Accountants for US and UK: Inventors Selling Patent Rights

A US citizen living in the UK who sells a patent they invented is usually taxed twice on paper: the IRS can treat the sale as long-term capital gain under IRC section 1235, while HMRC taxes the proceeds as income, often spread over six years. Getting the double tax relief right means reconciling those two very different answers on both returns.

That reconciliation is technical, year-specific and easy to get wrong, which is why inventors, scientists and founders who hold patents personally tend to work with specialist Accountants for US and UK returns rather than two unconnected advisers. At Jungle Tax we prepare both sets of returns together, so the characterisation, the timing and the foreign tax credit all line up. This guide explains how each system treats the sale, where the mismatches sit, and what to collect so the returns can be prepared correctly the first time, or corrected if they were not.

One boundary at the outset: this guide is about an individual who owns patent rights personally and sells them. A company exploiting patents can elect into the UK Patent Box regime, which is a separate corporation tax relief and is not covered here.

Who this guide is for

The typical reader is a US citizen or green card holder who is UK resident and who personally owns one or more granted patents or patent applications, whether as the original inventor or as someone who funded an inventor in exchange for an interest. The sale might be:

• an outright assignment for a single lump sum;
• a lump sum on signing plus milestone payments (regulatory approval, first commercial sale);
• an assignment priced wholly or partly as a percentage of the buyer's future sales or use, which looks like a royalty stream but is legally a sale; or
• a sale of an undivided share of the rights alongside co-inventors.

Each structure produces a different filing pattern in the US and the UK, and the differences compound across years.

How does the IRS tax an inventor who sells a patent?

The section 1235 rule

Since 2018, self-created patents, inventions, models and designs have been excluded from the general definition of a capital asset in the hands of the person whose efforts created them. Section 1235 survived that change. It provides that a transfer by a holder of all substantial rights to a patent, or of an undivided interest in all such rights, is treated as the sale of a capital asset held for more than one year. Three features make it unusually generous:

• No holding period test. The gain is long-term even if the patent was granted, and sold, within months.
• Contingent payments still qualify. Consideration payable periodically over the buyer's use of the patent, or contingent on its productivity, use or disposition, is still treated as sale proceeds rather than ordinary royalty income.
• It applies before grant. Rights in an invention can qualify once it has been reduced to practice, even if the patent application is still pending.

Long-term capital gain is taxed at federal rates of up to 20%, and the 3.8% net investment income tax may also apply to higher earners. Ordinary income, by contrast, can reach 37%.

Who counts as a "holder"?

A holder is the individual whose efforts created the invention, or another individual who acquired an interest from the inventor for money or money's worth paid before the invention was reduced to practice, provided they are not the inventor's employer and not related to the inventor. A company cannot be a holder, so an inventor who has already assigned the patent into their own company falls outside section 1235 on any later sale by the company.

When section 1235 fails

Section 1235 is denied, and the default rules apply, in three common situations:

• Related-party buyer. The section does not apply to a transfer to a related person. "Related" borrows the general related-party rules with a lower 25% ownership threshold in place of 50%, and family for this purpose covers a spouse, ancestors and lineal descendants but not siblings. A sale to a company in which the inventor (with family) holds 25% or more is the classic trap for founders selling a patent into their own start-up.
• Retained substantial rights. The Treasury regulations treat certain retained rights as fatal: a grant limited to a geographic area within the country of issue, a grant for less than the remaining life of the patent, a field-of-use restriction that withholds valuable rights, or a right for the seller to terminate at will. Retaining legal title purely as security for payment is normally acceptable. Whether a document is called a "licence" or an "assignment" does not decide the question; the substance of what passes does.
• Employment context. Where the invention was created under an employment or consultancy arrangement, the IRS may argue that payments are compensation for services rather than sale proceeds. The facts of the relationship and the drafting of the agreement matter.

If section 1235 does not apply, an inventor may still have a capital asset argument for rights acquired otherwise, but for a self-created patent the post-2017 rules point strongly towards ordinary income. That shift changes the foreign tax credit picture discussed below.

