Tax Alert

Luxembourg introduces draft law on new IP regime

28 August 2017

  • Share

Executive Summary

On 7 August 2017, Luxembourg’s Minister of Finance introduced in Parliament the long awaited draft law n°7163 (Draft Law) on the new intellectual property (IP) regime. This follows the abolishment of the old IP regime by the 2016 Budget Law.

The old IP regime, as set forth by article 50bis of the Income Tax Law, was terminated on 30 June 2016, with however a transitional period of five years, since it was not compliant with the so-called “nexus approach,” as established by the Organisation for Economic Co-operation (OECD) in the final report on Action 5 of the Base Erosion and Profit Shifting (BEPS) plan, on Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance.

Under the “nexus approach,” the application of an IP regime should be dependent on the level of research and development (R&D) activities carried out by the taxpayer itself.

The revised IP regime, to be introduced in the Income Tax Law through a new article 50ter, provides for an 80% tax exemption of the net income derived from qualifying IP. Based on the agreed nexus approach, the formula to be applied broadly corresponds to the proportion of qualifying expenditures compared to overall expenditures (nexus ratio) applied to the adjusted and compensated net eligible income from IP asset:

To view the formula, please download the PDF version.

Once approved by Luxembourg’s Parliament, the provisions of the new IP regime should apply as from fiscal year 2018.

Detailed discussion

Qualifying IP assets

In line with the nexus approach, qualifying IP assets are patents and other IP assets that are functionally equivalent to patents if those IP assets are legally protected under national or international provisions.

Functionally equivalent assets as listed by the Draft Law comprise utility models, supplementary protection certificates on patents for pharmaceutical and plant protection products as well as extensions of supplementary protection certificates for products intended for pediatric use, plant breeders’ rights and orphan drug designations. The Draft Law also includes copyrighted software in the list of qualifying IP assets, whereas marketing-related intangible assets such as trademarks or domain names no longer qualify under the new IP regime.

Under the nexus approach, the aforementioned assets are however only eligible for the new IP regime if they result from an actual R&D activity undertaken by the taxpayer itself.

Determination of the adjusted and compensated net eligible income from IP asset

1. Net eligible income from IP asset

The net eligible income is defined as the gross eligible income minus (i) the overall expenditures and (ii) the expenditures that are indirectly linked to a qualifying IP asset. The determination of the latter must be made in line with the general rules applicable to the determination of taxable income, taking into account all relevant facts and circumstances for a given case.

The gross eligible income includes income that is derived from the qualifying IP asset, being income received for the use or the right to use a qualifying IP asset, capital gains from the sale of a qualifying IP asset, embedded IP income from the sale of products or services and indemnities received in the framework of a judicial proceeding or an arbitration involving a qualifying IP asset.

As a matter of principle, the net eligible income must be determined on an IP-asset-by-IP asset basis. However, in circumstances where a tracking by asset is not achievable, the taxpayer may use a product-based approach in which case the determination of the net eligible income is made by product or service (or families of products or services) (see below).

Although the amount of the net eligible income realized during a given year constitutes the calculation basis of the amount that can benefit from the partial tax exemption, the said amount is still likely to be adjusted and compensated.

2. Adjustment of the net eligible income

According to the commentaries of the Draft Law, the adjustment aims at ensuring that the net eligible income benefits from the partial tax exemption only insofar as it exceeds the amount of (direct and indirect) expenses in relation with the qualifying IP asset.

To prevent the expenditures’ accounting treatment from having an impact on the amount subject to exemption, the Draft Law foresees two different methods to determine the adjusted net eligible income. The first method applies in the case of deduction of the expenses related to the constitution of the qualifying IP asset (i.e., eligible asset booked as an expense) whereas the second method applies in the case that the expenses have been activated (i.e., eligible asset is amortized).

First method

In the case that the expenses in relation with the constitution of the underlying qualifying IP asset have been deducted from the taxable income of the financial year during which they have been incurred, they must be “recaptured,” i.e., the amount of the net eligible income is adjusted by adding back the sum of such negative income of prior years, provided that they have not yet been compensated with a positive income derived from the same qualifying IP asset. As long as the net eligible income is still negative after the adjustment, the partial tax exemption is not granted.

Example:

 

Tax year
N
N+1
N+2

Eligible income

55,000

55,000

./. Expenses

(80,000)

Net eligible income

(80,000)

55,000

55,000

+ Sum of expenses to be recaptured

(80,000)

(80,000)

(25,000)

Adjusted net eligible income

(80,000)

(25,000)

30,000

Positive adjusted net eligible income

30,000

Second method

In the case that the expenses in relation with the constitution of the underlying qualifying IP asset have been activated, the same principle applies: the amount to be recaptured consists of the amortization expenses of the same financial year and of prior years (i.e., the amount of the net eligible income is adjusted by adding back the amortization relating to the qualifying IP deducted during the same fiscal year as well as the sum of such negative income of prior years), provided that they have not yet been compensated with positive income derived from the same qualifying IP asset, including the gross book value of the activated expenses. Again, only a positive net eligible income after adjustment can benefit from the partial tax exemption.

