The 'patent box' tax incentive, named after the ‘patent' box that you tick in your tax return, allows companies to pay a lower tax rate on income generated through the commercialisation of patented technology.

The Federal Government announced in its 2021-2022 budget on Tuesday that Australia will introduce a patent box tax incentive, effective from 1 July 2022. The specific details are yet to be developed. However, the general concept is that profits derived from the commercialisation of patented technology developed in Australia and owned in Australia will be subject to a reduced corporate tax rate of 17% (compared with the standard corporate income tax rates of 30% generally and 25% for small to medium enterprises).

At this stage the incentive is limited to profits from the commercialisation of medical and biotech patents, although the government has indicated that it may extend it to other industries (such as 'clean technology'). If successful, we expect that the scheme will be extended to other sectors as well.

The idea of a patent box is not new, and was considered by the Federal Government in 2015. It was rejected based on a concern that the decrease in tax revenue from lower tax rates would outweigh the increase in tax revenue from additional commercialisation activity in Australia – so the net overall tax impact would be negative.

The COVID-19 pandemic has shone a light on Australia's medical and biotech industries – both our high-calibre research and development output, and our comparatively low commercialisation and manufacturing capability. There is now a recognition that encouraging local commercialisation is not just about increasing the government's tax revenue, but also about fostering a broader innovation ecosystem and building local jobs and capability. As a result, the government has decided that now is the time to focus on incentives that target the last stage of the innovation lifecycle – commercialisation.

The government has said that details of the patent box scheme will be developed in consultation with industry.

Key features set out in the budget papers include:

• The research and development (R&D) underpinning the patent must be done in Australia
• The patent must be applied for after the budget announcement
• The patent must be granted (ie. not just applied for) for the reduced tax rate to apply
• The patent must be owned, and the income received, by an Australian company (or permanent establishment)
• The income must be derived directly from the patent (income from manufacturing, branding and other attributes of a patented product or method will not be covered).

Challenges that will need to be addressed in developing the scheme

There are several questions and challenges that will need to be addressed. These include:

How much of the R&D underpinning the patent must be done in Australia and how that will be assessed?

Questions include whether it should be a solely quantitative or partly quantitative and partly qualitative test, and what quantitative and qualitative measures could be applied. Life sciences R&D is often undertaken collaboratively across jurisdictions and over a number of years, so there will be many cases where not all of the R&D is done in Australia. Existing R&D tax incentive concepts could possibly be adopted.

Would limiting the scheme to patents applied for after the budget announcement achieve the government's policy objectives in an appropriate timeframe?

There is a long lead time between applying for a patent and earning income from commercialising the patented technology (usually 5 -10 years in the medical and biotech sector). Therefore, the scheme is unlikely to provide any meaningful benefit until at least 2026 – even though it will apply from 1 July 2022 and has been budgeted to cost more than $200 million over the forward estimates period.

How can you identify what portion of income is 'derived directly' from any particular patent?

There are often a number of patents underpinning a product, which may have been applied for at different times and owned by different companies. Where only some of those patents meet the eligibility criteria for the scheme, how will the relative contribution of those patents be assessed for the purpose of the scheme?

How will the scheme apply to complex patent/profit relationships?

For example, there are differences between scenarios where there is a patent for a new formulation of an existing drug, a patent for a new therapeutic use of a known (and already commercialised) product or a patent that claims a method for manufacturing a product (and not the product itself). Again, how will the relative contribution of the new formulation, new therapeutic use or new method of manufacture be assessed?

To what extent will income from sales of a particular product be 'directly derived' from the patent itself?

This is compared to, for example, the branding or packaging of the product. There is often significant goodwill associated with these aspects of medical products which may make this difficult.

Would know-how associated with a patent be recognised?

This is the case in a number of countries that already have a patent box scheme. Successful commercialisation of technology usually requires a combination of patented technology and confidential 'know-how'. Either one on its own is not sufficient, so separating their value may be artificial.

Would the Australian company need to be the legal owner of the patent?

Alternatively, it could be the economic owner (such as an exclusive licensee)? Corporate groups often hold their patents in a separate company and license the use of those patents to other members of the group.

Where the patent is licensed to another entity, how will the scheme interact with Australia's transfer pricing laws and controlled foreign company rules?

This is in terms of determining an appropriate arms' length price to form part of the profits subject to the scheme.

How would the 'single entity rule' under income tax consolidation provisions interact with the scheme?

In particular, where a subsidiary member of a corporate group is the legal holder of a patent and derives income from the patent, income tax consolidation rules would generally treat the holding company of the group as directly deriving income from the patent.

Will the exclusion of manufacturing income from the scheme achieve the government's policy objectives?

It is unclear what the intention of this exclusion is. On its face it suggests that the scheme will only apply to income received by the Australian company from licensing the patent to a third party manufacturer, rather than income derived from the company manufacturing products itself.

The patent box tax incentive has the potential to be a significant development for the Australian medical and biotech sectors. However, there is a lot of detail to work through to ensure that it operates as intended and achieves the government's policy objectives. It will be particularly important that the government consults with the sector and implements learnings from the experiences of other countries to ensure clear, workable parameters are adopted.

Organisations that operate in these fields should keep a close eye on the development of the scheme and take every opportunity to participate in the consultation process. Contact us to discuss how we can support you in that process.