A new legislative approach of the German tax authorities, which had been leaked in December 2016 (see our earlier report), was passed on Thursday, 27 April 2017, as one of the very last laws of the current Bundestag prior to the elections in September this year.
The bill 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 OECD BEPS Action Plan. The new rules should come into force with regard to royalties payable after 31 December 2017 (i.e., the Bundestag did not agree to the proposal of the Bundesrat to apply the rule retroactively as of 1 January 2016). It can be expected that the Bundesrat will nonetheless agree to the bill in its meeting on 2 June 2017.
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 own R&D costs during the development of the IP licensed.
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 member.
Therefore, the German Federal Ministry of Finance has developed and successfully introduced 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). The proposal is widely supported by the members of the conservative party (CDU) and the social democrats (SPD) and, therefore, the bill is pushed through the legislative process with very high priority in order to finalize the legislative process prior to the lapse of the term of the current Bundestag.
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 generally applicable tax rate in that country.
If the requirements are met, the royalty 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 unlimitedly 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, excluding however any expenses relating to marketing related IP, e.g., trademarks. Therefore, to the extent the licensor has not acquired the IP or the respective IP has been developed to related persons, IP other than marketing related IP should not fall within the scope of the proposed rule. Interestingly, in order to meet the OECD definition of the nexus approach, the German parliament has amended the wording in a way that it now refers directly to the OECD report on Action Point 5, 4th chapter. Furthermore, the current version also considers that in the case of transparent / disregarded entities a look-through approach needs to be applied in order to consider also the tax exposure at the level of the relevant partners/shareholders.
The next step in the legislative process will be a hearing with the Bundesrat (the representation of the Federal States in Germany). The bill is discussed by the finance committee of the Bundesrat on 19 May 2017 and it can be expected that the Bundesrat will agree to the bill in its meeting on 2 June 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 case. Therefore, the proposal will have a substantial impact on those structures which are using preferential systems outside of the OECD nexus approach. According to informal discussions with the tax authorities, the German tax authorities expect that the Forum on Harmful Tax Practices of the OECD will issue and update a list of non-compliant OECD member states, which will serve as the basis for the German tax qualification under the royalty barrier.
The further development will be carefully reviewed and we will provide a final update once the legislative process has been finalized.