The European Union's logo in the Irish language, to mark the golden jubilee of the signing of the Treaty of Rome

By a reasoned opinion under Article 226 of the EC Treaty, the European Commission has formally requested Ireland to change its tax law provision by which patent royalties are tax exempt only if research leading to the patent was carried out in Ireland.

The provision is incompatible with the freedom of establishment and the free movement of services. If there is no satisfactory reaction to the reasoned opinion within two months, the Commission may decide to refer the matter to the European Court of Justice.

Under Irish legislation (Section 243 of the Taxes Consolidation Act 1997) tax exemption of received patent royalties is granted only if the research leading to the patent was carried out in Ireland.

However, multinationals based in Ireland make use of the patent income exemption and the amount of research done in Ireland related to the patent, may well be only a small part of the total relevant R&D expenditure. 

The Commission considers the Irish tax provision on patents, contrary to Articles 43, 48 and 49 of the EC Treaty (freedom of establishment and free movement of services) and the corresponding articles of the EEA Agreement.

The Commission says that the provision dissuades Irish companies and individuals from contracting out research to institutions established elsewhere in the EU or in the EEA, since the income from any resulting patents would not be exempt, contrary to the rules which apply to domestic patents. Such legislation also dissuades Irish undertakings and individuals from setting up their research centres in other Member States, thus infringing their freedom of establishment.

The Department of Finance has confirmed that it has inserted an amendment into the Finance Bill that should meet the concerns of the commission. The amendment will enable firms conducting R&D in any state in the EEA (European Economic Area) to apply for tax exemption on royalties earned from patents in Ireland.

It has also changed the legislation to cap the level of exemption each firm can receive from patent royalty income. Firms will only be able to receive an exemption on royalty taxes of €5 million from January 2008.

A Department spokesman confirmed that Section 45 of the Bill will be debated in the Senate next week. He said it would broaden the definition of a "qualifying patent" so as to provide that the work leading to the invention which is the subject of the patent can be carried on elsewhere in the EEA.

The Commission's opinion issued on Friday, was based on the EC Treaty as interpreted by the European Court of Justice in judgments of 10 March 2005 and 8 July 1999 in Cases C-39/04 ('Laboratoires Fournier SA') and C-254/97 ('Baxter and Others').

The Commission's case reference number is 2005/2427.