TAX policies are considered, as sovereign functions of the State and traditionally, tax policies have been determined solely keeping the national interests in view. However, in the 90s, there was a realization that globalization of trade and investment while being mostly beneficial to the countries has, at the same time changed the relationship among domestic tax systems. The removal of non-tax barriers to international commerce and investment and the resulting integration of national economies also increased the potential impact that domestic tax policies can have on other economies. In May 1996, the G-7 countries, therefore asked the OECD to "develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases, and report back in 1998."

This was the origin of the OECD's Harmful tax Competition project. The project had a checkered history. The first report released in 1998, while recognizing that many factors affect the overall competitive position of a country, zeroed in on tax havens and preferential tax regimes that were considered harmful when they distort financial and, indirectly, real investment flows, undermine the integrity and fairness of tax structures, discouraging compliance by all taxpayers; re-shape the desired level and mix of taxes and public spending; cause undesired shifts of part of the tax burden to less mobile tax bases, such as labour, property and consumption; and increase the administrative costs and compliance burdens on tax authorities and taxpayers.

The report mentioned that because tax havens offer a way to minimize taxes and to obtain financial confidentiality, these are appealing to corporate and individual investors. Tax havens serve three main purposes: they provide a location for holding passive investments ("money boxes"); they provide a location where "paper" profits can be booked; and they enable the affairs of taxpayers, particularly their bank accounts, to be effectively shielded from scrutiny by tax authorities of other countries.

Although the OECD initially wanted to name and shame such jurisdictions, there were no consensus amongst the OECD members themselves and the project gradually lost its steam concentrating on improved standard on exchange of information. According to J.C.Sharman: "The OECD suffered a defeat when the central goal of the initiative- the prevention of tax havens from "poaching" geographically mobile investment by means of tax and regulatory concessions – was abandoned." [Havens in a Storm- the struggle for Global Tax Regulation]

The financial crisis of 2008 however brought the focus back on tax havens and effective exchange of information. Accordingly, the global forum was formed and a peer review process was introduced as a result of which, according to the OECD itself, there are hardly any non-cooperative jurisdictions left. Nevertheless, base erosion and profit shifting continued.

It is interesting to note that apart from the tax havens, the 1998 report had also identified preferential tax regimes in OECD member countries and others as being harmful. According to the report, the preferential tax regimes are targeted specifically to attract those economic activities, which can be most easily shifted in response to tax differentials, generally financial and other service activities. Such tax regimes can be particularly successful if targeted to attract income from base company activities and from passive investment rather than income from active investment.

The report prescribed four key factors assist in identifying harmful preferential tax regimes:

(a) the regime imposes a low or zero effective tax rate on the relevant income;

(b) the regime is "ring-fenced"; (c) the operation of the regime is nontransparent;

(d) the jurisdiction operating the regime does not effectively exchange information with other countries.

The OECD therefore planned to eliminate such preferential regimes. As a result of these efforts, as some commentators pointed out, states became more sophisticated in devising measures that provide similar advantages, but could fall outside the criteria.

The OECD's base erosion and profit shifting paper again identified preferential regimes as one of the key pressure areas. The subsequent action plan stated that the policy concerns relating to the race to the bottom in respect of mobile income tax base continues to be a concern. However, there was also the realization that the race to the bottom now a day takes less the form of ring fencing and more the form of across the board corporate tax rates reductions on particular types of income such as income from financial activities or from the provision of intangibles. Therefore Action plan 5, in addition to carrying forward OECD's old harmful tax project that focused on individual countries and jurisdictions, put more emphasis on the low tax rate on certain types of income.

It is in this context that there was a lot of talk about the various 'patent box' regimes put in place initially by Ireland in the 70s and subsequently by some European countries and China.The term 'box' comes from the practice of checking a box in order to avail the benefits of the regime. In the meantime, the UK, while being engaged in the BEPS work, proposed a patent box regime that reduces the effective corporate tax rate for income from patents to a mere 10% as compared to the general rate of 21%.

Although such regimes generate concerns relating to base erosion, there was no consensus on the issue amongst the European countries. While Germany considered the practice to be evil, the UK was of the opinion that the patent box regime that it introduced in 2013 was necessary to protect the competitiveness of its firms and for preventing firms to leave its shores. It was argued that IP- intensive industries are a key driver of growth and employment and therefore countries should be free to provide the incentive provided that same was in line with the principles agreed to by the Forum on Harmful Tax practices. There was abroad agreement though that there should be a nexus between the firm claiming the benefits and expenditures incurred by it and the benefits of the regime should be allowed only to a taxpayer that itself incurred expenditures, such as R&D, which gave rise to the IP income.

After a lot of parleys, in which it is not known what the role of the developing countries was, the UK and Germany submitted a proposal that called the adoption of a 'modified nexus' approach.

It was proposed that the expenditures that a taxpayer incurs on IP and which can be taken into account in the nexus approach calculation can, in limited circumstances, be increased by 30%.

At the same time countries that have IP regimes that are inconsistent with the nexus approach are expected to take steps to amend those regimes and the process to do this should commence in 2015. In addition there can be no new entrants to such IP regimes after 30 June 2016 and finally taxpayers benefitting from existing regimes that do not comply with the nexus approach will not be able to receive any additional tax benefits from those regimes after 30 June 2021.