Reporting mechanics on the US return

A qualifying sale is reported on Form 8949 and Schedule D. Where payments arrive over several years, the installment method generally applies to deferred fixed payments, and contingent payment rules apply where the total price cannot be known at signing. Basis for an inventor is usually modest, typically unrecovered patent prosecution and legal costs that were capitalised rather than deducted. We attach a short statement identifying the transfer as a section 1235 sale, because buyers frequently issue information returns describing contingent payments as royalties.

How does HMRC tax the sale of patent rights?

Income, not capital gains

The UK does not follow the US capital gain approach. Under the Income Tax (Trading and Other Income) Act 2005, Part 5, Chapter 2 (section 587 onwards), income tax is charged on profits from sales of the whole or part of any patent rights where the seller is UK resident, or where a non-resident sells rights under a UK patent. The charge sits in the miscellaneous income rules and is taxed at income tax rates, up to 45% (48% at the top Scottish rate), not at capital gains tax rates. "Patent rights" are defined broadly as the right to do, or authorise the doing of, anything that would otherwise infringe the patent.

The taxable profit is broadly the proceeds less the capital cost of acquiring the rights. For an original inventor who has not purchased the rights, that deduction is usually small. HMRC's own guidance on the charge is set out in its Capital Allowances Manual at CA75210, and the statutory text is available on legislation.gov.uk (ITTOIA 2005 s587).

The six-year spread

For a UK resident individual, the default position is that a capital sum is taxed in six equal portions: one-sixth in the tax year of receipt and one-sixth in each of the following five tax years. Where the price is paid in instalments, each instalment is spread over its own six-year window starting in the year it is received. The seller may instead elect to have the whole sum, or any individual instalment, taxed in the year of receipt. HMRC's manual gives the election deadline for individuals as 31 January following the end of the tax year after the year of receipt, roughly 22 months after the year of receipt ends.

For a non-resident seller of UK patent rights the default is reversed: the whole amount is taxed in the year of receipt unless the seller elects to spread it.

Should a UK resident elect out of spreading?

Spreading generally helps a seller whose other income is below the additional-rate threshold, because it keeps more of each slice in lower bands. For many high earners the marginal rate will be 45% in every year regardless, so spreading delivers mainly a cash-flow benefit. For a US citizen, however, the decision has a second dimension: it changes when UK tax is paid relative to when the US gain is recognised, and that affects the foreign tax credit. The election should therefore be modelled across both returns, not decided on UK numbers alone.

Contingent and royalty-style payments in the UK

Payments measured by the buyer's sales or use can be analysed differently from a fixed capital sum. Depending on the drafting, HMRC may treat them as further proceeds of sale within Chapter 2 or as royalty-type income under other provisions of Part 5. The characterisation affects whether spreading is available and whether tax may be deducted at source by a UK payer. The contract wording, rather than the commercial label, drives this.

US vs UK treatment at a glance

Issue	United States (IRS)	United Kingdom (HMRC)
Basis of taxation	Citizenship: worldwide income taxed regardless of residence	Residence: UK residents taxed on worldwide income, subject to the foreign income and gains regime for new arrivals
Character of sale by inventor	Long-term capital gain if section 1235 is met	Income under ITTOIA 2005 Part 5 Chapter 2
Holding period	Irrelevant under section 1235	Irrelevant
Contingent payments	Still sale proceeds under section 1235	Depends on drafting: sale proceeds or royalty-type income
Top headline rate	20% plus 3.8% NIIT	45% (48% in Scotland)
Timing	Year of sale, or as received under installment rules	Spread over six tax years by default, election to tax in year of receipt
Tax year	Calendar year	6 April to 5 April
Double tax relief	Foreign tax credit on Form 1116, subject to category and limitation	Credit for US tax under the treaty, limited for US citizens

The cross-border problem: capital gain on one side, income on the other

This is where generalist guidance stops and where most of the risk sits. A US citizen pays UK income tax on the proceeds, potentially at 45%, and then has to use that UK tax to offset US tax on a gain the US is taxing at 20%. Several things follow.

