German tax authorities have started utilizing existing income tax rules to impose royalty withholding tax on cross-border digital advertising services. According to news reports, tax authorities in one of the largest German states have ordered some German companies, situated in this state, to retroactively pay German withholding tax at a rate of 15% on payments to non-German online advertising providers, and other German states are likely to follow suit. To date, there has not been a response from Germany’s Federal Ministry of Finance on this issue nor has there been any known case filed in the German tax courts related to the imposition of withholding tax on cross-border online advertising services.
Online Advertising Services and German Tax Authorities’ (Perceived) Legal Basis
Under this new approach of the German tax authorities, it is expected that the German royalty withholding tax would only apply to online advertising services including both (1) display marketing services and (2) search engine marketing services. “Online marketing services” refers to the placement of advertising banners permanently, for a certain period or when searching for or downloading specific content (e.g., a video clip) by the internet user, while “search engine marketing services” refers to the linking of advertising content to certain keywords entered by the internet user.
The German tax authorities argue that a non-German company providing digital advertising services to a German advertising company constitutes a transfer of the use of technical procedures or algorithms (i.e., the respective technical know-how) for German tax purposes, regardless of the legal relationship between the provider and the recipient of the services. The German tax authorities further argue that the necessary tax nexus between Germany and these online advertising services is satisfied since the underlying technical know-how provided by the non-German company is being economically utilized by companies in Germany. Based on this reasoning, the tax authorities in one German state have imposed German royalty withholding tax at a rate of 15% on any payments made by German advertising companies to non-German providers for online advertising services. The affected German advertising companies were required to deduct the tax from their payments on behalf of the non-German providers and, since they had not withheld accordingly, were held liable for the tax even though the tax is related to the (alleged) limited tax liability of the non-German service providers.
Relief from German withholding tax may potentially be available (either by exemption or by retroactive refund) under German tax treaties. However, such treaty relief is subject to a certain German tax law regulation (i.e., a treaty override) that requires the non-German payee to meet strict substance requirements. Although a recent European Court of Justice decision rejected this regulation, the German tax authorities have continued to apply this regulation to royalties taking the position that the decision only applies to dividends.
This new approach for royalty withholding for digital advertising services is not expected to impact the current German tax treatment of cross-border licenses for transfers of software or databases, which has already been addressed by the Federal Ministry of Finance. On October 27, 2017, the Federal Ministry of Finance provided by decree that payments by German companies to non-German online service providers are only subject to German withholding tax if and to the extent that the German customers are granted full rights of use of the software or database for further economic utilization. This includes the transfer of use of copying, editing, distribution or publishing rights.
It is currently unclear how the imposition of German withholding tax on cross-border digital advertising services will develop in the future. As a result, the following scenarios must be considered:
(1) Worst-case scenario: The Federal Ministry of Finance agrees with this new practice by some of the German tax authorities and orders the tax authorities in all German states to implement the same practice. This scenario may have serious economic implications for all affected companies. In this case, it would likely take years before a higher tax court (possibly the European Court of Justice) would have a chance to decide the issue and would result in uncertainty and economic burdens for the companies engaging in these service arrangements.
(2) Best-case scenario: The Federal Ministry of Finance does not agree with this new practice and orders the tax authorities in all German states to cease this practice and continue to adhere to the previous tax practice (i.e., no withholding tax liability on cross-border online advertising).
(3) Intermediate scenario: The Federal Ministry of Finance does not get involved and leaves the issue to the German tax courts. In this case, it would likely take years before a final decision would bring legal certainty. Until that time, there could be significant economic burdens on all companies engaging in digital advertising service arrangements.
Eversheds Sutherland Observations:
There are strong arguments against the imposition of German withholding tax on cross-border online advertising services by the German tax authorities. These online advertising services do not include any transfer of know-how but rather are solely for the performance of services by the non-German service providers. The German companies receive no rights to use any technical know-how related to the digital advertising services at their discretion.
Given the uncertainty of the position of the German tax authorities, it will depend on the facts and circumstances of an affected company when determining how best to proceed. Companies generally should review the tax clauses in their existing cross-border online advertising service agreements to determine if they would bear the economic burden of any such withholding tax if imposed, and should consider that point when drafting such agreements in the future.