Germany: New Law to Close Patent Box Loopholes

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Bodo Bender

By Bodo Bender, partner, White & Case LLP, Frankfurt; email: bodo.bender@whitecase.com.

International tax issues have never been as relevant on the political agenda as they are today. The integration of national economies and markets has increased substantially. The same applies to the relevance and value of intellectual property rights in general. The ease of transferability of IP rights has also led to companies shifting their profits abroad using certain preferred tax regimes granted by individual jurisdictions, such as the patent box.

Notwithstanding the upcoming implementation of the OECD base erosion and profit shifting (“BEPS”) measures, the German legislature decided to enact a unilateral measure which goes beyond the original proposal of the OECD. The reason for this initiative is, inter alia, that the German tax administration feared that the OECD measures might easily be bypassed by non-member states of the OECD. Hence, the German draft bill provides for a tax penalty by restricting the possibility to deduct royalty payments if royalties are substantially low taxed under another preferential tax regime.

Post-BEPS Environment

The pending draft bill clearly needs to be considered against the background of the BEPS Action Plan. The BEPS package, in “Action Point 5: “Countering Harmful Tax Practices More Effectively” provides for the undermining of preferential tax regimes, such as patent boxes, which grant a preferential tax treatment for revenues without assessing whether the beneficial treatment reflects the engagement of the respective corporation with respect to income-generating activities. This issue has led to artificial profit shifting in the past.

The member states of the OECD have developed an objective methodology that is supposed to govern the conduct of granting of such tax advantages—the “nexus approach”. This approach uses expenditures in a country as a proxy for substantial activities, and ensures that taxpayers benefiting from these regimes did in fact engage in research and development (“R&D”) activities and incur actual expenditure on these activities. This approach will ensure that profits are taxed where the economic activities occur and the value is created.

Implementation on Track

On April 27, 2017, the German Federal Parliament adopted a draft bill against Harmful Tax Practices with regard to Licensing of Rights after the parliament's finance committee passed the draft bill without substantial changes. In order to meet the OECD definition of the “nexus approach,” the German parliament amended the wording of the draft bill during the legislative procedure to ensure that the interpretation of the “nexus approach” is consistent with the OECD report on Action Point 5.

It is expected that the German State Council ( Bundesrat) will approve the draft bill on June 2, 2017 without material revisions or amendments so that the legislative process can be finalized before the end of the current legislative term. The draft provides for new rules to apply to any royalty expenses “arising” after December 31, 2017. The German Federal Parliament, however, did not follow the proposal of the German State Council to apply the rule retroactively to payments made as from January 1, 2016. The legislature estimates that the implementation will lead to a total increase in tax revenues of between 30 and 50 million euros a year. On the other hand, implementation will definitely also entail increased administrative effort, since tax authorities will have to verify the affected IP structures, which can be quite complicated.

According to the wording of the draft, the application of the rule shall not be limited by any existing double tax treaty, meaning that the restriction shall apply even if this will constitute a “treaty override.”

Proposed Measures

The purpose of the draft bill is to introduce a new section in the German Income Tax Act (“GITA”) restricting the tax deductibility of royalties and similar payments made to related parties if such payments are subject to a non-OECD compliant preferential tax regime in the jurisdiction of residence of the recipient and are effectively taxed at a rate below 25 percent. Other than under the systematic approach of the German interest limitation rules ( Zinsschranke), royalty payments made to unrelated parties shall remain unaffected by the new law.

The tax deductibility may be wholly or partially denied if the following conditions are cumulatively met:

  •  the direct or indirect recipient of the royalty benefits from a preferential tax regime related to the royalty income;
  •  the licensee and the recipient of the royalty are related parties; and
  •  the effective taxation of the royalty income is less than 25 percent.

As an exemption, the royalties shall remain tax deductible, even if the conditions above are met, if the recipient satisfies the “nexus approach” as interpreted by German domestic law (see below).

Definition of License Expenses

The limitation of deductibility applies to expenditures for either the use or the licensed right to use intangible rights. The provision includes in particular, copyrights, for example, software, intellectual property rights falling under the scope of the German legislation (e.g., Patent Act, Copyright Act, Act on Designs and Utility Models) as well as comparable rights. Remarkably, the legislature excluded the application of the “nexus approach” escape clause in respect of payments for the use of trademarks (group brands), since tax regimes benefiting revenues for such trademarks are in general considered as harmful by the German legislature.

The wording of the draft bill complies with the corresponding German rule in the Income Tax Act (Section 50 paragraph 1 No. 3 GITA) which allows the conclusion that only temporary right of use falls under the scope of the draft provision, excluding ultimate disposals of intellectual property rights. However, often the distinction between a long term (but still temporary use) and an ultimate disposal of intellectual property rights is not entirely clear.

Related Parties

It was a special concern of the legislature to prohibit profit shifting within the context of international shareholding structures. For this purpose, the wording includes recipients that qualify as a related party of the licensee pursuant to the German Foreign Tax Act (“GFTA”) ( Auszensteuergesetz). According to Section 2 paragraph 2 of the GFTA a party is related to another person if, for example, it owns a direct or indirect participation of at least 25 percent in both relevant parties. The term “party” also includes permanent establishments ( Betriebsstätten).

