Getting the most out of tax benefits for R&D and royalty income.

| Taxand 22/04/10 22:45

GETTING THE MOST OUT OF TAX BENEFITS FOR R&D

AND ROYALTY INCOME.
2010-03-26

Spain

In recent times many companies

have been forced to focus their
energies almost exclusively on
their immediate concerns
aroused by the economic crisis:
drop in revenue, cash and credit
shortages, excess capacity, etc.
However, as the end of the crisis
seems to be drawing closer
companies need to plan
realistically for their future. In
this context optimising their
investment in R&D and other
intangibles will rank high in their agendas.

The Basque Country (an autonomous region of northern Spain) can offer
many opportunities to companies developing and owning intangibles:
qualified personnel, a well established entrepreneurial tradition and
business infrastructure, and subsidies and interest free loans. The
Basque Country also enjoys autonomy to enact its own tax legislation,
and it has used this to offer a unique set of tax benefits to R&D activities
and to the licensing of intangibles. Spain discusses the tax treatment of
intangibles under Basque autonomous corporate income tax legislation
and the tax saving opportunities it provides for businesses.

The tax benefits available with regard to intangibles include:

The royalty box regime.

Depreciation of intangibles.
Tax credits for research, development and innovation (R&D&I).
Personal income tax reduction for impatriates engaged in R&D&I activities.
Reductions in social security contributions for personnel engaged in
R&D&I.
Royalty box
Royalties benefit of an exemption of 60% of gross income, when the
intangible asset being licensed is developed by the company or 30%
when it was acquired from another person or entity.

It would not be appropriate to call this special tax regime a patent box
because it is not limited to royalties on patents or technological know-
how, but it also extends to royalty income accruing from any kind of
industrial or intellectual property, except for those items expressly
excluded by the law (mainly, copyrights and image rights). Thus, the
royalty generating assets that can benefit from this special regime also
include such intangibles as trademarks, commercial know-how and
software.

This broad definition of the scope of items that can benefit from the tax
reduction also avoids many of the complexities that may arise under
other patent box regimes. These often make it necessary in complex
agreements, such as franchises, to try to determine which part of the
remuneration is for technological knowledge and which part is for
commercial knowledge, such as trademarks or similar items of a
commercial nature. Under the Basque royalty box regime this issue
does not arise because the whole package can benefit from tax
reduction.

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Getting the most out of tax benefits for R&D and royalty income. | Taxand 22/04/10 22:45

A further extension of the scope of the tax reduction results is the fact
that qualifying IP includes not only self-developed intangibles but also
those acquired from third parties. However, in the case of assets
acquired the exemption is limited to 30% of the gross income, while the
exempt portion is 60% for intangibles developed by the company. In our
view, if an intangible holding company is set up and intangibles
previously developed by other group companies are transferred to it by
means of a qualifying reorganisation, such as a demerger, a contribution
of branch of activity or a qualifying contribution of assets, these assets
should be considered as self-developed and therefore benefit of the 60%
rate of reduction.

Since the reduction operates on gross income, all costs relating to that
income (development costs, depreciation of intangibles, general
management costs, financial costs, etc.) are deductible under general
rules. As a result of this, the intangible holding company can operate
with a very large margin without recognising taxable income.

There is no limit to the amount of income that can benefit from the
reduction or to the period of time during which it can be applied: the tax
reduction will apply for as long as the intangible keeps generating royalty
income.

Companies subject to Basque tax regulations are Spanish residents.

They can in principle benefit from a wide range of Spanish tax treaties
reducing the source taxation on royalty income.

Depreciation of intangibles
For the purposes of their depreciation, intangibles are classified in two
categories:

Intangibles with a limited useful life. These include intangibles which

legally or contractually are only enforceable for a limited period of time, for
example with patents. These intangibles may be depreciated for tax
purposes over five years, or within their useful life, if shorter.
Other intangibles, such as trademarks last indefinitely from a legal
perspective and do not represent a legal right (goodwill, clientele) and
therefore do not have a predetermined legal life. Such intangibles are not
systematically depreciated for book purposes, but only written off in case of
impairment. However, for tax purposes, these intangible assets can also
depreciate at a maximum 20% yearly rate. Moreover, depreciation can
also be taken for indirect goodwill, i.e. the part of the acquisition cost of a
subsidiary that represents the value of the subsidiary’s goodwill. Some
limitations and anti abuse provisions apply in connection mainly with
intangibles acquired in related party transactions.
Capitalised R&D expenditure can be freely depreciated for tax
purposes.

