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Intellectual Property Income Taxation: An Update

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September 28, 2016

By: Nick Pantaleo and Scott Wilkie

In 2013, we proposed a “patent” or “innovation” box to encourage research and development and generate positive “spillovers”, including contributing positively to Canada’s tax base. Though criticized by some as unwarranted targeted tax expenditures, we suggest patent or innovation boxes be viewed more broadly as adjustments to the effective and marginal effective tax rate. The proposal we offered foresaw the need to align R&D activity with resulting production and other spillovers, internalizing them indefinitely and clawing back the benefit if these positive spillovers accrued outside of Canada. In other words, we recognized the need to see tax expenditures by way of actual tax reductions to encourage R&D as a commitment by the government that justified the entrenchment of returns from success.

As we noted, patent or innovation boxes were not a new notion, though not well known in North America. As it turns out, our Commentary was more forward looking than we thought. The Organisation for Economic Co-operation and Development (“OECD”) together with the G-20 studied preferential tax regimes as part of its “Base Erosion and Profit Shifting” (BEPS) project. It concluded that the use of income tax preferences is not per se bad as long as a suitable operational nexus exists to the jurisdiction offering the support. In other words, any tax support to owners of intellectual property must be reflected in real and continuing business activity related to the intellectual property in the jurisdiction that sponsored its creation. In the course of the BEPS project, the United Kingdom and Germany reconditioned their patent boxes to align with the OECD / G-20 recommendations.

Interestingly, the Provinces of Quebec and Saskatchewan recently announced proposals for patent boxes. Their thrust is consistent with both the nexus imperative that the OECD / G20 recommend for acceptable preferential regimes and our design comments in 2013.

The possible use of such income tax–based strategies was recently recognized in OECD-sponsored working papers which considered a variety of factors affecting whether and to what extent encouraging economic development this way would be the best and least distortive use of public resources relative to expected returns.

The moderation of effective and marginal effective tax rates this way evidently is considered to be respectable enough to attract appropriately guarded recognition by the OECD/G-20 and to inspire two Canadian provinces.

If we were to offer one critical comment, it would be this: recognizing that a patchwork of separate provincial initiatives potentially risks inter-provincial base erosion. A national strategy might be more desirable.  

Nick Pantaleo and Scott Wilkie are co-authors, along with Finn Poschmann of the C.D. Howe Institute study Improving the Tax Treatment of Intellectual Property Income in Canada.

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