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The German Federal Ministry of Finance circular on the application of Section 4j of the German Income Tax Act (“royalty barrier”)

Local tax laws in many countries permit preferential tax treatment for certain proceeds that are realised from intangible assets (so-called “preferential regimes”). Examples of this are the “Innovation Box“ in the Netherlands and the “Patent Box“ in the UK. The tax rates for such income are frequently considerably below the rates that are applicable in Germany. In practice, groups that operate internationally exploit this difference through appropriate structures (e.g. the “sale-and-lease-back” of intangible assets) in order to reduce the overall tax burden. The legislators in Germany came out against this and introduced a rule in Section 4j of the Income Tax Act (Einkommenssteuergesetz, EStG) (the so-called “royalty barrier”), which has been effective for all expenses arising after the 31.12.2017. In addition, the Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) has now published a letter of implementation.

A restriction on the business expense deduction

The expenses related to the assignment of use of, or the right to use rights and other intangible assets fall under Section 4j EStG if the creditor is a party closely related to the debtor within the meaning of Section 1(2) of the German Foreign Transaction Tax Act. This criterion will normally be met where there is a stake of at least 25% in the share capital.

Additionally, such income received by the creditor has to be subject to a low rate of tax. The limit that has been drawn by the legislators in Germany for this is an income tax rate of 25%. If the income tax burden in the other country is below this level then the taxpayer in Germany may only proportionately deduct (on a “pro rata“ basis) the respective business expenses. In the case of an income tax burden of 10%, for example, the business expense deduction would have to be reduced by 60% (15/25).

The exemption provision (escape clause) ...

A restriction on the business expense deduction would not come into effect if the preferential regime in the other country complied with the OECD’s so-called “nexus approach”. This approach essentially takes into account that the intangible assets that underlie the proceeds were internally developed by the licensors themselves and not merely transferred to them.

Please note: Consequently, taxpayers in Germany face the challenge of checking that the foreign tax regulations comply with specific criteria. The law includes a reference to the guidance in the final report on Action 5 from the so-called “BEPS project” where the nexus approach is described in more detail, however, this is only helpful to a limited extent.

... and the reaction of the fiscal authority

The BMF published a circular, on 19.2.2020, that included a non-exhaustive list of harmful preferential tax regimes, i.e. ones that do not comply with the OECD’s nexus approach. The list, termed a “guideline”, only relates to the 2018 assessment period. In this way, those who apply the law can at least find out which regimes the German fiscal authority regards as harmful for the 2018 assessment period. These include, for example, the above-mentioned regimes in the Netherlands and the UK.

Furthermore, the BMF circular contains a list of foreign regimes that are still being checked with respect to their nexus conformity. However, there is unfortunately no statement in the BMF circular on the regimes that, in the opinion of the German fiscal authority, do comply with the nexus approach.

Recommendation: It is likely that on the date when the BMF circular was issued the vast majority of tax returns for 2018 had already been submitted. However, as it is now known which preferential regimes are regarded as harmful by the fiscal authority, where the respective issues are present it would be advisable to check if, potentially, corrections need to be made to the 2018 tax returns.

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