This article discusses the reasons for intellectual property (patent) box regimes, the OECD Base Erosion and Profit Shifting measures intended to counter abuse of such regimes, the consequential changes effected by countries to their regimes and, finally, the effects of these changes and whether these regimes will survive. The following article appears in Bulletin for International Taxation journal, published by IBFD.

1. Patent Boxes: The Rise, the Change or the Fall?
This article discusses the reasons for intellectual
property (patent) box regimes, the OECD
Base Erosion and Profit Shifting measures
intended to counter abuse of such regimes, the
consequential changes effected by countries to
their regimes and, finally, the effects of these
changes and whether these regimes will survive.
1. Introduction
Over the last two decades, national jurisdictions world-
wide have come to realize that attracting international
business specializing in innovation as well as research and
development (RD) has allowed them to import vitally
important knowledge-based technologies and other
capital resources, as well as create new domestic markets
and expand into promising international markets.
Attracting international business that competes on inno-
vationandRDhelpsjurisdictionsbuilduptheirnational
competitive advantages as countries seek to stabilize their
economic development and secure steady employment
growth. In order to achieve these ends, countries have
systematically provided generous RD tax incentives to
investors. However, this general practice among countries
hasinevitablyledtoacuteharmfultaxcompetition,giving
risetoaninternationalracetothebottomfortaxrevenues.
This article endeavours to analyse the rise of the various
RD tax incentives introduced by countries to stimu-
late economic growth and discuss relevant criticisms of
such RD tax incentives for giving rise to international
harmful tax regimes. The article focuses on the initiatives
taken by the G20 and the OECD, together with the Euro-
pean Union, to address the counterproductive repercus-
sions that the increased leniency of national tax regimes
may have on international stability of revenues and profit
shifting. It especially concentrates on the Action Plan1
of
the OECD/G20 Base Erosion and Profit Shifting (BEPS)
initiative, with the aim of deciding whether these policy
measures will have a serious effect on the survival pros-
pects for these potentially harmful tax regimes. Despite
any evidence to the contrary, the article maintains that
tax incentives should be maintained constructively with
regard to the policy discourse on international business
and taxation, with enhanced attention being given to
issues of real economic substance, thereby establishing a
nexus between the development of the valuable intangi-
bles and their exploitation.
* BSc (Econ.), FCA, ADIT and MSc Tax (Oxon), and International
Tax Transfer Pricing Partner at Taxatelier Ltd, Cyprus. The
author can be contacted at ctheophilou@taxatelier.com.
1. SeeOECD,Action Plan on Base Erosion and Profit Shifting(OECD2013),
Primary Sources IBFD, also available at www.oecd.org/ctp/BEPSAc
tionPlan.pdf.
2. RD Tax Incentives and Tax Policy
2.1. Categories of RD tax incentives
2.1.1. Opening comments
RD has been clarified as “work undertaken on a sys-
tematic basis to increase the stock of knowledge, includ-
ing knowledge of man, culture and society, and the use of
this stock of knowledge to devise new applications”.2
In
practice, RD can be classified into the following three
subcategories: (1) basic research; (2) applied research; and
(3) experimental development. Normally, the RD value
chain commences with the early stage of deliberation to
create ideas, i.e. basic and applied research, and progresses
to the development of valuable intangible assets, such as
copyrights, patents and trademarks.3
Having said that,
basic and applied research can generally be considered to
be riskier than experimental development if the ensuing
financial returns are taken into account.4
In addition,
RD tax incentives are provided either as “incremen-
tal-based”, i.e. the tax benefit is provided to the additional
amount of RD expenses incurred, or “volume-based”,
i.e. the tax benefit is provided to the whole amount of the
RD cost of each year, where the latter might be consid-
ered to be costlier, in terms of foregone tax revenue, and
less effective compared to the former. In contrast to the
United States, most international jurisdictions prefer to
legislate for volume-based tax incentives, both in terms
of simplicity and in avoiding the stop-and-go distortion
of the incremental schemes.5
Finally, RD tax incentives
can be effectively categorized into “input” and “output”
tax incentives (see sections 2.1.2. and 2.1.3., respectively).
2.1.2. Input tax incentives
Essentially, input tax incentives refer to the actual costs
incurred on both current expenditure and capital expen-
diture, with capital expenditures being less important
than current expenditures, as the former typically repre-
sent only 10% to 13% of business expenditure.6
In particu-
lar, current expenditure is incurred largely on labour and
supplies relating to RD activities.7
On the other hand,
output tax incentives broadly refer to the income side and
2. OECD, Frascati Manual 2002: Proposed Standard Practice for Surveys
on Research and Experimental Development p. 30 (OECD 2002).
3. P. Palazzi, Taxation and Innovation, OECD Taxn. Working Paper No.
9, p. 6 (OECD 2011).
4. S.E. Shay, J.C. Fleming R.J. Peroni, RD Tax Incentives: Growth
Panacea or Budget Trojan Horse?, 69 Tax L. Rev. 3, p. 444 (2016).
5. I. Guceri L. Liu, Effectiveness of fiscal incentives for RD: quasi exper-
iment evidence, Working Paper Series (Oxford U. Ctr. Bus. Taxn., 2015),
available at http://eureka.sbs.ox.ac.uk/6284/1/WP1512a.pdf.
6. Shay, Fleming Peroni, supra n. 4, at p. 428.
7. I. Guceri, Tax incentives for RD, ETPF Policy Paper p. 11 (Oxford U.
Ctr. Bus. Taxn. 2016), available at www.etpf.org/papers/PP005Incent.
pdf.
European Union/OECD/International Christos A. Theophilou*
286 Bu l l etin for In tern ation a l Ta x ation May 2019 © IBFD

2. are provided during the exploitation phase of the intellec-
tual property (IP).
