Germany Clarifies License Barrier Rule on Intra-Group Payments

On Jan. 28, 2022, the German Federal Ministry of Finance published two corresponding circulars providing significant clarification of the German license barrier rule which denies the deduction of operating expenses for intra-group royalty payments where (i) they are subject to low preferential taxation (preferential tax regime), and (ii) where the preferential tax regime does not require a substantial business activity at the level of the licensor (circulars by the Federal Ministry of Finance dated Jan. 5, 2022 and Jan. 6, 2022).

The U.K. patent box regime, the Luxembourg exemption from intellectual property (IP) income regime (both abolished with effect as of June 30, 2016) and the French reduced corporate tax rate on IP income (abolished with effect as of Dec. 31, 2018) are just a few examples of the 60 IP box regimes deemed preferential by the German tax authorities.

It remains open whether the Foreign Derived Intangible Income (FDII) regime introduced by the U.S. in 2018 is to be treated as a preferential tax regime. Cases of intra-group royalty payments to the U.S. are kept pending, which should put additional pressure on U.S. multinationals.

Background

To encourage regional research and development (R&D) activities, several countries have introduced preferential tax regimes for income or profits from the exploitation of intangible assets. In some countries, these tax privileges even apply to trademarks, which do not necessarily require any specific R&D activity.

The Organization for Economic Cooperation and Development (OECD) examined so-called IP box regimes closely in its Base Erosion and Profit Shifting project, with a critical assessment in its 2015 Action 5 report Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, introducing the OECD nexus approach.

According to the report, license arrangements are only tolerated if tax benefits are linked to a “substantial business activity” of the licensor.

The OECD Forum on Harmful Tax Practices (FHTP) continuously analyses IP regimes across the globe and frequently publishes a list of preferential tax regimes not compliant with the nexus approach (latest update in January 2022) . The EU member states, as well as other countries, have as a result agreed to abolish existing preferential tax regimes by June 30, 2021.

In the meantime, some countries have introduced harmless preferential tax regimes corresponding to the nexus approach, which use the grandfathering provision until June 30, 2021.

Scope of License Barrier Rule

The German license barrier rule applies to any taxpayer with an unlimited or limited income tax liability in Germany (i.e., resident company or permanent establishment) which pays royalties for the transfer of intangible rights and IP to a related party (parent or sister company or foreign 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 license barrier rule is deemed to exist where:

• the licensor’s income from the transfer of rights is subject to taxation that deviates from the standard taxation in the country of residence; and
• the tax rate on the relevant income is less than 25% (low taxation).

To escape the rule, the German taxpayer may show that the preferential tax regime requires substantial R&D activities relating to the transferred intangible.

Similarly to the OECD DEMPE (development, enhancement, maintenance, protection and exploitation) concept, financing the acquisition of relevant IP or contract R&D activities is insufficient to satisfy the nexus approach. Expenses relating to trademarks or marketing-related intangibles are never accepted.

The German tax authorities have now confirmed that they fully rely on the assessment of the FHTP.

If the taxpayer fails to substantiate an escape, income expenses are limited to the ratio between the actual tax rate paid and the 25% low tax rate (i.e., expenses multiplied by the balance between 25% less the actual tax rate paid divided by 25%).

The license barrier rule takes effect for all expenses incurred after Dec. 31, 2017.

Interpretation of License Barrier Rule by German Tax Authorities

In their circular dated Jan. 5, 2022, the German tax authorities emphasized that “standard taxation” refers to the regular tax rate applied to comparable legal entities irrespective of any tax privileges (e.g., from legal form, place of residence or kind of income).

According to the tax authorities, the assumption of a preferential tax regime is not limited to royalty income: Rather, any preferential tax regime which applies, among others, to income derived from intangibles or any individual tax ruling is in scope of the law.