Example:

 

Tax year
N
N+1
N+2

Eligible income

55,000

55,000

./. Expenses (including amortization)

(20,000)

(20,000)

(20,000)

Net eligible income

(20,000)

35,000

35,000

+ Amortization to be added back

20,000

20,000

20,000

./. Gross book value of qualifying IP asset

(80,000)

+ Sum of expenses to be recaptured

(80,000)

(25,000)

Adjusted net eligible income

(80,000)

(25,000)

30,000

Positive adjusted net eligible income

30,000

3. Compensation of the net eligible income

The compensation aims at offsetting the losses incurred by one qualifying IP asset with the profits incurred by another qualifying IP asset.

If the adjusted net eligible income, determined as described above, is negative, it must be compensated with any other positive adjusted net eligible income (and up to the amount of such positive income) derived from any other qualifying IP asset. In such case, the amount of the negative adjusted net eligible income (in relation with the qualifying IP asset that had such negative income) is reduced by the amount of the aforementioned compensation; i.e., the sum of expenses to be recaptured the following year is reduced by the amount that has been used to compensate the other positive adjusted net eligible income.

4. Specific situations

Migration to Luxembourg

In the case of transfer of the statutory seat or head office of a collective corporate company, or transfer of a foreign permanent establishment to Luxembourg – which implies that Luxembourg has going forward the right to tax the income derived by the company – the determination of the net and not yet compensated negative income of the qualifying IP asset is to be done as if there had been no migration, i.e., the aforementioned provisions apply. In addition, if there has been a step-up in value of the qualifying IP asset upon the migration, the difference between the carrying value and the net book value is included in the net negative income for purposes of determining the sum of expenses to be recaptured in relation to the qualifying IP assets. As a consequence, this difference will ultimately reduce the amount of the net income benefitting from the tax exemption.

Eligible asset already qualifying under the old IP regime

Where a qualifying IP asset has been an eligible IP asset under the old IP regime, the sum of expenses to be recaptured will be determined as follows:

  • As long as the old IP regime still applies, the expenses to be recaptured according to the provisions of the former regime constitute the expenses to be recaptured under the new regime.
  • When the old IP regime ceases to apply, the determination of the expenses to be recaptured is to be done as for any other qualifying IP asset for which the expenses in relation with the constitution of the underlying qualifying IP asset have been activated.

However, the remaining net book value of the qualifying IP asset at the date of opening of the first tax year for which the new IP regime applies will be taken over and is treated as negative income in relation with the qualifying IP asset under the new regime.

Eligible IP asset relocated in the context of a tax neutral transfer

If a qualifying IP asset is transferred in the context of a tax neutral transfer (e.g., contribution of an enterprise or autonomous part of enterprise to another company, merger or demerger), the determination of the net adjusted eligible IP income at the level of the beneficiary company is to be made as if no transfer took place, i.e., the net eligible income must be adjusted and compensated in the same way as it would have been adjusted and compensated at the level of the transferor.

Determination of the nexus ratio

The adjusted and compensated net eligible income obtained by application of the above described rules must then be multiplied by the nexus ratio, which is determined by the proportion of:

  • The qualifying expenditures incurred by the taxpayer over the lifetime of the qualifying IP asset or the product or service (or product or service family) derived from qualifying IP assets (i.e., the expenses incurred during the current financial year and prior financial years). In order not to penalize taxpayers having engaged costs for the acquisition of IP or having incurred subcontracted expenditures from a related party for the R&D activity of a qualifying IP asset, the amount of qualifying expenditures is increased by 30% as long as the increased amount of qualifying expenditures does not exceed the taxpayer’s overall expenditures.

Compared to:

  • The amount of overall expenditures incurred by the taxpayer over the lifetime of the qualifying IP asset or the product or service (or product or service family) derived from qualifying IP assets (i.e., the expenses incurred during the current financial year and prior financial years).

1. Qualifying expenditures

Under the Draft Law, qualifying expenses must have been incurred for the purpose of actual R&D activities undertaken by the taxpayer itself and directly connected to the constitution, the development or the improvement of a qualifying IP asset. The expenses are included in the determination of the ratio at the time they are incurred, regardless what the accounting or tax treatment is.