From the end of the 20th century onwards, countries have
introduced various tax incentives on the cost side using
three different methods. First, a tax system can provide an
accelerated or even full allowance in respect of a capital
RDassetthatwouldotherwisehaveresultedfromcapital
asset depreciation based on its useful life. Consequently,
the accelerated depreciation reduces the tax base in the
early years. Second, a super deduction or extra allowance
may be provided on the RD cost incurred – usually on
current expenditures – such as, for example, 60% more
than the actual cost, thereby shrinking the tax base. Third
and finally, a tax credit may be provided to reduce the tax
payable, which is commonly provided by states in respect
of current expenditure.8
In effect, tax credits constitute
a more preferable tax policy tool compared to enhanced
allowance, as, if there is a change in tax rates, tax credits
remain the same, whereas enhanced allowance gives rise
to a proportionate change in the tax base.9
Moreover, tax
credits are more attractive to start-ups and small and
medium-sized enterprises (SMEs), which have high cash
needs, compared to multinational enterprises (MNEs),
which have better access to finance and substantial profits
within the group to utilize any losses.
2.1.3. Output tax incentives
Incontrast,outputtaxincentiveshavebeenintroducedby
many countries to encourage the full exploitation of the
newly created valuable intangibles and to attract foreign
mobile capital. In this respect, many European countries
have introduced IP box regimes,10
in respect of which the
design varies from country to country. As a result, differ-
entiated IP box regimes can reduce the taxes payable on
the licence income received by the owner of the IP, either
by diminished tax rates or contracted tax bases, causing
theeffectivetaxrates(ETRs)todiffergreatlyamongcoun-
tries, such as in the case of the ETRs in Malta and France,
which are 0% and 15.5% respectively.11
In addition, these
regimes also vary in terms of eligibility of the intangible
assets that states can include in their IP box regimes. In
the case of the Netherlands and the United Kingdom, for
example, IP box regimes are limited to patents, whereas
in other countries, like Cyprus and Luxembourg, these
regimesextendaddedbenefitstomarketingintangiblesas
well. Furthermore, some countries, such as Luxembourg
and the United Kingdom, extend benefits to notional roy-
alties,whereasotherslimittheirbenefitstoroyaltyincome
only. Finally, some countries, like Belgium and the Neth-
8. R. Vlasceanu, Chapter 8: Intellectual Property Structuring in the Context
of the OECD BEPS Action Plan, in International Tax Structures in the
BEPS Era: An Analysis of Anti-Abuse Measures sec. 8.3.3., p. 238 (M.
Cotrut et al. eds., IBFD 2015), Books IBFD.
9. R.J. Danon, General Report, in Tax incentives on Research and Devel-
opment (RD), International Fiscal Association (IFA), Cahiers de droit
international vol. 100A, sec. 3.1.3. (IFA 2015), Books IBFD.
10. Which are also referred to as innovation box, patent box, licence box
and knowledge box regimes.
11. P.Evers,H.MillerC.Spengel,Intellectual Property Box Regimes: Effec-
tive Tax Rates and Tax Policy Considerations, 22 Int. Tax Pub. Fin. 3,
p. 6 (2013).
erlands, have limited their benefits to self-developed IP
assets, while others, such as Cyprus and Luxembourg,
have extended benefits to acquired IP assets.
2.2. Tax policy considerations on RD tax incentives
Following Adam Smith’s paradigm regarding simplicity,
efficiency, equity and neutrality for a “good tax system”,
James Mirrlees recommended that tax policymakers
introduce viable tax incentives into their policy consid-
erations so as to realize sustainability in respect of the
proposed metamorphosis of tax governance.12
Remem-
bering that RD activities are generally not undertaken
by all taxpayers, it appears that any related tax incentives
would not promote a sustainable tax system by adhering
to Adam Smith’s principles, in particular, equality and
ability to pay. Moreover, some might argue that RD tax
incentives can result in business decisions that disregard
the concept of neutrality, which, in turn, may change neg-
ative present value projects to positive ones, giving rise to
distortions in a tax system.13,14
Tax policymakers may also be tempted to subsidize RD
activities and use other related tax policy tools to stimu-
late innovation and foster growth and productivity. The
main reason for this practice is that countries may be
more willing to support these kinds of projects as they
have positive rent or knowledge spillovers and produce
other increased social benefits.15
Unlike governments,
companies underinvest in RD projects whose returns
arelowerthancosts,astheydonotseemtocareifthereare
social benefits and positive spillovers in these activities.16
In addition, SMEs and start-ups that invest in innovation
tend to face higher interest rates and more limited access
to capital, compared to large MNEs, due to possible asym-
metricinformationincapitalmarketsandmarketfailures.
Accordingly, countries may seem more willing to support
projects, where SMEs and start-ups would not, that have
positive externalities and spillover effects by providing
RD tax incentives.17
As a result, the private sector might
undertake projects with a higher social rate of return, as
the tax incentives would make the project profitable. Sim-
ilarly, as IP is highly mobile, RD tax incentives can also
attract foreign investment in the local economy, increas-
ing foreign direct investment and innovation.18
Recently, the RD tax incentives provided by some gov-
ernments have been the subject of severe criticism. To
begin with, it appears to be very difficult to quantify the
marginal spillover effects with regard to the marginal cost
needed to subsidize the project due to the limited access
to data available by companies for the companies to be
12. Å. Hansson C. Brokelind, Tax Incentives, Tax Expenditures Theories
in RD: The Case of Sweden, 6 World Tax J. 2, sec. 1. (2014), Journal
Articles Papers IBFD.
13. Danon, supra n. 9, at sec. 2.1.1.
14. Evers, Miller Spengel, supra n. 11, at p. 19.
15. Shay, Fleming Peroni, supra n. 4, at p. 441.
16. Guceri, supra n. 7, at p. 3.
17. Palazzi, supra n. 3, at p. 48.
18. P. Arginelli, Innovation through RD Tax Incentives: Some Ideas for a
Fair and Transparent Tax Policy,7WorldTaxJ.1,sec.3.3.(2015),Journal
Articles Papers IBFD.
287© IBFD Bu l l etin for In tern ation a l Ta x ation May 2019
Patent Boxes: The Rise, the Change or the Fall?

3. willing to undertake a project.19
Furthermore, RD tax
incentives may be poorly targeted, leading to the subsidiz-
ing of RD activities that would have been undertaken
anyway and resulting in “substitution”.20
In addition, IP
assets, being highly mobile, have been used extensively by
MNEsfortaxplanningpurposestoshiftprofitstolow-tax
jurisdictions and effectively pay less tax.