When examining low taxation, it is not the tax legally due that counts, but the tax actually levied and paid. Consequently, any downstream refund claims must also be included. In addition, cross-entity tax refunds to which the shareholder of the company receiving the royalty income is entitled in the case of a profit distribution must be taken into account.

The German tax authorities follow the analysis of the FHTP in identifying preferential tax regimes and have consequently included in their circular of Jan. 6, 2022 a non-exhaustive list of harmful regulations that do not comply with the OECD nexus approach, copied from the FHTP list.

Other regulations may be examined on a case-by-case basis. This includes cases:

• where the FHTP has listed foreign tax regimes as “non-IP regimes” for which it failed to examine compliance with the nexus approach (e.g., Swiss Cantonal special purpose companies);
• where an identified preferential tax regime has been abolished or adapted to the nexus approach during the transitional period until June 30, 2021, so examination by the FHTP has been discontinued (e.g., Aruba, Greece); or
• where individual tax rulings provide the foreign taxpayer with a similar preferential regime.

These examples show that, despite international consensus to abolish harmful tax regimes, the German tax authorities are going to continue examining foreign IP regimes beyond the deadline of June 30, 2021.

Administration of License Barrier Rule

To administer the license barrier rule in practice, the German tax authorities rely on the burden of proof and mandatory disclosure requirements. In a cross-border transaction, the taxpayer is in general required to disclose any information and documents requested by the tax authorities to the extent that it is feasible, relevant for tax purposes, and proportionate.

Accordingly, an increase in requests for information and documents on preferential tax treatment and individual tax rulings must be expected.

Failure to comply allows the tax authorities to assume a harmful tax regime and to base taxation on estimates.

The first step of the analysis is to identify a preferential tax regime within the scope of the license barrier rule. In cases where the FHTP has failed to determine whether a specific regime is nexus compliant, German tax authorities put the burden of proof on the taxpayer to show that the OECD requirements are met. The test does not focus on whether the licensor in fact has sufficient substance, but on whether the foreign tax regime requests substance as a condition for preferential taxation.

The same should apply where the foreign licensor is given a beneficial tax ruling. The German taxpayer will be required—to the extent legally possible—to provide information and evidence on the ruling and show that it complies with the OECD nexus approach.

Where a non-nexus conforming preferential tax regime 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 proof to the contrary by submitting records from the licensor’s accounts and relevant tax assessments.

In my view, this approach is highly questionable and not in line with German Federal Tax Court precedents on tax disclosure requirements.

For the transitional period where a state simultaneously offers two opposing preferential regimes (one nexus-compliant, the other not), the burden of proof is on the taxpayer to show that the foreign licensor only makes use of the harmless regime. As proof, confirmation from the foreign tax authority is required: This could be difficult when the foreign tax authority does not have a standard procedure for such a letter of confirmation.

Key Takeaways

• Germany denies the deduction of expenses from intra-group royalty payments to the extent that the licensor makes use of a preferential tax regime (IP box) which is not OECD nexus compliant.
• It is assumed that the foreign licensor is subject to preferential tax treatment when the FHTP has identified a non-nexus conforming preferential tax regime in the licensor’s country of residence. German tax authorities de facto place the burden on the German taxpayer to disprove this assumption.
• The German taxpayer must also prove that the foreign licensor makes use of a nexus conforming 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 enjoy preferential tax treatment but failed to assess its nexus compliance, the German taxpayer is required to support and satisfy the German tax authorities in their analysis of the nature of the foreign tax regime.
• The German taxpayer is obliged to provide information and evidence on any tax ruling providing preferential treatment to the foreign taxpayer and that the tax ruling complies with the nexus approach.
• In particular, the specifications with respect to the taxpayer’s disclosure obligations and the extent of the burden of proof seem somewhat disproportionate. Taxpayers should analyze in each individual case whether there are grounds to challenge requests from the German tax authorities.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Lars Haverkamp is a partner at Eversheds Sutherland Germany.

The author may be contacted at: larshaverkamp@eversheds-sutherland.com