The OECD has reached on February 20th 2015 a consensus on the underlying principles of the nexus approach applicable to Intellectual Property tax regimes.
The Luxembourg Ministry of Finance consequently announced on February 26th 2015 that the current Luxembourg IP Income Tax Regime (“IP Box”) will be amended to fall in line with this new approach.
However, as technopole companies will benefit from a long grandfather clause (the current regime will remain open until June 30th 2016), and as the reformed regime will be closely modeled after the current one, Luxembourg will prevail as the jurisdiction of choice for innovative companies with R&D activities.
1. Luxembourg IP Box, the Royal Regime
Article 50 bis of the Luxembourg Income Tax Law(L.I.R.) presented by the Law of December 21st 2007, introduced a very favorable Intellectual Property Box (also known as patent box or innovation box, hereinafter “IP Box”) regime in Luxembourg.
Luxembourg implements an 80% tax exemption on the net income derived by a company from royalties, capital gains and damages from the use/exploitation, or from the sale/alienation of IP rights in Luxembourg. The net income is defined as the overall income from the IP asset minus directly related expenses.
As such, the effective taxation amounts to 5,84% on said rights.
So, for example, if a company receives € 500.000 in royalties from the IP rights it licensed, with the amortization amounting to € 83.000 and the related expenses to € 16.667, the net income will amount to € 400.000.
With an effective taxation of 5,844%, the total tax liability is set at € 23.376.
The qualifying IP rights are patents, trademarks, service marks, software copyrights, domain names, design or models. They must have been created or acquired after December 31st 2007.
Those IP rights must not have been acquired from affiliated companies, that is to say:
the company acquiring the IP must not hold more than a 10% direct participation in the transferring company or;the transferring company must not hold more than a 10% participation in the share capital of the acquiring company or;the share capital of each of the acquiring company and transferring company must not be held for more than 10% by a common shareholder.
There is also a 100% exemption from net wealth tax on qualifying IP assets.
2. The OECD and G20 approach to IP Boxes
The OECD has been implementing since 2013 the Base-Erosion and Profit Shifting Action Plan (BEPS), which intends to crack down on practices deemed harmful to states and damaging tax competition.
Two consensus have already been adopted:
Countering Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance, BEPS Action 5Agreement on Modified Nexus Approach for IP Regimes, BEPS Action 5
Qualifying R&D expenditures incurred
Overall income from the IP asset x −−−−−−−−−−−−−−−−−−−−−−−
Overall R&D expenditures incurred
The modified nexus approach, adopted following the proposal put forward by the UK and Germany on November 11th 2014, proposes that benefits enjoyed from IP should be proportional to the R&D expenditures incurred by the company in the same jurisdiction. The expenditure in the context of outsourcing and acquisitions that can benefit from an IP tax regime is limited to 30%, and this expenditure must have actually taken place.
The OECD has given an example of how this “up-lift” would work: if a parencompany qualifying expenses amount to 100, the maximum up-lift amount is 100 x 30% = 30.If the parent company’s incurred costs for the acquisition of the IP asset amount to 10 and its subsidiary’s incurred R&D expenses amount to 40, then the overall qualifying expenses amount to 130.If the parent company’s incurred costs for the acquisition of the IP asset amount to 5 and its subsidiary’s incurred R&D expenses amount to 20, then the overall qualifying expenses amount to 125.
However, in 2013, the Commission launched an investigation on the newly adopted UK Patent Box regime and deemed it harmful to tax practice in the European Union and incompatible with the Code.
A State aid procedure was opened (Procedure number: SA.37657) on Luxembourg’s IP Box regime in 2014, and the inquiry was enlarged to ten member states, amongst which Belgium, Cyprus, France, the UK, and was further enlarged upon request by ECOFIN to all European IP Boxes.
However, in line with the positive advice of the Commission on the Spanish IP Box regime in 2008, the investigation was dropped shortly before the adoption of the OECD consensus on the modified nexus approach.
On December 9th 2014, the Code Group (legal department of the Commission and of the Council of the European Union) confirmed that they endorsed the modified nexus approach, and also found it compatible with EU legislation.
3. The European Union investigation
R&D promotion is a common interest target, according to article 197(1) of the Treaty on the Functioning of the European Union.
However, this common interest must be balanced with the fair competition objective, cornerstone of the EU internal market. As such, member states’ tax regimes must not constitute a State aid, that is to say an advantage conferred on a selective basis to undertakings by member states.
To this aim, the EU developed a code of conduct for business taxation (“the Code”), politically persuasive but not legally binding.
In 2008, the European Union Commission (“the Commission”) reviewed the Spanish IP Box regime and concluded that it was not a State aid.
However, in 2013, the Commission launched an investigation on the newly adopted UK Patent Box regime and deemed it harmful to tax practice in the European Union and incompatible with the Code.
A State aid procedure was opened (Procedure number: SA.37657) on Luxembourg’s IP Box regime in 2014, and the inquiry was enlarged to ten member states, amongst which Belgium, Cyprus, France, the UK, and was further enlarged upon request by ECOFIN to all European IP Boxes.
However, in line with the positive advice of the Commission on the Spanish IP Box regime in 2008, the investigation was dropped shortly before the adoption of the OECD consensus on the modified nexus approach.
On December 9th 2014, the Code Group (legal department of the Commission and of the Council of the European Union) confirmed that they endorsed the modified nexus approach, and also found it compatible with EU legislation.
4. So, is the Luxembourg IP Box regime threatened ?
The Luxembourg Ministry of Finance, Pierre Gramegna, answering to a Parliamentary question on the changes to be expected in Luxembourg following the adoption of the OECD consensus, has announced that the legislative procedure to amend the Luxembourg IP Box regime will be set in motion in 2015.
The current IP regime will thus be abolished.
But this change will not take place in one fell swoop, as the current Luxembourg IP Box Regime also enjoys a 5-year grandfather clause, which will enable companies to benefit from it until June 30th 2021.
Furthermore, this is not a revolution: as is already the case in other member states implementing such regimes, this reformed regime will most likely be closely modeled after the current one, which was already focused on attracting investment accompanied by real and substantial business activity.
Based on the European and OECD developments, it is likely that the new IP Box will apply to a narrower category of IP (trademarks will likely be excluded) and emphasis will be placed on the existence of a substantial economic activity. Companies will need to ascertain and track their R&D expenditure more closely. To compete with other IP Boxes, the taxation of the qualifying IP income should remain at a favorable rate, preferably averaging 6%.
The existing regime will be closed to new entrants as of June 30th 2016. As such, there is only limited time to implement an IP holding structure benefiting from the current regime.
Companies with significant IP assets or income should enter the current Luxembourg regime before June 30th 2016, while it is still open.