The ‘nexus’ ratio 'distilled'

Cyprus' existing IP Regime is a nexus-compliant regime offering favourable tax benefits to businesses undertaking their economic activities in the Republic. You all know that!!!

The nexus approach allows taxpayers to benefit from an IP regime to the extent that they can actually show they have incurred R&D expenditure resulting in income and value generation.

Governments, recognising that innovation is a key to economic growth and productivity have adopted as part of their fiscal policies income-based tax incentives which provide for lower tax rates on future income to arise out of todays' R&D investments. The same did Cyprus in 2016, by transposing into the ITL the “modified nexus approach” as per Action 5 of BEPS Action Plan.

The nexus approach is linking tax benefits to R&D spending, thus awarding in the form of tax reductions those businesses engaging in such activities and incurring such expenditure.

It uses expenditure as a proxy for quantifying R&D activity and as a basis for measuring how much of the profit will qualify for the deduction. The relief to be given is not fixed or predetermined like the old scheme.

This conceptual basis known as the ‘Modified Nexus Approach’ is expressed mathematically in the fraction shown below.

(QE+UE)/OE = PQ (%),

where:

QE = Qualified expenditure

UE = Uplift expenditure, being the lower of NQE or 30% x QE

OE = Overall expenditure (QE+NQE)

NQE = Cost of acquiring an intangible and/or outsourcing to related parties

PQ % = Profit qualification (%)

The fraction has to be recalculated at each year-end in order to take into account any major costs incurred for the improvement, enhancement and upgrade of the IP that would have an impact on the qualification %. It could be seen as a ‘cost accumulator’ formula measuring at each time how much of the R&D activity going on qualifies for the deduction.

The R&D fraction, measures R&D activity, and returns the profit qualification % to be applied on the company’s profits that will make it for the 80% deduction- Only ‘qualified profits’ will be eligible for the 80% deduction or putting it the other way round only 20% of the qualified profits will be subject to tax.

As the formula suggests, the more the qualified expenditure the higher will be the % to be applied on profits. The more the 'nexus' between R&D activity and income the more will be the tax benefit. A taxpayer (1) developing or improving internally an asset and/or (2) subcontracting work to unrelated parties ((1)+(2)=QE) would benefit more from the regime than a company (3) acquiring an existing intangible asset being (4) outsourced for improvements to related parties ((3)+(4)=NQE).

Plotting the combinations of Qualified expenditure with the formula's results on a graph it is more than obvious that the nexus formula 'stalls' at the point where qualified expenditure reaches the 77%. (The nexus ‘sexus’ point!).

The profits of a company, which is expending 77% or more (77%>QE>100%) on qualified R&D costs for the development of a qualified asset, will still be able to claim the 80% deduction on the whole profit making the effective rate of tax drop down to the well-advertised 2,5%.

In other words, qualified expenditure in the range 77% - 100% enables a Company to enjoy the maximum benefit. The table below illustrates the % of qualified profit as qualified expenditure moves across brackets.

As IP regimes are designed to encourage R&D activities and to foster growth and employment, introducing a substantial activity requirement to ensure that taxpayers benefiting from these regimes did in fact engage in such activities and did in fact incur actual expenditure on these activities was a natural measure against tax malpractice.

Take care for now

See you next time