no legal entities) as regards copyright income of authors and artists. Copyright income up to EUR 58.720 per year (indexed amount for tax year 2018) is considered as investment income subject to a final tax of 15% withholding tax instead of earned income which is subject to progressive tax rates (up to 50%). Above the amount of EUR 58.720, it should be analysed on the basis of the facts whether the income qualifies as investment income or earned income.

[1] Law of 9 February 2017 establishing a deduction for innovation income, Belgian Official State Gazette 20 February 2017.
[2] Qualifying expenditures consist of expenses made by the taxpayer itself in the context of R&D (A), as well as expenses related to the outsourcing of R&D activities to third parties (i.e. non-related parties) (B). Furthermore, it includes expenses made by the taxpayer for the outsourcing of R&D activities to related parties if these parties, on their turn, outsource the R&D to non-related parties and the outsourcing cost is invoiced to the taxpayer without mark-up (C).
[3] The category of overall expenditures has a broader scope and contains not only the qualifying expenses (A,B and C above), but also the expenses related to the acquisition of qualifying IP rights (D) and the expenses related to R&D outsourcing to related parties (other than those qualifying under (C) of footnote 2).