Pursuant to the “license barrier” rule in Sec. 4j German Income Tax Act, newly introduced as of 1 January 2018, arm’s length business expenses of a company incurred for the right to use intellectual property (“IP”) and certain other rights are not fully deductible from the income tax base, if (i) the corresponding licensing income of the licensor is taxed at a rate lower than 25% (“Preferential Taxation”), (ii) this low tax rate is not the standard tax rate applicable in the respective jurisdiction but results from a preferential tax regime (e.g. from a so-called “IP, patent or license box”) and (iii) the license payment is made to an affiliated entity.
The limitation of deductibility of license payments does not apply if the relevant Preferential Taxation qualifies as “nexus based” (i.e., does only refer to an IP regime whose benefits are limited to IP rights that are based on a substantial economic activity). The “nexus based” test would in particular be considered failed if the licensor did not develop the vast majority of the relevant IP right in the course of its own business activity (e.g., if the licensor merely acquired the IP right or the IP right was developed by a related party).
The percentage of the non-deductible license fee is determined by using the following formula: (25% ./. effective tax rate applicable to the licensing income) : 25%. Hence, the deductible amount of license fees at the level of the licensee depends on the tax rate applicable to the corresponding license income at the level of the licensor. For instance, if an effective tax rate of 15% was applicable at the level of the licensor, the non-deductible portion of the license fees at the level of the licensee would amount to 40%.
US Tax Reform
Coming also into effect on 1 January 2018, the US introduced the largest tax reform in over 30 years. This tax reform contains numerous changes and innovations. In particular, companies shall be incentivized to invest in the US.
With respect to IP rights, the US Tax Reform contains several provisions to encourage US-based companies not to off-shore ownership in IP rights to foreign entities but to develop and keep ownership of IP rights in the US. Among others, the corporate tax rate applying to Foreign Derived Intangible Income (“FDII”) is reduced. Taking into consideration all tax benefits granted, the tax rate on such income may only amount to 13.125%.
Impact of US Tax Reform on German “License Barrier” Rule
It is currently unclear whether the benefits of the US “FDII” provision might be considered a preferential regime within the meaning of the German “Licence Barrier” rule with the consequence that license payments made by a German entity (or permanent establishment) to its affiliated US entity are not fully deductible as business expenses for German income tax purposes. In such case, the license payments would be subject to income taxation in the US and also in Germany.
Pursuant to our knowledge, the German tax authorities currently tend to interpret Sec. 4j German Income Tax Act in a broad way and hence, the German provision may apply to payments made from a German entity to an affiliated company in the US. However, as an official written statement has not yet been published, the developments have to be closely monitored.