The instrument popularly known as the “IP Box,” introduced on 1 January 2019, allows taxpayers to claim a lower, 5% rate of corporate income tax or personal income tax in their annual tax settlements for income generated from commercialisation of qualified intellectual property rights they have created or developed through R&D activity. In this article we discuss how to benefit from the IP Box in the game development industry, who is eligible for the IP Box, and the conditions that must be met.
CIT and PIT payers
Because the IP Box is available to CIT and PIT payers, a preferential income tax rate may be claimed by taxpayers operating in corporate form (CIT payers) or natural persons operating a business (such as freelance programmers). This option is equally available to taxpayers operating in any branch of the economy. The practice of the tax authorities confirms that beneficiaries of the IP Box may include, for example, individuals entering into cooperation agreements on a B2B basis.
General conditions for use of the IP Box
The IP Box, and thus the 5% income tax rate, is available when all three of the following conditions are met:
- The taxpayer earns income from commercialisation of statutorily defined qualified intellectual property rights (QIPR), which also include copyrights to software. (Also earning income from other sources does not prevent use of the IP Box.)
- The subject of protection of rights qualifying for the IP Box (e.g. software) was created, developed or improved by the taxpayer as part of research and development activity conducted by the taxpayer (R&D).
- The taxpayer maintains the statutorily required records in a manner enabling determination of revenue, tax-deductible costs, and net income (or loss)—in other words, in practice, enabling determination of taxable income (or tax loss).
Claiming of the IP Box in the annual CIT or PIT return
The preferential (5%) rate of income tax is not applicable with respect to current settlements of CIT or PIT (in particular, it is not reflected for purposes of calculating monthly or quarterly income tax advances), but may be claimed after the end of the tax year in calculating the annual tax obligation and filing the annual tax return. Thus, potentially the IP Box may be claimed for prior years for which the CIT or PIT obligation has not become time-barred (up to and including 2019, when the IP Box entered into force), so long as the statutory conditions are met. (In practice it may prove problematic to meet the condition of maintaining the appropriate records, as the tax authorities require the records to be maintained on a current basis.)
Condition 1: income originating in qualified rights
A taxpayer, including one operating in the video game sector, may enjoy a preferential rate of CIT or PIT for income from commercialisation of QIPRs. The category of QIPRs includes rights to:
- Utility models
- Industrial designs
- Layout designs (topographies) of integrated circuits
- Supplementary protection rights to patents for medicinal products or plant protection products
- Medicinal products and veterinary medicinal products authorised for trading
- Protected plant varieties
- Copyright to computer programs
subject to protection under separate acts or ratified international agreements to which the Republic of Poland is a party, or other international agreements to which the European Union is a party.
To benefit from the preferential rate, it is sufficient to generate income from any one of the foregoing QIPRs. In the case of the video game industry in Poland, the most common QIPR is copyright to computer programs. But in other places, such as the US and Asia, the commonly employed form for protection of software is patent (which may be significant for entities planning expansion onto foreign markets). Rights obtained abroad protecting computer programs should also be reflected for purposes of the IP Box under the same rules as rights obtained in Poland, so long as they are subject to protection under statutes or international agreements to which Poland or the EU is a party.
Thus taxpayers from the video game industry may claim the IP Box for income from the transfer of economic copyrights to computer programs or grant of licences to such programs. The IP Box may also be applied to income from the sale of goods or services whose price reflects the price of copyright to computer programs or damages for infringement of such rights (e.g. obtained as a result of copying or elaboration of a program by a third party).
Use of the preferential income tax rate in the IP Box applies to independently created computer programs. Doubts may arise in a situation where the taxpayer elaborates or improves existing programs written by others, without acquiring the copyright or an exclusive licence from the owner (e.g. when software is used based on a nonexclusive licence for elaboration or improvement). It should be noted, however, that individual tax interpretations have been issued in which the tax authorities did not object to claiming of the IP Box by taxpayers hired by the holder of the copyright to modify or improve programs (e.g. individual interpretation by the director of the National Revenue Administration Information Centre of 20 November 2019, no. 0113-KDIPT2-1.4011.492.2019.1.KO).
