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Germany: Germany proposed limitations on tax deductibility of royalty payments

28 February 2017

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Linn-Alexander Braun
Alexander Linn Thorsten Braun

The German government decided on January 25 to introduce a bill into the legislative process that would limit the deductibility of royalty payments between related parties for payments that become due after December 31 2017.

The bill is based on a draft law published by the federal Ministry of Finance at the end of 2016.

The draft law addresses royalty payments that are subject to a "low taxation" of the royalty income at the level of the recipient due to the application of intellectual property regimes such as IP, patent or license boxes. The law is directed at beneficial "non-nexus"-based IP regimes. Low taxation of royalty income based on the general taxation of the recipient would not fall within the scope of the proposed rules.

The restriction on deductibility would apply only to royalty payments made between related parties. The draft law also targets payments made to indirect recipients that benefit from a preferential non-nexus-based IP regime resulting in low taxation. This approach would result in the disallowance of deductions in back-to-back royalty structures where only an indirect recipient benefits from the regime.

Low taxation under the draft law generally means an effective tax rate of less than 25%. The determination of whether the income is low-taxed would be made in accordance with the rules in the Foreign Tax Act.

However, low taxation would not automatically result in a full disallowance of the deduction of the royalty payment. The percentage of the disallowed payment would be calculated based on the applicable tax benefit at the level of the recipient (i.e. the difference between the applicable tax rate and a 25% tax rate). For example, if the tax rate at the level of the recipient is 10%, 60% of the royalty payment (which is 15/25%) would be non-deductible for German tax purposes and if the non-nexus based IP-regime provided for a 0% tax rate, the full amount of the royalty payment would be non-deductible.

The draft law contains exceptions to the deduction limitation for royalty payments made to subsidiaries of the German licensee that trigger the German controlled foreign company rules at the level of the subsidiary and for payments regarding trademark rights based on the definition in the Trademark Act.

"Nexus-based" preferential tax regimes that would fall outside the scope of the proposed rule include regimes whose benefits depend on a substantial economic activity (e.g. R&D). The draft law provides that a substantial economic activity would not exist where the recipient of the royalty payment did not fully or predominantly develop the underlying IP in its own business operations (e.g. if the IP was developed by related parties or acquired).

The outcome of the legislative process is unclear. However, because the draft law is supported by the governing coalition at the federal level, chances that the draft law will be enacted seem high.

Affected taxpayers should carefully monitor the legislative process.

Alexander Linn (allinn@deloitte.de) and Thorsten Braun (tbraun@deloitte.de)
Deloitte
Tel: +49 89 29036 8558 and +49 69 75695 6444
Website: www.deloitte.de






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