1. The US foreign tax credit limitation bites

The foreign tax credit is limited to the US tax attributable to foreign-source income in the relevant category. Because the US is taxing the gain at a preferential rate, the rules require foreign-source capital gain to be adjusted downwards when calculating the limitation (the capital gain rate differential adjustment). The practical result is that UK tax at income rates will very often exceed the US tax on the same proceeds. The excess is not lost immediately: unused foreign tax credits can generally be carried back one year and forward ten years in the same category. But they are only useful if there is future foreign-source income in that category to absorb them.

2. Which category (basket)?

For an individual inventor who is not running a licensing trade, gain on the sale of patent rights will usually fall in the passive category. An inventor who carries on an active trade of developing and selling patents may have a general category position. The category matters because excess credits in one basket cannot shelter tax on income in the other. UK tax on salary, for example, typically sits in the general category and cannot be used against passive gains, and vice versa.

3. Sourcing: is the gain foreign source at all?

US sourcing rules are different for fixed and contingent consideration:

• Fixed (non-contingent) price: gain on the sale of personal property is generally sourced by the seller's residence. A US citizen living abroad is treated as a non-resident for this purpose only if their tax home is outside the US and they pay foreign income tax of at least 10% of the gain. A UK resident paying UK income tax on the proceeds will usually satisfy this, making the gain foreign source.
• Contingent consideration: to the extent payments are contingent on the productivity, use or disposition of the patent, they are sourced as if they were royalties, by reference to where the patent is used. If the buyer exploits the patent in the US, those payments are US source for foreign tax credit purposes, even though the sale is a capital transaction.

US-source income ordinarily cannot absorb a foreign tax credit. For US citizens resident in the UK, the US-UK income tax treaty contains special relief provisions which, broadly, require the UK to give credit only for the US tax that would be due from a non-citizen, and then allow the US to treat the remaining income as foreign source so the UK tax can be credited against US tax. Applying those rules correctly is often what separates full relief from genuine double taxation, and it requires the relevant treaty position to be disclosed on the US return.

4. Timing differences

The US may recognise all of the gain in year one while the UK taxes one-sixth a year for six years, and the two tax years do not even coincide. Under the current foreign tax credit regulations, foreign tax imposed on an amount that the US recognised in a different year is generally associated with the category of the related US income, but the credit is claimed when the foreign tax is paid or accrued. A cash-basis claimant could therefore show a large US gain with little UK tax in year one, followed by five years of UK tax with no corresponding US income in those years. The carryover rules help, but only within their ten-year window and limitation. Options to manage this include:

• electing out of UK spreading so that UK tax and US gain fall closer together;
• making the US election to claim foreign tax credits on an accrual basis, which is irrevocable once made and affects every later year; and
• aligning the US installment treatment with the UK instalment profile where the contract allows.

5. Net investment income tax

The 3.8% net investment income tax is imposed outside the regular income tax chapter, and the IRS and the US courts have taken the position that the foreign tax credit cannot be used against it. Taxpayers have argued that the US-UK treaty provides relief; that remains a contested position that must be disclosed if taken. For a large patent sale, this alone can produce a residual US liability even where UK tax far exceeds US income tax.

6. What if section 1235 does not apply?

If the transfer fails section 1235, for example because the buyer is a related company, the US treats the proceeds as ordinary income. That is a worse US outcome in isolation, but it removes the rate differential adjustment and may let more of the UK tax be credited. The net position across both countries can be closer than the headline rates suggest, which is why the modelling must be done on both returns together.

Withholding and information returns

If the buyer is a US company

Payments to a US citizen are not subject to the non-resident withholding regime, so the seller should give the buyer a Form W-9. Without one, the buyer may apply backup withholding. US buyers frequently report contingent payments on Form 1099-MISC as royalties, which the IRS matching system will expect to see as ordinary income. The return must reconcile the information return to the section 1235 reporting with an explanatory statement, or a notice is likely.

If the buyer is a UK company

UK rules can require a payer to deduct income tax at source from certain patent royalties and, in some cases, from proceeds of sale of patent rights. Any UK tax deducted is credited against the seller's UK liability and forms part of the UK tax that is then claimed as a foreign tax credit in the US. The seller should obtain a certificate of tax deducted for each payment.

