Germany intends to restrict tax-deductibility of license payments to IP boxes
Proposed new legislation to end exploitation of non-OECD compliant IP tax regimes
14 December 2018
Action point 5 of the OECD BEPS report (2015) deals with preferential tax regimes for IP assets. Preferential tax regimes for IP assets are, in principle, accepted by the OECD as IP drives economic development and thus there is sound reason for jurisdictions to incentivise such activities through providing for preferential tax regimes. Accordingly, OECD takes the view that benefitting from preferential IP tax regimes (e.g. IP boxes) is legitimate provided the IP is the result of a substantial economic activity undertaken by the party claiming the tax benefits (so-called "nexus" approach of the OECD). Currently, most IP tax regimes are indifferent whether the IP is a result of substantial economic activities undertaken by the licensing entity itself. Therefore, most IP tax regimes need to be redesigned. As from mid 2021 they have to comply with the OECD requirements. In the meantime the current status may prevail with "passive" IP holders benefitting from harmful tax practices as the OECD calls it.
Germany will not wait until 2021 and has recently proposed new legislation to end exploitation of non-OECD compliant IP tax regimes to the detriment of the German revenue. The new rule proposed denies tax-deductibility of licence fees to the extent the licensor has not actively created and developed the licensed IP ("Nexus Test") and is subject to an effective tax rate of less than 25% with its licence fee income under a preferential IP tax regime.
The new licence test
Presumably as from 2018, the limited deductibility of licence payments applies to German tax residents if and to the extent (i) licence fees are paid to a related party, (ii) the recipient of the licence fees is not subject to regular taxation with the licence income, but benefits from a preferential tax regime with the effect that the licence income suffers a tax of less than 25%, and (iii) the German domestic "Nexus Test" failed.
In a nutshell, a party is a related party in case of a participation of 25% (adding direct and indirect shareholdings) or if a third party is subject to factual/legal control in the sense of the German CFC Rules.
A deviation from regular taxation exists if e.g. the licensor is subject to a preferential IP tax regime (IP box regime) and the effective tax rate actually paid (not only owed) is below 25%. An effective taxation does not occur where taxes paid by the licensor are refunded upon dividend distributions made by the licensor.
The "Nexus Test"
If the "Nexus Test" is satisfied, licence expenses are tax deductible irrespective of their taxation. The "Nexus Test" as described in the reasoning of the draft legislation (which follows the OECD approach) considers the expenses (whether capitalised or not) of the licensor and differentiates between "good" (qualifying) and "bad" expenses. Good expenses are those which are incurred for inventing and developing IP rights as well as outsourcing costs charged by unrelated parties. According to OECD rules some jurisdictions allow to artificially inflate expenses for genuine IP developments up to 30%. Such "uplifts" qualify as "good" expenses. "Bad" expenses accrue when IP rights are purchased or IP innovation and development is outsourced to related parties.
The German draft legislation requires that the IP has been fully or predominately developed by own business activities (which will not be the case if the IP right is purchased from another party or developed by a related party); if this is the case, the Nexus Test would not be satisfied.
To satisfy the "Nexus Test", the licensee needs to have documentation/information available with regard to the IP expenses incurred by the licensor (which may be difficult in practice).
Concept of limited tax deductibility
If the "Nexus Test" fails a portion of the licence fees will not be tax-deductible if and to the extent the effective tax rate is less than 25%. Such non-deductible portion is determined according to the following formula:
(25% - effective tax rate) / 25% x license fee = the non-deductible part of the licence fee.
Implications of the tax deductibility
As the draft legislation proposes a separate "Nexus Test" which refers to a substantial own business activity (rather than to "good" (qualifying) or "bad" expenses) the proposed wording of the law leads to an "all or nothing" approach as regards the "Nexus Test". In contradiction to the proposed wording of the law, the reasoning outlines the formula of the OECD which determines the amount of preferential income (and thereby the amount of in principle deductible license payments) by the proportion of "good" expenses to all expenses incurred for an IP right. The OECD approach would therefore lead to an in principle higher amount of deductible license payments in cases where the IP right is not predominantly developed by own business activities. This inconsistency of the draft law with the OECD approach has already been addressed by legal scholars and will hopefully be clarified in the final law.
Fees incurred for the utilisation of trademarks are subject to a different regime according to the draft legislation. Such fees are not deductible for tax purposes if they are paid to related parties and the recipient of the licence income is subject to a preferential tax regime such that the licence income is taxed at a rate of less than 25%. Note that even genuine expenses for developing the trademark do not make fees paid for utilisation of trademarks tax deductible.
The proposed tax regime aiming at the denial of tax-deductibility of licence expenses overrides existing tax treaties insofar as such treaties contain the non-discrimination clause of the OECD model convention (Art.24) (which is agreed in quite a few treaties entered into by Germany). According to the non-discrimination clause, licence expenses paid to a foreign party need to be dealt with for tax purposes as if paid to a domestic party. Licence fees paid to a German resident licensor are tax deductible and not subject to the new test outlined above (since no preferential IP tax regime may apply to a domestic licensor). Thus, the proposed legislation may overrule treaties; such treaty override has been tolerated by the German Constitutional Court in comparable cases.
Adverse implications on licensees
The proposed tax regime may have adverse implications on licence agreements and puts the licensee at risk. Usually licence agreements address withholding taxes, but rarely deal with the deductibility of licence expenses of the licensee or the providing of information to the licensee as regards the business expenses of the licensor. To the extent licensee and licensor are part of the same group this may be of minor relevance. Further, the proposed rules apply in case of a 25% shareholding. Thus, there may be cases where the mitigation of the non-deductibility of licence expenses may be more challenging.
The draft legislation was approved on 27 April 2017 by the German Lower House (Bundestag) and will be on the agenda of the German Upper House (Bundesrat) by mid May 2017. It is currently not clear whether the proposal will be further amended in the legislative process.