How The Cyprus IP Box Works In Practice Under The OECD "Modified Nexus" Approach

1. What qualifies under the Cyprus IP Box

According to Cyprus Income Tax Law (Article 9(1)(k)):

A qualifying IP asset is:

• a patent,
• a computer program (copyrighted software), or
• other IP that is the result of R&D activity and not a marketing-related intangible.

To benefit, the IP owner must also meet the nexus requirement — i.e., the IP income must come from its own R&D activities (or outsourced to unrelated parties) that created the IP.

2. What does not qualify

• Trademarks
• Brand names
• Image rights
• Customer lists
• Marketing intangibles
• Franchise or license fees primarily for brand use or know-how that is not R&D-based

For instance, marketing material and franchise agreements, intangible assets such as trademarks, brands, image rights are not considered qualifying intangible assets.

3. Franchise agreements — how they fit

• If the franchise agreement mainly covers brand, trademark, and marketing support, → Not qualifying IP as it is marketing focussed.
• If the agreement licenses use of proprietary software systems, internal platforms, or technology that were developed through qualifying R&D, → Qualifying IP (subject to nexus test).

In other words, franchise agreements could be subject to the reduced Cyprus Corporation Tax rate of 2.5% if they do not relate to marketing activities but rather to proprietary software systems.

In practical terms, if your franchise model relies on the franchisee using the franchisor's proprietary software, operating system, or tech tools that were developed in-house, the portion of franchise income attributable to that IP could fall under the Cyprus IP Box.

But you'll need to:

• segregate the income streams contractually (software vs brand),
• demonstrate R&D activity in Cyprus or by the Cyprus entity, and
• document the nexus link (development costs → IP asset → income).

Example

How should the franchise agreement be structured in order to qualify for the Cyprus IP Box Regime.

1. Separate the income streams in the contract

Cyprus tax authorities and transfer pricing rules (as well as OECD BEPS Action 5) expect you to segregate income clearly by function.

So instead of one undifferentiated "franchise fee," break it down, for example, like this:

Example clause (simplified)

"The Franchisee shall pay to the Franchisor:
(a) a Software Licence Fee equal to 3% of Gross Revenue, for the use of the Franchisor's proprietary management software systems and related support; and
(b) a Brand Royalty Fee equal to 2% of Gross Revenue, for the use of the Franchisor's trademarks, trade names, and brand identity."

This ensures:

• (a) can potentially qualify under the IP Box (if the software is developed and owned by the Cyprus entity and meets nexus requirements),
• (b) remains outside the regime (as it's marketing-related).

2. Demonstrate that the software is "qualifying IP"

The Cyprus entity must show:

1. It developed or enhanced the software internally (or via unrelated contractors),
2. It owns the economic rights to the software, and
3. The software is protected under copyright law (registered or inherently copyrighted).

This can be supported by:

• R&D cost breakdowns (Cyprus entity's development costs, payroll, etc.),
• Technical documentation and version control logs,
• Copyright registration (optional but helpful),
• Functional descriptions showing the system's innovation or custom development.

3. Keep a nexus-tracking file (mandatory for IP Box)

Cyprus IP Box uses the Modified Nexus Fraction:

You must maintain:

• records of R&D costs incurred in Cyprus,
• costs for acquired IP or outsourced R&D (to related/unrelated parties), and
• calculations showing how these link to income from the franchisees' use of the software.

It is strongly advisable keeping this in an annual Excel workbook or TP file.

4. Support with Transfer Pricing (TP) documentation

A Transfer Pricing study is a study performed by independent tax experts at a fee where they express their opinion as to the reasonableness of the rates used in commercial agreements using 3^rd party evidence, benchmarking and industry data.

A Transfer Pricing Study should:

• identify the distinct IP assets (software vs brand),
• allocate fees based on comparable licensing benchmarks,
• and demonstrate that the 3% and 2% (or whatever ratio you use) is arm's length.

That allocation protects your structure if challenged by the Cyprus Tax Department.

5. Summary — How to make it IP Box compliant

Example

EU Franchisor relocating to Cyprus to enjoy the 2.5 Corporate Tax Offered to based on the Cyprus IP Box Regime.

Facts

An EU company currently owns several franchise agreements with UK clubs.

• These franchise agreements cover software, systems, and patented IP — so, in principle, the underlying IP assets may qualify under the Cyprus IP Box.
• The owner relocates to Cyprus and wants to set up a new Cyprus company that will acquire the IP and the franchise agreements from the EU entity.

The question:

Will the Cyprus company be able to benefit from the Cyprus IP Box regime after acquiring those agreements/IP?

The key issue: the Modified Nexus Approach

Cyprus applies the OECD "Modified Nexus Approach" (per BEPS Action 5). Under this rule, only income that can be linked to R&D activities carried out by the same taxpayer (or outsourced to unrelated parties) qualifies for the IP Box deduction.