Foreign account reporting

Large sale proceeds landing in UK accounts often push balances over the FBAR threshold and the Form 8938 thresholds for the first time, or include accounts that have never been reported, such as escrow or retention accounts. Escrow arrangements held abroad should be reviewed for reporting, and existing UK pension, ISA and investment accounts should be checked at the same time, since a sale is often the moment a long-standing omission is noticed.

Records and information to request from the buyer

Good preparation starts with the right documents. Before the first return is prepared we ask for:

• the executed assignment and any side letters, including every rights reservation, termination right and field or territory limitation;
• a schedule of all consideration: upfront payment, milestones, contingent payments and any equity received;
• for contingent payments, the buyer's periodic statements showing the basis of calculation and, critically, the countries in which the patent is used or products are sold, because this drives US sourcing;
• confirmation of the buyer's ownership structure, to test the 25% related-party rule;
• any employment, consultancy or research agreement under which the invention was developed;
• patent prosecution invoices and other costs to support basis and the UK capital cost deduction;
• US information returns issued by the buyer, and UK certificates of tax deducted; and
• bank statements showing receipt dates and exchange rates for each payment, since both the US gain and the foreign tax credit are computed in dollars.

Worked example: how the pieces fit

Consider a UK resident US citizen who assigns all substantial rights in a medical device patent to an unrelated US buyer for a $3 million upfront payment plus 4% of US net sales for ten years. The rights are not limited by territory or field, and the inventor retains no termination right.

• US: the transfer should qualify under section 1235. The upfront payment is long-term capital gain; the contingent payments are also capital gain as received. The upfront gain is likely foreign source (residence-based, with UK tax above 10%); the 4% payments are likely US source because the patent is used in the US.
• UK: the upfront payment is income under Part 5 Chapter 2, spread over six years unless the inventor elects otherwise. The royalty-style payments need separate analysis of their UK character.
• Relief: UK tax on the upfront payment will exceed the US tax on it, creating passive-category carryovers. The US-source contingent payments need the treaty relief provisions to avoid double taxation, and NIIT remains a likely residual cost.

The figures are illustrative; the real calculation turns on the inventor's other income, the exchange rates on each receipt date and the precise contract wording.

Already filed the sale wrongly? How to correct it

We regularly see returns where the sale was reported as UK capital gains tax, where the US return treated contingent payments as ordinary royalties, or where no foreign tax credit was claimed at all. Each can usually be put right:

• US amended returns. Form 1040-X can recharacterise the income and claim the foreign tax credit. The usual refund window is three years from filing, but claims arising from foreign tax credits benefit from an extended ten-year period, which is valuable where UK tax is paid in later years under spreading.
• UK amendments. A self assessment return can generally be amended within 12 months of the 31 January filing deadline. After that, an overpayment relief claim may be available within four years of the end of the tax year. Where income has been under-declared, HMRC's disclosure routes should be used promptly, as penalties are lower for unprompted disclosure.
• Missed US returns altogether. Where a US citizen in the UK has not been filing, a patent sale often brings it to light. The IRS Streamlined Foreign Offshore Procedures can bring non-wilful filers into compliance with three years of returns and six years of FBARs, generally without failure-to-file penalties. See our IRS streamlined filing service for how this works.

The UK spreading election also has a deadline; if it has passed, the default treatment generally stands, which makes early review important.

Why one team should prepare both returns

Each step above affects the other country's return. The UK spreading election changes the US foreign tax credit profile; the US sourcing of contingent payments changes how the treaty relief operates; a related-party sale changes US character and therefore the limitation calculation. Two advisers preparing two returns in isolation will rarely optimise the combined position. Our US-UK tax accountants prepare the US and UK returns in a single process, and our high-net-worth team handles the larger, multi-year transactions where carryovers and NIIT matter most.

Speak to specialists before the next filing deadline

If you have sold, or are about to sell, patent rights you hold personally while living in the UK, the returns for the year of sale set the pattern for up to six UK tax years and ten years of US credit carryovers. Getting the first year right is far cheaper than unwinding it later. To arrange a confidential review of your sale documents and prior returns, please contact our cross-border team.