Maximizing the benefits of innovation tax incentives

Luxembourg's tax system for Intellectual Property (IP) provides a partial exemption from direct taxes for eligible taxpayers in certain industries that create IP, or where the business’s added value is based on IP – such as video games and payment solutions. 

Despite being in effect for five years, not all qualifying companies are availing themselves of the regime’s advantages due to prevalent misunderstandings and intricacies surrounding the system. Proper guidance, however, can help businesses benefit from potential tax savings.

Maximizing the tax benefits of Luxembourg's IP regime: overcoming misconceptions and complexities

In March 2018, the latest IP tax regime was introduced in Luxembourg. The previous regime was replaced to align Luxembourg legislation with the so-called “nexus approach”, which was established by the OECD in one of the reports on the Base Erosion & Profit Shifting plan for the countering of harmful tax practices.

This latest regime grants Luxembourg taxpayers a partial exemption from direct taxes (80% of eligible IP income), with an application restricted to software, patents and other IP assets functionally equivalent to patents, for an amount of income proportionally equivalent to the level of research and development (R&D) costs directly incurred by the Luxembourg taxpayer.

Five years after the regime was implemented, we observe that the tax benefits are not always used by companies that are entitled to them, such as software developers or companies whose business is heavily driven by innovative software. In fact, we have discussed with many Luxembourg entities in the TMT (Telecommunications, Media and Technology) sector wherein software is fully or at least partially developed in Luxembourg and have learnt that they are not applying the IP regime despite normally being in a position to prove that they meet all the necessary conditions.

On the one hand, we have noticed that some companies engaged in the in-house development of IP are basically unaware that the IP regime is an option for them and have the view that because the software is not explicitly licensed to its customers or related parties, the IP regime cannot be applied. However, one noteworthy aspect of the Luxembourg IP regime is the comprehensive definition of “eligible income” which enables not only consideration for actual licensing of the IP to be eligible but also income related to the intellectual property assets, which is included in the sale price of a product or service (“embedded IP income”). Thus, Luxembourg companies that sell products or provide services containing intellectual property developed in-house to benefit from the IP regime. For instance, entities like payment solution companies, ID authentication companies, or video game companies can remarkably benefit from the IP regime.

On the other hand, we have identified taxpayers that believe the IP regime is highly complex and assume its benefits will not be worthy to cover the implementation costs. This assumption is however not entirely accurate. While we agree that the conditions of the IP regime are not free of complexity, the analysis should normally be done once and in the first year of implementation. Costs are therefore high during the first year but based on our experience such costs are not material compared to the cost savings the IP regime is expected to bring down the line, in the large majority of cases.

Quantifying tax savings

An exploratory feasibility analysis is therefore recommended to companies in order to identify and quantify the regime’s tax benefits. This stage will include identifying the IP assets owned by the company, their expenditures, and the eligible income, which should help to estimate the tax savings available for them.

In the second stage, the implementation takes off. The first year may be complicated and time-consuming since the company must adjust to and become familiar with the requirements of the law in terms of the expenses and income that will be subject to the regime. This launch effort will pay off, however, since implementation costs will be reduced from the second year onwards.