On June 29, 2022, the German Ministry of Finance (MoF) issued an important circular (the “2022 Circular”) in the ongoing saga of the application of German Tax Act Section 49, Germany’s extraterritorial taxation of intellectual property (IP) transactions. Section 49, a long-ignored provision of German law, provides that German tax applies to transactions involving IP registered on a German IP register regardless of whether the IP holder has a permanent establishment (PE) in Germany. Essentially, Section 49 deems German-source income to exist by virtue of the mere IP registration even in the absence of a permanent establishment or other traditional taxable nexus.
In a circular issued on November 6, 2020 (the “2020 Circular”), the MoF confirmed the application of Section 49 to prior and future transactions notwithstanding significant concerns as to extraterritoriality, constitutionality, burdensome tax compliance and administration, and difficulties in application and enforcement.1 Importantly, when the MoF reconfirmed on February 11, 2021 (the “2021 Circular”) that Section 49 applies despite its 70+ year dormancy, it provided a simplified procedure to ameliorate the law’s impact in certain circumstances, in particular where an income tax treaty was applicable. The 2021 Circular provided a mechanism under which taxpayers clearly covered by an income tax treaty could apply for an exemption to the application of Section 49 with respect to royalties paid through September 30, 2021 (subsequently extended to June 30, 2022). The deadline to apply for the exemption was initially set to expire on December 31, 2021 (subsequently extended to June 30, 2022).
The 2022 Circular extended the relevant time periods for another year. Perhaps more importantly, the MoF not only extended the deadlines but also released an important analysis of Section 49 and made significant recommendations regarding its future application.
Background on Section 49
Section 49 contains a provision that imposes German income tax when there has been a license or sale of IP that is registered on a domestic IP register. Prior to the issuance of the 2020 Circular, the German tax authorities had not actually applied this provision because it was unclear how to interpret and implement the law. In particular, the wording of the provision indicates that the tax applies even where there is no German party or other German connection to the transaction and where the German registered IP is just one component of a global transaction.
2020 Circular and Treaty Exemption Deadlines
With the 2020 Circular, the MoF confirmed this interpretation and made clear that in the case of a license agreement, the licensee is responsible for withholding and remittance of tax. In the case of a sale (potentially including a perpetual license), the seller/perpetual licensor must file a return and pay the tax. The 2020 Circular emphasized that the law applies retroactively to all open tax years, which (under German law) could therefore apply as far back as 2013.
The provision was initially supposed to be abolished with retroactive effect as foreseen under a draft bill on the modernization of the relief from withholding taxes and the certification of withholding tax paid (Abzugsteuerentlastungsmodernisierungsgesetz) published in November 2020. The final bill, however, discarded the abolishment. As a consequence, extensive tax compliance obligations immediately began to apply even where Germany has already ceded taxing rights under an applicable double tax treaty.
Cognizant of the complicated and lengthy regular taxation procedure, the MoF provided in its 2021 Circular a procedure that allows taxpayers, which are clearly entitled to treaty protection, to follow a so-called “simplified” process to claim treaty protection for a limited period of time. This simplified procedure is subject to specific preconditions and initially applied to taxable events realized up to and including September 30, 2021. If the preconditions are met, a licensee can refrain from withholding tax at source. The licensor or the licensee as its representative has to file an application for exemption from withholding with the German tax authorities. In the case of a sale, no withholding taxes are due on capital gains. Instead, an (annual) non-resident tax return (declaring German-source income in an amount of zero euros) can be filed if treaty protection is available. In such case, it is not necessary to determine the sales proceeds allocable to the German-registered IP (which can be difficult if the German-registered IP was sold as part of a global portfolio). With its circular dated July 14, 2021, the MoF extended the simplified procedure for royalty payments received before July 1, 2022. The 2022 Circular further extended the time period for the simplified procedure to royalty payments received before July 1, 2023, provided that the application for exemption is submitted by June 30, 2023.
