Tax Connect Flash | Germany | Royalty restrictions: Bill to "combat harmful tax practices in connection with the assignment of rights"
The German government has approved a "royalty restriction" bill which restricts royalties and other intangible assets being deducted as operating expenses. The Bill will now continue its way through the formal legislative procedure before ultimately becoming statute.
If revenue earned from licences, patents, concessions or trade mark rights is not taxed or is only taxed at a low rate in the right holder's country of residence, corporations can take advantage of the disparity between the tax rates in different countries by claiming income from royalties as a deductible business expense in countries with special preferential regimes. In recent years a growing number of countries, particularly in Europe, have introduced preferential tax regimes, known as licence box or patent box regimes, for revenue from licences and patents to encourage multinational organisations to relocate intangible assets to those countries. Until recently the German government was also considering introducing a patent box regime, but has now opted for a different course: The German government wishes to discourage the use of patent boxes in other countries.
Hitherto the cost of using licences or patents in Germany has been fully tax deductible as a business expense. This is set to change when the new legislation comes into force on 1 January 2018. It will affect remuneration for intangible assets in the broader sense (such as for know-how) which is paid to "related parties", i.e. essentially payments to other entities of a corporate group.
If the royalties are subject to low tax in the country of the receiving entity, the entity paying the royalties will no longer be able to claim them as a tax-deductible business expense or will only be able to do so to a lesser degree. The new legislation will introduce two criteria for determining whether a country operates a low-tax regime. First, the income from such royalties is taxed at less than 25%. This rate of taxation must take account of all the factors affecting the taxation of such income such as tax exemptions or any notional business expenses. Second, the income has to be taxed at a preferential rate. This means that it is taxed below the standard tax rate which applies to the royalty recipient.
Escape: substantial business activity
The royalty restriction does not apply to payments where the preferential tax regulation only applies to rights arising from "substantial business activity" and where such rights would not fall within the scope of the German Trademark Act (Markengesetz) in Germany. Substantial business activity is deemed to exist if the royalty recipient developed the rights exclusively or almost exclusively itself in the context of its business activity. Under the new legislation this will not be the case if the right has been acquired or developed by related parties, i.e. other entities of the corporate group. The German government takes the view that this exception is in line with the OECD's nexus approach (agreed under the BEPS project); however, in actual fact the Bill still leaves many questions open. For example, the nexus approach also allows the royalty-paying company pro rata deduction for business expenses in respect of acquired rights where the recipient incurs certain research and development costs. In our view, this is not addressed by the Bill in its current form and this omission should be remedied to ensure compliance with the OECD's approach.
Prorated deductibility of business expenses
If the criteria for restricting the tax-deductibility of business expenses are satisfied, the percentage of non-deductible business expenses in Germany would be reduced under the new regime by the percentage by which the tax rate in the other country falls short of 25%. If, for example, the tax rate in the other country is only 10% (i.e. two fifths of the 25% required for full deductibility), then only two fifths (40%) of the business expenses would be tax-deductible. Where royalty income in other countries is fully exempt from tax, it will not be eligible for tax-deductibility in Germany at all.
The objective of the Bill is to discourage companies from transferring intangible assets from Germany to countries with patent boxes by limiting tax deductibility of royalty income. As a result of the threefold restriction (preferential taxation, expenditure within the corporate group and excluding substantial business activity) the Bill considerably reduces the scope of restrictions on the tax-deductibility of royalty expenditure; in its current version the Bill nonetheless offers plenty of scope for interpretation - particularly as it does not clearly define core terms. We expect further clarification in this respect in the course of the legislative procedure. Companies which already use foreign patent boxes and deduct related expenses in Germany or are planning to do so, should follow the upcoming legislative process closely to identify the need for any necessary adjustments in good time.