Newsletter - Edition 28

Tax and IP Issues Arising from Current Government Thinking on Technology Transfer

Oxford Innovation Society Lecture, March 1999
Arthur Andersen & Garretts, Mr David Yeoward and Ms Caroline McCubbin

The Government is asking why Britain lags behind international competitors when it comes to translating the fruits of research into products and processes despite the UK's first class science base. This relatively poor position may be put down to a number of factors. However, it is important to appreciate the positive measures that have been taken by the Government to put in place a favourable environment for the support and exploitation of our research base and the importance of dealing carefully with intellectual property (IP) rights.

General IP Issues Raised by Technology Transfer

Academic culture encourages the free circulation of ideas and in fact the UK has approximately 10% of all world scientific journal citations. Companies, however, need to keep elements of potential IP confidential until they can be protected. Of course, the whole of the UK's higher education system, including the salaries of academics, are linked to publication record and, therefore, reconciling both standpoints is a fundamental issue which must be addressed to maximise the exploitation of research.

Efforts are also required to bridge culture gaps when technology transfer is carried out between all parties concerned. It is particularly important that younger academics understand how exploitation works and that more mature academics are supportive of commercialisation and, therefore, encourage that within their younger students. Despite the take off of exploitation within the past decade, commercialisation is still viewed by some as detraction from pure academic research.

It is also essential that IP issues are addressed at the outset of any technology transfer deal. There are frequent examples of parties to collaborative research proceeding on contradictory assumptions about the ownership of the rights over IP simply because these issues are not established at the outset.

Key IP Decisions Faced by Technology Transfer Professionals

The key decision faced by technology transfer professionals is what is the optimal exploitation path? This should be the subject of logical analysis and the two main options open would generally be either to license the technology out with a royalty stream back to the institution and apportionment of the royalty stream to the academic, or to form a new company into which the key IP will either be "assigned" (which is analogous to a sale) or licensed. Financial gain to the institution, academic founders and venture capitalists is usually then by way of the taking of an equity stake in the new company. Often the financing for the start up will come from several sources, such as business angels, venture capitalists and established pharmaceutical companies, who may all take equity stakes in the business.

Questions the Government is Asking

Within the document "Budget 98 Innovating for the Future", the Government was seeking consultation on the barriers which exist to research and development and technological innovation generally. Two of the issues explored within the consultation document are first, the ability of UK firms to access technology and the relationship between the science and engineering base and industry; and secondly, the relationship between IP and its protection and dissemination.

It can be recognised from the Government's consultation that first, IP rights are in fact the key to attracting finance and collaboration, being the main asset in the armoury of research institutions when it comes to exploitation. As regards finance when adopting the start-up company route, investors will be looking for management with a responsible and knowledgeable approach to IPR. There are numerous stark examples of the ramifications of failing to protect potentially protectable rights.

It is also essential at the outset to consider the proposed market for the technology and ensure that the IP rights underlying the technology is protected in each country in which the technology is to be marketed and sold.

The second observation that can be made is that although in the UK we have a good IP system, the mechanisms of IP protection are always in need of review since technology is always ahead of legislation. This is particularly so in the IT and biotechnology fields where our national legislation is continually being updated to reflect what comes out of Brussels.

The final observation relates to the benefits awarded to employee inventors under current legal provisions. At present, employees are given little additional incentives for their part in the innovation process and the creation of IPRs. Despite legislation introduced to compensate employees whose inventions resulted in outstanding benefit to the employer, awards of compensation are not made to employee inventors as frequently as they might. The purpose of the relevant provisions in the Patents Act 1977 was undoubtedly to encourage employees to play a more active role in the creation of IP rights but this has not occurred in practice resulting in the loss of opportunities for the economy as a whole. Having said this many Universities apportion royalties from licensing arrangements between the central administration of the University, the relevant department and the academic inventor(s).

Government Proposals to Date

Prior to the March 1999 Budget, the Government outlined its attempts to narrow the productivity gap between the UK and its competitors. The Government has, therefore, taken the vital first steps to enhance the science base and the economic value derived from it.

The Comprehensive Spending Review set out an additional £1.4 billion injection of funds to ensure that the UK continues to be world beating at generating research knowledge. Key aspects are:

A £600 million joint infrastructure fund endowed equally by Government and the Wellcome Trust for new equipment and buildings.
A proposed £25 million science enterprise challenge to endow up to eight new institutes for enterprise, bringing enterprise and business skills into the science curriculum.
The University Challenge Scheme, which aims to pull ideas with commercial potential out of the laboratory.
A review of the tax treatment of IP and royalties.
The creation of a "balanced IP rights system" to encourage investment and efficient means of disseminating information to widen the process of innovation.

