What Records Does a Cyprus IP Box Claim Need?

The obligation is in the Regulations, per asset

The Cyprus IP Box is claimed on a fraction, and the records behind it are not a matter of good housekeeping. Regulation 5 of the Income Tax (Intangible Assets) Regulations 2016 provides that persons claiming the deduction under section 9(1)(k) of the Income Tax Law are obliged to keep accounting books and records of income and expenditure per intangible asset.

Per asset, not per company. That single phrase decides most of what follows, because a company that records development spend against a general account has not kept the records the Regulation describes, however complete its bookkeeping is in every other respect.

Regulation 4(2)(b) then does something stronger. Among the costs it excludes from qualifying expenditure is any cost that cannot be shown to be directly connected with a specific qualifying intangible asset. The evidence is not support for the claim. It is part of the definition of what counts.

Whether a particular cost meets that test on a particular set of facts is a question of application rather than of reading, and it is decided by the Tax Department. Where the answer is genuinely uncertain on a material amount, a Cyprus advance tax ruling is the mechanism for settling it before the return is filed rather than after.

The documentation standard behind the Regulation

Regulation 5 is two sentences and it does not say what the books and records have to contain. The standard it implements does. The nexus approach comes from Action 5 of the OECD and G20 Base Erosion and Profit Shifting Project, and that report sets a documentation floor which a jurisdiction operating a compliant regime has to require.

The nexus approach mandates that jurisdictions include several documentation requirements. Jurisdictions may draft their own specific guidance on these documentation requirements, but they must require at least the following forms of documentation from any taxpayer benefiting from the IP regime:

• If the taxpayer is not tracking directly to the IP asset but is instead tracking to products, the taxpayer must provide documentation showing the complexity of its IP business model and providing justification for using the product-based approach.
• The taxpayer must show that it had a qualifying IP asset (either because the income and expenditures are being tracked to that IP asset or because the product was produced using that IP asset).
• In calculating net IP income, taxpayers must reduce the amount of IP income by any deductions or other tax reductions that arose from the same IP asset (or product). Taxpayers must therefore provide documentation of all relevant deductions and other tax reductions and show why such benefits, if any, were not used to reduce the amount of IP income benefiting from an IP regime.
• Taxpayers that incur expenditures for general or speculative R&D must either show a link between such expenditures and the IP asset or product or provide an explanation for how such expenditures were divided pro rata across IP assets or products.
• The taxpayer must show that both qualifying expenditures and overall expenditures were tracked according to the same IP asset or product as the income and it must provide documentation on this tracking to show that the expenditures and income were linked.
• If the taxpayer acquired an IP asset from a related party, the taxpayer must prepare documentation substantiating the arm’s length price. This should include documentation on the overall expenditures that the related party transferor incurred.

OECD (2015), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5 - 2015 Final Report, OECD and G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris, paragraph 61.

Read against Regulation 5, those six items are what per asset means in practice. Two of them are about linkage rather than amounts: that qualifying and overall expenditure were tracked to the same asset as the income, and that general or speculative research spending is either linked to an asset or apportioned on a stated basis. A third requires income from the asset to be reduced by the deductions arising from that same asset. A ledger that reports a correct annual total without recording any of that satisfies none of the three.

The report is equally direct about the position where the tracking does not exist.

Not engaging in such tracking will not prevent taxpayers from earning IP income in a jurisdiction, but it will prevent them from benefiting from a preferential IP regime.

Same report, paragraph 53. It describes a gate rather than a penalty. The income is still earned and still taxable, and what the absent records remove is the deduction.

Three features of the fraction that follow from that

• It is per asset. Expenditure has to be capable of allocation to a named asset, which means the asset has to be delineated before the spend is allocated to it.
• It is cumulative. It runs over the life of the asset rather than resetting each year, so a gap in an early year stays in the numerator and the denominator for as long as the asset earns.
• It is fixed at the time of spending. The Regulations provide that qualifying expenditure enters the formula at the time it is incurred, regardless of its treatment for accounting or tax purposes.

