January 28, 2022
German Ministry of Finance publishes guidance on German royalty deduction limitation rule
On 27 January 2022, the German Ministry of Finance (MoF) published new guidance relating to the German royalty deduction limitation rule dated 5 January 2022 and 6 January 2022. The German royalty deduction limitation rule (Sec. 4j Income Tax Act) partially or wholly disallows the deduction of royalty payments preferentially taxed, directly or indirectly, at the recipient level under a non-Organisation for Economic Co-operation and Development (OECD) (non-nexus) compliant preferential tax regime at an effective rate of below 25%.
The first decree (dated 5 January 2022) relates to the general application of the German royalty deduction limitation rule, includes a very restrictive interpretation and thus mandates a broad application. Moreover, it includes various details from a procedural perspective and covers in particular the burden of proof. According to the guidance, taxpayers claiming a deduction have to provide substantial documentation regarding the taxation of the income at the level of the recipient and further details on, e.g., the (economic) ownership of the licensed intangible property (IP).
The second decree (dated 6 January 2022) provides an update concerning specific harmful preferential regimes in light of the above-mentioned guidance for the taxable periods 2018 through 2020. It essentially identifies and lists harmful preferential tax regimes which should be covered by the rule in a non-exhaustive list. The status of the United States (US)-Foreign Derived Intangible Income (FDII) deduction remains unchanged and is still under review (for background, see EY Global Tax Alert, German Ministry of Finance publishes guidance on royalty deduction limitation rule, dated 26 February 2020).
In the first decree dated 5 January 2022, the MoF provides a comprehensive explanation of its interpretation of the German royalty deduction limitation rule. In particular, the MoF elaborates on the definition of a "preferential regime" as well as the review of such preferential regimes as to their compliance with the OECD nexus approach.
According to the law, a preferential regime is generally given if the respective royalty income is taxed deviating from regular taxation in the jurisdiction of the recipient. According to the MoF, regular taxation in this sense means the statutory tax rate applying to income generated by other taxpayers in the same jurisdiction equal or similar to the recipient of the income in question without applying any benefits. Moreover, it is deemed irrelevant whether the beneficial treatment is only granted in general, upon application or by way of an individual tax ruling.
Unfortunately, the MoF does not specify how this is to be applied when different (statutory) tax rates apply to different types of businesses or income. However, the guidance provides that the definition of a preferential regime in the meaning of the rule is not limited to typical IP boxes and does not require only the inclusion of royalty income as such. Rather, a preferential regime covered by the rule could also include various other types of income according to the MoF. In other words, it is essentially deemed sufficient that there is a higher tax rate that applies to any other types of income. Whether this very broad understanding is an appropriate interpretation of the law is expected to be controversial, in particular given that the explanatory notes provided by the legislature when the law was introduced, state rather unambiguously that the purposes of the rule is to target known IP boxes providing for a partial or full exemption of royalty income or preferential tax rates for royalty income.
A preferential regime in the meaning of the rule only exists if the preferential regime in question is not compliant with the OECD nexus approach. In this regard, the guidance confirms that the rule generally follows the assessment of the Forum on Harmful Tax Practices (FHTP). However, the guidance acknowledges that the FHTP only reviews IP regimes regarding their compliance with the nexus approach, whereas this is not the case for "other" regimes the FHTP may classify as a harmful tax practice. Hence, according to the MoF, this review for such other regimes needs to be an individual assessment, independent from the OECD.
From a procedural perspective, the MoF confirms, in line with general principles, that the burden of proof as to whether a preferential regime exists is with the tax authorities. However, the MoF further stipulates that the taxpayer has to provide the required documents and information due to the obligation to cooperate on international matters. According to the guidance, this in particular means that the taxpayer may have to provide relevant excerpts from the books and records of the recipient of the payments as well as documentation of the foreign tax assessment and the basis thereof. These documents have to show that the payments are included in the income of the recipient and have not been: (i) decreased by fictitious expenses; (ii) partially or fully exempt; or (iii) subject to a reduced tax rate. Moreover, it needs to be shown that the recipient of the income is the (economic) owner of the licensed rights or, in case of sublicensing, who the (economic) owner of these rights is and based on what arrangement the recipient of the payment is in a position to license such rights (economically) owned by another party.
Also, the burden of proof is supposed to be with the taxpayer to the extent it is claimed that a specific preferential regime not yet analyzed by the OECD is compliant with the OECD nexus approach.
The second decree dated 6 January 2022 lists numerous identified, non-nexus compliant and therefore harmful preferential regimes which are generally subject to the German royalty deduction limitation rule. Essentially, the decree is an update of the previous decree published in 2020 and has two parts: The first part lists all harmful preferential regimes identified by the tax authorities to date. The full list of the identified harmful preferential regimes (the majority of them already being phased out or being phased out in the near future) can be found here. The most important update in this regard seems to be the inclusion of special cantonal tax incentives under Swiss law, leading to covered Swiss entities being subject to no or lower taxation (e.g., "mixed company" status). Even though these rules have been abolished as of the end of 2019, their classification as a harmful preferential regime in the meaning of the rule would have effect from the date of introduction of the royalty limitation rule, meaning from 2018.
The second part lists preferential regimes which are still under review; those are certain preferential regimes of Jordan, Lithuania, Paraguay and the US FDII deduction. Moreover, the decree maintained the stipulation that the FDII deduction results in an effective taxation at 13.125% and, similar to the previous version of the guidance, does not address the fact that the FDII deduction is, in essence, a lump-sum deduction applied to the income derived by the recipient overall. As the potentially non-deductible portion of royalty payments is generally calculated by applying a formula making reference to the effective taxation at the level of the recipient of the income (formula: (25% – effective tax rate at recipient's level in %) / 25%), this is an important factor to be taken into account as well.
According to the decree, the deduction of a royalty paid into a preferential regime which is currently listed as "under review," (i.e., including all royalty payments made to a US recipient benefiting from FDII), is allowed, provided that no other reasons for a denial of the expense are present. The relevant tax assessment must be kept open for those taxpayers until the review procedure is finalized to ensure that the expense can still be partially denied if the regime ultimately was qualified as harmful. It is currently unknown when the MoF or, as the case may be, the FHTP will finalize the review of the US FDII deduction.
For additional information with respect to this alert, please contact the following:
Ernst & Young GmbH, Munich
Ernst & Young LLP (United States), German Tax Desk, New York