Introduction and background
On 22 March 2018, the Luxembourg Government voted to approve the Luxembourg’s new Intellectual Property (IP) regime, which will enter into force with retroactive effect as from 1 January 2018. The law voted is generally in line with the provisions of the draft bill of law, which was issued in August 2017. In brief, Luxembourg taxpayers are, as from 1 January 2018, able to benefit (under certain conditions) from an 80% (corporate) income tax exemption applicable to specific income derived from certain assets (such as patents and copyrighted software). In addition, the assets which qualify for the 80% exemption are fully exempt from net wealth tax.
The new regime replaces the former IP regime which has been abolished as of 30 June 2016 since it was not in line with the so-called “modified nexus approach”, as defined in the OECD Report on Action 5 of the BEPS Action plan.
Key features of the new IP regime
The income and gains qualifying for the 80% income tax exemption would equal the Net Eligible Income (subject to certain specific adjustments) from Eligible Assets multiplied by a specific ratio. The ratio equals the Eligible Costs (with an uplift of 30% but capped at the Total Costs) over the Total Costs, as further clarified below. According to the Luxembourg government, this ratio implements the modified nexus approach, as only the R&D activities having a nexus with the Luxembourg taxpayer benefit from the IP tax regime. The key elements of the new IP tax regime are as follows.
Determination of the qualifying income for the 80% exemption
ii. utility models,
iii. complementary protection certificates for patents for medicine and plant protection products,
iv. extensions of a complementary protection certificate for paediatric medicines,
v. plant variety certificates,
vi. orphan drug designations and
vii. software protected by copyrights.
Eligible Assets must have been constituted, developed or improved after 31 December 2007. The filing date for registration is decisive. Trademarks and domain can no longer qualify (where they could qualify under the former IP regime).
Net Eligible Income: royalties, income embedded in sold products or services, capital gains and certain indemnities, all in relation to Eligible Assets, minus all costs directly and indirectly linked to Eligible Assets.
Eligible Costs: the costs (excluding acquisition of Eligible Assets, financing and real estate costs) in direct relation to R&D for the constitution, development or improvement of an Eligible Asset conducted by the taxpayer (including its permanent establishment located in the EEA) or outsourced to third parties.
Total Costs: Eligible Costs plus acquisition costs of an Eligible Asset and costs of R&D outsourced to related parties in relation to an Eligible Asset.
Amendment to initial bill of August 2017
A specific provision on the treatment of R&D expenses, incurred by a foreign permanent establishment of a Luxembourg head office, has been added to the initial bill. The provision specifies that such expenses are included in the R&D qualifying expenses (if directly connected to the Eligible Assets and required for actual R&D activities) for the determination of the nexus ratio, provided that all of the following conditions are satisfied:
i. the expenses are allocated to the head office of the foreign permanent establishment according to the provisions of a double tax treaty;
ii. the foreign permanent establishment is situated in the European Economic Area (i.e. EU Member States plus Iceland, Liechtenstein, and Norway), not being Luxembourg;
iii. the foreign permanent establishment is operational at the time the qualifying IP income is generated; and
iv. the foreign establishment does not benefit from a similar IP regime in the country where it is situated.
Moreover and as mentioned before, the abovementioned expenses can only be considered for the purpose of the determination of the nexus ratio if they are directly related to the constitution, development or improvement of an Eligible Asset allocated to the Luxembourg head office. Therefore, the Luxembourg head office should
i. perform and control all relevant functions related to the R&D activities (such as development, enhancement, maintenance and exploitation of the activities) carried out by the foreign permanent establishment, that generated the expenses, and
ii. bear all the risks that are related to those functions.
The above results in the following formula to determine the income which is eligible for the 80% exemption:
Net Eligible Income X (Eligible Costs with 30% uplift/Total Costs).
Considering this formula, companies which effectively want to benefit from the exemption are encouraged to reduce their costs of R&D outsourced to related parties and/or increase their costs of R&D outsourced to third parties. Alternatively, it could be considered to convert related R&D centres to branches of the Luxembourg company owning the Eligible Asset as this will increase the ratio and hence, the income eligible for the 80% exemption. Furthermore, as the acquisition costs of the Eligible Asset are included in the Total Costs, passively held IP no longer generates any income which could benefit from the 80% exemption.
The passed law furthermore provides that the 80% tax exemption in principle (subject to exceptions) is to be applied on the basis of each IP-asset individually.
Timing and impact
As said, the start of the new law’s period of effectiveness has been set to 1 January 2018. However, taxpayers owning IP assets that benefited from the former IP regime (before it was repealed as of 30 June 2016) and which IP assets no longer qualify under the new regime, can continue to benefit from the former regime during a transitional period lasting until 30 June 2021.
The new IP regime is beneficial for Luxembourg’s economic diversification objectives and will provide incentives for private R&D investments.