At last, the Luxembourg parliament adopted the draft law (the "Law") on its new intellectual property tax regime (the "New IP regime"), applicable as from 1 January 2018.1
The New IP regime is introduced by means of a new article 50ter of the Luxembourg Income Tax Law of 4 December 1967, as amended ("LITL").
What's in it for you?
In a nutshell, a 80% tax exemption on income (including capital gains) derived from eligible IP assets as well as a full net wealth tax exemption on these assets.
Why was the New IP regime needed?
The New IP regime is part of the Luxembourg government's strategy to maintain Luxembourg's competiveness, to encourage research and development ("R&D"), to foster start-ups, to consolidate and diversify Luxembourg's economy, especially in the fields of Fintech (for more information read Pierre Reuter's "carte blanche") and, more recently, space mining (for more information read Simon Recher's and Pierre Reuter's "carte blanche").
In addition, one of the European Union's ("EU") long term goal is an economy based on knowledge and innovation. Tax incentives for intellectual property ("IP") are in line with this purpose and accepted by both the Organization for Economic Co-operation and Development ("OECD") and the EU.
Unlike the previous Luxembourg IP regime abolished with the law of 18 December 2015 (for more information "Luxembourg - Main New 2016 Tax Measures At A Glance", the New IP regime is in line with the international and European tax standards, namely the OECD's modified nexus approach and action 5 of its plan to tackle Base Erosion and Profit Shifting ("BEPS") by countering harmful tax practices.
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How does the New IP regime and the modified nexus approach work?
What are eligible IP assets?
How does the computation work?
What are eligible expenditures?
What are overall expenditures?
What are acquisition costs?
What is net eligible income?
According to OECD's modified nexus approach, value creation is measured by the expenditures incurred to create, develop and improve IP assets. Thus, the modified nexus approach implies a substantial activity requirement for intangible property (such as patent boxes). Luxembourg applies in its New IP regime such a modified nexus approach, which means that taxpayers are eligible for the exemptions of such a regime only if they can establish a direct link between (i) eligible IP assets, (ii) eligible expenditures, and (iii) eligible income resulting from such eligible IP assets.
OECD, EU and Luxembourg aim to encourage R&D activities. That's why income and expenses are eligible - provided that the conditions are met - even if the research did not reach any conclusive and/or profitable results.
What are eligible IP assets?
Eligible IP assets can be divided into two categories, being:
1 ) Inventions protected by:
- Patents
- Utility models
- Additional/supplementary protection certificates for patents on pharmaceutical and phyto-pharmaceutical products
- Additional/supplementary protection certificate extensions for pediatric medicine
- New plant variety certificate (not eligible under the previous IP regime)
- Orphan drug designations
2) Copyrighted software, protected under national or international provisions
The eligible asset must have been created, developed or improved in the context of specific R&D activities after 31 December 2007.
Unlike under the previous Luxembourg IP regime, marketing-related IP assets like trademarks or domain names are not eligible. According to the modified nexus approach, marketing-related IP assets can indeed never qualify for the tax benefits under an IP regime. For the sake of legal certainty, the State Council (Conseil d'Etat) recommended to include an exhaustive list of assets falling into this scope. Whilst this recommendation is sensible considering the broad definition of marketing-related IP assets, it seems understandable that the Luxembourg legislator did not want to delimit this concept at local level. Indeed, in our view, more guidance on this point should be provided by the OECD or the EU.
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How does the computation work?
The 80% exemption of the income calculated using the above formula is however subject to certain conditions. For instance, the amount of eligible expenditures (including the 30% uplift) is capped at the amount of the overall expenditure.
Further, taxpayers have to track the eligible expenditures, overall expenditures and eligible net income for each individual eligible IP asset. In line with the modified nexus approach, they need to demonstrate the link between expenses and income (including capital gains). Whilst this is generally determined on an asset-per-asset basis, there is an exception for taxpayers with a very rich and complex IP activity with several eligible assets. In these cases, taxpayers can regroup the information per product / services, respectively per family of product / services.
Finally, expenditures as well as income used for the computation above must be determined in line with the arm's length principle.
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What are eligible expenditures?