These issues were considered further in the 1998 Competitiveness White Paper which deals with a whole area of creating and exploiting knowledge. Examples of the proposals include a national network of Faraday Partnerships building on the initial work of the Engineering and Physical Sciences Research Council (EPSRC); an increased contribution to the Teaching Company Scheme, together with increased funding for a SMART and Foresight LINK. The Government also recognises that both business people and scientists alike must build alliances across the world and to stimulate this the Government strongly backs UK participation in the European Union's framework programmes for research to ensure that UK businesses are able to exploit their research effectively. Finally the Government has proposed a specific IPR Action Plan with targets such as agreeing EC Directives on copyright and the information society, introducing a world wide system for electronic trading and IP, reviewing the impact of fees charged by the patent offices and pushing for a European Community patent.

Budget 1999

In the latest Budget the Government has also reiterated its backing of the exploitation of University science. Matters addressed include taxation measures, such as research and development credits and also stock options for people moving into high technology start-ups. The Government also announced incentives to encourage:

Large companies to invest in smaller ones by contributing management and capital at crucial stages.
An extra £100 million to the joint infrastructure fund; and
An extra £15 million to the University Challenge taking that fund value to a total of £65 million.

Current Government Thinking on Tax and Technology Transfer

In the 1999 Budget, the Chancellor announced that the Inland Revenue would produce a number of technical notes concerning budgetary reforms to promote innovation. These notes and the comments from interested parties will be collected over the summer and will then form part of the Budget 2000 Finance Bill.

The technical notes suggested a scheme of Research and Development tax credits designed to remove some of the barriers to investment that beset small and medium sized companies. It is aimed at those spending £50,000 or more each year on R&D. However, unlike Scientific Research Allowances, all R&D benefiting from the tax credit must be carried out in the UK and the company carrying out the R&D must be entitled to all rights in the results.

The expectation is that the tax credit would be set at 50% of current R&D revenue spending, defined as direct staff costs and the cost of consumables. Thus a company paying tax at the small companies rate of 20% would make a saving on their R&D spend (as defined) of 30% on cost. It is also proposed to extend the scheme to give assistance to the many companies who could benefit from this relief but are not making taxable profits.

The mechanics of the rebate are illustrated as follows: a company spending 100 on R&D would benefit from a further credit of 50. In order to establish the quantum of the rebate to which the company is entitled this spend plus credit is subjected to the small companies tax rate of 20% with the output discounted at 20% (the rate adopted in the technical notes) to give a repayment of 24 to be claimed through the company's self assessment return.

Corporate venturing relief has also been suggested in the technical notes and is designed to encourage better established companies to develop "mutually beneficial relationships" with smaller companies that show promise. This could give the investee company access to skills, knowledge or marketing facilities together with financial assistance whilst the venturer might get access to R&D being undertaken by the smaller company. The proposed scheme will deliver corporation tax relief at 20% to the investing company.

This relief may be made available for indirect investment through a venture capital fund. However, the Government is keen to discourage portfolio investments by financial institutions so the investor company must be a trader or a member of a trading group.

Also suggested in the technical notes is an Enterprise Management Incentive Scheme which is intended to help small companies with potential for growth to recruit and retain high calibre managers with a free-standing, flexible and easy to operate tax-advantaged share scheme. The particular target group for this incentive is managers in mature businesses with the expertise to take the smaller companies forward.

The tax aspects of the proposed scheme are designed to give key employees the opportunity to benefit from a capital gains tax rate as low as 10% depending on the size of the shareholding and the length of time the shares have been held. The relief would also remove the employers National Insurance burden at a time when money is likely to be tight and ensure that participating managers would not need to dispose of a tranche of their shares on exercise of their option to meet the associated tax bill.

The reform of the taxation of IP is widely acknowledged to be overdue. The system proposed will bring the tax system into line with the accounts as long as generally accepted accounting principles have been followed. It is expected that compliance costs would be reduced as a result of the greater certainty that taxpayers would enjoy from this reform.

The Inland Revenue has confirmed that any IP reform will not affect expenditure qualifying for 100% Scientific Research Allowances. This is obviously subject to any enhancement provided by the new regime of Research and Development tax credits.

The consultation has also looked at streamlining the rules governing royalties. The ideas which are being mooted, such as applying the deduction rule to all UK IP whether the transaction is of a capital or revenue nature would have the effect of dramatically extending the UK tax charge. It is suspected that taxpayers and their advisors will strenuously resist this sort of simplification!

There is obviously great potential for these initiatives to change between now and the next budget and Arthur Andersen and Garretts will certainly be making representations in a number of areas. However, these reliefs do represent a substantial incentive to innovation. For example, the interaction of Corporate Venturing and R&D tax credits has the potential to deliver tax savings of 50% whilst the Enterprise Management Incentive Scheme could deliver substantial benefits to risk takers in the growth businesses of the future