The Relationship Between Patents and Taxes

Patents and taxes play two fundamental roles in today’s economies, each shaping innovation, entrepreneurship, and economic growth. Both patents and taxes are critical elements of the business world and marketplace that can impact a company’s financial success. As a patent owner or applicant, it is essential to understand the intricate relationship between the two, specifically how tax policies intersect with patent strategies and influence economic outcomes.

Definitions – Patents and Taxes

A patent is legal protection for new inventions or innovations granted by the government (the United States Patent and Trademark Office, USPTO) that gives the patent holder exclusive rights to prevent others from producing, selling, or using the invention. These exclusive rights can be held for up to 20 years, depending on the type of patent, utility, design, or plant. For more information of the different types of patents, click each button:

Utility Patents

Design Patents

Plant Patents

The purpose of a patent is to encourage innovation and technological advancement through the granting of legal protections from the government to ultimately promote economic growth. This exclusivity of the rights granted incentivizes inventors to disclose their inventions to the public, thereby contributing to the pool of knowledge available for further innovation and development. With the facilitation of technological progression, comes economic growth, as companies and individuals invest in research and development across multiple different industries. Patents serve as both a reward and an incentive to inventors for their creativity and contribution to society.

Taxes are also a contribution to society; they are compulsory financial charges imposed by governments on individuals, businesses, or other entities to fund public expenditures and government operations. These financial levies are enforced by law, therefore failure to pay taxes as an individual or business entity will ultimately result in legal consequences such as financial penalties or in extreme cases, prison time. Simply put, taxes are financial contributions individuals and businesses are required to make in order to support government services and programs.

Taxes play a crucial role in financing public services and infrastructure, redistributing wealth, and achieving economic and social objectives. There are various types of taxes, including:

1. Income Taxes: Taxes levied on individuals’ or businesses’ income, including wages, salaries, profits, and other sources of earnings. Income taxes can be progressive (tax rates fluctuate in accordance to income levels) or flat (same tax rate applies regardless of income).
2. Corporate Taxes: Taxes imposed on the profits earned by corporations or businesses, varying across jurisdictions. Corporate taxes can have significant implications for business decisions such as investment, expansion, and capital allocation.
3. Property Taxes: Taxes assessed on the value of real estate or tangible assets, such as land, buildings, and vehicles. Property taxes are typically levied by local governments and are used to fund public services at the municipal or county level.
4. Sales Taxes: Taxes imposed on the sale of goods and services. Sales taxes can be levied at the point of sale (retail sales tax) or embedded in the price of goods and services (value-added tax).
5. Excise Taxes: Taxes imposed on specific goods or activities, such as alcohol, tobacco, firearms, gasoline, and luxury items. Excise taxes are often used to discourage consumption of certain products or to address externalities such as environmental pollution.
6. Capital Gains Taxes: Taxes levied on the profits earned from the sale of capital assets, such as stocks, bonds, real estate, or intellectual property. Capital gains taxes may apply to both individual and corporate taxpayers.
7. Payroll Taxes: Taxes withheld from employees’ wages or salaries to fund social insurance programs such as Social Security, Medicare, and unemployment benefits. Employers are also required to contribute to these programs on behalf of their employees.
8. Import and Export Duties: Taxes imposed on goods imported into or exported from a country. Import duties (tariffs) are intended to protect domestic industries and generate revenue for the government.

What is a Tax Patent?

A tax patent is a patent that claims a method or a system for reducing or deferring taxes. Prior to 201, and the implementation of the America Invents Act, a person could invent a new way of reducing or deferring taxes and potentially get a patent on the method or system to perform the new tax method. Tax patents are part of a group of patents called business method patents. These kinds of patents were often the subject of litigation. 

After the implementation of the America Invents Act, tax patents are effectively prohibited. Under the Leahy-Smith America Invents Act, Pub. L. No. 112-29, sec. 14(a). For purposes of evaluating an invention under section 102 or 103 of title 35, United States Code, any strategy for reducing, avoiding, or deferring tax liability, whether known or unknown at the time of the invention or application for patent, shall be deemed insufficient to differentiate a claimed invention from the prior art.

