IP rights with a nexus to Germany can create a variety of tax issues under German tax law. These include aspects of German or foreign IP rights generating “German source income,” questions of withholding tax obligations, a potentially limited deductibility of royalty payments in Germany, and reporting obligations under “DAC 6.” This LawFlash briefly outlines some important aspects of German taxation of IP rights for corporations that are not tax resident in Germany.
GERMAN SOURCE INCOME FROM IP RIGHTS
Corporations that are neither registered nor maintain their place of management in Germany qualify as nonresidents for tax purposes and are – except when tax treaty protection is available – subject to German taxation with income from German sources, so-called “limited tax liability” (“beschraenkte Steuerpflicht”). The various types of German source income are listed in Sec. 49 Einkommensteuergesetz (EStG - German Income Tax Act). Sec. 49 EStG applies to nonresident individuals as well as to corporations and covers several scenarios of IP-related German source income.
Any income including royalties and sales proceeds generated by German or foreign IP rights or knowhow that is attributable to a German permanent establishment (PE) maintained by the nonresident owner (or user) of the IP rights triggers German taxation under both German domestic tax law and most German tax treaties. This typical PE scenario leads to the issue of a proper attribution and allocation of assets, income, and expenses to the PE versus the headquarter. Income attributable to a German PE will be subject to a taxation of some 29% to 32%, comprising 15% corporate income tax plus 5.5% solidarity surcharge thereon and trade income tax, levied by the municipality in which the PE is located, at different local rates.
Even without maintaining its own PE in Germany, the nonresident owner of the rights incurs German source income derived from rental or usufructory leasing, or the sale of rights that are situated in Germany or recorded in a German public book or register or that are exploited in a German (third party) PE or other German base. For example, IP rights licensed by a nonresident owner to a German licensee who uses it in a German PE is sufficient to create German-source income for the owner under German domestic tax rules. Except in the case of treaty protection, German taxation will include corporate income tax at 15% plus 5.5% solidarity surcharge thereon but no trade income tax.
The same applies if a non-German owner sells his IP rights to a German or a non-German tax resident purchaser. However, under Art. 13 para. 5 of the OECD Model Tax Convention and the respective provisions of the German tax treaties, a capital gain from the sale of IP rights should only be taxable in the territory in which the seller is resident, unless the IP is attributable to a German PE of the seller.
According to a leading decision of the German Federal Fiscal Court, the term “sale” within the meaning of Sec. 49 EStG requires a remuneration/consideration (quid pro quo). Hence, a contribution of such rights into a corporation or partnership without any consideration, in particular without the granting of newly issued shares, should in general not qualify as a sale and should not trigger German source income.
Furthermore Sec. 49 EStG includes income from rental and usufructory leasing which is not already covered by the foregoing if the IP rights are situated in German territory or recorded in a German public book or register or if they relate to a German (third party) PE or other domestic base.
The German tax rules for IP rights do not precisely define the term “IP rights.” Sec. 49 EStG only mentions “rights” that are registered or used in Germany. However, the “core” IP rights include patents, trademarks, utility models, and design rights.
Finally, Sec. 49 EStG separately deals with German source income derived from “knowhow” – although it neither defines nor even expressly uses the term “knowhow.” It only stipulates that income from German sources includes income from “… the provision of the use and enjoyment of, or the right to use and enjoyment of, commercial, technical, scientific, and similar experience, knowledge, and skills, such as plans, models/samples, and processes, that are or have been used in the domestic [i.e. German] territory…” Therefore, “knowhow” is considered a so-called “open type term” under German tax law that requires “detailing and refinery” – a typical approach in German law that provides a level of uncertainty.
WITHHOLDING TAX ASPECTS OF ROYALTIES
A German licensee of IP rights has an obligation to withhold German taxes at source on behalf and on account of a nonresident licensor, if no exemption applies. Sec. 50a EStG lists the types of income from German sources that are subject to a withholding tax. It includes “income from the remuneration for the provision of the use (and enjoyment) of, or the right to use (and enjoyment) of, in particular, copyrights and commercial IP (Schutzrechte), of commercial, technical, scientific, and similar experience, knowledge, and skills, such as plans, models/samples, and processes, that are or have been used in the domestic [i.e. German] territory …”
The tax rate is 15% plus 5.5% solidarity surcharge of the gross amount of the royalty.
