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Luxembourg’s new IP Box regime allows companies to benefit in some cases from large tax exemptions. Pierre Kihn of Office Freylinger explains how.
After abolishing the old IP Box regime in 2016, in April 2018, the Luxembourg parliament passed a law on introducing a new article 50ter into the Income Tax Law. It provides for an 80% exemption on income derived from the commercialisation of certain IP rights, as well as a 100% exemption from net wealth tax.
The new rules will be applicable from fiscal year 2018 (which each company can determine).
The new legislation is fully compliant with the 2015 agreement reached under the OECD/G20 base erosion and profit shifting (BEPS) project for IP Box regimes and in particular with the “modified nexus approach” set out in the BEPS final report on action 5, “Agreement on Modified Nexus Approach for IP Regimes”.
"Taxpayers must thus track and trace expenditure and income to IP assets to justify a claim that expenditure qualifies under the IP Box regime."
This modified nexus approach requires (i) that substantial economic activities are made in the benefiting country; and (ii) that a direct link between the income benefiting from the preferential IP Box regime and the research and development (R&D) expenditures that contribute to the income must be shown. Taxpayers must thus track and trace expenditure and income to IP assets to justify a claim that expenditure qualifies under the IP Box regime.
The key features of the law are summarised below.
Patents, utility models, supplementary protection certificates for certain drugs and phyto-pharmaceutical products, orphan drug designations and plant breeder’s rights; and
Such IP assets need to have been created, developed, or improved in the framework of qualifying R&D activity after December 31, 2007.
Qualifying net income
- Income derived from the use of, or a license to use, qualifying IP rights (ie, royalty income);
- IP income embedded in the sales price of products or services directly related to the eligible IP asset;
- Indemnities based on an arbitration ruling or a court decision directly linked to a breach of a qualifying IP right; and
- Capital gains derived from the sale of the qualifying IP rights.
The regime applies on a net income basis, meaning that expenses relating to the qualifying IP asset need to be deducted from the gross qualifying income.
If net losses were incurred on qualifying IP rights in previous tax years, the losses need to be taken into account in the first year in which the taxpayer has net positive income. As required by the OECD and the EU, this mechanism is intended to ensure that net losses incurred in relation to the preferential IP regime would not be able to offset other income taxable at the standard rates on a permanent basis.
The existence of substantial activity is determined under the modified nexus approach, by the presence of qualifying expenditures that are in direct relation with the income derived from the IP rights. Only revenues that result from investments in R&D activities will benefit from the exemption.
The proportion of qualifying net income entitled to the benefits (nexus ratio) will be determined based on the ratio of the qualifying expenditures and the overall expenditures.
Qualifying expenditures includes four broad categories:
R&D expenditure incurred by the taxpayer for the creation, development or improvement of qualifying IP rights. It does not include the costs of acquisition of the IP rights, real estate costs, interest and financing charges or costs that cannot be directly linked to the eligible IP asset.
Expenditure for general and speculative R&D or expenditure for unsuccessful R&D that can be linked or prorated across qualifying IP assets to the extent documented by the taxpayer.
R&D expenditure incurred by a permanent establishment of the taxpayer under the conditions that:
- The permanent establishment is located in a country within the European Economic Area.
- It is operating at the time the eligible income is derived.
- It does not benefit from a similar regime in its country of establishment.
The IP rights and revenues resulting from the R&D activity performed in the foreign jurisdiction must be allocated to Luxembourg taxpayer based on the relevant double tax treaty. This will be the case when the Luxembourg taxpayer exercises the significant functions and assumes the risks linked with the R&D activity performed in the permanent establishment.
R&D expenditure outsourced to an unrelated party (including when outsourcing is channelled through a related party but only if the latter does not mark-up the outsourcing costs).
Overall expenditure is defined as the sum of the above qualifying expenditure, IP acquisition costs, and outsourcing costs to related parties.
The nexus ratio is determined on a cumulative basis and expenditures are included at the time incurred, regardless of the treatment for accounting or tax purposes.
A 30% increase applies to qualifying expenditure up to the amount of overall expenditure under the condition that the nexus ratio remains below 1.
The new regime obliges taxpayers to track income and expenditure to determine the nexus ratio and the net eligible income per type of qualifying IP asset and provide evidence of this to the tax administration.
A product-based approach may be used, where expenditure and income are tracked and traced to products or services, or families of products or services, arising from qualifying IP assets, when the taxpayer is engaged in a complex IP-related business and tracking per individual asset would be unrealistic and based on a subjective determination.
These groupings include all IP assets that arise from overlapping expenditure and contribute to overlapping streams of income. Taxpayers using this approach have to produce objective and verifiable documentation that justifies the appropriateness of this approach.
Finally, in an intragroup context, all transactions have to be properly determined and documented according to the new transfer pricing guidelines deriving from BEPS actions 8 to 10.
Based on the new IP Box regime, if a company incurs all the expenditure to develop a qualifying IP asset, all income derived from the commercialisation of that IP would qualify for benefits, leading to an effective tax rate of approximately 5.2%.
The law incorporates the requirements of BEPS action 5 and aligns Luxembourg’s IP regime with global standards. It also contains provisions intended to deal with the coexistence of the new regime with the transition provisions of the old IP Box regime, which remain applicable until June 30, 2021.
The new IP Box regime is beneficial for Luxembourg’s economic diversification objectives and provides further incentives for private R&D investment.
Pierre Kihn is the managing partner of Office Freylinger, a Luxembourg-based IP boutique firm. He is a chemical engineer, a European patent attorney, and a European trademark and design attorney. He can be contacted at: email@example.com
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