Thus it is vital for the possibility of applying the IP Box to analyse contracts with clients and programmers cooperating in a B2B model concerning the basis for mutual settlements and costs connected with the computer program.
Another fundamental issue for the possibility of claiming IP Box relief by the video game industry is the interpretation of the notion of “copyright to a computer program.” A computer program is subject to copyright protection if it manifests creative activity of an individual nature. In practice, protection extends to the program’s source code. Nonetheless, a video game is designed to be used as a whole, and thus for tax purposes may be deemed a as single (consolidated) work. Creative activities carried out during the process of developing a game include combining, adjusting and interaction of all elements making up the game, so that they ultimately achieve the effect of a single product as intended by the team of developers. Thus we could refer to a specific integration within a video game of such elements as source code, output code, instructions, description of operating procedures, dialogue track, and graphics.
It should also be noted that a computer program may be incomplete, or even contain certain errors or gaps. Pre-alpha, alpha and beta versions, test or demo issues, are also computer programs, and thus may constitute QIPRs for purposes of the IP Box (so long as they meet the conditions for being regarded as a work).
Condition 2: creation of rights in R&D
The subject of protection of commercialised QIPR must be created, elaborated or improved by the taxpayer as part of its own R&D activity.
R&D activity is not a subjective category, i.e. it is not necessary for the taxpayer applying the IP Box to hold the status of an R&D centre or other subjective characteristics. Nor does the taxpayer have to qualify for R&D relief under the CIT Act or the PIT Act (which is a separate instrument from the IP Box). What is relevant is the objective aspect of the taxpayer’s activity.
R&D activity is defined as creative and systematic work, including scientific research and experimental development, undertaken in order to increase the stock of knowledge and to devise new applications of available knowledge.
The peculiarities of operations in the video game industry (as in IT as a whole) leading to introduction of innovations, mainly involving work whose results are intangible, generate difficulties in identifying which operations constitute R&D activity and which are ordinary activities of a non-innovative nature. To determine whether particular activities may be classified as R&D work, the definition adopted by the OECD in the “Frascati Manual” may be helpful. According to the manual, R&D may cover processing of information in new fields, such as the development of new operating systems or languages, as well as development of new applications or significant upgrades of existing operating systems and application programs.
The Frascati Manual also provides examples of activities not regarded as R&D. These are routine activities not embodying scientific or technological advances or eliminating technological uncertainty. Thus the following, for example, are not regarded as R&D:
- Development of business application software and information systems using known methods and existing software tools
- Creation of websites or software using existing tools
- Use of standard methods of encryption, security verification and data integrity testing
- Customisation of a product for a particular use, unless during this process knowledge is added that significantly improves the base program
- Adding user functionality to existing application programs
- Routine debugging of existing systems and programs.
Consequently, any research work in the IT industry, including the video game sector, whose aim is not routine activity but generally technological progress and growth of the field, should be deemed to be work qualifying as R&D.
Development work is defined as acquiring, combining and exploiting currently available knowledge and skills from the field of science, technology and commerce, as well as other knowledge and skills, for planning of production, as well as creating and designing new, modified or improved products, processes and services.
To meet the conditions of the IP Box, R&D work on a project must be systematic. The most appropriate definition of the systematic nature of the work refers to conducting activity in an orderly fashion, according to a certain system, methodical and planned. Significantly, for work to be systematic, the continuity of the activity is not essential, nor is the length of time it is conducted, or the existence of a plan for the taxpayer to conduct similar activity in the future. It appears sufficient that the taxpayer has planned and conducted at least one R&D project, for which it has adopted a defined aim, timetable and resources.
Condition 3: relevant documentation
A taxpayer wishing to claim IP Box relief is required to maintain separate, detailed accounting records in a manner enabling calculation of the tax base for the 5% rate, including the connection between the costs incurred for R&D work with the income from QIPRs resulting from the R&D work.
