German bill would combat harmful use of preferential IP regimes
TAX ALERT |
On Jan. 25, 2017, the German government adopted a draft bill that provides significant limitations on royalty deductions or other deductions of expenses for the use of foreign IP in Germany. The draft bill is based on the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) considerations on preferential tax regimes (Action 5) and targets holding company structures, which are benefiting from non-BEPS compliant preferential tax regimes.
Action 5 of the BEPS framework addresses concerns primarily about preferential tax regimes that risk being used for artificial profit shifting and about a lack of transparency. A central part of Action 5 is the ‘nexus approach.’ This approach allows a taxpayer to benefit from a preferential IP regime only to the extent that the taxpayer itself incurred qualifying research and development (R&D) expenditures that gave rise to the IP income.
Given that most German double tax treaties provide a 0 percent German tax rate on royalties paid to non-German companies and taking into account that not every treaty partner is part of the OECD, the new law would prevent the use of non-German holding company structures taking advantage of preferential tax regimes that are not complying with the nexus approach. According to the draft law, deductions for amounts paid a German entity to non-German entities for the use of foreign IP shall be limited where the royalty earnings are:
- Received by an affiliated company of the German entity or branch
- Subject to a preferential tax regime
- Effectively taxed at a rate less than 25 percent
As a result, the expense deduction is basically limited to the amount of the payment multiplied by a fraction of the numerator of which is the actual tax rate on the royalty divided by 25 percent. For example, where a preferential tax regime provides a tax rate of 10 percent for royalty income, which is subject to the new draft regulation, the German deduction would be limited to two-fifths of the payment.
Notably, the draft legislation would not apply to preferential tax regimes, which require relevant substance in accordance with the OECD nexus approach. Substance in this regard means that the IP is the result of R&D located in the location where the royalty income is earned. The BEPS framework provides that non-compliant preferential tax regimes, such as that of the United Kingdom, are closed to new patents from July 1, 2016. Existing patents will still be covered until July 1, 2021, when non-compliant preferential IP regimes as they currently exist will be closed to all patents, regardless of eligibility. The adoption of the German draft bill therefore would currently affect preferential tax regimes in a couple of OECD member states that are not yet complying with the BEPS framework. The new rules would be effective by Dec. 31, 2017.
The draft bill is currently subject to the official legislative process and may be subject to significant amendments as it progresses through the German legislature. However, since the draft bill has been adopted by the government, it is likely that the bill will be passed prior to the German elections in September 2017. Therefore, the consequences of the new regulation should be considered in any German-related tax planning involving preferential tax regimes.