So — it's not enough that the Cyprus company owns the IP.
It must also have undertaken or financed the R&D that created or improved that IP.

What happens in the above scenario if the IP is acquired from another group company:

Case 1: The EU company did all the R&D → Cyprus company buys the IP

Then, the Cyprus company will not automatically qualify for the IP Box, because it didn't perform the R&D that created the IP.

Acquired IP from a related entity is non-qualifying R&D cost, and that part of income is excluded from the beneficial fraction.

• Therefore, the Cyprus company cannot claim the 80% IP Box deduction on existing IP it merely purchases from a related EU entity, unless it continues R&D development/improvement of that IP in Cyprus.

But there is a pathway to qualification.

You can transition into the IP Box regime legitimately by performing qualifying development work in Cyprus after the acquisition.

Here's how it works:

So, the Cyprus company will initially not qualify, but as it invests in further R&D, an increasing portion of the income (from updated IP) will fall within the IP Box deduction.

5. Franchise agreement aspect

The franchise agreements themselves are contracts — not IP assets. What matters is the IP embedded in them (software, patents, systems).

Once the Cyprus company owns the IP and licenses it through the franchise agreements, IP income (royalties, license fees) from those agreements can qualify — but only to the extent that the underlying IP qualifies under the nexus rules.

If the agreements cover software systems and patents, those assets are theoretically qualifying IP, but again, only if the Cyprus company has R&D nexus.

6. Summary

Practical recommendation

To benefit fully from the Cyprus IP Box:

1. Transfer the IP from the EU company to the Cyprus company at market value (with proper TP documentation).
2. Begin R&D activity in Cyprus — even if it's further development of existing IP (new features, code, process improvements).
3. Track qualifying R&D costs meticulously in Cyprus.
4. Apply the IP Box gradually as new qualifying IP versions are created and commercialised through franchise agreements.

Over time, you can phase out the old non-qualifying IP and replace it with new qualifying versions, making the whole structure IP Box compliant.

Calculation of the Tax Implication during the Transition Period

Let's calculate this step-by-step using Cyprus's IP Box regime (modified nexus approach), assuming:

• The Cyprus company acquired the IP for €500,000 (non-qualifying cost because it was acquired from a related EU company).
• It spends €100,000 per year in qualifying R&D to enhance the software (qualifying costs).
• The IP earns €200,000 per year in net IP income (royalty income minus direct expenses).
• Cyprus corporate tax rate = 12.5%.
• The IP Box allows an 80% deduction on qualifying profits under the nexus formula.

Step 1: Apply the Modified Nexus Formula

{Qualifying Profit} = {Overall IP Income} * {(Qualifying Expenditure + 30% uplift)} / {Total Expenditure}

Each year:

• Qualifying Expenditure = €100,000
• Non-Qualifying Expenditure (acquisition) = €500,000
• Uplift = 30% of €100,000 = €30,000 (limited to non-qualifying portion, but okay here)

So,{(100,000 + 30,000)}/ {(100,000 + 500,000)} = {130,000}/ {600,000} = 21.67%

Step 2: Qualifying Profit and Tax Computation (per year)

So, only €1,083 tax per year on IP income, plus any tax on non-IP income (if applicable).

Step 3: Over 5 Years (assuming constant figures)

Breakdown by Tax Type

Summary

Interpretation:

• At €1M of IP income, the Cyprus IP Box gives an effective tax rate around 0.5%.
• If R&D spending increases each year, the qualifying fraction rises — meaning even more income falls under the exemption over time.

Summary Answer

If the only income earned by the Cyprus company is the €1,000,000 per year of IP income (royalties/licensing income) from qualifying IP assets, and
all expenses and structure comply with Cyprus substance and nexus requirements,

then the only tax payable is the Cyprus corporate income tax after applying the IP Box deduction — i.e. ≈ €5,418 per year (effective rate ≈ 0.5%) in your example.

There are no other Cyprus taxes applicable to that income stream.

Breakdown by Tax Type

Key Compliance Requirements

To maintain this treatment, ensure:

1. Substance in Cyprus — management and control exercised in Cyprus (board, accounting, etc.).
2. R&D activity or enhancement occurs in Cyprus (developers, contractors, etc.).
3. IP Box nexus file maintained annually (showing qualifying vs non-qualifying costs).
4. Transfer pricing documentation to support royalty rates and IP acquisition price.
5. Timely filing of tax return (Form IR4) and IP Box computation.

Additional Confirmations

• No withholding tax applies on royalty payments to non-residents for rights used outside Cyprus.
• No other Cyprus taxes apply on qualifying IP income
• No SDC or withholding tax."

Conclusion:

If the Cyprus company:

• is tax resident in Cyprus,
• only earns €1,000,000 from licensing/royalty income from qualifying IP,
• meets the R&D nexus requirements, then its only tax exposure is the 12.5% corporate tax on the 20% taxable portion of qualifying profits — resulting in ~0.5% effective tax in your example.