First and foremost, the records must contain:
- Itemisation of each QIPR
- Determination of the revenue, tax-deductible costs, and net income (or loss) attributable to each QIPR
- Itemisation of costs attributable to each QIPR, in a manner enabling determination of the qualifying net income.
Additionally, taxpayers working on creation of more than one QIPR are required to maintain records for each R&D project, with a breakdown for:
- Project description
- Start and end time
- List of persons taking part in work on each project
- List of works created in each project, attributed by name to the persons performing the work.
Thus a taxpayer creating, for example, a video game must itemise all of the QIPRs arising in connection with the game development and maintain a separate record for each of them. It is possible to treat a game as a single (aggregate) QIPR, but such situations seem to be in the minority. Maintaining entries in a manner ensuring determination of the aggregate income from the QIPR or use in the product or service is permissible in particular when a division into specific QIPRs is not possible.
The record must be prepared with cumulative recognition of expenses with respect to specific tasks (based on a set of documents confirming the incurred expenses). The cumulative set of documents should thus cover the expenses from start of the R&D activity aimed at creation, elaboration or improvement of the QIPR, through the end of the given calendar month.
The regulations do not dictate how the records should be maintained for purposes of the IP Box. In particular, the records do not have to be prepared in a uniform manner, according to a specified template. Maintaining full accounting is also not required. An acceptable method of maintaining the accounting books is a tax ledger of revenue and expenses. In the case of taxpayers who maintain such a ledger, the requirement to ensure itemisation of the records for each QIPR project may be fulfilled by preparing, via a computer spreadsheet, a cumulative monthly set of documents confirming the expenses incurred for the QIPR project as of the end of the given month.
These records must be maintained on an ongoing, current basis, even though the IP Box is applied to annual taxable income. The tax authorities take the strict position that creation of separate records after the fact in order to meet the requirements of the IP Box regulations eliminates the right to apply the IP Box, even when the retrospective records allow for correct determination of the basis for taxation at the 5% rate (e.g. individual interpretation by the director of the National Revenue Administration Information Centre of 27 November 2019, no. 0115-KDIT2-1.4011.405.2019.2.KK).
The electronic version of the record should be archived, and the spreadsheet should be structured to allow data to be generated at a later date showing the state as of the end of specific calendar months.
Value of income taxed at 5% rate
The amount of income subject to taxation at the preferential 5% rate is the product of the income from QIPR achieved in the given tax year and an adjustment known as the “nexus factor”:
income taxed at 5% CIT or PIT = income from QIPR × nexus factor
If the taxpayer generates income from more than one QIPR, the basis for taxation is the sum of the products calculated for each QIPR.
Income (or loss) from QIPR is income (or loss) from:
- Fees or receivables under a licence agreement involving QIPR
- Sale of QIPR
- QIPR reflected in the sale price of goods or services
- Damages for infringement of QIPR awarded in a contentious proceeding (judicial or arbitration).
Net income is the surplus earned during the tax year of revenue from this source over the costs of generating the revenue. If the costs exceed the revenue, the difference is a loss from the source of the revenue. Thus for purposes of calculating income from QIPR, revenue-earning costs should also be reflected, including indirect costs.
The amount of revenue from commercialisation of QIPR may be established in particular based on sales invoices issued, corresponding to provisions of concluded contracts. For the purpose of determining net income from QIPR, this revenue should be reduced by the direct and indirect costs of earning the revenue. This should not present problems when all of the costs involve QIPR. It may prove problematic, however, when the taxpayer creates software as part of its business, qualifying for the 5% tax rate, but also conducts maintenance work not qualifying for the IP Box. In that case, it is hard to allocate a specific figure of indirect costs (e.g. for internet, telephone, or electricity) to these two categories of revenue. It seems that in this case, the rule that should be applied is that when a taxpayer incurs costs to generate revenue from taxable sources as well as costs connected to revenue from other sources, these costs are recognised pro rata in the proportion of taxable revenue to total revenue. Thus it would appear warranted to add up all indirect costs incurred as part of the taxpayer’s commercial activity and allow the costs pro rata, in the proportion of revenue from QIPR to other revenue.