In contrast, though, it is widely accepted that long-term
tax incentives compared to short-term tax incentives tend
to produce higher social benefits and positive spillovers,
especially in the early stages of SMEs, resulting in coun-
tries being generous in providing benefits in respect of
RD tax incentives.21
Consequently, policymakers need
to assess and increase the possibility for providing RD
tax incentives on RD activities where the social benefit
is greater compared to the private benefit.22
2.3. Input and output tax policy choices and IP tax
incentives
There are many reasons countries use tax incentives to
promote RD. First, input tax incentives can be easily
traced, as they can be quantified based on the costs
incurred in respect of RD activities, thereby ensuring
that they directly reduce the expected rate of return on
a given investment. As a result, input tax incentives are
assumed to be simple and effective tax policy tools.23
On
the other hand, in terms of efficiency, input tax incen-
tives are not always easy to quantify, as it is difficult to
assess their effect on subsidized projects because these tax
incentivesmayormaynotinfluenceinvestmentdecisions,
depending on business circumstances.24
Moreover, input
tax incentives may be poorly targeted, as they are likely
to be provided in respect of research projects, especially
in relation to basic research, regardless of their ultimate
success. In practice, positive spillovers may not necessar-
ily be realized, which, in turn, may increase the prospect
of inefficiency in providing input tax incentives. In addi-
tion, input tax incentives are not as effectively construc-
tive in relation to successful IP assets, as output tax incen-
tives are normally granted to successful IP assets (ex post).
Furthermore, especially in EU Member States, companies
may realize higher returns, as they can successfully claim
tax input incentives on RD expenditure twice, double
dipping in respect of RD costs, due to weak coordina-
tion among the EU Member States.25
Second, as SMEs are likely to have limited access to capital
markets and, therefore, be liable to higher interest rates in
respectofloanscomparedtolargeMNEs,inputtaxincen-
tives can be used by SMEs to increase cost efficiencies and
strategic effectiveness. In particular, refund tax credits,
in cash or to be set off against other taxes, such as social
insurance taxes or VAT, can enhance the cash flow posi-
19. Hansson Brokelind, supra n. 12, at sec. 4.1.
20. Id., at sec. 4.2.
21. I. Guceri, supra n. 7, at p. 22.
22. Shay, Fleming Peroni, supra n. 4, at p. 446.
23. Arginelli, supra n. 18, at sec. 4.3.1.
24. Hansson Brokelind, supra n. 12, at sec. 4.2.
25. Danon, supra n. 9, at sec. 3.4.
tion of SMEs in the early stages of RD activities, where,
typically, SMEs do not realize profits.26
Nevertheless,
especially in the European Union, Member States might
face State aid investigations, as the provision of input tax
incentives can be regarded as selective, both by providing
incentivestoaparticularclassoftaxpayersorbyproviding
them with attractive refunds on their taxes.27
Third and finally, input incentives are generally provided
to companies that only internally develop IP assets and
not in respect of developing specialized RD research
centres that indirectly pass on the knowledge to compa-
nies when the RD is outsourced.
On the output side and, in particular, in relation to IP
box regimes, countries tend to provide tax incentives for
the exploitation of newly successful innovative IP assets,
as there are also positive external spillover effects outside
the company and into the general economy.28
Having said
that, studies have demonstrated that, even if an IP has
developed outside a country either by being acquired or
contracted out, that IP may be internally exploited, giving
rise to increased productivity and growth and resulting
in positive spillovers by exploiting further innovative IP
assets.29
Another advantage is that IP box incentives are
less risky, as they are only provided to successful IP assets,
therebysavingtime.Inthiscontext,itshouldbenotedthat
countries have introduced IP box regimes for a number
of reasons. First, to attract foreign investment to their ter-
ritories so as to increase tax revenue. Second, by attract-
ingforeigninvestments,whichincreasesemploymentand
growth,suchcountriesattractfurthernewinnovativeand
knowledgeIPbusinesses,whosepositiveexternalitiesspill
over into the country. Third and finally, to deter domestic
IP businesses from transferring these activities from one
country to another.30
Nonetheless, IP boxes have been criticized extensively
for being an ineffective tool and, therefore, less effec-
tive compared to input tax incentives in promoting RD
for a number of reasons. First, IP box regimes increase
administration burdens and overall complexity for both
taxpayers and tax administrations, as they have to adopt
new necessary standards. Second, it is most likely that
IP box regimes will result in a loss of revenue because a
reduction in either tax rates or the tax base may be sig-
nificant in respect of a national economy. (A study in the
United Kingdom revealed that, as at June 2010, there was
a loss of revenue amounting to GBP 1.1 billion a year.)31
Third, IP box regimes tend to be poorly targeted, as ben-
efits are granted to new successful IP assets that would be
exploited anyway, giving rise to inefficiencies in innova-
tion. Fourth and finally, IP box regimes tend to increase
26. A.Fairpo,Taxation of Intellectual Property4thedn.,p.182(Bloomsbury
Prof’l 2016).
27. Hansson Brokelind, supra n. 12, at secs. 2.3.-4.
28. Id., at sec. 4.
29. Arginelli, supra n. 18, at sec. 3.3.
30. Id.
31. Evers, Miller Spengel, supra n. 11, at p. 2.
288 Bu l l etin for In tern ation a l Ta x ation May 2019 © IBFD
Christos A . Theophilou

4. tax competition among countries, creating a race to the
bottom regarding tax revenues.32
That being said, many IP box regimes, which have been
introduced, do not require any substance and RD activ-
ities in the residence state. In addition, MNEs tend to cen-
tralize their IP assets in an IP holding company for their
effective administration.33
Consequently, MNEs tend to
structure their activities, on the one hand, by placing their
IP assets in a low or no-tax jurisdiction, usually one with
an extensive treaty network so as to reduce the withhold-
ing tax paid on royalties in the source jurisdiction and,
on the other hand, by locating their RD activities in a
high-tax jurisdiction. As a result, the income in the low or
no-tax jurisdiction remains untaxed, while the expenses
in the high-tax jurisdiction result in a greater reduction
of the tax base compared to a low-tax jurisdiction. MNEs
have often been accused of using aggressive tax planning
structures such as the “double Irish with a Dutch sand-
wich” structure or a Luxembourg IP holding company
interposed with back-to-back licensing arrangements to
realize their aims, such as base erosion and profit shift-
ing.34
3. IP Boxes, the OECD and the European Union
3.1. Introductory remarks
Following the negative publicity attracted by MNEs such
as Apple, Google and Starbucks for not paying their “fair
share” of tax, the G20 authorized the OECD to suggest
measures to counter tax planning schemes. In response,
theOECD,incollaborationwiththeEuropeanUnion,has
developed the BEPS Action Plan in respect of the OECD/
G20 BEPS initiative and, in October 2015, introduced 15
Actions that “should provide countries with domestic and
international instruments that will better align rights to
taxwitheconomicactivity”.35
Specifically,theOECD/G20
BEPS initiative does not deal with input tax incentives
but, rather, further extends its scope to harmful tax plan-
ning schemes, thereby focusing especially on IP structur-
ing. Accordingly, these measures can essentially be either
domestic or treaty anti-avoidance rules.
