• Cyprus: IP Tax Regimes: A New Tomorrow
  • September 15, 2015
  • Law Firm: Kinanis LLC - Nicosia Office
  • Major developments are currently in progress with regards to IP tax regimes as part of the Organisation's for Economic Co-operation and Development (OECD) Action 5 of the Base Erosion and Profit Shifting (BEPS) Action Plan.

    In September 2014, OECD published their progress report on "Countering Harmful Tax Practices More Efficiently, Taking into Account Transparency and Substance", setting out the progress made under Action 5. A major part of Action 5 concerns the strengthening of the "substantial activity" requirement used to assess preferential regimes so as to realign taxation profits with substantial activities.

    One of the approaches considered in the September report with regards to IP regimes is the nexus approach. Following work within the OECD Forum on Harmful Tax Practices (FHTP), the Modified Nexus approach was developed whereby there should be a "direct nexus" between income, tax benefits and Research and Development (R&D) expenditure. In particular, this approach has to ensure that the major economic activities must be undertaken in the jurisdiction of the country in which the preferential tax regime for IP exists and requires that the tax benefits have to be connected with the R & D expenditures.

    UK and Germany made a joint proposal in November 2014 in order to address some of the changes required to be made to the "Modified Nexus Approach" and the work which requires to be done in order to reach an agreement within 2015. The proposal was based on four elements, the uplift qualifying expenditure, closure and abolition of existing IP regimes, grandfathering and track and tracing. The joint proposal was welcomed by all OECD and G20 countries and will form the basis of work which is still ongoing by the FHTP (Forum of Harmful Tax practices) to determine the mechanisms by which the four elements will take effect.

    The following publication will analyse the modified nexus approach and its effect on the existing IP tax regime in Cyprus.

    A. ANALYSIS OF THE NEW PROPOSED IP REGIME

    MODIFIED NEXUS APPROACH

    As stated above, this approach is founded on the principle of rewarding taxpayers for expenditure undertaken by themselves for the development of patents or products within the jurisdiction in which the preferential tax regime exists. Thus the effect of the said approach is that only a proportion of royalty income, applicable only on qualifying expenses, will be taxed under the preferential tax regime. The remaining royalty income will be taxed under normal tax rates.
    • QUALIFYING IP ASSETS
    Under the Modified Nexus Approach, the only qualifying IP assets are patents and other patent-like IP assets which are protected by registration or any other relevant procedure. The Modified Nexus Approach explicitly excludes from receiving benefits marketing-related IP assets such as trademarks.

    More guidance is expected to be published on this definition by the FHTP, addressing, in particular, cases of IP assets which are not protected by patents, yet are still products of technical innovation, such as computer programs protected by copyright.
    • QUALIFYING EXPENDITURE
    The expenditure which qualifies for preferential tax treatment under the regime is that which relates to research and development of patents or products. The definition excludes acquisition costs and outsourcing expenditure.

    Businesses already using beneficial patent regimes called Patent Box regimes, may qualify for preferential tax treatment, yet on a smaller proportion of their income generated from IP income, such as income received in the form of royalties.

    In other words, in order to maximize the proportion of income which qualifies for such beneficial tax treatment, the qualifying taxpayer must undertake expenditure in-house.
    • UPLIFT OF QUALIFYING EXPENDITURE
    To reflect concerns of business that the new approach disregards IP acquisition costs, provision has been included in the proposal that taxpayers will have the possibility to uplift their qualifying expenditure by up to 30%, provided that expenditure in the context of outsourcing an acquisition has actually taken place. The 30% limitation relates to the overall amount of both outsourcing and acquisition costs. It is noted that acquisition costs and expenditures for outsourcing to related parties are not included in qualifying expenditures, but are taken into account in determining the above limitation.

    The consequence of uplifting is that taxpayers receive preferential treatment on a higher proportion of their income.

    Examples how Modified Nexus Approach is expected to apply

    Example 1

    Costs relating to the IP

    Qualified expenses 100

    Acquisition cost 10

    R&D expenses outsource to a subsidiary company 40

    Therefore total costs for the IP 150

    Calculations
    • Maximum up-lift amount = Qualified expenses 100 x 30 % = 30
    Therefore overall qualifying expenses including a limited percentage of outsourcing and acquisition costs is (100+30) 130.

    Royalty income taxed under the preferential tax regime as per Modified Nexus Approach will be as follows:

    130/150 * Royalty income = Royalty income taxed under the preferential tax regime

    Example (2):

    Costs relating to the IP

    Qualified expenses 100

    Acquisition cost 5

    R&D expenses outsource to a subsidiary company 20

    Therefore total costs for the IP 125

    Calculations
    • Maximum up-lift amount = Qualified expenses 100 x 30 % = 30
    Therefore overall qualifying expenses including a limited percentage of outsourcing and acquisition costs is (100+25) 125. The maximum up-lift amount is not used in this case because actual expenses are less than the maximum up-lift amount.

    125/125 * Royalty income = Royalty income taxed under the preferential tax regime
    • GRANDFATHERING
    By June 2015, the FHTP will have devised appropriate mechanisms to be applied both by companies and taxauthorities in order to tackle thedifficulties which may result during the transitional period. Such rules will relate to the tracking of previous expenditure as well as to the mechanisms via which existing regimes will be brought in line with the Modified Nexus Approach.
    • TIMEFRAME
    Work on implementation of the above changes is expected to be finalized by 30th June 2015 and the new regime implementing the Modified Nexus Approach to take effect no later than the 30th of June 2016. This means that new entrants to the current IP regimes can only be accepted until the 30th June 2016. For those taxpayers benefiting from the current regimes, they shall be able to keep such entitlement until the 30th June 2021, whereby there will be a final abolition of the old regimes.

    B. EFFECT ON CYPRUS IP TAX REGIME

    As from 2012 assets protected under the relevant Cyprus IP laws can benefit from special treatment in the Income Tax Law. Specifically, royalty income received from such assets and proceeds from the sale of such assets is subject to maximum effective tax of 2.5%.

    The above mentioned changes which OECD is considering will have a great impact on IP companies wishing to benefit from Cyprus IP tax regime. As a first step in order to benefit from the said regime until 2021, Cyprus IP holding companies must enter the scheme prior to June 2016.

    Following their entrance into the scheme, Cyprus IP companies will still be able to benefit from the Cyprus IP tax regime, within the confines of the Modified Nexus approach as analyzed above. A Cyprus IP company, provided that it establishes substance in Cyprus for R&D purposes and there is direct connection between income and production, can use the Cyprus IP tax regime beyond 2021.

    Cyprus with its infrastructure, supply of highly qualified personnel and lower operating costs, provides the economic ability to a wide range of companies, whether small, medium or large, to establish themselves in Cyprus and continue to benefit from the Cyprus IP tax regime.

    CONCLUSION


    There is still a lot of work to be done to finalize the proposed provisions as stated above and clarification is needed for a number of issues in order for the new rules to be analyzed further and understood entirely by the business world. One thing is certain however, that businesses need to take the proposed changes from now into account when they structure their operations.

    HOW KINANIS LLC CAN ASSIST
    • Registration of IP whether national, community or international.
    • Providing International Tax Optimization Advice.
    • Consultation if an IP asset is protected under the law.
    • Advising and drafting IP transactions, including financing, acquisitions, sales and licenses.
    • Restructuring advice to groups in order to retain relief under the new regime.
    • Assistance in setting up offices in Cyprus
    • Assistance in setting up an appropriate board of directors for the IP company