The Nexus between Patents and Taxes

Both patents and taxes are essential components of the business world, and understanding their relationship can be valuable to companies seeking to reduce their tax liability. The multifaceted nexus between patents and taxes creates a complex landscape that influences business decisions, investment strategies, and public policy.

Tax Implications of Patent Ownership

Patents are considered assets, therefore are subject to taxation. The tax implications of patent ownership are significant and can vary depending on several factors, such as the jurisdiction in which the patent is held, the amount and type of income generated from the patent, and the legal structure of the patent owner (individual, corporation, partnership, etc.). Understanding these tax implications is crucial for patent owners to effectively manage their intellectual property and optimize their financial position.

Patents have the ability to generate taxable income through several means including licensing fees, royalties, or proceeds from the sale of patented products or services. Taxable income is the portion of an individual or entity’s gross income that the IRS deems subject to taxes. The tax treatment of patent-related income may vary depending on the nature of the income (e.g., ordinary income, capital gains), the jurisdiction in which it is earned, and applicable tax laws.

The tax treatment of patent-related income may vary depending on the nature of the income (e.g., ordinary income, capital gains), the jurisdiction in which it is earned, and applicable tax laws. For example, profits derived from the sale of patents or the transfer of patent rights may be subject to capital gains tax. The capital gains tax is the levy on the profit that an investor makes when an investment is sold. When it comes to patents, capital gains tax rates may vary depending on factors such as the holding period of the patent (short-term vs. long-term, depending on when the patent was sold and when it expires) and the taxpayer’s income level.

Tax Deductions for Patent Expenses

On the other side of taxes are tax deductions. Patent expenses can be eligible for tax deductions, depending on jurisdiction. A tax deduction is an amount that an individual or entity can subtract from their taxable income to lower the amount of taxes owed. Expenses related to the patent application process, maintenance, enforcement, and defense of patents may be tax deductible for tax purposes, reducing the taxable income attributable to patents.

Patent expenses may include legal fees, filing fees, and further costs associated with patenting an invention such as designing a prototype, patent maintenance, and/or patent enforcement. Although it is possible to file a patent application pro se, it is likely patent applicants are working with a patent practitioner. Patent practitioner fees may be IRS qualified deductions. Depending on the practitioner, there are legal fees at every step of the patent application process. Carson Patents complete the patent application process in 5 broad steps: (1) prior art search; (2) patentability study; (3) patent application writing; (4) patent application filing; and (5) patent prosecution; For more information the approximate costs to patent an innovation, check out our patent cost estimates page.

Important Note: A prototype is not a requirement for the filing of a patent application at the USPTO. For more information, take a look at our reduction to practice article.

Carson Patents

Pass-Through Entity Taxes as Patent Holders

A pass-through entity is a type of business structure in which the income generated by the entity is not taxed at the entity level but instead “passes through” to the owners or shareholders. It is the responsibility of the owners or shareholders to report this generated income on their individual tax returns and pay taxes at their respective tax rates. Through this arrangement, business owners and shareholders only pay taxes on their personal income generated through this business and don’t have to pay additional corporate taxes for running the company. Pass-through entities are not subject to corporate income tax at the entity level, whereas traditional C corporations income is taxed both at the corporate and individual levels.

The most common business structures of pass-through entities are: (1) partnerships, (2) limited liability companies (LLCs), and (3) S-corporations. If a pass-through entity is holds any patents, the income generated from those patents should hold the same tax treatment as any other generated income of this business structure. Meaning, income generated from patents should be reported on the individual tax returns of the patent holder. If the patent is held by a business entity, the owners of the business entity is responsible for reported the generated income on their individual tax returns.

Foreign Patent Related Tax Considerations

When patenting inventions internationally, it’s crucial to consider foreign tax implications, as they can significantly impact the overall cost of obtaining and maintaining patents in multiple jurisdictions. Patent owners with international operations or patents held in multiple jurisdictions should evaluate the tax implications of cross-border transactions and income earned abroad. The tax treatment of patent-related costs and income can vary depending on the tax laws and regulations of each country, as well as any applicable international tax treaties, agreements, or regulations.

Tax Strategies for Patents

Businesses can use a variety of tax strategies to minimize their tax liability while simultaneously protecting their intellectual property. In some countries, tax incentives are provided to encourage the development and use of patented technology. This draws companies into their economy through the use of various tax strategies, which can include structuring patent-related transactions to maximize tax efficiency, taking advantage of available deductions and credits, and managing the timing of income recognition and expenses.