3.2. The “nexus approach” and the new substance
requirements under Action 5 of the OECD/G20
BEPS initiative
3.2.1. The proposed new substance requirements
Action 5 of the OECD/G20 BEPS initiative revamped the
OECD’s work in the Report on Harmful Tax Competi-
tionof1998,36
whichproposedthatthesubstantialactivity
requirement is one of the key factors in deciding whether
a regime may be considered to be potentially harmful.37
32. R. Griffith, H. Miller M. O’Connell, Corporate Taxes and Intellectual
Property: Simulating the Effect of Patent Boxes, Inst. Fiscal Stud., Brief-
ing Note 112 IFS (2010), available at www.ifs.org.uk/bns/bn112.pdf.
33. Fairpo, supra n. 26, at p. 420.
34. Vlasceanu, supra n. 8, at sec. 8.2., pp. 225-229.
35. OECD, supra n. 1, at p. 11.
36. OECD, Report on Harmful Tax Competition (OECD 1998).
37. OECD, Action 5 Final Report 2015 – Countering Harmful Tax Practices
More Effectively, Taking into Account Transparency and Substance p. 23
Effectively, the OECD proposed the “nexus approach”,
which, in essence, provides that, for an IP box scheme to
apply, there would have to be a nexus and economic sub-
stance in the residence state that provides the regime, on
the one hand, and the RD activities giving rise to the
relevant IP in the same state, on the other.38
Moreover, it
would take into consideration expenditure that related to
any input RD activities in measuring these activities. In
particular, a “nexus ratio” would be used to calculate the
income receiving the tax benefit, which would be equal
to [(qualifying expenditure + up-lift expenditure)/total
expenditure]×overallIPincome.39
Suchasituationwould
ensure that income from the exploitation of the IP, such as
royaltyincome,wouldhaveadirectlinkwithRDexpen-
ditures incurred on that particular IP, as the latter would
beusedtocalculatetheformer.Inbrief,thisincomewould
be considered to be non-harmful and ensures that coun-
tries with such regimes would use to stimulate the devel-
opment of new IP assets and not to attract highly mobile
IP resulting in harmful tax competition.
Entitlement would also limited to “qualified assets”, i.e. IP
assets and patents, which would be “functionally equiv-
alent to patents”, excluding marketing IP assets, such as
trademarks.40
In this way, expenses would be limited to
“qualifying expenditure”, which would be first expenses
incurred only by the taxpayer, which would be directly
connected to the IP asset, and second, expenses incurred
by outsourcing to unrelated parties. Nevertheless, a 30%
“up-lift” would be permitted under this formula.41
Finally,
the burden of proof would lie with the taxpayer in calcu-
lating the income correctly and the tax administration
in verifying such a proof, as the proof would treated as a
rebuttable presumption.42
3.2.2. Evaluation of the nexus approach
The “nexus approach” has numerous results. First, prior
to the OECD/G20 BEPS initiative, IP box regimes had
been criticized as not encouraging taxpayers, in partic-
ular SMEs, to develop new innovative IP assets and for
beingavailableforacquiredintangiblesorintangiblesthat
existed before the IP regimes were introduced.43
With the
nexus approach, all of these deficiencies would be reduced
significantly, as there would have to be a direct nexus
between the RD activities incurred by the taxpayer and
the IP income. As a result, it would be difficult for an IP
asset to be transferred to a low-tax jurisdiction. In addi-
tion, if an IP asset were moved to such jurisdiction so as
to be eligible for benefits, it would have to undertake RD
activities in that country in relation to that IP.44
Similarly,
(OECD 2015), Primary Sources IBFD [hereinafter the Action 5 Final
Report (2015)].
38. Id., at p. 24.
39. Id., at p. 25.
40. Id., at p. 26.
41. Id., at p. 27.
42. Id., at p. 35.
43. See sec. 2.
44. P.Arginelli,Chapter5:TheInteractionbetweenIPBoxRegimesandCom-
pensatory Tax Measures: A Plea for a Coherent and Balanced Approach,
in EU Law and the Building of Global Supranational Tax Law: EU BEPS
and State Aid sec. 5.4.1., p. 109 (D. Weber ed., IBFD 2017), Books IBFD.
289© IBFD Bu l l etin for In tern ation a l Ta x ation May 2019
Patent Boxes: The Rise, the Change or the Fall?

5. in relation to tax planning techniques used by MNEs, if
the location of the IP assets differed from the country in
which the RD activities were carried out, typically con-
tracted out to related parties, there could be a ceiling of
30% on the uplift on the expenses incurred by the related
party.45
On the contrary, with regard to IP box regimes that were
compliant with the OECD/G20 BEPS regimes, simplic-
ity would be undermined for the taxpayers, especially
because every year such taxpayers would be required to
calculate the income qualifying for the tax benefit and
keeptrackofallyearscumulatively,i.e.thenexusapproach
would be an additional approach.46
In a similar vein, sim-
plicity would be reduced for tax administrations, which
would also have to review and monitor these calculations
annually. Accordingly, in order to be efficient, the posi-
tive spillovers, together with any increase in tax revenue,
would have to be higher than the administration costs
and any loss of revenue from the existing regimes com-
bined. Equally, problems would arise in terms of how to
ascertain that the income exploited was directly linked
to RD expenditure.47
A similar deficiency would tend
to arise, as the nexus approach focuses on the output
side rather than on the input side, thereby following the
merits of volume-based incentives as opposed to incre-
mental-based incentives (see section 2.1.). In addition, the
nexus approach would remain inefficient in relation to
SMEs incurring RD expenditure, as it would be an out-
put-based rather than an input-based approach.
