Germany clarifies license barrier rule on intra-group payments
On January 28, 2022, the German Federal Ministry of Finance issued two corresponding circulars providing important clarifications on the German licensing barrier rule which denies the deduction of operating expenses for intra-group royalty payments when (i) they are subject to low preferential taxation (preferential tax regime), and (ii) where the preferential tax regime does not require substantial business activity at the level of the licensor (Circulars of the Federal Ministry of Finance of the January 5, 2022 and January 6, 2022).
The UK patent box regime, the Luxembourg intellectual property (IP) income exemption regime (both abolished with effect from June 30, 2016) and the reduced rate of French corporate tax on IP income (abolished with effective as of December 31, 2018) are just a few examples of the 60 IP box regimes deemed preferential by the German tax authorities.
Whether the Foreign Derived Intangible Income (FDII) regime introduced by the United States in 2018 should be treated as a preferential tax regime remains open. Cases of intra-group royalty payments in the United States are held in abeyance, which should put additional pressure on American multinationals.
In order to encourage regional research and development (R&D) activities, several countries have implemented preferential tax regimes for income or profits derived from the exploitation of intangible assets. In some countries, these tax privileges even apply to brands, which do not necessarily require a specific R&D activity.
The Organization for Economic Co-operation and Development (OECD) took a close look at so-called IP box regimes in its Base Erosion and Profit Shifting project, with a critical assessment in its 2015 Action 5 report. Addressing harmful tax practices more effectively, taking into account transparency and substanceintroducing the OECD nexus approach.
According to the report, licensing agreements are only tolerated if the tax benefits are tied to “substantial business activity” by the licensor.
The OECD Forum on Harmful Tax Practices (FHTP) continuously analyzes intellectual property regimes around the world and frequently publishes a list of preferential tax regimes that do not comply with the nexus approach (latest update in January 2022). EU member states, together with other countries, have therefore agreed to abolish existing preferential tax regimes by June 30, 2021.
In the meantime, some countries have introduced innocuous preferential tax regimes corresponding to the nexus approach, which use the grandfather clause until June 30, 2021.
Scope of the licensing barrier rule
The German license barrier rule applies to any taxpayer with unlimited or limited income tax liability in Germany (i.e. a resident company or a permanent establishment) who pays royalties for the transfer of intangible rights and intellectual property to a related party (parent or sister company or foreign company). a permanent establishment). The royalties must be subject to a preferential tax regime at the level of the foreign related party.
A preferential tax regime within the meaning of the licensing barrier rule is deemed to exist when:
- the licensor’s income from the assignment of rights is subject to taxation which deviates from normal taxation in the country of residence; and
- the tax rate on the income concerned is less than 25% (low tax).
To escape the rule, the German taxpayer can demonstrate that the preferential tax regime requires significant R&D activities relating to the transferred intangible asset.
Similar to the OECD’s DEMPE (Development, Improvement, Maintenance, Protection and Exploitation) concept, funding for the acquisition of relevant R&D or intellectual property is insufficient to satisfy the nexus approach. Expenses related to brands or immaterial goods related to marketing are never accepted.
The German tax authorities have now confirmed that they fully trust the FHTP’s assessment.
If the taxpayer fails to substantiate an evasion, the income expenditure is limited to the ratio of the actual tax rate paid to the reduced tax rate of 25% (i.e. the expenditure multiplied by the balance between 25% minus the actual tax rate paid divided by 25%).
The license barrier rule takes effect for all expenses incurred after December 31, 2017.
Interpretation of the License Barrier Rule by the German tax authorities
In their circular dated 5 January 2022, the German tax authorities pointed out that “standard taxation” refers to the normal tax rate applied to comparable legal entities, regardless of any tax privilege (e.g. legal form, place of residence or type of income). ).
According to the tax authorities, the hypothesis of a preferential tax regime is not limited to royalty income: on the contrary, any preferential tax regime that applies, inter alia, to income derived from intangible assets or to any decision individual tax falls within the scope of the law.
