Innovation Boxes and Patent Boxes: Congress Is Focusing on Corporate Tax Giveaways, Not Corporate Tax Reform


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After weeks of hinting about an “innovation box” tax proposal, U.S. Reps. Charles Boustany, Jr. (R-LA) and Richard Neal (D-MA) Wednesday released draft legislation that would provide a massive giveaway for high-tech and pharmaceutical companies as well as other industries that generate income from patents and copyrights. The details of the legislation raise the very serious concern that the “innovation box” could be the tax break minnow that swallows the corporate income tax whale.

The legislation would create a special low tax rate of 10.15 percent for income generated by intangible property such as patents, trademarks and copyrights. This is nearly a three-quarters discount on the 35 percent federal income tax rate.

The big question is how much such a low tax rate would cost. As we have argued, the patent box concept is ripe for exploitation and abuse, for two reasons. First, the legislative process, with immense lobbyists influence, will likely expand the definition of “income from intangible property” beyond recognition, and second, sophisticated corporate tax departments are certain to seek ways of undermining the system by reclassifying  as much of their income as possible to qualify for this tax break.

The federal tax code is littered with examples of a simple concept that morphed into an administrative nightmare once it went through the legislative process. The most salient example is the special lower corporate tax rate for manufacturing. When lawmakers floated this tax break in 2004, the ostensible goal was to lower U.S. manufacturers’ taxes. But when the dust settled, the final law expanded the concept of “manufacturing” to include roasting beans for coffee (an early example of the lobbying clout of Starbucks) and film and television production. When policymakers initially began discussing the manufacturing tax break, few would have imagined that the Walt Disney Company  would reap more than $200 million a year in tax breaks for “manufacturing” animated films.

In the 10 years that the “manufacturing deduction” has been in place, the business world has changed in ways that were unimaginable in 2004, and so has the tax break’s reach. Open Table Inc. now annually collects tax breaks for “manufacturing” reservations at your favorite local restaurant.

 It is reasonable to conclude that the legislative sausage making process will similarly contort the definition of “intangible property”. Even those who think a properly-defined “innovation box” is a good idea may shudder at the product that emerges from Congress.

The second concern with the proposed “innovation box” tax break is how corporations might seek to game the system once such a box is in place. It would be very difficult to disprove the claim that a dollar of corporate profit is generated by the research and development that yields patents and copyrights. Corporate profit is the function of many economic forces, of which corporate R&D expenses are only one. When big pharmaceutical corporations claim that huge chunks of their U.S. profits are generated by their investments in intangibles such as trademarks, evaluating these claims will require a huge enforcement effort by the Internal Revenue Service—a vital branch of government that already is finding its enforcement abilities hampered by funding shortfalls.

This second problem—namely, the endless inventiveness of corporations in finding ways of gaming the system to reduce their taxes—may be the reason Congress’s official bean counters at the Joint Committee on Taxation have been unable to produce a revenue estimate on the cost of patent box legislation.

A third huge problem would be the mismatch between the 35 cents on the dollar that deductions for the costs of producing patents, etc. would provide to companies and the 10 cents on the dollar that the profits from such property would be taxed. In effect, the government would pay for 35 percent of the costs, but get back only 10 percent of the profits in taxes. That’s a negative tax rate.

Few would argue directly that the biggest corporate tax dodgers should get a special prize for their tax-avoidance efforts—yet the innovation box would provide huge windfalls for companies such as Apple and Microsoft that appear to have saved billions by artificially shifting their intangible property into low-rate tax havens. The focus of corporate tax reform should be, first and foremost, to make sure that corporate scofflaws are held to account and made to pay their fair share. An “innovation box” would instead offer a brand new tax break for these companies.

At a time when federal corporate income tax collections are near historic lows as a share of the U.S. economy, the unanswered questions about the direction and enforceability of the proposed “innovation box” tax giveaway should, alone, be enough to stop this idea in its tracks.

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