Germany proposes tax deduction limits on royalties paid to related companies

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by Ninja-Antonia Reggelin

In a surprising move, the German finance ministry has published a draft law that would disallow tax deductions for some royalty payments made by multinationals to related group companies.

The law is designed to thwart multinational group tax avoidance that is facilitated by harmful tax regimes set up by foreign countries.

The draft law, proposed December 19, 2016, would limit the tax deduction for a cross-border royalty payment made to a related group company when the same payment is taxed as income to the group member at a low rate and through a preferential tax regime that does not require substantial business activity as provided for in the OECD/G20 base erosion profit shifting (BEPS) Action 5 modified nexus approach.

For most commentators, the new restriction (“Expenses for Assignment of Rights” article 4j income tax act (EStG)) was unexpected as there had been no official indications that such a rule was being developed beforehand

Preferential tax regimes

The German finance ministry explained that an increasing number of countries have introduced special preferential regimes (i.e. IP, license or patent boxes) which have created harmful tax competition where substantial business activity is not a necessary condition.

While there is agreement that the OECD’s BEPS Action 5 modified nexus approach should be followed, countries may in the future introduce tax regimes that lack a substance requirement, the ministry said.

As the draft law states, intangible assets such as patents, licenses, concessions or trademark rights can easily be transferred to different owners and across borders.

Also, many German double tax treaties (including those with non-OECD countries not bound by the BEPS agreement) include a 0 % tax rate on royalty payments, thus multinational companies can shift these payments to countries that do not require substance.

German royalty deduction limit

The new deduction limits would be applied to all expenses incurred after December 31, 2017. This is in obvious breach to the OECD’s agreement, which includes grandfathering rules until June 30, 2021, for patent boxes introduced before June 30, 2016.

It should be noted that the modified nexus rules specify that there can be a lack of substantial business activity if the license holder did not develop the right fully or substantially through its own business activity. Also, the rules, do not address contract/commissioned research.

Low tax rate

The proposal limits deductions for royalty payments only where the related payment is subject to tax at a rate lower than an “ordinary rate,” namely under 25 %.

The deduction is restricted proportionately to the difference below the 25 % tax threshold ((25% – effective tax rate at recipient’s level in %) / 25%). Because the restriction of the deduction is incurred by the license holder, the rule can be considered as corresponding taxation.

The proposal states that all rules relating to the income taxation of licensing of rights must be taken into account. These include tax reductions, add backs, reliefs, credits or reliefs. Currently it is unclear how to account for tax loss carryforwards or carrybacks.

The new rule would be applied irrespective of whether a double tax treaty is in force with the other country.

Also, there is also no clarification for companies operating on different fiscal years that would have to apply different rules for royalty expenses within their same operating year.

In German, the new rule is referred to by many tax professionals as “Lizenzschranke” or royalties barrier, in reference to the interest barrier. A similar royalties barrier was introduced in Austria in 2014.

The draft law will need to pass Parliament and the Federal Assembly within the next six months due to upcoming federal elections in September 2017 and could be further changed. Interested stakeholders have been invited to comment.

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Ninja-Antonia Reggelin

Ninja-Antonia Reggelin

Ninja-Antonia Reggelin is based in Berlin, where she is head of tax policy at a business association.

She previously worked at the OECD, contributing to the project that led to the publication of the BEPS Action Plan. Prior to that, she was with PwC Germany, where she focused on international tax structuring.

Ninja holds a Master’s degree (LL.M.) in International Trade Law from Bond University Australia and a Master’s degree (M.A.) in International Relations from the University of Kent Brussels School of International Studies.