An exemption may apply for royalties paid by a related party, typically within a group of enterprises that are resident in the European Union.
Another important exemption is provided in the tax treaties that follow the OECD Model Tax Convention. Under Art. 12 para. 1 of the OECD Model Tax Convention, royalties should only be taxable in the territory in which the recipient is resident. This applies to the extent the royalties are at arm’s length. Art. 12 para. 2 of the OECD Model Tax Convention defines royalties as ”payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience.”
Even if treaty protection is available for the royalty payments, certain German tax law formalities have to be observed.
Under the provision of Sec. 50d EStG, in order to benefit from a tax treaty that limits or eliminates the German right of taxation on royalties, an exemption from withholding tax must be applied for with the Bundeszentralamt fuer Steuern (German central tax office - CTO) in Bonn, Germany. The official CTO’s form sheet must be used. One element of the exemption process is the provision of a certificate of residence of the recipient of the royalties (in a treaty territory). If the CTO issues a certificate of exemption, the licensee is entitled to restrain from withholding tax at source. Since this process typically takes a few weeks it should be started in a timely manner. If taxes have already been withheld, they may be refunded. As of the beginning of 2021, a legislative process is underway in Germany to “modernize” the tax provisions for withholding taxes on dividends and royalties that will change the current process.
In addition, under the provision of Sec. 50d para. 3 EStG, which is widely understood as a kind of unilateral “treaty override,” certain additional requirements apply for the exemption from withholding taxes. Under this rule, the release under a tax treaty triggers to the extent (i) the ultimate beneficial recipients of a royalty payment (in particular shareholders of a corporation licensing out the IP right) would be entitled to a treaty benefit if they were receiving the payment directly (in lieu of the licensor), or (ii) the licensor as the receiving corporation maintains its own business activities and has sufficient economic substance to do so or there are sound business reasons for the interposition of that corporation.
RESTRICTIONS OF THE DEDUCTIBILITY OF ROYALTY PAYMENTS
Although German tax law in general provides a very broad concept of deductible business expenses for income tax purposes, some exemptions apply. Besides the limitations for the deduction of interest payments, restrictions apply to royalties as well. Sec. 4j EStG stipulates restrictions on the tax deductibility of “expenses for the provision of the use or for the right to use rights, in particular, of copyrights and commercial IP (Schutzrechte), of commercial, technical, scientific, and similar experience, knowledge, and skills, such as plans, models/samples, and processes, are, regardless of the provision of an existing double tax treaty.”
This affects the deductibility of royalty payments made to a recipient who is resident in a “low taxation-area” and who is a “related person” of the licensee within the meaning of the German Aussensteuergesetz (German foreign tax act). A territory is classified as a “low taxation-area” if taxation of the royalty payment received is below 25%. In such case, the royalty payment is only partially deductible. Complicated extensions of that rule and exemptions apply, which include a reference to Chapter 4 of the 2015 OECD Final Report and the “nexus concept” provided therein. Under the provisions of Sec. 4j EStG, special care has to be taken if, for example, IP rights are licensed out by a foreign group “patent-box” to a German group entity as the licensee.
‘DAC-6’ TAX REPORTING OBLIGATIONS OF CROSS-BORDER TRANSACTIONS
The European Union has introduced a directive on tax reporting obligations for cross-border transactions that meanwhile have become effective in all EU member states. In a nutshell, the DAC 6 reporting obligation of cross-border transactions aims at the identification and reporting of what is considered “aggressive” (but not necessarily illegal) cross-border tax planning. Cross-border means that at least parties resident in one EU member state and in one non-EU country or in two or more EU member states are involved in a transaction that meets one or more of certain “hallmarks.” With respect to the details of DAC-6, we refer to the Morgan Lewis LawFlashes on this topic.
Cross-border transactions that relate to IP rights may fulfil a number of different “hallmarks,” depending on the structure of the transaction. For example, the transfer of IP rights to a company residing in a territory that provides for a “patent-box”-regime with a preferential taxation of income from IP rights may trigger a reporting obligation. Consequently, any transaction that includes an element of IP rights should be scrutinized carefully in order to avoid penalty payments – not only if Germany but if any EU member state is involved.
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