New IP Circular

By the law of 17 April 2018, a new intellectual property (“IP”) regime was introduced in Luxembourg (“IP Law”) which is embedded in Article 50ter of the Luxembourg income tax law (“ITL”).

As a reminder, the IP Law provides for an 80 percent exemption on income derived from the marketing of certain IP rights, as well as a full exemption from net wealth tax. Eligible assets are patents, utility models, and other IP rights that are functionally equivalent to patents as well as software protected by copyright. The new IP regime is based on the “modified nexus approach” in line with the recommendations of the BEPS final report on action 5, following which only revenues that are directly related to qualifying expenses can benefit from the exemption.

Although the explanatory text that accompanied Bill No. 7163 provides tangible examples to illustrate the application of the IP Law, further guidelines were highly expected regarding certain concepts laid down in the IP Law and the application of the nexus ratio. This is now done with Circular 50ter/1 issued by the Luxembourg tax authorities on 28 June 2019 (the “IP Circular”).

In particular, the IP Circular clarifies the following:

• Eligible IP assets: The IP Circular clarifies the meaning of “marketing-related IP assets” which are specifically excluded from the benefits of the IP regime. The IP Circular refers to that purpose to the definition provided by the OECD  regarding marketing intangible assets which include intangible assets that contribute to the commercial exploitation of a product or service and/or have significant promotional value for the product concerned such as trademarks, trade names, domain names and customer lists.
• Research and development (R&D) activities: The IP Circular provides a definition of “R&D activities” by reference to item 27 of Article 1 of the Law of 17 May 2017 relating to the promotion of research, development and innovation. The concept is of peculiar importance as the eligible IP assets are only those that have been constituted, developed or improved as part of the R&D activities carried out by the taxpayer itself. In this respect, when the constitution of the IP asset is carried out by several persons, only the person that (i) has incurred its own expenses in relation to the R&D activity and (ii) is able to assume the risks linked with its own R&D activity may benefit from the IP regime.
• Date of constitution of the eligible asset: The eligible asset must have been created or acquired after 31 December 2007 to benefit from the new IP regime. The IP Circular provides as a rule of thumb that the constitution date is deemed to correspond to the date on which the eligible asset acquired protection under a domestic or international law. For some assets, the filing of the patent application already grants such protection. In this case, the constitution date is deemed to correspond to the filing date. Conversely, if the filing of the patent does not grant such protection, it is still possible to benefit from the exemption for eligible income generated during this period to the extent the protection title is eventually granted. In the event that the protection title has not been granted, the exempted amounts during the previous tax year(s) must be added back to the taxable profits of the tax year during which the protection has been rejected. Regarding software, the constitution date is deemed to correspond to the end of the R&D activities where the software becomes marketable.
• Eligible expenses:

1. - Article 50ter ITL does not provide any details on what could be eligible expenses. However, it lists 4 categories of eligible expenses amongst which “acquisition costs”. The “acquisition costs” are those directly linked to the eligible asset being created or developed and reflected in the value of that IP asset. Following the IP Circular, the “acquisition costs” concept is to be understood in a broad sense (by contrast with the “eligible assets” which are precisely identified in Article 50ter of ITL).
2. - The IP Circular provides the following list of examples of eligible expenses:
   1. - staff costs for researchers, technicians or other support staff;
   2. - costs of instruments and equipment;
   3. - costs of small equipment and tools;
   4. - costs of raw materials and similar products;
   5. - costs of studies;
   6. - administrative costs;
   7. - additional overheads;
   8. - costs related to the production and development of prototypes or pilot installations.

• Eligible income:

1. - According to Article 50ter ITL, eligible income includes inter alia:
   1. Income received as remuneration for the use or concession of the use of an eligible asset, i.e. royalties. The IP Circular clarifies that remuneration paid in return for obtaining exclusive rights of distribution of a product or service in a given territory does not constitute royalties in this context.
   2.  Income directly related to eligible assets that are embedded in the sale price of a product or service, i.e. the embedded royalties. Based on the IP Circular, this income corresponds to the royalties that an independent third party would pay for the granting of a license to use the eligible asset in connection with the manufacture of a product or the supply of a service. The amount of royalties is the percentage of the sale price of the product or service that the taxpayer would be willing to sell to an independent third party in order to market those products or services. The determination of the rates and amounts of royalties payable to an independent third party shall be made on the basis of the principles and criteria set out in Article 56bis ITL.
   3. Compensation obtained in court proceedings or arbitration involving an eligible asset. The IP Circular specifies that such compensation is paid as a result of the violation of the monopoly conferred by the eligible asset.
2. - In all cases, where a sale agreement, a licensing agreement, an agreement for the sale of a product or service, an agreement or a court decision does not exclusively relate to an eligible asset, the income derived therefrom must be split in order to allocate the share of income directly attributable to the eligible asset. The split must be made based on information included in the agreement or the court decision and on all other relevant information. An in-depth analysis of other agreements (if any) involving comparable IP assets by the same taxpayer may provide valuable information.

• Product family: According to Article 50ter ITL, each IP asset must be tracked individually, and income and expenses linked to each asset need to be identified. By way of exception, the asset-by-asset approach does not apply to a closely linked family of products or services. The IP Circular defines the family of products or services as a set of products or services manufactured or created  to have the same use or satisfaction.
• Examples : The IP Circular provides a series of examples on the determination of the exempt amount in the following various situations:
  1. - Where the expenses have been capitalised;
  2. - after a migration to Luxembourg;
  3. - during the transition from the former IP regime to the new one;
  4. - the offsetting of an adjusted net eligible negative income derived from an eligible asset against an adjusted net eligible positive income derived from another eligible asset;
  5. the transfer of an eligible asset in the context of a corporate restructuring;
  6. - the application of the 30% uplift when computing the amount of eligible expenses;
  7. - in case of available tax credits.
• Documentation requirements: The IP Circular stresses the necessity of very detailed supporting documentation including information on, inter alia, the tracking of eligible expenses, total expenses and eligible income in relation to each qualifying IP right family of products or services, the R&D project, the staff (their qualification and the time spent on each eligible asset, the related costs), etc. The documentation must demonstrate that all intra-group transactions are carried out in line with the transfer pricing guidelines deriving from BEPS actions 8-10.