For almost a year, there has been a fierce debate about whether Germany has the right to tax (based on a very old and formerly unenforced rule) income from intellectual property (IP) transactions (typically licensing or sale) between two non-German parties on the basis that the IP is (fully or partly) entered on a German register (eg patents and trademarks). Several hundred multinational enterprises (MNEs) filed protective disclosures of their IP structures in 2020 to avoid potential compliance failure allegations (see section 1 below for relevant structures).
Hope was given in November 2020 that Germany would clarify that a mere German IP registration was not a sufficient 'nexus' to attract German taxation, but that clarification as included in an initial draft bill amending the German Income Tax Act (ITA) has now been dropped. Although this draft bill is expected to be finalised in May 2021, it seems unlikely that the clarification will resurface in the next months.
Based on public letter decrees from the German tax authorities (GTA), it is now clear that every MNE with German-registered IP (GRIP) will have to take action for all open tax years (typically since 2013), regardless of whether the income recipient (eg the licensor of IP or the IP seller) is ultimately protected from German tax claims under an applicable double tax treaty (DTT) or not. For MNEs that are clearly protected by a DTT, a new decree issued on 11 February 2021 (the Decree) provides some relief with regard to certain filings, but it leaves all others now faced with a German tax claim that is questionable both on the merits and as regards the potential scope and amount of the claim (see section 2 below). This is essentially now forcing many MNEs into disputes and tax litigation with the GTA.
Actions required according to the GTA decrees include the following if the relevant transactions included (at least to some extent) GRIP:
- Apart from clear DTT protected cases (for details see section 3 below), non-German resident licensees are required to assess and potentially pay German withholding tax (WHT) and file returns for all open tax periods. Non-German resident IP sellers have to file returns in all cases and (unless DTT protected) this includes calculating a gain attributable to the GRIP disposal.
- In order to determine the portion of the royalty or proceeds attributable to GRIP as part of a broader IP package, the GTA intend to apply a top-down valuation method based on the overall (global) revenue; cost-based approaches have been rejected. This may potentially result in the allocation of a significant portion of the overall royalty or gain to GRIP. Ultimately, the valuation method will determine the German tax burden which may in practice be considerable (see section 4 below).
- In many cases, relief under applicable DTTs ('treaty relief') can ultimately be claimed – albeit potentially burdensome application procedures remain. However, treaty relief may be denied under German anti-treaty shopping rules (which are expected to be tightened in the upcoming months, for more detail see US multinationals and German dividends – withholding tax relief at risk?). Further, treaty relief may not be available in any event, particularly where low-tax offshore jurisdictions are involved (see section 5 below).
- Based on the above, it can be concluded that a considerable number of MNEs, in particular those based in the US, may be facing a significant tax bill from the GTA. Companies faced with this tax bill that do not agree such tax is due will have no choice but to challenge the tax assessments and litigate. (For structures with biggest exposure, see section 6 below.)
If not already completed, every group with GRIP should now review its IP structure (including potential changes since 2013). Where any in-scope structures or transactions are identified, filings with the GTA are likely to be required (which at a minimum is likely to include applications for treaty relief). Preparing such filings can be time consuming and should be initiated promptly in order to meet the relevant deadlines, at the very latest once there is clarity on the intended changes to the ITA (see section 7 below).
1. When does the issue arise?
Typically, the issue arises in a group structure with a central IP company, usually located outside of Germany, if the IP comprises GRIP (or according to the view of the GTA also IP registered on European IP registers if the protection also includes Germany). The IP company holds the (economic) ownership in all the IP required by the group operations. The IP is either directly licensed to relevant operating group companies or indirectly via a chain with other group companies serving as regional IP companies (eg an Irish company acting as the IP company for Europe).
In the following example structure, not only the royalties paid by the German licensee are subject to German WHT of 15.8 per cent (typically on the full amount of royalties paid), but also the royalties payable by the French and the Irish entity to the extent attributable to GRIP.
This is just one example of a structure affected by the revised interpretation of the law. In practice, the cases are very diverse and situations may be very different. The rules may also apply to an internal reorganisation of the central IP company where IP (including GRIP) has been transferred to another group company.
