Today, the German Federal Council (Bundesrat) approved a bill introducing limitations on German tax deductions available in respect of royalty payments. The bill had been passed by the German Federal Parliament (Bundestag) on 27 April 2017. The new rules principally target payments to so-called “patent” or “IP box” entities whose preferential tax treatment in their jurisdiction of establishment are not in line with the OECD “nexus” approach (which, broadly, requires entities benefitting from tax incentives related to IP development to be actively engaged in the development of the relevant IP). The new rules are an example of Germany’s implementation of Action 5 of the OECD’s BEPS Action Plan (Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance).
The new rules will be included at section 4j of the German Income Tax Act (CITA, Einkommensteuergesetz), providing for limitations on the deductibility of royalties paid by a person subject to German tax (including German permanent establishments of foreign entities) to a foreign related party. The limitations will apply where:
- the royalty payment is subject to tax in the hands of the beneficiary of the payment at a “low” rate, (i.e. an effective (rather than nominal) tax rate of less than 25%) (the “preferential tax treatment”); and
- the beneficiary of the payment is a person related to the payer pursuant to sec. 1 para. 2 of the German Foreign Tax Act (FTA; Außensteuergesetz).
In order to assess whether a preferential tax treatment is in place, all tax deductions, exemptions and tax abatements in relation to the royalty income that are applicable under the tax law of the jurisdiction in which the beneficiary of the payment is tax-resident must be considered. Hence, the German tax implications are directly tied to the foreign tax regime.
The limitation of the deductibility is applied for income tax, corporate income tax and trade tax purposes.
The limitation pursuant to sec. 4j CITA does not apply if the beneficiary of the payment carries out substantial R&D activities with own resources (applying the OECD Nexus Approach, the core incomegenerating (i.e R&D) activity is carried out by the beneficiary of the payment). However, set-ups in which the beneficiary of the payment acquires (rather than develops) the IP or in which the IP is developed by related or unrelated contract developers on behalf of the beneficiary of the payment will be caught by the new rules. For royalty payments in relation to the use of trademarks (Markenrechte), the limitations apply irrespective of the business activities of the beneficiary of the payment.
The limitations on deductibility take effect as a disallowance of deductible expense in proportion to the difference between the “low” tax rate and the “acceptable” minimum rate of 25%.
A licensor’s royalty income is subject to a tax rate of 10% in a non-German jurisdiction. The royalties paid by a German licensee to the licensor amount to EUR 10m in FY 01. The licensee and the licensor are related parties pursuant to sec. 1 para. 2 FTA.
Non-deductible portion of royalty payments = [EUR 10m x (1-(10/25)) = EUR 6m]
Given that the tax rate in the foreign jurisdiction is 40% of the minimum rate set out in the new rules, the allowable deduction is limited to 40% of the royalty payment expense, accordingly.
The new rules apply to royalties paid or accrued after 31 December 2017.
Although the compliance of the new rules with German constitutional and EU law is under debate, businesses should now turn their intention to the potential impact of these rules. Some existing IP holding structures may require adjustments that need to be implemented by 31 December 2017. In that respect it should be noted that, even where established “patent box” jurisdictions (such as Luxembourg, the Netherlands, the UK etc.) are updating their laws to comply with the OECD nexus approach, in most case grandfathering rules mean that structures in place for existing IP may still trigger the new German rules.