On 25 January 2017, the German Federal Government adopted a draft law against harmful practices in connection with transfers of rights. By introducing the draft law, the Federal Government is implementing BEPS Action Point 5 (“Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance”) in German law. Action Point 5 sets out the substantive requirements that so-called patent boxes must fulfil to be granted preferential tax treatment (preferential tax regimes). This means that a state may only grant preferential tax treatment if the intellectual property from which the royalties arise has been created in the applicable state itself (the “nexus approach”).
The draft law restricts the tax deductibility of licence and other costs for transfers of rights in Germany, if such costs are not taxed or are only taxed at a low rate for the recipient (creditor) as the result of a harmful preferential tax regime. A preferential tax regime is harmful when the state granting preferential tax treatment also grants preferential treatment for royalties that do not meet the conditions of the nexus approach.
Under the draft law, licence payments in Germany will in future only be deductible to a limited extent if the royalties are subject to a low rate of tax (less than 25 %) for the creditor under a preferential tax regime and the creditor is associated with the debtor. This excludes payments to patent boxes that have substantial activity, which are still treated as operating expenses. There is no substantial activity if the creditor has not developed the right or has not predominantly developed the right in the course of its own business activity. There is furthermore no substantial activity in this sense, in particular, if the right has been acquired or has been developed by an associated party. A tax regime that gives preferential treatment to royalties from the transfer of rights that would fall under the Trade Mark Act under German law will in any case be treated as non-substantial activity.
If the above conditions are met, the licence payment will be non-deductible if the actual tax burden is below the 25 % limit. Example: A German GmbH makes licence payments to its foreign sister company. The foreign sister company makes use of a patent box regime that does not follow the nexus approach. The royalties are taxed at 5 %. Under the regulation, (25 % - 5 %) / 25 % = 80 % of the licence payments are non-deductible in Germany.
It should be noted that the new law includes a so-called “treaty override” provision. This effectively “overrides” any provision in an applicable double-taxation treaty that is more favourable to the taxpayer.
It is recommended that companies that make applicable licence payments consider the new provisions and review whether to take action. The law is set to come into force on 1 January 2018.