A new legislative approach of the German tax authorities leaked last December 19 will have a significant impact on the tax deductibility of royalties owed to related persons being subject to a preferential back end tax regime for IP not being in compliance with the Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Action Plan. Its implementation in 2017 can be expected.
Action Point 5 of the OECD BEPS Report already limits IP tax regimes
The OECD member states have agreed in Action Point 5 of the BEPS Report that member states will require a minimum substance level with regard to preferential tax regimes applicable to income generated from IP (e.g., IP boxes or patent boxes), i.e., the so called Nexus approach for the back end tax regimes. Substance in the meaning of the Nexus approach is the ability to demonstrate that the licensor has borne its own R&D costs during the development of the licensed IP.
German fear of tax evasion irrespective of the OECD measures
German tax authorities are concerned that nonetheless countries will continue to maintain or even establish tax benefits for income stemming from IP and, thus, multinational companies are able to shift profits from Germany to low tax jurisdictions, either disregarding the OECD agreement or not being a member of the OECD.
Therefore, the German Federal Ministry of Finance has developed a draft implementing a limitation of the deductibility of royalties paid by German tax residents for income tax purposes (at the moment, arm’s length royalties are generally 100% deductible for income tax purposes and 93.75% for trade tax purposes).
Details of the proposed earning-stripping rule
The proposal is aimed at minimizing the tax deductibility of royalties paid to recipients who are beneficiaries of a harmful preferential tax regime providing for a low or non-taxation of the recipient.
According to the draft Sec 4j of the German Income Tax Act, any royalties paid to a related party and passing the arm’s length test should only be deductible to the extent the royalty is subject to minimum taxation of at least 25 % or, if not, the lower tax rate is the standard tax rate in that country.
If the requirements are met, the royalties are deductible only in the amount representing the ratio of the actual tax burden of the recipient to a minimum tax burden of 25 %.
Example: Assuming a preferential tax rate of 10% on IP related income, the non-deductible portion of a royalty paid by a German resident licensee to a related person benefiting from that IP tax regime would be 60% ((25%-10%)/25%). Thus, 40% (10% equals 40% of 25%) would be deductible for German tax purposes (subject to further limitations, e.g., for trade tax purposes).
As an exception from this rule, the royalty can still be deducted without limit if it can be proved that the income received is directly related to qualified expenses in the meaning of the OECD Nexus approach, (i.e. own R&D expenses borne), excluding however any expenses relating to marketing-related IP, e.g., trademarks. Therefore, to the extent the licensor has not acquired the IP and the respective IP has not been developed by related persons, IP other than marketing related IP should not fall within the scope of the proposed rule.
The next step in the legislative process will be a hearing with the chancellor and the other ministers on the 25 January 2017. According to the proposal, the limitation shall apply to any royalty payable after 31 December 2017.
The German tax authorities once again demonstrate their willingness to set borders to tax planning activities beyond what has been agreed at OECD or G20 level. Given that the limitation applies to payments to related parties which have already passed the arm`s length consideration for related party transactions, the proposal establishes another barrier for IP tax structures. Again, the German tax authorities require, in a cross-border scenario, a lower minimum tax rate than the average German tax rate of 30 %.
A thoughtful review of the definition of the relevant preferential system will be required in order to estimate the impact of the suggested rule, leading to additional administrative costs and compliance uncertainties for German taxpayers. It can only be assumed that a related party in Germany has sufficient knowledge about the tax treatment of its counterparty abroad.
Also the proposed exceptions will not be easily demonstrated to the tax authorities in most cases. Therefore, the proposal will have a substantial impact on those structures which are using preferential systems outside of the OECD Nexus approach.
We will carefully review further development and post updated information during the legislative process.