The administration of these cases and the filing requests become even more difficult if entities outside the group are affected as licensee, licensor or intermediary (eg third-party licence cases). The GTA have so far not excluded such structures despite it being difficult to deal with the filing and related obligations in practice.
2. What are the potential arguments before court?
There are substantial arguments that can be put forward in litigation to challenge the taxation of such IP transactions between non-German companies – both on the merits and as regards the potential scope and amount of the tax charge.
- Although the drafting of section 49 ITA references the registration nexus, it is undisputed for German tax rules that the interpretation of the law does not stop with its wording, but also requires the law to be applied in a systematically consistent way. The taxation of IP transactions between non-Germans with no other nexus besides registration does not fit into the other codified cases of tax liability for non-German residents where income is usually generated in Germany or at least transferred out of Germany. This makes it a very unorthodox rule from an international tax law perspective that the GTA are now seeking to apply for the first time almost 100 years after its establishment.
- Under its constitution Germany is bound to comply with generally accepted principles of international law. It is doubtful whether international law principles are compatible with Germany taxing an IP transaction in which no German resident company or German permanent establishment is involved. This is particularly the case where Germany obliges a non-German licensee to withhold taxes and subjects a licensor/licensee to a very formalistic German WHT procedure although neither have any nexus whatsoever with Germany.
- Even if it is conceded that Germany has a right to tax in these circumstances, it is still unclear and highly disputed how the relevant tax base should be assessed. It appears that the GTA’s top-down approach for allocating the part of the licence relating to the GRIP is unlikely to reflect the economic reality.
What are companies expected to do under the decrees of the German federal ministry of finance dated 6 November 2020 and 11 February 2021?
In a first decree dated 6 November 2020, the GTA have made it clear that they intend to enforce the rules in both licence and disposal cases. Having already been presented with a vast number of cases for taxable periods up to and including 2013 only, the GTA issued a further decree on 11 February 2021 (in German and in English (unofficial translation)) to facilitate the filing and withholding requirements in certain circumstances.
Royalties for German registered IP
Generally, the (non-German resident) licensee of GRIP must file WHT returns and remit WHT to the GTA unless the licensor has obtained an exemption certificate from the German Central Tax Office (CTO). In particular, the assessment of the tax base is difficult and poses many as yet unanswered questions (see section 4 below).
A simplified procedure exempts the licensee from filing WHT returns and remitting WHT to the GTA for royalties paid or payable for periods up to and including 30 September 2021 if certain conditions are met. These include (amongst others):
- at the time of receipt of the royalties, the licensor was a resident of a country with which Germany has concluded a DTT applicable at that time;
- the licensor was entitled to relief from taxes levied in Germany under the DTT, which must take into account the potential application of the German anti-treaty shopping rule; and
- the licensor files an application with the CTO by 31 December 2021 for exemption from WHT containing the disclosure of the relevant contractual relationships. Generally, the GTA expect separate applications and disclosure of agreements even if a central licensor has standard contracts with many group affiliates (which is very impractical and in no way 'simplified' if the DTT protection of the licensor is clear).
For periods from 1 October 2021 onwards, the relevant licensee will have to file WHT returns and remit WHT to the competent GTA unless an exemption certificate has been applied for and subsequently granted by the CTO.
The GTA have reserved the right to reject the aforementioned simplified procedure resulting in the licensee having to file WHT returns and to remit WHT for periods up to 30 September 2021 if licensor's entitlement to relief under the DTT or applying the German anti-treaty shopping rule is 'doubtful'. In particular, according to the Decree this may be the case:
- in light of the limitation of treaty benefits; or
- with respect to hybrid or dual resident companies.
Non-German resident licensees are required to file WHT returns and to remit applicable WHT to the competent GTA in all other cases, ie in the absence of an applicable DTT or non-availability of treaty relief (eg by application of the German anti-treaty shopping rule).
Disposal of German-registered IP
A transferor that has disposed of GRIP (or otherwise transferred it in a way which triggered a gain under German tax law) since 2013 is required to file a tax return for the relevant year to the competent local tax authority (in practice the Munich tax office). However, a so-called nil return may be filed if:
- the taxpayer is a resident of a state with which Germany has concluded a DTT applicable to the assessment period in which the capital gain was recognised;
- the taxpayer is within scope of the DTT;
- the capital gain is attributed to the taxpayer according to the DTT; and
- the DTT assigns the exclusive (final) right of taxation for this income to the state of residence.
