Following the OECD and G20 actions to tackle harmful tax practices, the 2015 OECD Report on BEPS Action 5 (Countering Harmful Tax Practices More Effectively Taking into Account Transparency and Substance) sets the outer limits for regimes which provide for a preferential tax treatment for income arising from qualifying intellectual property (IP regimes).
The BEPS Action 5 Report focuses on the endorsement of the so-called "modified nexus approach" which makes the benefit of an IP regime conditional on the extent of R&D activities performed by the qualifying taxpayer. This introduces a substantial activity requirement as a condition to the granting of a preferential IP regime.
All OECD and G20 members (including Belgium) have agreed to this substantial activity requirement in order to realign taxation of profits with the substantial activities that generate them. These countries have therefore committed to enforce the new approach in their domestic legislation by 30 June 2016. In that framework, the Belgian government has designed a new Belgian IP regime compliant with the modified nexus approach on which an agreement was reached today at the Council of Ministers. The preexisting IP regime (Patent Income Deduction) was already abolished by a Law of August 3, 2016 with a certain grandfathering period.
Grandfathered Patent Income Deduction (PID)
Belgium introduced in 2007 its current IP regime which comes down to a tax deduction equal to 80% of the corporate taxpayer's qualifying patent income (the "patent income deduction" or PID).
The PID applies to income arising from patent licences (royalties) and patent income included in product or service income (embedded royalties) and such both with respect to self-developed patents and patents acquired or licensed from another party subject to the condition of further development by the Belgian taxpayer. Capital gains on the underlying IP rights do not qualify for PID.
The development of own patents or further development of acquired or licensed patents must (except for SMEs) be performed through an R&D centre that qualifies as a branch of activity. Such R&D centre can be located in Belgium or abroad (e.g. at the level of a foreign permanent establishment of the Belgian taxpayer). However, while a minimum of economic R&D substance is thus required, the taxpayer can outsource its R&D activities to both related and unrelated parties, without such having an impact on its PID benefit.
For self-developed patents, the 80% PID applies to the gross patent income. For acquired or licensed patents, the PID is on the other hand limited to the net patent income. Any excess PID because of insufficient taxable base cannot be carried forward or carried back and is thus definitely lost. Apart from patents, supplementary protection certificates and as accepted by the Belgian tax authorities knowhow which is inherent to the patent or inseparable therefrom, no other IP qualifies for the PID. Patents for which the application is still pending do also not qualify, which is generally considered to be a weakness of the current PID regime.
Especially because of the possibility to outsource R&D activities without such having an impact on the PID entitlement and the fact that the PID applies on the gross income (of self developed patents), the PID regime was not fully compliant with the modified nexus approach. Instead of amending the PID regime in that respect, the Belgian legislator decided to completely abolish it and replace it with a new IP regime, the Innovation Income Deduction (InnID).
Such, however, not without grandfathering the current PID till 30 June 2021 as allowed by the BEPS Action 5 Report. Under this grandfathering, taxpayers can still benefit from the PID for patent income realised through 30 June 2021 to the extent it relates to patents for which the taxpayer filed an application prior to 1 July 2016, or which were acquired or licensed in prior to that date. The grandfathering can, however, not be invoked with respect to patents which are directly or indirectly acquired from a related party after 1 January 2016 if they did not benefit from an IP regime at the level of that related party.
Making use of the grandfathering also excludes the taxpayer until 1 July 2021 from the new InnID for income generated by the relevant patent. The benefit of the grandfathered PID for certain patent income should, however, not exclude the taxpayer from making use of the InnID for the income generated by other IP assets. A combined use of both regimes is thus possible in the period 1 July 2016 till 1 July 2021.
New Innovation Income Deduction (InnID)
In the context of implementing the modified nexus approach, the Belgian government is now taking the opportunity to introduce a complete new IP regime, called Innovation Income Deduction, which has a larger scope than the PID and also allows for a carry forward. The new IP regime will come into force (retroactively) as of 1 July 2016.
First draft legal texts were already prepared on this InnID in April, May of this year but a formal decision within the government on the introduction of the new regime was delayed in the context of comments raised by business community regarding the manner in which costs incurred during the development phase have to be taken into account for the InnID calculation and what the exact OECD requirements are in this respect.
85% tax deduction for qualifying income from patents, copyrighted software, breeders rights, orphan drugs and data or market exclusivity
Like the PID, the InnID constitutes a tax deduction for certain qualifying IP income. The percentage of this deduction is, however, increased to 85%. It is also provided that this percentage can be adjusted going forward.
Compared to the PID, the scope of the regime is enlarged to the following categories of intellectual property:
i. patents and supplementary protection certificates; ii. copyrighted software resulting from the taxpayer's recognised research or development projects; iii. breeders rights acquired after 30 June 2016 or for which the application is filed on or after 1 July 2016; iv. governmental data or market exclusivity regarding crop protection, medicines for humans and animals and orphan drugs; and v. orphan drugs registered with the European Medicines Agency and acquired after 30 June 2016 or for which the application is filed on or after 1 July 2016.
The taxpayer qualifies for InnID if he is the owner, co-owner, usufruct holder or holder of any exclusive or nonexclusive license or other right on the relevant IP.
