February 11, 2021
German Ministry of Finance finalizes guidance on German extraterritorial taxation of intellectual property
On 11 February 2021, the German Ministry of Finance (MoF) finalized additional guidance addressing the currently discussed nonresident taxation of royalty income and capital gains relating to rights solely because these rights are registered in a public German book or register.
Initially, it was proposed to eliminate this debatable rule given the significant administrative burden that it causes for both taxpayers and the tax authorities as well as that Germany should eventually not have a taxing right under applicable treaties (see EY Global Tax Alert, German Ministry of Finance publishes draft law concerning the modernization of withholding tax relief and extraterritorial taxation of IP, dated 20 November 2020).
However, the proposed change of the law was not pursued further by the German Government (see EY Global Tax Alert, German Government issues draft law on modernization of withholding tax relief and various additional topics, dated 20 January 2021). In order to simplify the administration of the rule in all open cases, the MoF has now finalized additional guidance following a first public letter decree on 6 November 2020 (see EY Global Tax Alert, German Ministry of Finance publishes guidance on German taxation of extraterritorial intellectual property, dated 6 November 2020).
According to the guidance, nonresident licensees can abstain from withholding, declaring and transferring taxes for relevant payments made up to 30 September 2021 if certain requirements are met. Most importantly, this only applies if treaty eligibility of the recipient of the royalty payments is not doubtful and an application for an exemption from withholding tax is filed by the recipient of the payments by 31 December 2021.
It is currently unclear whether another legislative attempt to address the topic will be made at a later point in time, taking into account the additional information becoming available to the tax authorities through the process set forth in the guidance. In light of the general election in Germany to take place in September 2021, we do not expect a new legislative initiative before then and any further developments will likely be impacted by the results of the election.
"Extraterritorial" intellectual property (IP) transactions include the licensing or sale of IP rights between, or in the case of a sale by, parties not resident in Germany.
Based on the wording of the German statute provisions (Sec. 49 (1) No. 2f and No. 6 Income Tax Act (ITA)), where a non-German resident person licenses or sells IP that is registered in a German public register (German-nexus IP), Germany can claim a taxing right under domestic law.
Under the plain language of the statute, a German taxation right may cover German-nexus IP licensing or sale transactions which take place solely between, or in the case of a sale by, nonresident parties. The statute also does not differ between transactions which occur between related or unrelated parties.
Taxation of royalty income is generally administered by way of a withholding tax of 15.825% to be withheld, declared and transferred by the licensee. A capital gain is generally taxed through a nonresident tax return to be filed by the seller. The rule is currently subject to a controversial debate and causes significant efforts for both taxpayers as well as the German tax authorities. The elimination of the proposal to abandon it was therefore an unfortunate development in particular for cases in which the IP licensor or seller is covered by a German tax treaty, which grants exclusive taxing right to the foreign jurisdiction.
Royalty payments already made or to be made by 30 September 2021
The guidance stipulates that a licensee can abstain from withholding, declaring and transferring withholding tax on royalty payments made to a foreign licensor in the past or by 30 September 2021, if the following requirements are met:
A licensee can only abstain from withholding tax if all of these requirements are cumulatively met for a specific licensor. The guidance further allows that a licensee may apply for the exemption instead of the licensor if the licensor authorizes the licensee to do so. If the license no longer exists, the licensee can apply for an exemption even without an authorization of the licensor if it can be demonstrated that the (former) licensor is either not able to or not willing to do so.
In addition, this simplification is not applicable in cases in which the actual eligibility of the licensor for treaty benefits is doubtful, taking into account not only the treaty but also the German domestic anti-treaty shopping rules. According to the guidance, relevant doubts exist in particular in the case of dual-resident or hybrid entities or in the case of other qualification mismatches. If the recipient of the royalty payments is a tax transparent partnership for German tax purposes, the guidance allows application of this relief if the requirements are met at the level of the partners.
If the Federal Central Tax Office should reject the application for an exemption from withholding tax, the guidance provides that all withholding tax returns for the remuneration in question must be filed within one month after the rejection. This applies even if an appeal is filed against the rejection of the application. The guidance is not entirely clear whether this only applies to withholding tax on payments for which the licensee abstained from withholding in accordance with the guidance or whether this also applies to "historic" royalty payments.
If this stipulation is also deemed applicable in cases in which taxes have not been withheld prior to the publication of the guidance for other reasons, it would seem to be contradicting a decision of the Federal Fiscal Court dated 25 November 2002 (I B 69/02, Federal Tax Gazette II 2003, p. 189). In this case, the Federal Fiscal Court held that an obligation to file a withholding tax return only exists if tax has actually been withheld by the licensee. Absent actual withholding by the licensee, an obligation to file a withholding tax return would not exist according to the court but the licensee could still be held liable for the tax by the tax authorities on the basis of a liability assessment notice.
