Throughout the ongoing review, orchestrated by the Organisation for Economic Co-operation and Development, of the measurement and allocation of international income, the significance of manifestations of “intangibles” – intangible property in the legal sense but also features of the uniqueness of multinational enterprises and their products and services – have been at the forefront. One of the main reasons is the mobility of information, ideas, and, indeed, contractual rights, all of which may be very valuable, but all of which, too, can be “placed” by their “owners” where those owners wish them to be, without the need for the usual trappings of industrial business. There is a clear opportunity relying on private law constructions, then, effectively to influence the allocation of international income associated with the exploitation of “intangibles” despite where the activities to create those dimensions of intangible value may have taken place.
However, the tax story is not limited to “income shifting”. There is a fiscal dimension, understated in the OECD’s work but evident in its Report on Action 11 of the Base Erosion and Profit Shifting Project, concerning how the levers of taxation may be mobilized to encourage economic development. A common example in Canadian taxation are investment tax credit and enhanced ductions for expenditures on scientific research and development – a particular example of tax expenditures, meant to facilitate economic development not only by supporting innovation advancements but through “spillover” effects that result in community building to host innovation activities and those who conduct them. In vogue in the international environment, considered in the course of the OECD’s base shifting inquiry has been the “patent box” notion, in sum the ownership of contractual rights to or to exploit the outcome of innovation activities, carrying the concomitant entitlement to resulting income. Pointedly, the tax issue is whether “mere” ownership is enough, or something more is required, using the OECD’s functional associations of “development, enhancement, maintenance, protection, exploitation” as well as the requirement that countries sponsoring and supporting research be the places where ensuing industrial activity to exploit them take place.
There is an obvious tension between the kinds of tax avoidance that are possible by merely assigning rights to valuable property to low tax environments that have little to do with how those property and related rights were created or where they may be exploited. On the other hand states have an obvious interest in cultivating innovation, with resulting industrial production and the economic offshoots from it, which in a world without a universal tax system or fiscal objectives gives rise to the implicit possibility of what often disparagingly is referred to as “tax competition” but more benignly entails tax expenditures meant to foster economic development and wider community prosperity. With Nick Pantaleo and Finn Poschmann, in 2013 I wrote about this in a C.D Howe Report (Improving the Tax Treatment of Intellectual Property In Canada, C.D. Howe Institute Report 379).
Quebec has been a leader in Canada to embrace the contemporary features of tax-sponsored intellectual property development in the vein of patent boxes, and has recently modified its program. Three McGill law students offer their insights on the Quebec law and practice; theirs are interesting comments in the conversation about the relationship between tax-sponsored activities and desirable ties to claim and internalize within broader economic development the fruits of research and development citizens collectively undertake via public support for private R & D. This is “international” conversation in the usual sense but also in the Canadian tax context of relative provincial and territorial interests too. We welcome this contribution by Zachary Bensemana, Jacob Krane-Paul, and Danielle Maor.
An Examination of Quebec’s Evolving Patent Box Regime and the OECD’s BEPS Action Plan
The economic development of a country is closely linked to its domestic innovation. In an increasingly globalized world, there is heightened competition among countries to retain innovative businesses that will contribute to the economy and produce income. For decades, governments around the world have encouraged innovation by incentivizing research and development (R&D) in their jurisdiction through tax credits and deductions. Over the past few years, however, an increasing number of jurisdictions have sought to retain and promote domestic innovation by giving businesses a reduced tax rate for income derived from intellectual property (IP), specifically patents. This tax incentive, known as a patent box, seeks to make a country’s corporate tax rate more competitive by taxing income derived from IP at a much lower rate than other business income.
This paper will begin by analyzing the international minimum standards established by the OECD regarding countries’ adoption of the patent box. Then, the two iterations of the patent box in Québec – previously the DIMC and currently the IDCI – will be compared to analyze the evolving tax regime.
2. OECD’s Minimum Standard
The patent box policy is not without scrutiny. The regime has been criticized for its harmful effect on competition for foreign investment and for creating a “race to the bottom” among countries seeking to lower their tax rates to attract corporations. To maximize their bottom line, corporations would simply shift IP-derived profits to a different jurisdiction if its associated tax rate proves advantageous. As such, the OECD considers the patent box regime to be a harmful tax practice that leads to base erosion and profit shifting (BEPS).
In response to the adverse effects resulting from profit shifting and tax avoidance by multinational corporations, the OECD adopted the BEPS Project. Action 5 of the Project sets out a minimum standard for the BEPS framework, requiring members to follow a “nexus approach” toward granting tax benefits. The nexus approach mandates that corporations seeking the deduction engage in “substantial activity” in the given jurisdiction. As a proxy for measuring substantial activity, the nexus approach identifies corporate expenditures, analyzing the ratio between the expenditures in the given jurisdiction and the overall expenditures. Only income derived from this substantial activity will benefit from the patent box tax rate.