The nexus factor is an adjustment factor applied for calculation of the final basis for taxation at the preferential 5% rate under the IP Box.
The nexus factor is calculated according to the formula
where each letter refers to costs actually incurred by the taxpayer:
- “a”—for R&D related to QIPR directly conducted by the taxpayer
- “b”—for acquisition of R&D results related to QIPR other than those falling under “d” from an unrelated entity (within the meaning of transfer-pricing regulations)
- “c”—for acquisition of R&D results related to QIPR other than those falling under “d” from a related entity (within the meaning of transfer-pricing regulations)
- “d”—for acquisition of QIPR by the taxpayer.
It follows that the greater the qualifying costs falling under category “a” or “b” incurred by the taxpayer, the greater the portion of income that may be subject to the preferential 5% CIT or PIT rate. But the greater the qualifying costs falling under category “c” or “d” incurred by the taxpayer, the lower the portion of income that may be taxed at 5% CIT or PIT.
Eligible costs should be reflected in the nexus factor regardless of how they are recognised in tax costs according to general tax rules. Consequently, costs for purposes of calculating the nexus factor should be understood more broadly (functionally) than for purposes of determining tax-deductible revenue-earning costs under the other provisions of the CIT Act or PIT Act. On the other hand, under the IP Box, this particular method of including costs in the nexus factor applies only for purposes of calculating this factor, and the IP Box does not alter the rules for treatment of these costs for other purposes, including for calculating the net income which is multiplied by the nexus factor.
Eligible costs for purposes of the IP Box are not identical to eligible costs for purposes of R&D tax relief. For example, the tax authorities have recognised expenses for accounting support and telecommunications services as costs falling under item “a” above (e.g. individual interpretation by the director of the National Revenue Administration Information Centre of 21 February 2020, no. 0113-KDIPT2-1.4011.654.2019.2.MM), whereas for purposes of R&D relief these items would not constitute eligible costs. It seems, by the way, that it would be hard to argue that most taxpayers use accounting or telephone services for R&D.
Numerous doubts are also raised by the eligibility of fees for subcontractors for the IP Box, in particular the fees of numerous persons cooperating in a B2B model via individual businesses. Depending how the regulations are interpreted, such costs could be assigned to either item “b” (as the result of R&D work, raising the nexus factor) or item “d” (reducing the nexus factor). Interpretations of the IP Box made so far by the tax authorities seem to reward the use of programmers operating their own businesses. All of the fees obtained from sale of software created entirely by a programmer, as well as work connected with improvement or modification of software, qualifies for inclusion in the IP Box relief.
This consequently raises the question of whether the entities paying such fees to programmers should classify these fees under item “d” (as the programmers are selling QIPRs). Otherwise, two entities could claim the same relief for the same QIPR, while classifying the same rights differently (the programmer as the sale of QIPR and the buyer as the purchase of R&D results). However, it seems that this approach may be too restrictive. On the part of the programmer, commercialisation of QIPR arises on the revenue side and determines the very possibility of applying the IP Box, indicating the added value from QIPR, while on the part of the entity cooperating with the programmer, the value of the same QIPR arises on the cost side and may affect the level of the nexus factor.
For the video game industry, the IP Box offers a very attractive tax solution, which may be exploited not only by firms employing programmers to prepare products (IT systems), but also by programmers operating their own businesses, who as business operators cannot claim the preferential deduction of 50% revenue-earning costs.
But any taxpayer wishing to take advantage of the IP Box relief should carefully verify whether they meet the conditions for applying the 5% income tax rate, so that they can easily prove in the event of an audit that they are properly claiming this tax preference.
Joanna Prokurat, tax adviser, Tax and State Aid practice, Wardyński & Partners