In January 2024, the Department of Finance released a consultation paper on a proposed patent box regime, aiming to tax income from certain intellectual properties (IP) at preferential rates lower than the current federal rate.

The consultation, which ran until April 15, sought feedback on seven key questions on the suitability of a patent box regime, and the appropriate design of such a regime if Canada were to adopt one. The potential adoption of a patent box initiative is designed to incentivize companies to conduct research and development (R&D) and commercialize their resulting IP within Canada.

The consultation paper acknowledges that Canada faces challenges in attracting and retaining IP. Notably, the paper mentions that businesses in Canada outlay more to entities in other countries for the use of IP than they receive from international sources for the same purpose. The government therefore hopes that implementing a proposed patent box regime could serve as a tool to boost R&D in Canada.

This regime would complement the government's commitment of $600 million over the next four years to enhance the Scientific Research and Experimental Development ("SR&ED") program. Additionally, the government has temporarily revised the capital cost allowance deduction rates of certain classes of property, now permitting full (100 per cent) deductions of costs related to patent investments, albeit with specific conditions and restrictions, all of which are further detailed in "New rules for deducting patent costs."

Patent box regimes in other jurisdictions

The concept of a patent box is not new. For example, the United Kingdom introduced a patent box regime in 2013, reducing corporate tax rates to 10 per cent on profits derived from patented inventions — substantially less than the standard corporate tax rate. Eligibility for this regime generally requires companies to actively hold and manage patents, and to segregate income specifically attributable to patented products to determine eligible profits. (See our guide to Doing Business in the UK)

Many other European countries, such as France, Belgium, Italy and Ireland, offer similar incentives.

Some Canadian provinces have already embraced the measure. In Québec, the Innovative Companies Deduction proposes a reduced corporate tax rate of two per cent on income derived from the commercialization of qualifying IP. In Saskatchewan, the Commercial Innovation Incentive offers a reduced corporate income tax rate of six per cent for 10 years on income derived from the commercialization of eligible IP, which can be extended to 15 years if the related R&D is conducted in Saskatchewan.

OECD BEPS project and its impact on patent box regimes

Canada's proposed patent box regime raises a key question:

Could a company strategically shift its IP ownership to a patent box jurisdiction to benefit from reduced corporate tax rates on its commercialization?

Consider the potential combined savings if the Government of Canada implemented the patent box regime at the federal level, and a company decided to commercialize its IP in Québec or Saskatchewan.

While the prospect of such tax savings sound enticing, any allocation of profits generated from the exploitation of IP must consider recent changes to global transfer pricing guidelines.

In 2013, the OECD released its Action Plan on Base Erosion and Profit Shifting ("BEPS") to address significant issues in the international tax landscape, primarily focusing on aligning profits with the location of economic activities. The BEPS project emerged in response to concerns that multinational entities ("MNEs") were exploiting gaps and mismatches in tax rules to artificially shift profits to low or no-tax jurisdictions where they had little or no economic activity.

Instead, the recent OECD guidance provides that profits should be aligned with the Development, Enhancement, Maintenance, Protection and Exploitation ("DEMPE") functions related to the IP. This principle impacts the patent box regime by requiring that profits follow the location where these DEMPE functions are performed and the associated risks are assumed.

From that perspective, the Government of Canada's consultation paper recognizes the importance for any proposed patent box regime to take into account BEPS principles, and specifically the outer limits of the "nexus approach." This approach stipulates that the benefits of an IP regime should be available only to taxpayers who have directly incurred qualifying R&D expenditures that are responsible for generating the IP income.

Therefore, in the absence of R&D activities in Canada, companies are unlikely to reap the full benefits of a federal patent box regime.

Future of R&D and patent box regime in Canada

Many MNEs currently operate in Canada under a "contract R&D" approach, where routine R&D activities are conducted in Canada, but the strategic management and direction of the MNE's R&D activities are performed by a related party in another jurisdiction. When the OECD principles are considered, it seems doubtful that a MNE which currently utilizes the contract R&D approach in Canada would migrate its higher value R&D functions, assets and risks to Canada to benefit from the preferential rates under the patent box regime.

However, a patent box regime would incentivize Canadian-based companies to continue and expand current R&D efforts in Canada to benefit from preferential rates. This could lead to increased R&D activities and retention of IP within Canada, aligning with the government's strategic goals.