Tax credits for R&D&I

Tax credits are available for expenditure not only in research and
development but also in technological innovation. While research and
development is aimed at an absolute technological advance, innovation
may simply represent a technological improvement for the company,
although equivalent technology may already be available to others. It
includes the development of new products, services or processes, or
substantial improvements to the existing ones, the construction or
fabrication of prototypes, and pilot or demonstration projects, technical
diagnosis and the cost of obtaining quality certifications.

The basic rate of the tax credit for R&D expenditure is 30%. This basic
rate is further increased for the amount of R&D expenditure in excess of
the average two preceding years, the cost of works subcontracted with
qualifying research centres and for labour costs of qualifying researchers.
The rate for technological innovation is 15% or 20%, depending on the
particular type of expenditure. The applicable tax credit rates are
summarised in the following box.

Tax Incentives.

R&D

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Getting the most out of tax benefits for R&D and royalty income. | Taxand 22/04/10 22:45

Investments: 10%
Expenses:
Basic rate 30%
Increase over average expenditure of two
+ 20%
prior years
Specially qualified expenditure: + 20%
Labour costs on qualified researchers
Fees paid to qualified research centres
Total maximum rate 70%

Technological innovation
Industrial design 15%
Production process engineering 15%
Royalties: patents, licenses, technical know-
15%
how
Fees paid to qualified research centres 20%
Quality certifications 20%

The tax credits are computed on the amount of gross R&D&I

expenditure, less the after-tax amount of grants received in their
connection. For these purposes, the after-tax amount of a grant is
deemed to be 72% of the gross grant, even though the effective tax rate
for a company engaged a R&D&I activities will often be significantly
lower than the 28% nominal corporate income tax rate.

These tax credits can offset the company’s tax liability in full. Unused
amounts can be carried forward indefinitely.

There are uncertainties concerning the classification of technological

projects relating to research, development or innovation, and which
expenses should be allocated to the research, development or innovation
phases rather than being classified as ordinary production costs. In
order to obtain legal certainty in advance of the tax credits being
available for a particular project, taxpayers may obtain an advance
binding ruling on the classification of the company’s projects as R&D or
technological innovation and the reasonability of the project’s budget.

Acquisition of tangible fixed assets to be used in R&D&I activities

Investments in tangible fixed assets to be used in R&D&I activities also
qualify for a tax credit of 10% of their cost.

Furthermore, these assets also benefit from free depreciation for tax
purposes, with the exception of buildings, which can be depreciated over
10 years for tax purposes (instead of the general minimum 30-year
period for the tax depreciation of buildings).

Special personal income tax regime for impatriates

Individuals who were not previously Spanish tax residents and become
tax residents in the Basque Country as a consequence of taking up a job
as researchers involved in R&D activities can opt to be treated as non
residents in their first six years of residency in Spain. In practice
impatriates receive two benefits:

They are only taxable on their Spanish-source income. Thus they can
shelter their financial income from Spanish taxation by simply not importing
their net worth into Spain. Also, if they derive part of their remuneration
from activities carried out outside Spain, such remuneration will not be
taxable either.
Spanish source income will be taxed at a flat rate of 24% (compared to a
top marginal personal income tax rate of 45%).
This tax regime can reduce salary costs for a company by up to one
fourth when negotiating remuneration packages on an after-tax basis
with highly remunerated individuals.

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Getting the most out of tax benefits for R&D and royalty income. | Taxand 22/04/10 22:45

Social security contributions

A reduction of 40% is available for the social security contributions of
personnel employed in R&D or technological innovation activities.

Taxand’s Take
R&D&I and intangible holding companies set up in the Basque Country
can benefit from a combination of generous tax incentives for the
development and licensing of intangibles, which, together with the
available non-tax incentives and the overall business climate and
infrastructure, offer very favourable opportunities for R&D&I activities and
the management of intangible assets.

Your Taxand contact for further queries is:

Daniel Armesto
T. +34 (944) 700 699
E. Daniel.Armesto@garrigues.com

Get your Taxand Global Guide to R&D Incentives here

More news from Spain:

New developments in case law on withholding tax treatment of dividends

under Spain-Netherlands tax treaty
Transfer pricing assessed on imports by customs authorities is binding for
corporate income tax purposes

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Your Taxand contact for further queries is:

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T. +34 (944) 700 699
E. Daniel.Armesto@garrigues.com

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