In order to catch cases of interpositions, the draft rule expands the limitation on “indirect” license arrangements where payments are in essence routed through a recipient towards another related party which benefits from an unqualified preferential regime. Back-to-back royalty structures involving unrelated intermediates should, however, not be covered by the wording and might therefore be considered as an alternative structure.

Low Taxation under Preferential Tax Regime

“Low” taxation is defined by the German legislature as a tax burden of less than 25 percent at the level of the beneficiary. Interestingly, this is less than the current German corporate income tax rate of 15.825 percent. Tax regimes providing for a regular low taxation rate not preferring a special type of income (such as IP revenues) shall not be detrimental, which leads to difficulties in drawing distinctions between “regular low taxation” and “preferential low taxation.” As a distinctive characteristic the approach of the privilege shall be considered.

However, the draft bill covers any other aid granted, such as reductions, reliefs, credits as well as discounts. The provision shall also include fictional operating expenditures linked to license revenues. If any such benefits have been granted under the respective regime leading to an effective tax burden of less than 25 percent, a significant preferential taxation is assumed, even if the statutory tax rate is more than 25 percent.

Nexus Approach

As an exception to the rule, the restriction is not applicable if the preferential IP tax regime follows the “nexus approach.” The beneficiary is obliged to disclose and to prove that the IP right has been developed predominantly in the course of its substantial local business activities. Facts and evidence need to be presented that the beneficiary did in fact engage in R&D activities and incurred actual expenditures on activities related to the development of the IP right. However, substantial business activities cannot be carried forward if the IP right was acquired or if it was developed by another related party.

In the course of the legislative process the wording of the draft bill was amended by introducing the reference to Action 5 of the OECD BEPS report—the origin of definition of the “nexus approach.” The explicit reference aims to address concern around the initial draft that the domestic interpretation might lead to deviations in the application of the provision. This amendment can only be welcomed but already led to concerns in German literature that a reference to the BEPS report (which does not have the legal characteristic of a formal multinational law or directive) might not be in compliance with the demands the German constitution stipulates for the determination of German legal provisions.

Tax Consequences

If the aforementioned requirements are met, the royalty payments are deductible only in the amount representing the ratio of the actual tax burden of the recipient. By means of the limitation of deduction the legislature intends to effect a balanced and commensurate tax burden in practice. The licensee shall only be able to carry forward expenses for royalty payments if the licensor was tax burdened with regard to corresponding revenues. The minimum threshold is a tax burden of 25 percent at the level of the beneficiary. If the taxation falls below this threshold, the draft bill provides for an instructive sample for the determination of the deductible percentage. By way of example, the following calculation shall apply:

Assuming the beneficiary's place of business is located in a preferential regime, royalties amount to 100. The tax rate applicable would be 30%, however the preferential regime allows for deductions in the amount of 60%, so that the taxable income is only 40. The actual tax burden would therefore be effectively 12% (40 x 30%). Actual business expenses will be disregarded. As a result of low taxation 52% of the royalty payments would be disallowed ((25% -12%) / 25%).

How Can Implementation Affect a Business?

Even though the implementation is not yet in place, there are steps the taxpayer can take to examine whether its business is affected by the legal amendment, and if so to smooth the transition and manage the changes.

The crucial steps would be:

1. Analyzing: Review of the business operations to identify whether within the relevant shareholding structure a potential preferential tax regime might be applicable falling under the scope of the draft bill. If so, the taxpayer should verify the applicable tax rate of the royalty income.

2. Reviewing: Proving the actual amount of the income tax attributable to the royalty income, and whether the required information is available to prove a sustainable business activity pursuant to the “nexus approach,” after thorough examination of the actual business activity relating to the IP right.

3. Planning: Taking into account alternative structures for the assignment of royalty payments. Potentially the revenue needs to be routed to an affiliated company which is able to satisfy the “nexus approach” adequately. It may also be worth considering outsourcing license revenues to a third party outside the shareholder structure, since those are not covered by the wording of the draft bill.

Conclusion and Perspective

The German legislature has introduced a draft bill, which is expected to be approved shortly. The new law sanctions German resident companies making royalty payments to foreign affiliates which benefit from low taxation abroad due a patent box or similar preferential tax regime. Depending on the actual tax rate abroad royalty payments may be fully or party disallowed and therefore non-deductible in Germany. If the recipient of the royalties did engage in R&D activities and incurred actual expenditures in relation to the IP right in accordance with the “nexus approach” as defined Action 5 of the OECD BEPS report the limitations under German law shall, however, not apply.

The new royalty limitation rules are complex and put significant administration effort on both the tax payer and the tax administration while the estimated annual tax revenues are fairly limited. The German Federal Ministry of Finance already indicated to publish official guidance on the application and interpretation of the new rules in the course of 2017. It is expected that this decree will in particular include further guidance about preferential tax regimes in other jurisdictions that are considered to be in the scope of the new German limitation rules. Multinational groups with German affiliates may need to revisit and potentially adjust their royalty structures in Germany.

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