On June 28, 2022, the MoF also released a revelatory report (the “MoF Report”) outlining its insights on the application of Section 49. The report provides some important insights and recommendations on the MoF’s approach to Section 49 in the context of prior and future transactions. Some of these insights and recommendations include:
- A recognition of the considerable criticism of Section 49 and a recommendation in a non-published letter to the Finance Committee of the German Parliament that Section 49 should not be applied to future transactions except where the transaction involves a non-cooperative tax haven. According to the MoF, very few of the fundamental legal issues that arise in respect of the extraterritorial application of Section 49 have been ruled on in a court of law, so legal risks remain with regard to cases that have been decided to date (by administrative authorities only) or are awaiting a decision. In particular, the MoF admits that in light of the movement of the two-pillar model in the framework of BEPS, the necessity of linking the German taxation right to an entry in the register should be reconsidered. Given that the introduction of global effective minimum taxation will ensure effective taxation internationally, German extraterritorial taxation requires additional justification. In order to counter arrangements with states and territories that do not comply with internationally recognized tax reporting standards and thereby promote tax evasion, tax avoidance and unfair tax competition, taxation should be maintained in relation to non-cooperative tax havens (i.e., non-cooperative states and territories within the meaning of the Tax Haven Defense Act). When dealing with these tax jurisdictions, there is a presumption that the arrangements are harmful to tax. In line with the work of the EU Code of Conduct Group (Business Taxation) and the decisions of the European Council in this regard, additional withholding tax measures against non-cooperative tax jurisdictions are permitted. The non-cooperative tax jurisdictions are currently limited to nine countries (American Samoa, Fiji, Guam, Palau, Panama, Samoa, Trinidad and Tobago, US Virgin Islands and Vanuatu). If the application of Section 49 to German-registered IP is actually abolished (except for these non-cooperative jurisdictions), any extraterritorial future transactions involving German-registered IP that are not linked to non-cooperative tax havens should not trigger any German tax liabilities.
- A confirmation that significant tax revenue can still be collected by applying Section 49 to prior transactions involving tax havens (without treaty protection). This will be particularly relevant to taxpayers that unwound IP structures that were not compliant with BEPS. These include so-called “CV/BV” and “Double Irish” structures where IP was typically held in a tax haven. The MoF also especially emphasizes that the new rules to eliminate the application of Section 49 to IP transactions should apply to future transactions only. Therefore, BEPS-related IP on-shoring transactions completed prior to the introduction of the new rules could still trigger German tax liabilities. The MoF does not address the timing of a potential prospective change of the law to abolish the rule for taxpayers not resident in non-cooperative jurisdictions within the meaning of the German Tax Haven Defense Act. Given the connection made in this regard to the OECD BEPS project, it seems reasonable to expect such a change in conjunction with the implementation of Pillar One and Pillar Two legislation, which is currently anticipated during the first half of 2023.
- A recognition that Section 49 will be difficult to apply in third-party licensing scenarios and an acknowledgment that enforcement of Section 49 in such context will be challenging. It could be interpreted that the MoF will eventually limit the application of Section 49 to third-party transactions implemented in the past. Compared to intra-group transactions, the MoF notes that for third parties, to whom the licenses are granted or sold, it is harder to procure the information required for the application of Section 49. This is because, usually, only the remuneration creditor has the information required for the tax assessment—especially the eligibility for relief under a double taxation treaty. According to the MoF’s analysis, in the case of third-party licenses, there are ultimately only a few cases that can actually be taxed in Germany. At the same time, the compliance burden for companies is considerably higher than in cases within a corporation or group of companies and in some cases can be fulfilled only to a limited extent in practice. Against this background, MoF seems to be reconsidering the application of the Section 49 taxation to such third-party cases.
With the release of the 2022 Circular and the MoF Report, the MoF is recognizing the significant challenges in enforcing Section 49 as well as the limited tax revenue to be gained in the future as Pillar Two is implemented around the world. The ongoing focus of the MoF seems to be prior cases not protected under a tax treaty, in particular BEPS-related IP on-shoring transactions. This can be seen in the statistics noted in the MoF Report as well as the increase in compliance resources devoted to the issue. The MoF seems to have recognized the significant opportunity here and has identified 56 priority cases for examination. The MoF also has identified intra-group IP restructurings involving 35 multinational groups. With its report, the MoF has indicated that it intends to remain in this battle for the long term.
1 For more details on the background of Section 49 and the November 6, 2020 Circular, please see our analysis at https://www.mayerbrown.com/en/perspectives-events/publications/2020/12/german-tax-circular-has-wideranging-implications-for-ip-transactions-and-ma.