When looking at low taxation, it is not the tax legally due that counts, but the tax actually collected and paid. Therefore, any downstream refund claim must also be included. In addition, inter-entity tax refunds to which the shareholder of the company receiving the royalty income is entitled in the case of a profit distribution should be taken into account.
The German tax authorities follow the analysis of the FHTP to identify preferential tax regimes and have therefore included in their circular of January 6, 2022 a non-exhaustive list of harmful regulations not in line with the OECD nexus approach, copied from FHTP list.
Other regulations may be reviewed on a case-by-case basis. This includes cases:
- where the FHTP has listed foreign tax regimes as “non-IP regimes” for which it has not reviewed compliance with the nexus approach (eg, Swiss cantonal special purpose corporations);
- where an identified preferential tax regime has been abolished or adapted to the nexus approach during the transitional period until June 30, 2021 such that the FHTP review has been discontinued (e.g. Aruba, Greece); Where
- when individual tax rulings grant the foreign taxpayer a similar preferential regime.
These examples show that, despite the international consensus to abolish harmful tax regimes, German tax authorities will continue to review foreign intellectual property regimes beyond the June 30, 2021 deadline.
License Barrier Rule Administration
To administer the licensing barrier rule in practice, the German tax authorities rely on burden of proof and mandatory disclosure requirements. In a cross-border transaction, the taxpayer is generally required to disclose any information and documents requested by the tax authorities insofar as this is feasible, relevant for tax purposes and proportionate.
As a result, an increase in requests for information and documents on preferential tax treatment and individual tax rulings is to be expected.
Failure to comply allows tax authorities to assume a harmful tax regime and base taxation on estimates.
The first step in the analysis is to identify a preferential tax regime under the licensing barrier rule. In cases where the FHTP has failed to determine whether a specific scheme complies with the nexus, the German tax authorities place the burden on the taxpayer to prove that the OECD requirements are met. The test does not focus on whether the licensor in fact has sufficient substance, but whether the foreign tax regime requires substance as a condition of preferential taxation.
The same should apply when the foreign licensor benefits from a favorable tax ruling. The German taxpayer will be required, to the extent legally possible, to provide information and evidence about the ruling and to show that it complies with the OECD nexus approach.
When a preferential tax regime that does not comply with the link in another country is identified and confirmed, the circular assumes that the licensor benefits from it.
In this case, the German tax authorities expect the taxpayer to provide evidence to the contrary by submitting documents from the grantor’s accounts and relevant tax notices.
In my opinion, this approach is highly questionable and does not comply with the precedents of the German Federal Tax Court regarding tax reporting obligations.
For the transitional period where a state simultaneously offers two opposing preferential regimes (one compliant, the other not), the burden of proof is on the taxpayer to demonstrate that the foreign licensor only uses the innocuous regime. As proof, a confirmation from the foreign tax authority is required: this can be difficult when the foreign tax authority does not have a standard procedure for such a confirmation letter.
Key points to remember
- Germany disallows the deduction of expenses from intra-group royalty payments to the extent that the licensor uses a preferential tax regime (IP box) that is not in line with the OECD link.
- It is assumed that the foreign licensor is subject to preferential tax treatment when the FHTP has identified a non-conforming preferential tax regime in the licensor’s country of residence. The German tax authorities de facto impose on the German taxpayer the burden of disproving this assumption.
- The German taxpayer must also prove that the foreign licensor uses a link-compliant tax regime where two IP box regimes are available at the same time.
- If the FHTP has identified a “non-IP regime” where a foreign licensor may receive preferential tax treatment but has not assessed their nexus for compliance, the German taxpayer is required to support and satisfy the authorities. German tax authorities in their analysis of the nature of the foreign tax regime.
- The German taxpayer is required to provide information and evidence on any tax ruling granting preferential treatment to the foreign taxpayer and that the tax ruling complies with the nexus approach.
- In particular, the details regarding the taxpayer’s disclosure obligations and the extent of the burden of proof seem somewhat disproportionate. Taxpayers must analyze on a case-by-case basis whether to contest the demands of the German tax authorities.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Lars Haverkamp is a partner at Eversheds Sutherland Germany.
The author can be contacted at: [email protected]