Under this minimum standard, the OECD ensures that taxpayers receive benefits on the condition that their R&D activities are sufficiently tied to the jurisdiction in which they claim the patent box tax deduction. Substantial activities are measured through qualifying expenditures put towards the development of the IP asset. This expenditure category is one of four variables in the OECD’s nexus ratio:
Income Receiving Tax Benefits = X/Y × Z
where X is the qualifying expenditures incurred to develop the IP asset, Y is the overall expenditures incurred to develop the IP asset, and Z is the overall income from the IP asset.
The amount of income subject to tax benefits is proportional to the qualifying expenditures on substantial activities versus the total expenditures put toward developing the IP asset. Qualifying expenditures are defined differently depending on the jurisdiction, but they must have been incurred by the taxpayer as a means of completing R&D activities. Non-qualifying expenditures include “interest payments, building costs, acquisition costs, or any costs [indirectly] linked to [the] IP asset.” Non-qualifying costs are not factored into overall expenditures, except for IP acquisition costs. Overall expenditures include “all qualifying expenditures, acquisition costs, and expenditures for outsourcing that do not count as qualifying expenditures.” In effect, under the OECD’s nexus approach, all income derived from the IP asset will benefit from the preferential rate except in circumstances when a portion of the R&D was outsourced or acquired by the taxpayer.
3. Patent Box Regime in Québec
A. 2016 Patent Box
In 2016, the government of Québec introduced the “deduction for innovative manufacturing corporations” (DIMC), effective as of January 1st, 2017. The DIMC is the first patent box regime in the province, focused on promoting “the marketing and manufacturing in Québec of innovations designed by Québec businesses.” This regime lowered the tax rate from 11.8% to 4.0% for revenue from an eligible patent. Under the DIMC, a corporation may claim the tax deduction for up to 50% of the net income attributable to a patent from a qualified property. To be eligible, the patent must be held by a corporation established in Québec, be derived in whole or in part from R&D conducted in Québec and be issued under the Patent Act or an equivalent Act from another jurisdiction.
The DIMC was constructed very narrowly: it was only applicable to corporations that (1) engaged in manufacturing and processing activities accounting for at least 50% of all activities, (2) had $15 million in paid-up capital for the last taxation year, and (3) incurred $500,000 of R&D expenses.
B. 2020 Patent Box
As part of its 2020–2021 budget, the government of Québec introduced the “incentive deduction for the commercialization of innovations” (IDCI), effective as of January 1st, 2021. The IDCI provides that eligible revenue from the commercialization of intellectual property includes the sale or rental of goods, service delivery, royalties from concession, and revenue from litigation of the IP. These revenue streams will be taxed at an effective rate of 2% as opposed to the general corporate tax rate in Québec of 11.5%. To qualify for the deduction, a business must (1) be established in Québec, (2) commercialize eligible IP in the province, and (3) have incurred R&D expenses in Québec, which is consistent with the OECD’s “nexus approach.” Eligible IP refers exclusively to “software protected by copyright, patents, certificates of supplementary protection for drugs and plant breeders’ rights.” Like with the DIMC, under the IDCI regime, the government reserves the right to levy a special tax to reclaim a deduction that was falsely given, such as when a patent or eligible R&D work becomes invalidated within the year.
To foster innovation and commercialization in the province, the government is providing $333.7 million over six years, including $91.8 million for the introduction of the IDCI. Québec contends that with the introduction of the IDCI, businesses conducting R&D and commercializing IP in Québec will benefit from the most competitive tax rate in North America. For comparative purposes, the general combined tax rate on corporate income in Québec will be 17.0% with the IDCI, whereas the Canadian average is 26.5% and the US average is 28.2%.
The 2020–2021 Québec budget details how to calculate the IDCI deduction available for qualified innovative corporations.
IDCI = [ (A × (B/C)) - D] × E/F × G
There are three terms to multiply: (1) the profit of the qualified asset specifically attributable to the innovation, (2) a nexus ratio, and (3) a corrective calculation to reimburse a corporation as if it paid a tax rate of 2%.
The profit attributable to the innovation is calculated in two parts. First, the total net income of the qualified innovative corporation (A) must be multiplied by the percentage of the corporation’s gross income that came from the qualified asset (). Next, the value of D must be subtracted. Its value is either the larger of either 25% of the former calculation or 10% of a new term. The subtracted term (D) either sets 75% of an asset’s income as attributable to the protected innovation or a larger percentage if the corporation received a sufficiently small tax deduction from Québec for R&D.
The nexus ratio () is the ratio of the R&D expenditures of the eligible corporation in Québec as compared to expenditures in other jurisdictions. The nexus ratio follows the OECD’s requirement that sufficient R&D activities are carried out in the region in which the patent box applies.