In these circumstances only, the gain attributable to GRIP from such disposal does not need to be calculated.
4. How is the German tax base to be assessed?
The GTA take the view that the basis for the WHT charge shall be the respective gross royalty for the use of GRIP determined in accordance with the relevant contractual provisions (as per the “top-down approach” described above). However, such agreements often include a variety of IP rights (eg without any registration or with registrations in many other jurisdictions rather than just Germany) for which an aggregate fee is charged. Unless the agreement provides for a specific allocation of part of the fee to GRIP, the 'appropriate' portion of the aggregate fee attributable to GRIP has to be determined by the licensee. Ultimately, such allocation has to be accepted by the GTA as appropriate or, for lack of an alternative, be estimated.
The GTA have already rejected a simple cost-based-calculation of such allocation, ie based on the ratio of costs for registering and maintaining rights in different jurisdictions to the overall costs in relation to IP. The same applies for methods where the royalty attributable to Germany is determined as a (fictitious) percentage of turnover or profit (eg based on database studies).
Any estimation of an appropriate allocation by the GTA is likely to involve a revenue-based approach and a calculation based on the share of German revenue as compared to the overall revenue derived from all territories covered by the underlying agreement. Such calculation is likely to lead to a higher tax burden than under other allocation methods. Unless the underlying tax liability can be successfully challenged, the calculation of the appropriate allocation of licence fees or sale proceeds is likely be at the core of any dispute with the GTA.
5. What is the catch for treaty relief?
Licensors – even if a DTT is in place – can only benefit from any treaty relief if they can meet the requirements of the German anti-treaty shopping rules and/or any potential limitation of benefits (LOB) under the relevant DTT. In particular, the German anti-treaty shopping rules require a review of the relevant licensor’s shareholder structure.
- In most cases, however, the structure will not have been set up with a view to satisfying the relevant anti-treaty shopping or LOB rules as this was not a requirement at the time the structure was implemented. Therefore, these specific requirements demanded by the GTA may not have been considered when the structure was set up.
- Further, for the past (since 2013), the relevant structure may have not been documented in a way sufficient to prove that anti-treaty shopping rules or LOB tests are met.
- The Decree also foresees special cases where the GTA will need to closely examine the DTT entitlement, in particular, in relation to hybrid companies.
- Last, but not least, the German anti-treaty shopping rules are expected to be further tightened in the coming months. Such changes could make it even more difficult for (US) MNEs to claim treaty relief for structures with interposed (holding) companies (for more detail see US multinationals and German dividends – withholding tax relief at risk?). The draft bill setting out these changes was endorsed by the German government on 20 January 2021.
6. Which structures have the biggest exposure?
- Structures with companies in low-tax offshore jurisdictions:
- Treaty relief is generally not available to an offshore licensor as Germany has not entered into DTTs with such low-tax offshore jurisdictions.
- Anti-treaty shopping rules may prevent treaty relief being available even if the offshore company solely acts as a (holding) company interposed between the licensor and its ultimate parent.
- Structures with hybrid or dual resident companies or other qualification conflicts that can result in the treaty entitlement being disputed in the first place or the German anti-treaty shopping rules applying.
- Lack of sufficient documentation for past periods (since 2013).
- Other structures where DTT entitlement is not fully clear.
7. What to do next?
If not already completed, potentially affected MNEs need to review their existing IP structures.
Any review should include prior reorganisations of such structures as the GTA intend to review periods from 2013 (inclusive) onwards. In light of potential discussions around the availability of treaty relief, this applies to both the current group structure and its evolution over time.
If in-scope cases are identified, the GTA expects the parties to relevant transactions to disclose the latter and file the necessary returns which includes an allocation of licence fees and sale proceeds to GRIP unless the simplified procedure applies.
If the identified cases fall within the scope of the simplified procedure (where it is clear DTT protection is available), applications for tax exemption certificates will need to be prepared. Where such exemption is not available, licensees only have a month to file the necessary WHT returns, consequently it might be necessary to analyse and prepare an appropriate and reasonable allocation of licence fees and sale proceeds to GRIP in parallel.