BEPS: German draft law on Anti-Patent-Box provision

BEPS, or Base Erosion and Profit Shifting, is a financial strategy employed by multinational companies. By using BEPS, large companies use rights transfers to shift profits from higher-tax jurisdictions to lower-tax jurisdictions - ‘eroding’ the revenues of higher-tax economies.

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. The law is set to come into force on 1 January 2018.

Action Point 5 sets out the requirements that so-called patent boxes must fulfil to be granted preferential tax treatment (preferential tax regimes). A state may only grant preferential tax treatment if the intellectual property from which the royalties arise has been created in the state itself (this is known as 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 only be deductible to a limited extent if the royalties are subject to a tax rate less than 25% for the creditor – provided this occurs 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). Further, there is no substantial activity in this sense 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 falling under the Trade Mark Act 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. For example, if 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.

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.

We recommend that companies that make applicable licence payments consider the new provisions and consider whether to take action.