On 19 December 2016, the Federal Ministry of Finance published a draft bill on the limitation of the deduction of royalties. The bill is intended to focus on foreign IP boxes incompatible with the OECD nexus approach, and to make their use unattractive.
The draft bill provides for a limitation of the deductibility of royalties paid by a German corporation or permanent establishment to a foreign related party or to its head office, respectively. According to the draft bill, the limitation of royalty deduction applies, when:
- license income is subject to preferential, low taxation, meaning taxation below 25%,
- and where such low taxation does not require substantial business activities of the licensor, substantial business activity being in particular development activities with own resources.
The new draft bill particularly limits the deduction of royalties on intellectual property acquired by the licensor or developed for the licensor by related contract developers. In case license payments relate to trademarks, the deduction of license payments is limited regardless of whether using the foreign IP box requires substantial business activities or not.
Where license income is taxed at a tax rate of less than 25%, the deduction of corresponding license charges is denied in proportion to the under taxation. Example: The income tax for the licensor amounts to a tax rate of 12.5%. Accordingly, the shortfall of taxes also amounts to 12.5% of the taxable income. Accordingly, only half of the license payments is deductible.
It is not entirely clear, if the foreign income tax burden is calculated based on gross license income. In our systematic and literal reading of the bill, the wording implies that actual taxes paid have to be seen as a proportion of net license income as determined under German tax law. Deductibility is limited with regard to income tax, corporate tax and trade tax. The rules shall prevail over contradictory provisions in double tax treaties and, therefore, constitute a treaty override.
Further rules deal with multilevel licenses (stepping stone or treaty shopping structures) as well as permanent establishments.
The new rules shall apply for all license charges paid or accrued after 31 December 2017. According to the government, the proposed limitation of royalty deductions is fully in line with the OECD’s BEPS Action Item 5.
The further legislative procedure is to be awaited. In case the new rules will be passed, many multinationals will have to review, and possibly adjust, their license and distribution structures.