The Luxembourg Government has, on 4 August 2017, submitted a bill  to Parliament for the reintroduction of a regime of taxation of intellectual property (IP) rights in Luxembourg.
The new regime is intended to replace the former IP tax regime, which had been repealed in 2016. The latter will co-exist with the new regime until expiry of a transitional period ending on 30 June 2021. During that period, taxpayers eligible to both regimes will have to irrevocably opt for one of the two regimes.
The bill is largely inspired by the modified nexus approach adopted by the OECD in its report on BEPS Action 5 on Harmful Tax Practices.
In essence, it proposes to reintroduce an exemption of 80% of the net income derived by a taxpayer from qualifying IP rights, as well as a full net wealth tax exemption of such IP rights.
However, in line with the modified nexus approach, only a certain proportion of the net income from a qualifying IP right (after compensation and certain adjustments) would benefit from that 80% exemption. This proportion (the Nexus Ratio) may vary from 0% to 100%, depending on the research and development activities undertaken by the taxpayer.
The Nexus Ratio corresponds to the ratio between (i) the expenses which the taxpayer incurs for the constitution, development or improvement of that IP right (Qualifying Expenses), and (ii) the total expenses relating to that IP right (Total Expenses). Qualifying Expenses may be increased by an up-lift of up to 30% (without however exceeding the amount of Total Expenses).
The taxpayer must ensure a proper tracking and documenting of Qualifying Expenses, Total Expenses and qualifying IP income for each qualifying IP right, in order to establish the link between these expenses and the qualifying IP income. If the taxpayer demonstrates that a tracking with respect to each qualifying IP right would not be possible due to the complexity of its research and development activities, the tracking may be made for each type of products or services, or for each group of products or services.
Qualifying IP rights
Qualifying IP rights include the following IP assets which were constituted, developed or improved after 31 December 2007 by incurring Qualifying Expenses:
inventions protected by virtue of national or international provisions in force by a patent, a utility model, a supplementary protection certificate for a patent on a pharmaceutical or a phytopharmaceutical product, an extension of a supplementary protection certificate for a pharmaceutical product with paediatric use, a plant breeders’ right, or an orphan drug designation; and
software protected by copyright by virtue of national or international provisions in force.
Trademarks, designs and domain names are not covered by the new regime.
Qualifying IP income
Qualifying income includes arm’s length income of the taxpayer:
which is received as consideration for the use or the granting of the right to use a qualifying IP right;
which has a direct relation with a qualifying IP right and is included in the sale price of a service or a good (to be isolated from the total sale price in conformity with arm’s length principles);
which is realised upon the disposal of a qualifying IP right; and
indemnities obtained in the frame of legal or arbitral proceedings relating to a qualifying IP right.
Before application of the Nexus Ratio, the qualifying IP income is reduced by the Total Expenses and the expenses indirectly incurred by the taxpayer in relation to a qualifying IP right. Certain adjustments also need to be made for amortisation and prior years’ losses. Positive and negative net income from different qualifying IP assets also needs to be compensated before application of the Nexus Ratio.
The net adjusted and compensated qualifying income is then multiplied by the Nexus Ratio to obtain the amount of qualifying IP income which can benefit from the 80% exemption. As described above, the Nexus Ratio corresponds to the ratio between Qualifying Expenses and Total Expenses. Qualifying Expenses may be increased by an up-lift of up to 30% (without however exceeding the amount of Total Expenses).
Qualifying Expenses are the expenses necessary to conduct research and development activities of the taxpayer, and which relate directly to the constitution, development or improvement of a qualifying IP right.
These expenses must be incurred by the taxpayer for its own research and development activities or paid by the taxpayer to an unrelated party (or a related party paying these sums on to an unrelated party without any margin). They include expenses incurred by a permanent establishment of the taxpayer, provided it is located in the European Economic Area (other than Luxembourg), to the extent that such permanent establishment is operational at the time the eligible income is realised and that it does not benefit from a similar regime for IP in the State in which it is located.
Qualifying Expenses do not include acquisition costs directly related to the constitution, development or improvement of a qualifying IP right, to the extent reflected in the value of the qualifying IP right (Acquisition Costs), interest and financing costs, real estate costs and other costs which do not directly relate to a qualifying IP right.
Exceptionally, expenses incurred for general or speculative research and development, or expenses for research and development which have not lead to the creation of a qualifying IP Right, may constitute Qualifying Expenses (under certain conditions).
Total Expenses include arm’s length expenses necessary to conduct research and development activities of the taxpayer paid to related parties, Qualifying Expenses and Acquisition Costs.
Following uncertainty after the repeal of the former IP tax regime, it is now clear with this bill that the Luxembourg Government wishes to continue incentivising research and development activities in Luxembourg while complying, at the same time, with the latest international tax standards. In this respect, the modified nexus approach, which aims at ensuring a certain level playing field across OECD countries, allows less latitude for OECD countries to design favourable IP tax regimes.
A certain alignment of the IP tax regimes of the OECD countries may therefore be expected. Differentiators such as income tax rates, types of qualifying IP rights and Qualifying Expenses to consider will therefore become increasingly more important to determine the jurisdiction of choice for a taxpayer to perform its research and development activities. The fact that the Qualifying Expenses also include those incurred by permanent establishments located in the European Economic Area could give Luxembourg a competitive advantage in this respect.