Second, IP box regimes before the OECD/G20 BEPS ini-
tiative, particularly those that did not require any sub-
stantial or economic activity to be undertaken in a res-
ident state, were criticized for not deterring domestic IP
assets from relocating to another jurisdiction or attract-
ing foreign RD activities.48
On the contrary, IP box
regimes that would comply with the OECD/G20 BEPS
initiative, would counter, in general, the relocation of
domestic RD activities to a foreign jurisdiction, as the
IP exploitation income would be restricted by the nexus
ratio that would require a link between the RD activi-
ties and the creation of the IP asset to be exploited. Simi-
larly, the nexus approach would retain the RD activities
and the IP asset exploitation in the same country, permit-
ting countries with generous RD tax incentive regimes
to attract investments to their jurisdiction. As a result,
the 30% uplift in the nexus approach would make it more
flexible and attractive to outsource some RD activities,
such as basic research, which might not be the case in the
resident state.
Third, another reason that pre-BEPS IP box regimes
were introduced by policymakers was to attract foreign
IP assets that would be exploited domestically, stimulat-
ing the direct use of IP assets. As studies have indicated,
this would tend to increase knowledge-based capital and
45. OECD, Action 5 Final Report (2015), supra n. 37, at p. 27.
46. Id., at p. 29.
47. Arginelli, supra n. 44, at sec. 5.3.2., p. 106.
48. See sec. 2.
spillovers in the residence state.49
Notably, nexus compli-
ant IP box regimes would not apply in relation to newly
created and then acquired IP assets, as the nexus ratio
would restrict the income giving rise to the benefit.
Fourth and finally, policymakers introduced IP box
regimes before the OECD/G20 BEPS initiative to attract
mobile capital, increasing tax revenue and enhanc-
ing growth in specific service sectors, such as the pro-
vision of services by accountants, bankers and lawyers.
This situation is particularly relevant to countries with
small internal markets that are ring-fenced. In contrast,
in larger markets that are not ring-fenced, the revenue
forgone from reducing the ETRs on existing businesses
could be significantly higher compared to any additional
tax revenue that might derive from attracting new and
mobile foreign capital.
3.3. Other protective tax measures for IP box regimes
3.3.1. Controlled foreign company rules and Action 3 of
the OECD/G20 BEPS initiative
In principle, Action 3 of the OECD/G20 BEPS initiative,
which consists of six building blocks, would effectively
strengthen controlled foreign company (CFC) rules.50,51
Normally, CFC rules require the resident state to tax
undistributed profits derived in the source state where
the latter has a significantly lower ETR, such as an IP box
regime, sheltering the profits realized there. In this sense,
despite the fact that IP box regimes could easily meet the
low-tax threshold requirement, certain exceptions could
be applied in relation to widely agreed international stan-
dards, such as nexus compliant IP box regimes. Similarly,
the Anti-Tax Avoidance Directive (2016/1164)52
has rec-
ommended the implementation of CFC rules in all of the
Member States, which, in general, are similar to those
proposed in Action 3. However, the Anti-Tax Avoidance
Directive (2016/1164) includes a carve out provision that
makes the CFC rules inapplicable when the CFC in ques-
tion“carriesonasubstantiveeconomicactivitysupported
by staff, equipment, assets and premises, as evidenced by
relevant facts and circumstances”,53
which effectively is a
similar requirement of a nexus compliant IP box regime,
and means that article 7 of the Anti-Tax Avoidance Direc-
tive (2016/1164) only restrictedly applies in the European
Union.54
In contrast to the Member States, this rule does
not apply to third countries that permit their tax author-
ities to tax royalty income, even if there is substantial eco-
nomic activity.
49. Id.
50. OECD, Action 3 Final Report 2015 – Designing Effective Controlled
Foreign Company Rules (OECD 2015), Primary Sources IBFD.
51. Arginelli, supra n. 44, at sec. 5.6., p. 126.
52. Council Directive (EU) 2016/1164 of 12 July 2016 Laying Down Rules
against Tax Avoidance Practices that Directly Affect the Functioning
of the Internal Market, arts. 7 and 8, OJ L 193 (2016), Primary Sources
IBFD [hereinafter the Anti-Tax Avoidance Directive (2016/1164)].
53. Id., at art. 7.
54. Arginelli, supra n. 44, at sec. 5.6., p. 124.
290 Bu l l etin for In tern ation a l Ta x ation May 2019 © IBFD
Christos A . Theophilou

6. 3.3.2. The transfer pricing effect of Actions 8-10 of the
OECD/G20 BEPS initiative
Another area that invites serious contention is the con-
troversial issue of IP ownership and IP income entitle-
ment that is addressed in Actions 8-10 of the OECD/G20
BEPS initiative.55
The aim of Actions 8-10 is to ensure
that the transfer and use of IP between related parties are
properly allocated in line with value creation. Effectively,
Actions 8-10, among other things, provided guidance on
the definition of intangibles and, therefore, would try to
giverisetocertaintyforbothtaxpayersandtaxauthorities
by uniformly using a cross-border definition of what con-
stitutes intangibles. Furthermore, the ownership of the
intangibles would not be limited to the legal owner, but
could also be assigned to the economic owner. Accord-
ingly, the owner of the intangible, whether the legal or
economic owner, could be entitled to IP income depend-
ing on a functional analysis for assets used, risk assumed
and functions performed. In the context of such a func-
tional analysis, with regard to IP, for an entity to be enti-
tled to IP income, the entity should have the “financial
capacity” to assume the risks and at the same time be in
a position to bear and control those risks associated with
thedevelopment,enhancement,maintenance,protection,
and exploitation (DEMPE) functions.56
Consequently,
for example, in an extreme case, it could be assumed
that an entity that is the legal owner of an IP asset has
licence income from its related entities. It could further
be assumed that such an IP entity does not perform any
functions to control risks or have the financial capacity to
assume those risks and, therefore, is only entitled to a risk-
free rate of return. As a result, it appears to be likely that
taxpayersarrangeboththeircontractsandtheirsubstance
requirements in line with entrepreneurial risk according
to the DEMPE functions.