A fraction assembled at the year end from a bank statement is therefore a reconstruction rather than a record. It may be an accurate reconstruction. It is still being built from documents that were not created to answer this question, and on the wording of Regulation 4(2)(b) a cost that cannot be shown to connect to a named asset falls outside qualifying expenditure rather than sitting in it unsupported. The fraction then multiplies through into qualifying profit, so an approximation at this stage carries into every figure built on it.

What general research spending does, which is more forgiving than it looks

The Regulations do not require every euro to be tied to one asset.

Expenditure on outsourcing relevant research and development to unconnected persons, and expenditure of a general and theoretical nature for research and development, which cannot be allocated to the qualifying expenditure of a specific asset with which it is directly related, may be apportioned pro rata across the qualifying intangible assets or products.

So a platform team working across several products is not something the Regulations have no answer to. What the Regulations do not do is prescribe the basis of apportionment, and that is where the difficulty usually sits: the basis has to exist, be applied consistently, and be capable of explanation.

On a material amount, or where products share development unevenly, that is again a question better settled by a Cyprus advance tax ruling than argued afterwards on a year that has already been filed.

Connected persons, which is the exclusion most often missed

Regulation 4(2)(b) excludes amounts paid or payable, directly or indirectly, to a connected person for carrying out research and development, whether or not the amounts relate to a cost sharing agreement. Outsourcing to an unconnected person is qualifying expenditure; the same work bought from a connected one is not.

That exclusion does not merely remove the cost from the numerator. The same amount sits in overall expenditure, so it remains in the denominator, and the fraction falls further than the size of the payment alone suggests.

A file therefore needs evidence that each outsourced developer is unconnected: no common ownership, no common control, and not acting for the shareholders.

Why the code repository carries the weight

For software, the repository is usually the only contemporaneous record that ties a payment to work on a specific asset.

An invoice says software development and a figure. A commit history says who wrote what, when, and in which repository. Matching the two is what turns a payment into a cost that can be shown to be directly connected with a specific asset, which is the test Regulation 4(2)(b) sets.

Most of a file can be rebuilt from somewhere. The commit history cannot, which is why it carries weight.

What a repository in the company's name does not establish. The organisation display name is free text, and so is the location field. Anyone with access types them, so a screenshot of either shows that somebody typed a word.

Evidence that tends to establish the position instead:

• The organisation is owned by an account the company controls, registered on the company's own domain rather than to an individual.
• Billing is addressed to the company and paid from the company's account. This is the cheapest piece of evidence to produce and the easiest to correct.
• More than one owner account, each company controlled, so access survives one person leaving.
• Each qualifying asset maps to a repository or a named, stable set of repositories, in a list that is maintained and dated.
• Every contractor commits under a named account that can be matched to their agreement and their invoices.
• The canonical copy is not held in a personal account, and no second organisation holds part of the same asset.

On ownership, the Regulations are wider than they first appear. A qualifying intangible asset includes one for which only economic ownership exists, so legal title is not in every case the question. What the file still has to answer is how the company came to hold the asset at all, which for commissioned development means the agreements under which it was written.

What the records have to be able to answer

Four questions, which is a useful way to read Regulation 5 rather than a substitute for it.

1. What is the asset. Delineated well enough that expenditure can be allocated to it. A named product with a defined codebase answers this. The phrase our software does not.
2. What was spent on it. Who was paid, for what, in which period, against which asset, and whether they are a connected person.
3. How the company came to hold it. The route from whoever wrote the code to the company, which for commissioned work is the agreements.
4. What it earned. Income by source, so income from the qualifying asset is separable. Overall income is gross income for the year less the direct costs of earning it, and it includes embedded income from products and services that rely on the asset. Affiliate commission, resale and unrelated services are not income from the asset.

The timing question is the one that decides whether any of it is possible. The Regulations fix expenditure in the formula when it is incurred, so the answers have to be capable of being given for each year as it passes, rather than assembled once at the end from whatever survives.

The same material tends to answer a second question. Where a company is asked to show economic substance, an asset list, the agreements behind commissioned work and a reconciliation of spend to output are evidence about where the activity happened. And where the position on a particular asset is genuinely uncertain rather than simply untested, a Cyprus advance tax ruling is the mechanism for settling it in advance, and an application rests on the same records.