In the case of outsourcing of such R&D activities, only expenditures paid to unrelated parties are treated as qualifying expenditures. Expenditures paid to related parties (within the meaning of article 56 of the Income Tax Law), independently from their location and from the type of contractual engagement (subcontract or other contractual form) are not comprised in the qualifying expenditures, unless the expenditures are paid through a related party to an unrelated party without any mark-up (i.e., pass through costs).

It should be noted that expenditures incurred by a permanent establishment may be treated as qualifying expenditures, provided that:

  • The permanent establishment is located in a State party to the Agreement on the European Economic Area (EEA Agreement) other than Luxembourg
  • The permanent establishment is operational at the time of the realization of the eligible income
  • The permanent establishment must not benefit from a similar IP regime in the State of its location

Costs for the acquisition of an IP asset, for the acquisition of a right entitling to engage in research activities and for the use or the right to use an IP asset are defined as “acquisition costs” and do not constitute eligible expenditures. The same holds true for interest and financing expenses, property-related costs and other expenditures that are not directly linked to a qualifying asset (exceptions as regards expenditures for general and speculative R&D as well as R&D costs which have not directly led to the creation of eligible IP assets are however foreseen).

2. Overall expenditures

The overall expenditures comprise, in addition to the qualifying expenditures, the acquisition costs and any payments made to a related party for R&D activities made by such party for the benefit of the taxpayer and which are directly linked to the constitution, the development or the improvement of a qualifying IP asset. Those expenditures are to be taken into account in the year where they were incurred, irrespective of their accounting or tax treatment.

Determination of the net income benefitting from the partial tax exemption

The net eligible income benefitting from the tax exemption of 80% will be determined by applying the nexus ratio to the adjusted and compensated net eligible income.

The partial tax exemption is however subject to the following additional conditions:

  • The taxpayer must be able to track the qualifying expenditures, the overall expenditures and the eligible income derived from each qualifying IP asset, in order to establish the link between such income and expenses.
  • Where such tracking becomes unrealistic due to a plurality of qualifying IP assets, the taxpayer may track and trace products or services (or product or service family) arising from IP assets rather than applying an IP-asset-by-IP-asset approach. Under such product-based approach, the taxpayer is required to include all qualifying expenditures linked to the development of all IP assets that contributed to the product in “qualifying expenditures” and to include all overall expenditures linked to the development of all IP assets that contributed to the product or service (or product or service family) in “overall expenditures.” The taxpayer must justify on the basis of objective and verifiable information that the product-based approach is appropriate and consistent with the organization of R&D research and development activities.
  • Overall expenditures and eligible income must be determined in line with the arm’s-length principles.
  • The taxpayer must keep documentation at the disposal of the Luxembourg tax administration that demonstrates the compliance with the aforementioned provisions.
  • For income related to IP legally protected, exemption applies from the date of application for IP protection. If the application for IP protection is subsequently denied or withdrawn, the benefits of the partial exemption are clawed back.

Net wealth tax

As it was already the case under the old regime, qualifying IP assets are exempt from net wealth tax.

Interaction between the old and the new IP regime

As foreseen by the 2016 Budget Law, the old IP regime continues to apply, subject to certain conditions, until 30 June 2021, while the new regime should apply as from fiscal year 2018. As a consequence, both regimes will co-exist during a certain period.

The Draft Law leaves it to the taxpayer to choose to apply the provisions of one or the other regime. The option for the new IP regime will however apply to all qualifying IP assets; it is thus not possible to apply the provisions of the new regime to determined qualifying assets only, whereas the provisions of the old IP regime would continue to apply to other qualifying assets. There is however one exception: if a determined IP asset does not qualify for the new IP regime, the provisions of the old IP regime will continue to apply during the transitional period to the income generated from such IP asset, regardless of an option for the new IP regime to apply to other qualifying IP assets.

Restriction as regards the rollover provision

Subject to certain conditions, the taxation of capital gains derived from the sale of certain assets may be deferred if the sales proceed are reinvested in a replacement asset (i.e., the said rollover regime for capital gains).

The Draft Law specifies that a qualifying IP asset does not qualify as a replacement asset under the rollover regime for the tax deferral of capital gains, i.e., the aforementioned tax deferral on capital gains is not granted if the sales proceeds are reinvested in an IP asset that would qualify under the new IP regime.

Implications

The new legislation is complex and subject to some strict conditions. Therefore, companies should be prepared for the new requirements they will have to meet in order to benefit from the new IP regime.

Groups may want to review and reconsider their current business model, especially where R&D activities are split between group companies. Since the new IP regime requires accurate tracking of expenditures and income in relation with qualifying IP assets, it is important to review the existing systems and processes and, where required, to put into place appropriate mechanisms to be able to identify the various income streams and to collect data on R&D expenditures.

 

Download this Tax Alert as a PDF file.