Nonetheless, in contrast to Action 5 of the OECD/G20
BEPS initiative, in respect of which the substance require-
ments are effectively in line with the location of the sci-
entists who are basically developing the IP, the sub-
stance requirements regarding the recommendations of
Actions 8-10 are largely based on risks. In other words, in
order for taxpayers to satisfy the new risk approach, they
would only need a few high-calibre individuals to bear
and control the risks and, at the same time, a cash-rich
IP entity that would normally have the financial capac-
ity to assume those risks as well. Consequently, although
under Action 5 the OECD has recognized that the people
who are developing an IP, such as scientists, are the most
importantelementofthenexusratio,thiscontradictswith
the OECD’s position with regard to Actions 8-10, in which
the key persons would be a few individuals making key
decisions who would therefore be in the position of con-
trolling the risks.
55. OECD, Actions 8-10 Final Report 2015 – Aligning Transfer Pricing Out-
comes with Value Creation (OECD 2015), Primary Sources IBFD.
56. R. Collier J. Andrus, Transfer Pricing and the Arm’s Length Principle
After BEPS p. 209 (Oxford U. Press 2017).
3.3.3. Treaty entitlement and Action 6 of the OECD/G20
initiative
With regard to treaty entitlement, many countries with an
extensive treaty network are generally considered to be a
tax-favourable jurisdiction for locating IP assets during
the exploitation phase in the sense that article 12(1) of the
OECD Model57
gives an unlimited taxing right to the res-
ident state over any royalty income. On the other hand, it
restricts the source state in imposing withholding taxes
on royalty payments to non-residents. Action 6 proposes
two treaty anti-abuse provisions that are also included in
the four BEPS Minimum Standards.58
First, a limitation
onbenefits(LOB)clauseisproposed,whichisanobjective
test and would require certain specific substance require-
mentstobemetfortherelevanttaxtreatytoapply.Second,
the principal purpose test (PPT) has been proposed as a
more general anti-abuse provision compared to the LOB
test. In effect, a tax treaty would apply only if it was “rea-
sonable to conclude” that the “principal purpose” of pro-
viding the benefit accorded with the “object and purpose”
of the tax treaty. In contrast to the LOB, which would be
an objective test, the PPT would be a subjective test and it
would therefore give rise to more uncertainty, as it would
be difficult to clarify the meaning of the term “principal
purpose”.
The PPT would depend largely on the judgement of tax
administrators, which would differ from country to
country in terms of what would be regarded as “reason-
able to conclude”. In this regard, the Commentaries on
the OECD Model provide various examples as to whether
and when the PPT should be applied. Accordingly, it
appears to be likely that the PPT would not apply “where
an arrangement is inextricably linked to a core commer-
cial activity, and its form has not been driven by consid-
erations of obtaining a benefit”.59
It can be argued that the
substance requirements of Actions 8-10 could make the
PPT inapplicable without taking into consideration the
substance requirements of Action 5, as this was the inten-
tion of the OECD.60
However, it can also be argued that
combining the substance requirements of both Action 5
and Actions 8-10 would enhance a taxpayer’s position if a
tax official reasonably concluded that granting the treaty
benefits would not accord with the object and purpose
of the tax treaty.61
Nevertheless, the PPT could still apply
and, as a result, deny treaty benefits, even if the substance
requirements of both Action 5 and Actions 8-10 were met,
as this would not accord with the object and purpose of
the tax treaty. Consequently, in contrast to the other pro-
tective measures, the PPT is expected to provide further
uncertainty, particularly in granting treaty benefits.
57. Most recently, OECD Model Tax Convention on Income and on Capital
(21 Nov. 2017), Treaties Models IBFD.
58. Vlasceanu, supra n. 8, at sec. 8.3.2., p. 235.
59. OECD Model Tax Convention on Income and on Capital: Commentary
on Article 29, para. 182, Example M (21 Nov. 2017), Treaties Models
IBFD.
60. R.J. Danon, Chapter 2: Intellectual Property (IP) Income and Tax Treaty
Abuse: Relevance of BEPS Actions 5 and 8-10 for the Principal Purpose
Test, in Taxation of Intellectual Property under Domestic Law, EU Law
and Tax Treaties sec. 2.4, p. 26 (G. Maisto ed., IBFD 2018), Books IBFD.
61. Id., at sec. 2.4, p. 27.
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Patent Boxes: The Rise, the Change or the Fall?

7. Interestingly, the majority of international jurisdictions
opted into the PPT test rather than the LOB test when
signing the Multilateral Convention to Implement Tax
Treaty Related Measures to Prevent Base Erosion and
Profit Shifting (the Multilateral Instrument, or MLI).62
This was a departure from the prevailing mode of think-
ing in the United States, which did not adopt the PPT in
the US Model (2016).63
Similarly, article 6 of the Anti-
Tax Avoidance Directive (2016/1164) includes a general
anti-abuse rule (GAAR), which is similar to the PPT. As
a result, treaty shopping and tax planning techniques
that favour the shifting of the IP asset to more favourable
treaty jurisdictions are limited extensively or may even be
ending following the adoption of these rules.
3.3.4. Other treaty anti-abuse provisions
Another treaty anti-abuse provision is included in the
US Model (2016) that denies the treaty benefit regard-
ing royalty payments. According to article 12(2)(a) of
the US Model (2016), in order to be entitled to the treaty
benefit, the recipient and beneficial owner of the royalty
payment should not be located in a jurisdiction that is
considered to be a “special tax regime”, i.e. a state with
a statutory tax rate of less than 15%, on the one hand, or
of 60% less than the US statutory tax rate, on the other.64
Most IP box regimes provide for an ETR below 15%, ren-
dering it non-eligible for treaty benefits. Nonetheless, an
exemption applies when RD activities are undertaken
in contracting states, highlighting, in essence, the nexus
approach of IP compliant regimes. Equally, a similar pro-
vision has been included in the Commentaries on the
OECD Model (2017), under which contracting states can
deny treaty benefits with regard to either interest or royal-
ties paid to a person resident in the other contracting state
that has a special tax regime where a nexus compliant IP
box would not be considered to be a special tax regime.65
Interestingly, no OECD member country nor non-OECD
jurisdiction has made an observation in this respect and,
therefore, it can be argued that a nexus compliant IP box
is widely considered to be non-harmful by various coun-
tries. Similarly, the proposed amendment to the Interest
and Royalties Directive (2003/49)66
effectively mandates
that the reduction in the withholding tax to zero of the
Member State in which the royalty expense is paid may
apply if the ETR is at least 10% of the Member State in
which the income is received.67
Nevertheless, as this vio-
lates the freedom of establishment, the European Union is
proposing to combine the Interest and Royalties Directive
(2003/49) with a substance test that is similar to a nexus
compliant IP box regime.