Alternatively, the tax authorities could collect the tax from the licensor in such a case. It is currently proposed to amend the law to change this mechanism and to implement an obligation to file withholding tax returns even if the tax has actually not been withheld. The fact that a change of the law is deemed necessary to achieve this result and the explanatory notes provided for the proposal further support the assessment of the Federal Fiscal Court as to the currently applicable rules.
Royalty payments made after 30 September 2021
The exception explained above does not apply for royalty payments received by a licensor after 30 September 2021. According to the guidance, the general provisions of the ITA apply in this regard.
Capital gain transactions
If rights registered in a German public book or register are sold, the guidance provides that a nonresident tax return has to be filed by the seller. According to the guidance, this applies even if Germany cannot tax the capital gain in accordance with an applicable treaty. In such cases, meaning where a seller is resident in a jurisdiction with which an applicable treaty exists at the moment of the sale and this treaty prevents taxation in Germany, a nil return can to be filed and it is not required to determine the potential German tax basis.
There are various arguments that can be provided against this view and this is the first time that the tax authorities have explicitly promoted an obligation to file a nonresident tax return in a case in which taxation in Germany is prohibited by an applicable treaty for income derived by a nonresident taxpayer. However, given that the German anti-treaty shopping rules do not apply on the capital gains in question, residency of the seller in a treaty jurisdiction should already be sufficient to demonstrate the necessary in such cases unless the treaty includes specific limitation of benefits clauses (e.g., the treaty between Germany and the United States).
From a procedural perspective, the guidance stipulates that such tax returns do not have to be filed electronically unless the tax authorities explicitly request electronic filing in a specific case. Further, the rules provided for the disclosure of license agreements including the stipulation on a translation of the essential sections of the agreements into German apply accordingly. Even though not stated explicitly, it appears reasonable to assume that this only is relevant in cases in which the nonresident return is not a nil return filed in accordance with the above.
For the first time, the guidance also addresses the determination of the income in cases in which a bundle of rights is licensed or sold and remuneration for the rights registered in Germany is not agreed separately.
In such cases, an appropriate allocation has to be prepared. The guidance provides that the starting point for such an appropriate allocation is the overall royalty payment or capital gain. Following a top-down approach, this overall amount needs to be allocated to the rights registered in Germany based on causality. The result of the approach has to reflect the (portion of the) income derived from the rights registered in Germany. A determination solely based on the cost of the registration, i.e., registration costs plus a specific margin, is deemed inappropriate. Likewise, bottom-up approaches allocating income based on a percentage of income of profit of the licensee are deemed inapplicable even if the percentage is determined based on, e.g., a benchmark study.
If the tax authorities cannot determine or calculate the relevant income, in particular because the taxpayer violates obligations to cooperate, the guidance provides that the tax authorities will estimate the tax basis. For purposes of this estimate, an allocation key will be calculated based on German revenues and the revenues in the territory covered by the (bundled) agreement and this key is to be applied on the overall income. As an example, if a license agreement covers worldwide rights and the worldwide revenues are 200 with 20 of revenue in Germany, the allocation key would be 10% and 10% of the overall royalty payment would be allocated to the rights registered in Germany for purposes of this estimate.
In light of the unfortunate decision to not move forward with the proposal to eliminate nonresident taxation of IP solely because of registration in a German public book or register, the guidance is, overall, a positive response by the tax authorities. Even though the guidance makes it even more necessary to carefully review and assess the next steps for affected businesses, it provides for a reasonable timeframe to do so. If applications for exemptions from withholding taxes are filed based on this new development, it appears crucial to prepare the applications with the utmost care and supported by substantial documentation given the significant adverse consequences of a rejection (filing of withholding tax returns within one month after rejection).
Through the process described in the guidance and the further handling of affected cases, additional information and insights may become available to the tax authorities and the German Government. Another attempt to address the topic through legislation at a later point in time is therefore not generally ruled out. However, there is a general election in Germany in September 2021, and it appears very unlikely that a potential new attempt will be made until then or immediately after. Moreover, the results of the election will of course influence this question as well.
For additional information with respect to this Alert, please contact the following:
Ernst & Young GmbH, Munich
Ernst & Young GmbH, Freiburg
Ernst & Young GmbH, Frankfurt
Ernst & Young GmbH, Stuttgart
Ernst & Young GmbH, Düesseldorf
Ernst & Young LLP (United States), German Tax Desk, New York