The problem with the nexus approach is that it is difficult to trace income from the particular expenditure and it leaves the field wide open for tax planners. As Martin Sullivan points out: "When a modern business generates profits, it is from a wide and often complex combination of inputs, such as plant, equipment, materials, good location, a skilled workforce, favorable government regulation, clever management, and technological prowess. It is hard to trace profits back to a particular input. If you ask a baker the cost of eggs that went into making a cake, she could tell you to the penny. If you ask the baker what the income is from those eggs, she would look at you quizzically, and then if you insisted, she would have to hire a consultant who, despite a lot of technical mumbo-jumbo, would only provide a good guess." [http://www.taxanalysts.org/tax-analysts-blog/patent-box-good-intentions-gone-bad/2015/06/08/165116]

The OECD 2015 final report on action plan 5 has also come up with a complicated process to determine the income subject to tax benefits by applying the following formula:

Qualifying expenditures incurred to develop IP assets ÷ overall expenditures incurred to develop IP asset x Overall income from IP asset= Income receiving tax benefits. This ratio is known as the 'nexus ratio'.

The OECD report then lays down as to who could be the qualifying taxpayers, what are the IP assets, what are the qualifying expenditures, what are the overall expenditures, what are the overall income; what happens when R&D activities are outsourced, what treatment is to be given to acquired IP.

The report cautions that since the nexus approach depends on there being a nexus between expenditures and income, it requires jurisdictions wishing to introduce an IP regime to mandate that taxpayers that want to benefit from an IP regime must track expenditures, IP assets, and income to ensure that the income receiving benefits did in fact arise from the expenditures that qualified for those benefits.

Commentators have criticized OECD's capitulation in the face of demands from the UK and others. It has been pointed out that this measure will incite tax competition amongst nations and would contribute to what is known as the race to the bottom in so far corporate tax is concerned.

The Indian Scene:

Like many other countries India has been giving liberal deductions for R&D expenditures carried out by the taxpayers. The deductions come under the expenditure on scientific research as laid down in section 35 of the Income Tax Act. Over the years, the scope of the businesses that can avail of the deduction has been limited somewhat but certain industries were getting weighted deductions up to 200%. The Finance Minister having announced in the budget his intention of bringing down the headline corporate income tax in India to 25% over a period of 4 years, an exercise was undertaken to simultaneously prune some of the tax breaks. The CBDT accordingly issued a press release on 20.11.2015 about its plan to prune some tax breaks and invited comments on the phasing out plan. One of the provisions in fact related to the tax break in respect of scientific expenditure.

From the above, it is clear that all that has been done is to restrict the weighted deduction to some extent till 2020 and thereafter 100% deduction will be allowable in respect of various R&D expenditure.

In the meantime, taking a cue from the above mentioned OECD approved patent box regime, the government has come up with its own patent box regime in the form of Section 115BBF. It bears repetition that OECD has not recommended that patent box relief be given by countries. In fact, globally, the patent box regimes are under scrutiny. However, the explanatory memorandum mentions that this has been done apparently for encouraging indigenous research & development activities and to make India a global R & D hub. It has been stated that the aim of the concessional taxation regime is to provide an additional incentive for companies to retain and commercialize existing patents and to develop new innovative patented products. Apparently, this will encourage companies to locate the high-value jobs associated with the development, manufacture and exploitation of patents in India.

The new section 115BBF (effective 1st April, 2017) provides that where the total income of the eligible assessee income includes any income by way of royalty in respect of a patent developed and registered in India, then such royalty shall be taxable at the rate of ten per cent (plus applicable surcharge and cess) on the gross amount of royalty. It has been stipulated that no expenditure or allowance in respect of such royalty income shall be allowed under the Act.

This concessional tax regime in respect of royalty from patents has been made available only to a person resident in India, who is the true and first inventor of the invention and whose name is entered on the patent register as the patentee in accordance with Patents Act, 1970.

In terms of the section, of course, the regime is optional. It may be noted that under the Income Tax Act, intangibles are depreciable assets subject to 25% depreciation on the written down value. Therefore, the taxpayers will have to find out which of the options is more beneficial. Section 115BBF however provides that once having exercised the option to be assessed under the preferential regime, if the taxpayer opts out subsequently, then the taxpayer will not be eligible to claim the benefits of the preferential tax rate for the next five years. There is nothing in the section to indicate in which year the option should be exercised. The only restriction seems to be that the option should be exercised before filing of the return of income.

The Indian patent box regime differs from the OECD prescription in some ways. Whereas the OECD allows permanent establishments of foreign companies in the country as also permanent establishments of domestic companies abroad to benefit from the regime, the Indian law restricts the operation only to Indian residents. Besides, the true and first inventor restriction also does not appear to be there in the OECD prescription. Besides, the concessional rate is applicable only to the royalty income from the patents and unlike in the case of action plan 5 does not include income from the possible capital gains that may arise from the alienation of the patent rights.

The Indian regime also restricts its operations to patents registered in India under the Patents Act. Its operation is limited to inventions that are capable of being used in any kind of industry.

More importantly under the OECD sanctioned plan, there has to be nexus between the expenditure on research and the preferential rate of tax. This is why the trace and track approach has been suggested by the OECD. Under the Indian scheme, however, there is no direct linkage between the expenditure and the patent box regime. However, the Indian regime is restricted to patents 'registered and developed' in India. Explanation (a) to the section mentions that the term "developed" means at least seventy-five per cent. of the expenditure incurred in India by the eligible assessee for any invention in respect of which a patent is granted under the Patents Act, 1970.

The Indian experiment shows that tax competition is alive and kicking. For developing countries dependent on corporation tax for a large part of revenue, this may not be welcome news. Besides, the OECD paper itself mentions that the incentive can be front ended or back ended. We already have front ending of the expenditure on certain research and development. These have not been done away with. Only the weighted deduction has been proposed to be discontinued. Therefore for some of the product and processes, it is possible to incur expenditure and take deduction till the development of patents and then get the benefit of concessional tax rate in respect of royalty therefrom.