62. Multilateral Convention to Implement Tax Treaty Related Measures to
Prevent Base Erosion and Profit Shifting (7 June 2017), Treaties Models
IBFD [hereinafter the Multilateral Convention or MLI].
63. US Model Income Tax Convention (17 Feb. 2016), Treaties Models
IBFD.
64. Arginelli, supra n. 44, at sec. 5.6.4., p. 129.
65. Para. 85 OECD Model: Commentary on Article 1 (2017).
66. Council Directive 2003/49/EC of 3 June 2003 on a Common System of
Taxation Applicable to Interest and Royalty Payments made between
Associated Companies of Different Member States, OJ L 141 (2013) (as
amended through 2013), Primary Sources IBFD.
67. See also Arginelli, supra n. 44, at sec. 5.6.3., p. 127.
3.3.5. Linking rules and switch-over clause
Countries are introducing the “linking rules” into their
domestic law. For instance, Germany restricts the deduc-
tion of royalty expenses, paid to a non-resident company,
up to a specified cap where the royalty income is subject
to privileged taxation. However, this rule does not apply
where such privileged taxation is considered to be nexus
compliant.68
For this measure to be effective, it must be
applied by a large number of countries. Finally, coun-
tries tend to include switch-over clauses in the tax trea-
ties that they conclude when providing double tax relief to
permitthemselvestobeabletoswitchfromtheexemption
method to the credit method. This may be the case where
the source state is likely to impose taxes on the income at
alowlevel,presumablyanIPboxregime,therebyallowing
the income to flow untaxed to the resident state.
4. Present and Prospective Influences
The reactions of countries to the release of the Final
Reports of the OECD/G20 BEPS initiative vary. To begin
with, there are countries that have amended their national
laws extensively to comply with the recommendations of
Action 5, such as Cyprus and Luxembourg. Cyprus, for
example, has achieved the required compliance standards
by modifying its existing IP box regime, introduced in
2012, which provided an 80% exemption on gross royalty
income. In particular, Cyprus has also moved to limit the
eligible assets in respect of trade intangibles by excluding
marketing intangibles and by introducing the nexus ratio
into the equation, together with the relevant limitations of
the qualifying expenditures according to Action 5.69
Sim-
ilarly, Luxembourg, which since 2008 has had a similar
regime to that of Cyprus, achieved full compliance with
Action 5 by excluding marketing intangibles from eligi-
ble assets and by incorporating the nexus ratio into their
internal law.70
As a result, both countries can retain their
ETRs, i.e. Cyprus at 2.5% and Luxembourg at 5.2%, with
regard to their IP box regimes. On the other hand, other
countries with regimes that are similar to the Action 5
proposals have made limited changes into their laws by
introducingonlythenexusformula.Casesinpointarethe
Netherlands71
and the United Kingdom,72
as both coun-
tries have maintained their ETRs of 7% as of 1 January
2018 (previously 5%) and 10%, respectively.
Furthermore, there are countries that have repealed their
existing IP box regimes, such as Liechtenstein,73
and
countries that have alternatively introduced a new IP box
regime, like India in 2016. India’s IP box regime has been
68. M. Valta, Chapter 1: Taxation of Intellectual Property (IP) in Domestic
Tax Law, in Maisto ed., supra n. 60, at sec. 1.3, p. 13.
69. N. Neofytou, The IP Box Regime in Cyprus Has Now Been Amended pp.
1-3 (Redimus Publications 2016).
70. R.O. Hoor, K. O’Donnell M. Bentley, The New Luxembourg IP Tax
Regime: Opportunities for the Post-BEPS Era pp. 3-5 (Bloomberg BNA
TPIR 2017).
71. D. Oosterhoff B. de Nies, Evaluation of the Innovation Box, 23 Intl.
Transfer Pricing J. 6 (2016), Journal Articles Papers IBFD.
72. Fairpo, supra n. 26, at p. 236.
73. European Commission, EU Code of Conduct Group (Business Taxation)
(Report to the Council of the European Union 2017), available at http://
data.consilium.europa.eu/doc/document/ST-14784-2017-INIT/en/pdf.
292 Bu l l etin for In tern ation a l Ta x ation May 2019 © IBFD
Christos A . Theophilou

8. criticized for not following the Action 5 proposals, despite
the fact that India’s IP box regime came into effect after
the Action 5 proposal had been published.74
In particular,
as only patents are eligible, India excludes assets that are
similar to patents, such as computer software.
India also excludes from eligible persons any non-resident
company with a permanent establishment in its jurisdic-
tion, as well as any new owner of the IP asset as the Indian
regime only applies to original owners disregarding any
subsequent transfer of ownership rights. Moreover, any
capital gain resulting from the sale of the IP asset may
also not benefit from the reduced rate. Finally, there is
no definition of qualifying expenditures as applied in the
nexus ratio.
The European Union is committed to requiring countries
to adopt the recommendations of Action 5 either directly
or indirectly. On the one hand, the European Union, as
a supranational organization, requires Member States to
adopt the Action 5 proposal directly through the influ-
ence of the Commission as reported in the EU Code of
Conduct Group (Business Taxation). Judging from the
final report issued in October 2017, of all Member States,
only France had failed to fulfil any of the required cri-
teria and Italy’s regime appeared to be harmful, as it
extended its IP box regime to trademarks.75
On the other
hand, in December 2017, the European Union published
a list of blacklisted countries, including those that do not
appear to comply with certain criteria such as the BEPS
Minimum Standards that include the Action 5 propos-
al.76
As a result, 17 countries have been blacklisted for not
cooperating with the European Union and another 47
countries have committed to amending their regime fol-
lowing discussions with the European Union. However,
the reaction of several countries was immediate. From
January 2018, some jurisdictions have been removed from
the blacklist, as they have begun to amend their regimes.
Similarly, more than 110 countries globally have commit-
ted to adopting the findings of the OECD/G20 BEPS ini-
tiative, and particularly the four BEPS Minimum Stan-
dards that include the Action 5 recommendations.
