Italy addresses tax treatment of third-party payments under patent box rules

 By Gian Luca Nieddu, Partner Transfer Pricing & Tax Value Chain, Hager & Partners, Milan area

Italy’s tax authority on 24 April clarified the tax treatment under the patent box rules of contributions to research and development expenses made by a third party under a co-development and license agreement.

The applicant in the guidance, Risposta n. 120, is an Italian company active in the pharmaceutical industry which, in 2015, purchased the right to develop and exploit a patent concerning a molecule.

After the acquisition of the IP, the applicant signed a co-development and license agreement with another company. The agreement obliged the licensee to pay the applicant company, i.e., the licensor, a royalty fee for the right of exclusive use of the IP.

The agreement also required the licensee to pay the applicant company an additional amount (approximately three times higher than the envisaged royalty fee) to contribute to the applicant’s cost for IP development and obtaining regulatory approval.

The Italian company was solely responsible for the R&D activity and for obtaining regulatory approval.

Accordingly, the applicant asked the Italian tax authorities whether the development and regulatory contributions paid by the licensee are revenues eligible for the patent box calculations.

Recalling Circular Letter n. 11/2016 and the provisions of the Ministry of Finance Decree issued 28 November 2017, the Revenue – Central Directorate Office for Small and Medium Enterprises, clarified that the case concerns the indirect use of IP.

Therefore, royalty fees the applicant receives from the licensee for the exclusive use of the IP are eligible for the patent box regime. The applicant also bears all R&D expenses connected to the IP.

Focusing on the specific question submitted by the applicant, the Italian tax authority pointed out that an analysis must first address whether the proceeds received by the applicant are royalties for the use of an intangible asset or are compensation for a contractual or non-contractual liability for non-fulfillment or violation of property rights.

It is stressed that to determine the subsidized income, one must subtract from the eligible proceeds the tax-relevant costs directly and indirectly connected to them.       

Consequently, even if the Italian tax authority does not challenge the fundamental role of the IP and, if in the absence of it, no agreement would have reached, the development and regulatory contributions differ from mere IP licensing royalty fees. 

Under the agreement, therefore, the fees are classified as reimbursements and are thus not eligible for the patent box regime, the tax authority concluded.

Nexus ratio

The tax authority also clarified the calculation of the nexus ratio.

In general terms, the numerator equals the costs of research and development activities, relevant for tax purposes, incurred for the maintenance, growth, and development of the intangible asset.

The denominator consists of the overall costs, relevant for tax purposes, incurred to produce the intangible asset.

The numerator also includes costs relating to the relevant activities incurred by the beneficiary linked to a cost-sharing agreement, at least up to the proceeds constituted by the charge-back of the costs to the counterparties participating in a cost-sharing agreement.

In other words, the numerator of the nexus ratio represents eligible  R&D activities and includes the research and development directly conducted by taxpayer beneficiary of the patent box regime, or that the taxpayer has outsourced to independent service providers, or borne in the context of eligible intercompany relationships.

In the instant case, the development and regulatory contributions paid to the applicant benefit both the applicant and the licensee because the costs for IP development and regulatory affairs are for pre- and post-clinical protocols aimed at obtaining international authorizations which will be exploited not only by the applicant (the sole company to conduct the relating R&D activities and to bear the relating costs) but also by the licensee (due to the exclusive exploitation right granted by the agreement).

Therefore, the Italian tax authority concluded that, for purposes of the patent box, applicant company costs for the co-development project that are covered by licensee contributions can not be included in the nexus ratio calculation because the applicant company is not affected by research and development costs that also generate benefits for it.