New German bill combats harmful use of preferential IP regimes
INSIGHT ARTICLE |
On June 27, 2017 Germany implemented a bill which provides significant limitations on royalty deductions or other deductions of expenses for the use of foreign intellectual property (IP) in Germany. The bill is based on the Organisation for Economic Co-operation and Development’s (OECD) considerations on preferential tax regimes (Base Erosion and Profit Shifting (BEPS)Action Item 5) and targets holding company structures, which are benefiting from non-BEPS compliant preferential tax regimes.
Action 5 addresses concerns about preferential tax regimes that risk being used for artificial profit shifting and 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 prevents the use of non-German holding company structures to take advantage of preferential tax regimes that do not comply with the nexus approach. According to the new regulation, deductions for amounts paid by 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 and
- effectively taxed at a rate less than 25 percent.
As a result, the expense deduction is limited to the amount of the payment multiplied by a fraction 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 regulation, the German deduction would be limited to 2/5 of the payment.
Notably, the legislation does not apply to preferential tax regimes, which are compliant with the OECD nexus approach. This means that the IP needs to be the result of R&D located where the royalty income is earned. Moreover, under the nexus approach the only IP assets that can qualify for benefits under an IP regime are patents and functionally equivalent IP assets that are legally protected and subject to approval and registration processes, where such processes are relevant. The nexus approach explicitly excludes marketing-related IP assets such as trademarks from receiving benefits.
While the OECD would like IP regimes to be in compliance and closed to newly transferred patents beginning July 1, 2016, they have indicated that countries may enact grandfathering provisions to allow taxpayers to benefit under an existing regime until July 1, 2021. The implementation of the German regulation therefore affects preferential tax regimes in several OECD member states which are not yet compliant with the BEPS framework. The new rules are effective by January 1, 2018. The consequences of the new regulation should be considered in any German related tax planning involving preferential tax regimes.