On 25 January 2017, the German government approved a bill to combat harmful tax practices in connection with the assignment of rights. The aim is to stop multinational companies from using royalty payments to shift their profits to countries with special preferential regimes (known as patent box or IP box regimes), and the bill thus serves to implement Action 5 of the BEPS project (Base Erosion and Profit Shifting) of the OECD and of the G20 “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance”. The BEPS project is to prevent tax competition among countries and to stop aggressive tax planning by international corporations.
2. Key features of the bill
The centrepiece of the bill is the introduction of a new government draft in the form of Sec. 4j Income Tax Act (EStG RegE) governing the tax deductibility of royalty payments and of other expenditures for the assignment of rights.
(i) Preferential regime (low taxation of recipient) Sec. 4j (1) EStG RegE assumes taxation at a low rate, by the jurisdiction where the recipient resides, of the income resulting from the assignment of rights (“preferential regime”). Such taxation at a low rate shall be deemed to exist if the proceeds of an obligee from the assignment of rights are taxed at less than 25%. This definition must take into account all provisions impacting the taxation of revenue from licensing, notably any tax cuts, exemptions, credits, or relief. In particular, lower taxation may also result from the fact that the jurisdiction where the company resides does not tax royalty income at all. Hence, the royalty restrictions are to cover any payments to companies residing in countries that have special tax rates and benefits for royalty income in place.
(ii) Related party as obligee The personal scope of application of the proposed legislation is limited to payments between “related parties” within the meaning of Sec. 1 (2) Foreign Taxation Act (AStG). Such a related party shall be deemed to exist if a company, on account of a shareholding under corporate law, may exert material influence on (foreign) companies (especially where a stake of at least 25% is involved). Royalty payments to unrelated third parties are not affected by Sec. 4j EStG RegE and will remain deductible without any restrictions. The focus of the bill is thus, in particular, on international groups of companies.
(iii) No substantial business activity of obligee The royalty restrictions will not apply where low taxation results from the fact that the obligee’s (= licensor’s) revenue is subject to a preferential regime (income taxation < 25%) that is limited to rights based on substantial business activities. However, the bill does not include any positive definition of the scope and quality of such requisite substantial business activity. Rather, the bill merely provides for a negative delimitation according to which a substantial business activity does not exist where the relevant rights have not been self-developed, but acquired. It is unclear whether or not the construction of the concept of “own research or development work” as laid down in Sec. 8 (1) No. 6 lit. a) AStG may additionally be referred to for a concretisation of “substantial business activity”.
b) Legal consequences
If, due to a preferential regime, income from royalties paid to a related party by the user of the rights is taxed at a low rate or not at all, then the corresponding expenditures are not to be deductible as operating expenses (or only on a pro rata basis). Based on the principle of taxation congruence, the tax-deductible portion on the part of the obligor will increase in proportion to an increase in the licensor’s income tax.
The bill uses the following formula for calculating the restriction: (25% – income tax load in )/(25)
3. Assessment and Outlook
Linking low taxation to an income tax load of less than 25% is problematic since this would affect not only tax havens. In a number of EU member states the rate is less than 25%. It still needs to be discussed whether or not this constitutes a breach of the freedom of establishment guaranteed under EU law.
Moreover, the vague concept of “substantial business activity” tends to create uncertainty as to what degree of “substance” will suffice. Such a broad definition of an exception, leaving the requisite interpretation and delimitation to the authorities and courts, is flawed and will lead to unnecessary legal uncertainty.
The bill clearly focuses on the configuration of “foreign group company and domestic operating profit company”. Whether it may cover any deviating configurations is doubtful. Corresponding tax planning can be anticipated.
The question is whether – in view of other jurisdictions – Germany may be forging ahead. Royalty restrictions have to date been implemented only in very few European countries, such as Spain or Ireland. The legislator will certainly have to consider the type and scope of possible detrimental effects (relocations of enterprises, etc.).