C. 2016 vs 2020 Patent Box Regimes
The new tax benefit is more generous to innovative corporations than its predecessor. Both the IDCI and the DIMC were aimed at fostering an internationally competitive tax regime to incentivize R&D and the commercialization of IP in Québec. However, the IDCI’s tax rate is half the DIMC’s and allows for a significantly higher amount of product revenue to be deducted; there is a ceiling of 50% of product revenue in the DIMC compared to a floor of 75% in the IDCI.
Moreover, the DIMC requires $15 million in paid-up capital and half a million on R&D expenditures. It also narrowly defined what qualified as IP by limiting the tax credit to patents. On the other hand, the IDCI does not require any paid-up capital nor minimum R&D expenditure to qualify for the tax deduction, thus allowing start-ups and small businesses to obtain tax credits for their innovations. Additionally, the IDCI now broadens the definition of IP; not only are patents included, but so are certificates of supplementary protection for drugs, plant breeders’ rights, and software copyrights, which are functionally equivalent to patents. In this regard, Québec now casts a wider net for innovation incentives by reducing certain eligibility requirements for corporations and broadening the scope of what qualifies as IP.
The new nexus ratio is the only element of the IDCI considered more restrictive than those set out in the DIMC. Where the previous regime required a certain amount of local expenditure, the new one offers benefits to the corporate taxpayer that are proportional to its R&D presence in the province. The nexus ratio serves to anchor the benefits of this tax incentive by trading tax dollars for local innovation and commercialization.
The implementation of the nexus approach in Québec’s new patent box regime is consistent with the minimum standard set forth under Action 5 of the OECD’s BEPS Project. On its surface, the IDCI presents a seemingly straightforward set of requirements for a deduction. However, qualifying income derived from substantial activity becomes a contentious legal issue; one which may breed interpretative inconsistency. A substantial amount of litigation will be required to crystallize the definition of this term. Consequentially, time and money will be diverted from the ultimately desired outcomes: economic growth and product innovation. One proposed alternative to the patent box and its additional complexities is the reduction of the corporate tax rate. Some economists and tax scholars argue that a low corporate tax rate will better retain domestic businesses and drive economic growth and IP innovation.
See Relevant Weblinks:
 See Albert De Luca and Joanne Hausch, “Policy Forum: Patent Box Regimes – A Vehicle for Innovation and Sustainable Economic Growth” (2017) 65:1 Can Tax J 39 at 40–41.
 Ibid at 40.
 See Michael J Graetz & Rachael Doud, “Technological Innovation, International Competition, and the Challenges of International Income Taxation” (2012) 113 Colum L Rev 347 at 352.
 See Albert De Luca and Joanne Hausch, supra note 1 at 41.
 Ibid at 44.
 See Jason J Fichtner & Adam N Michel, “Don’t Put American Innovation in a Patent Box: Tax Policy, Intellectual Property, and the Future of R&D” (2015) at 2, online (pdf): The Mercatus Center at George Mason University <www.mercatus.org/system/files/Fichtner-Patent-Boxes-MOP.pdf>.
 See OECD, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (Paris: OECD, 2015) at 23.
 Ibid at 23–25
 Ibid at 23.
 Ibid at 24–25.
 Ibid at 24.
 Ibid at 25.
 Ibid at 27.
 Ibid at 28.
 See Québec, Finances Québec, The Québec Economic Plan – March 2016, (Québec: Finances Québec, 2016) at B.78 [Québec, 2016–2017 Budget]; Taxation Act, CQLR c I-3, ss 737.18.36–737.18.42 as it appeared on 13 October 2020.
 Québec, 2016–2017 Budget, supra note 18 at B.78.
 This was the effective general corporate tax rate in Québec in 2017 (see Revenu Québec, “Corporate Income Tax Changes” (16 April 2015), online: Revenu Québec <www.revenuquebec.ca/en/press-room/tax-news/details/100337/2015-04-16/>).
 See Taxation Act, supra note 18, s 737.18.41.
 RSC 1985, c P-4.
 See Taxation Act, supra note 18, s 737.18.36.
 See Québec, Government of Québec, Budget 2020–2021: Budget Plan, (Québec, 2020) at C.51 [Québec, 2020–2021 Budget].
 Ibid at C.53.
 Ibid at C.52.
 See Québec, Government of Québec, Budget 2020-2021: Additional Information, (Québec, 2020) at A.25 [Québec, 2020–2021 Additional Information].
 Québec, 2020–2021 Budget, supra note 25 at C.51.
 Ibid at C.53.
 Ibid at C.54.
 The new term is [B – ((A + H) x (B / C))]. It is the difference between the gross income from the relevant asset (B) and a new number obtained by adding the corporate net income (A) to the amount of relevant corporate R&D deductions (H) and multiplying by the percentage of the corporation’s gross income that came from the qualified asset (B / C). See Québec, 2020–2021 Additional Information, supra note 30 at A.22.
 Ibid at A.22–A.23.
 Ibid at A.23.
 See Québec, 2020–2021 Budget, supra note 25 at C.52.
 See Jason J Fichtner & Adam N Michel, supra note 7 at 3.
 Ibid at 4.