Briefly,RDtaxincentives,followingthenexusapproach,
are no longer to be distinguished in relation to input and
output tax incentives, as income and expenditures must
be considered together. This generally applies to both
Member States and third countries that follow EU and
OECD policies as noted previously in this section. None-
theless, other countries may introduce RD tax incen-
tives to the extent that such tax incentives do not conflict
with established EU policies on the subject, as they try
to trade with the European Union and other third coun-
tries that follow EU and OECD policies. According to the
latest progress update of the OECD assessment review,
which comprises more than 120 member jurisdictions
74. P. Jain, India’s New Patent Box Regime, 82 Tax Notes Intl. 13, pp. 1281-
1283 (2016).
75. European Commission, supra n. 73.
76. Council of the European Union, The EU list of Non-Cooperative Juris-
dictions for Tax Purposes (2017), available at www.consilium.europa.eu/
media/31945/st15429en17.pdf.
of the inclusive framework, apart from one exception, all
of the other IP regimes have now been either amended
or abolished so as to comply with the nexus approach.77
As a result, on the one hand, policymakers must consider
both types of incentives together when introducing RD
tax incentives as this might result in either negative ETRs
or in providing a double subsidy on the identical RD
activities, as taxpayers may claim both.78
Furthermore, in
the context of the nexus approach, countries that already
have an IP box regime most likely will have the follow-
ing two options: (1) to comply with the nexus approach
so as to not be considered a harmful tax regime, thereby
avoiding being backlisted; or (2) abolish their regime, as
the other contracting state, i.e. the source state, will not
be willing to grant treaty benefits in such circumstances
(see section 3.2.).
On the other hand, taxpayers will have to consider either
the location for IP asset exploitation in advance, as it will
no longer be beneficial to move their IP assets to another
jurisdictionasundertheoldregime,orenhancetheirpres-
ence and substantial activities in respect of the existing IP
assets situated in a tax-favourable jurisdiction. Undoubt-
edly, such substance requirements will need to consider:
(1) the people that are developing the IP, such as the sci-
entists, to comply with Action 5 and the nexus approach;
(2) the people that are taking the risk and the decisions
in respect of the royalty income in order to comply with
Actions 8-10 of the OECD/G20 BEPS initiative and the
DEMPE functions; and (3) the objective LOB test and the
subjective PPT. Moreover, MNEs will be interested in a
jurisdiction with simple bookkeeping procedures and
rebuttable presumptions.
In light of the foregoing, countries with low or no-royalty
income tax regimes that are currently nexus compliant
will largely be considered as not being harmful and, there-
fore, comply with both EU and OECD tax policy. Accord-
ingly, bearing in mind that a large number of countries
are committed to following the EU and OECD minimum
standards,intheauthor’sopinion,thenexusapproachwill
largely endorse the harmonization of the IP box regimes
worldwide, particularly where that involves cross-border
royalties.Inthisregard,theauthoralsobelievesthatnexus
compliant IP regimes will continue to exist because addi-
tional protective measures, which countries are introduc-
ing with regard to royalty income (see section 3.2.), are
providingexemptionstonexuscompliantregimes.Exam-
ples of these protective measures are the implementation
of linking rules in Germany, and the denying of treaty
benefits where countries have a special tax regime, in the
UnitedStates.Interestingly,thisviewappearstobeinline,
to a large extent, with both the EU Member States under
the proposed amendment of the Interest and Royalties
Directive (2003/49) and among OECD member countries
and non-OECD countries (see section 3.2.).
77. OECD, Harmful Tax Practices – 2018 Progress Report on Preferential
Regimes Inclusive Framework On BEPS: Action 5 (OECD 2019).
78. Danon, supra n. 9, at sec. 3.2.
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Patent Boxes: The Rise, the Change or the Fall?

9. Consequently, remembering that IP box regimes will con-
tinue to exist in a largely harmonized context, this devel-
opment will lead countries to compete on input tax rather
than on output tax incentives. In this sense, the author
believes that the most attractive jurisdictions will be those
that provide the best combination of a low ETR and, at the
same time, generous input tax incentives, minimizing the
IP development risk in the early stages of research, such as
is the case for tax credits with refunds.79
As a result, coun-
tries introducing such measures will provide further tax
incentives to their taxpayers, enabling them to be more
attractive. In addition, the implementation of tax incen-
tives on payroll cost, such as in Belgium and the Neth-
erlands, may appear to be attractive.80
In sum, in order
to encourage innovation and attract IP assets, countries
will be more willing to provide input tax incentives by
focusing on the basic and applied research to minimize IP
development risk, resulting in a race to the bottom. Con-
versely, in order to prevent countries from entering into
such a race, RD direct subsidies could be made more
efficient by providing them to universities and similar
researchinstitutionsthatperformbasicresearch.81
Finally,
79. C. Shi, IP Boxes in Light of the BEPS Project and EU Law – Part II, 56
Eur. Taxn. 9, sec. 4. (2016), Journal Articles Papers IBFD.
80. Vlasceanu supra n. 8, at sec. 8.3.3.2., p. 242.
81. Shay, Fleming Peroni, supra n. 4, at p. 455.
such direct subsidies are generally considered to be more
targeted compared to those for the general commercial
and industrial sectors.
5. Conclusions
In practice, it is difficult for anyone to be granted the
benefit of IP box regimes without both undertaking the
related RD activities and controlling and assuming the
risks in the residence state. Ideally, both policymakers and
taxpayers should consider input and output tax incentives
withregardtothelocationoftheirIPassetpriortomaking
adecision.Furthermore,countrieshavealsostrengthened
their anti-avoidance provisions when it comes to income
arising from IP assets, such as CFC, LOB and PPT rules,
washing out any IP box benefits. As a result, it will be hard
for countries to attract highly mobile foreign capital. Sim-
ilarly, it will be difficult for local mobile capital to move
abroad. However, all these defensive measures largely
exclude nexus compliant IP box regimes and, therefore,
substance and RD activities are of great importance
for an IP box regime to apply. Consequently, countries
may now be competing in respect of RD tax incentives
that minimize the risks involved in IP development, the
most efficient of which are cash refund tax credits and tax
incentives on payroll costs.
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