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The ‘royalty barrier’ rule – BMF sets out the requirements for preferential regimes

Since the introduction of the ‘royalty barrier’ rule (Section 4j of the German Income Tax Act), limits have been placed on the tax deductibility of royalties paid by taxpayers in Germany to related parties abroad if, in the recipient’s country, the royalty payments are subject to a beneficial tax scheme with tax charged at a rate of less than 25% (preferential regime). These limits on deductibility do not apply if the relevant preferential regime complies with the so-called “nexus approach”, as defined in the OECD’s 2015 Final Report on BEPS Action 5, “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance”. Two new Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) circulars set out the rules for situations where tax treatment differs from the standard tax treatment.

Preferential regimes

At the start of the year, the BMF published two administrative directives about the royalty barrier rule. According to the circular from 5.1.2022 (reference: V C 2 - S 2144-g/20/10002 :007) and the one from 6.1.2022 (reference.: V C 2 - S2144-g/20/10002 :005), for a preferential regime, the requisite difference from standard tax treatment will be deemed to exist if a taxpayer with a legal personality comparable to that of the payment creditor, without any concessions, would have had to bear a higher rate of tax. Here, the assumption of a preferential tax regime should not be limited to the well-known IP/patent or licence boxes, but instead should also extend to constellations where arrangements between the recipient of the payments and the foreign fiscal administration (tax rulings) based on individual cases mean that a different taxation comes into effect.

When answering the question as to whether or not the tax rate is at least 25% you need to focus on the tax that is actually levied and paid while deducting any potential downstream refund claims or cross-entity tax refunds.

In compliance with the nexus approach

As regards compliance with the nexus approach, the BMF refers to the current, modified classification by the OECD Forum on Harmful Tax Practices (FHTP); if no respective analysis has been performed by the Forum to date then conformity with the nexus approach has to be determined in the course of the (German) domestic taxation procedure. In 2020 already, for the 2018 assessment period, the BMF published a (non-exhaustive) list of preferential regimes that were classified as not conforming to the nexus approach. At the start of 2022, the respective lists were also published for the 2019 and 2020 periods as well as a list of preferential regimes whose acceptability is currently still under review (as in the case of the US ‘Foreign-derived intangible income’ regime - so-called FDII). Until the review is concluded, the latter expenditure should, in principle, be recognised as business expenses in German tax assessment notices, although the assessments will be subject to subsequent checking.

Burden of proof

In addition to the statements discussed above, the BMF also commented, in particular, on the burden of proof. If the German fiscal administration proves the existence of a preferential regime in a particular foreign country then the taxpayer has to provide evidence that, at the level of the recipient, the payments were not subject to a harmful (or non-compliant) preferential regime. This would generally only be possible by providing the recipient’s accounting records (if necessary, supplemented by the basis for the calculations) as well as other documents and data.

Recommendation: As the, in some cases, strict interpretations by the BMF make clear, greater attention will need to be directed to royalty payments to related parties abroad as regards the deductibility of expenses in Germany. It may be necessary for precautionary measures to be taken in good time with respect to preparing evidence. From 2022, at least, it is however likely that the provisions on the royalty barrier will lessen in importance in relation to OECD member states, since they have undertaken to abolish or make acceptable modifications to preferential regimes that do not conform to the nexus approach by 30.6.2021

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