Patent Box Regimes

Patent box regimes provide a reduced tax rate on profits derived from patented technology. These regimes are currently available in several countries, including the United Kingdom, France, and the Netherlands. Patent box regimes are designed to encourage companies to invest in research and development and to locate their intellectual property in a particular jurisdiction. 

It is argued that patent box regimes can lead to base erosion and profit shifting, as well as jurisdictions competing to offer ever-lower tax rates in order to attract companies. Due to the increasing global scrutiny of patent box regimes in recent years, several countries have introduced or are considering reforms to limit the tax benefits that companies can receive from these schemes. 

Under a patent box regime, companies are typically able to benefit from a reduced tax rate on profits generated from their patented products and technologies. The exact tax rate and eligibility criteria vary by jurisdiction, but some countries offer a tax rate as low as 5% or 10% for qualifying intellectual property.

Transfer Pricing

The next strategy is transfer pricing, which involves allocate profits from patented products or technologies among different subsidiaries in different countries of a multinational corporation. To put it simply, it means setting prices for transactions between different parts of a company. A common tax strategy used by multinational corporations, by using transfer pricing a business can allocate profits to low-tax jurisdictions, reducing its overall tax liability.

An example of this would be when a multinational corporation holds a patent, and uses transfer pricing to allocate the profits from the sale of products incorporating the patented technology. The company may set a higher price for the sale of products in a high-tax jurisdiction, which would generate more profit in a lower-tax jurisdiction where the company has a subsidiary that holds the patent.

International Tax Planning

International tax planning is another important tax strategy for businesses with patents. As patents are often registered in multiple countries, companies need to consider how tax laws in each country may impact their overall tax liability. Companies may be able to take advantage of tax treaties between countries to reduce its tax liability. Using patents to reduce tax liability can become an issue if a company relies too heavily on their patents to reduce its tax liability. This may be perceived as engaging in tax avoidance or even tax evasion, which has legal and reputational consequences.

Case Studies

Several well-known companies have used patent-related tax strategies to their advantage. Apple has been accused of transfer pricing to allocate profits from high-tax jurisdictions to low-tax jurisdictions. One specific example is Apple’s use of an Irish subsidiary called Apple Operations International (AOI). AOI held intellectual property rights and received substantial amounts of income from Apple entities worldwide for the use of these assets. However, due to favorable tax arrangements in Ireland, AOI’s tax liability remained considerably low. This tax strategy allows companies like Apple to take advantage of the different tax rates and regulations in different countries, in order to minimize their tax liability.

In response to the tax avoidance allegations, Apple argues that it complies with tax regulations and requirements in the jurisdictions where it operates. The company contends that its subsidiaries’ profits in low-tax jurisdictions are a result of genuine economic activities, including research and development, manufacturing, and sales.

Pfizer is another multinational corporation who has employed a tax strategy when it comes to their intellectual property. Pfizer has utilized patent box regimes in countries such as the United Kingdom and Spain. Patent boxes are tax incentive schemes that allow companies to apply a lower tax rate to profits earned from intellectual property. In the United Kingdom, a patent box regime was introduced in 2013, offering a reduced corporate tax rate of 10% on profits from patented innovations. Pfizer took advantage of this, which has allowed the company to reduce its tax liability on profits generated from its patented products and technologies in the UK.

Pfizer has also benefited from Spain’s patent box regime, which offers a reduced tax rate of 12.5% on profits derived from intellectual property. The company has reportedly shifted profits from its Spanish subsidiaries to take advantage of this tax incentive.

Well-known tech company Samsung has also indulged in international tax planning strategies to reduce its overall tax liability. Samsung has been reportedly known to use transfer pricing, international tax planning, and royalty payments to minimize it’s tax liability. Some of their strategies involve transfer pricing, shifting their profits to subsidiaries located in countries with lower tax rates or tax incentives, in order to minimize the amount of taxes owed in higher-tax jurisdictions. Or the strategy of pricing goods and services exchanged between related companies at a level that may not reflect market prices, in order to allocate profits to lower-tax jurisdictions.