The understanding of eligible expenditures is fundamental as they serve as an indicator of substantial activities in the context of the New IP regime and the modified nexus approach.
Eligible expenditures are only those incurred by the taxpayers (including under certain specific conditions their foreign permanent establishment) for the creation, development or improvement of an eligible IP asset in the context of R&D activities. These expenditures include expenses made by taxpayers in the context of their own R&D activities as well as expenses (e.g., payments) to non-related entities (i.e., in the context of outsourcing) and related parties (in the sense of article 56 LITL, provided that the related party pays the amount received without a margin to a third party). Expenditures for general, speculative or unsuccessful research can also be eligible under certain conditions.
Acquisition costs, interests and financing costs as well as building costs are not eligible expenditures.
Eligible expenditures have to be taken into account when they incur, independently of their accounting or tax treatment.
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What are overall expenditures?
The overall expenditures include all (i) eligible expenditures, (ii) acquisition costs and (iii) expenses (e.g., payments) made to related parties, as long as they are related to R&D activities for the creation, development or improvement of an eligible IP asset.
Overall expenditures have also to be taken into account when they incur, independently of their accounting or tax treatment.
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What are acquisition costs?
The acquisition costs are those made for the creation, development or improvement of an eligible IP asset and incurred for:
the acquisition of an IP asset;
the acquisition of rights to do research; and
the remuneration for the use of right to use an IP asset.
To be, however, considered as an acquisition costs however, the latter must be reflected in the value of the IP asset.
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What is net eligible income?
Net eligible income is
- the sum of:
- remunerations perceived for the use or the right to use an eligible IP asset;
- remunerations perceived for a product or service whose price is linked to the eligible IP asset;
- capital gains realized on the sale of an eligible IP asset; and
- compensation received in the context of a judicial or arbitral procedure in connection with the eligible asset;
- minus the overall direct and indirect expenditures linked to the eligible IP asset.
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What happens, if your income is eligible for the previous and the new IP regime?
Even though the previous IP regime has been repealed by the law of 18 December 2015 (for more information "Luxembourg - Main New 2016 Tax Measures At A Glance"), there is still a grandfathering period until 30 June 2021.
The Law provides that taxpayers with assets eligible under both regimes choose one of the two. This choice will have to be applied by the taxpayers to all assets eligible to both regimes and will simply be made in the context of their tax returns. Note that the choice is irrevocable once the tax return is filed. Eligible assets of the previous IP regime only will not be impacted by this choice.
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What's next?
Under the pressure of the OECD's BEPS plan and its modified nexus approach, the new IP regime is less attractive than under its previous version. However, this comes without surprise in the context of the general tendency to tackle harmful tax practices in the world.
To actively promote R&D and to be competitive, the introduction of the anticipated New IP regime was nevertheless simply a must. Further, it should be highlighted that there are new attractive features, not covered by the previous IP regime, such as the integration of certain inventions, or the possibility for a foreign permanent establishment of a taxpayer to benefit from this New IP regime (under certain conditions).
Contrary to some other countries, Luxembourg chose not to introduce the third category of eligible IP asset set out by the OECD. Had Luxembourg opted for this category, other IP assets could have benefitted from the New IP regime provided that they were (i) non-obvious, useful and novel, and close to the two permitted categories mentioned above (such as Know-How for instance), and (ii) certified as such by a transparent certification process and a competent government body, independent from the tax administration.
However, the definition of this third category of eligible IP assets is rather broad and vague. Further, Luxembourg has currently no local appropriate certification mechanism. Therefore, Luxembourg opted for legal certainty instead of implementing this category in a way that might be criticized in the future by the OECD or the European Commission.
Indeed, bearing in mind the past criticism of the misuse of patent boxes and alike, the Luxembourg Government intends to carefully monitor the use of this third category of eligible IP assets, to observe the certification mechanism used by other EU member states and to analyze how they work out in and for those countries, before introducing it.
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1 The Law will only become effective once it has been published in the Luxembourg Official Journal.
Authored by Gérard Neiens and Jean-Philippe Monmousseau
Hogan Lovells (Luxembourg) LLP is registered with the Luxembourg bar.