As to qualifying IP income, the following categories are foreseen in the InnID proposal:
i. royalties; ii. royalties embedded in product or service revenue and equal to the compensation that would be due to the taxpayer if the products or services would be produced or the relevant production of delivery processes would be followed by a third party on the basis of a license; iii. subject to a reinvestment condition, the sales price (not just the capital gain) received upon the transfer of an IP right which qualifies as a fixed asset and which was created at the latest in the last preceding taxable period or acquired at the latest in the last 24 months before the transfer; and iv. indemnities for IP infringements and received as a result of a judicial or arbitral decision, settlement amongst parties or insurance coverage.
An important change compared to the PID is that the InnID will also apply to income derived from patents and supplementary protection certificates for which the application is still pending. The tax deduction for such income will be temporary, with a possible claw back in case the patent or protection certificate would ultimately not be obtained. Income from marketing related intangibles (trade names, trademarks, etc.) does not qualify for InnID.
Another major change is obviously the enlargement of the scope to copyrighted software. As many enterprises in today's world develop and use specific software applications for their businesses, the InnID may constitute an attractive tax incentive to lower the effective tax rate on the business income generated with the help of such software.
A carry forward of excess InnID is provided for, without any limitation in time or use.
Qualifying income: implementation of modified nexus approach
To determine the IP income that can benefit from the InnID, the regime is fully aligned with the modified nexus approach.
Consequently, the InnID can only apply to the net IP income, i.e. the amount of royalties, embedded royalties, sales proceeds or indemnities decreased with the amount of R&D expenses, incurred by the taxpayer itself or through outsourcing as well as the amount of IP acquisition costs that are expensed. Any negative IP income must first be compensated with future positive IP income.
Upon the first use of the InnID, the original draft legal texts provided that all relevant expenses incurred during tax years ending after 30 June 2016 would need to be deducted from the qualifying IP income with any negative balance being carried forward and reducing future qualifying IP income. The proposal finally agreed upon by the Council of Ministers today takes based on discussions with business community and the OECD a more refined approach to this and now also allows to spread and offset such development costs against the IP income over a period of 7 years.
Subsequently, this income must be proportionated on the basis of the taxpayer's in-house R&D activities versus those which are outsourced or acquired. The BEPS Action 5 Report and the InnID regime proposed by the Belgian government therefore provide for the following formula (the so-called "nexus ratio"):
Under this formula, the qualifying expenditures include the following expenses: (a) R&D expenditures incurred by the taxpayer itself and (b) R&D expenditures for unrelatedparty outsourcing, including those recharged (without markup) by related parties. As allowed in the BEPS Action 5 Report, the qualifying expenditures can be increased with 30% (socalled "uplift") to maximum the amount of overall expenditures.
The overall expenditures include all qualifying expenditures plus (c) the expenditures for acquisition of IP or a license thereon and (d) the R&D expenditures for related party outsourcing.
Through this formula, the benefit of the InnID is proportionated to the R&D activities performed by the taxpayer itself versus those performed outside the company. Expenditures from unrelated party outsourcing are nevertheless treated as qualifying expenditures as companies are not expected to outsource the fundamental valuecreating R&D activities to an unrelated party.
In exceptional circumstances and subject to obtaining a tax ruling, the InnID allows taxpayers to obtain a derogation from the above formula to allow them to apply the 85% tax deduction to a higher amount of IP income. This is, however, only possible in case the result of the above formula, before the 30% uplift, amounts to at least 25%.
Expenditures need to be taken into account at the time they are incurred, regardless of their treatment for accounting or tax purposes. In other words, expenditures that are not fully deductible in the year in which they are incurred, e.g. because they are capitalised, will still be included in full in the nexus ratio for that year.
The nexus ratio also follows an additive approach which means that the expenditures to be taken into account include all expenditures incurred during the life time of the relevant IP. Hence, these numbers will increase every time a taxpayer incurs expenditures, that qualify as qualifying or overall expenditures. In the absence of sufficient proof regarding the expenditures incurred over the IP's lifetime for the application of such additive approach, the InnID proposal provides till assessment year 2019 that the nexus ratio will be calculated on a threeyear basis, i.e. on the basis of the expenditures incurred during the relevant taxable period and the two preceding tax years.
Tracking of IP assets, income and expenditures
The qualifying IP income and nexus ratio must in principle be determined for each IP asset separately. This means that the taxpayer wanting to benefit from the InnID will need to identify the relevant income and expenditures on an asset-per-asset basis.
This obviously requires taxpayers to implement sufficient "tracking" and the tools thereto to allow them to link R&D and related expenditures with the relevant IP asset and the income it produces. Which parameters one should apply to do this tracking will vary on a case-by-case basis and may imply tracking per cost centre, product, R&D activity, etc.
In case the taxpayer can prove that it is practically impossible to track income per IP asset, it is also possible to apply this tracking per type of product or service or even per group of products or services which result from the IP assets.
G iven the conclusions in the BEPS Action 5 Report and the requirement to implement the modified nexus approach as of 1 July 2016, one should welcome the Belgian government's actions to introduce a new Belgian IP regime.
Particularly positive is the fact that the government, while being held to the outer limits set by the OECD, takes the opportunity to enlarge the scope of the new regime (compared to the existing one) by also including sales proceeds, copyrighted software, orphan drugs and breeders' rights and by granting the tax benefit while patent applications are still pending.
Also the fact that the government makes use of the flexibilities allowed under BEPS Action 5 and that any excess InnID will be available for carry forward can be applauded.
We will further follow up on the legislative process till formal voting by Belgian parliament and will inform you in due course.