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24. July 2018 | License barrier § 4j EStG from 2018 in Germany

27. October 2018 | License barrier according to § 4j EStG: Simply explained with example and graphic

17. January 2019 | Withholding tax according to § 50a EStG: Licenses – Artists – Supervisory Boards

24. May 2022 | Save taxes with licenses despite the license barrier in § 4j EStG (this contribution)

IP rights – i.e. intellectual property rights, such as patents and copyright – are harmful in the view of the OECD, unless the licensor has substance. Only then can the licensee deduct the expenses for the licenses. In contrast, licensed trademark rights should always be harmful regardless of whether the licensor has substance. The only exception is if the licensor has established himself in a tax haven. We explain which trademark rights are disadvantaged and how you can avoid the disadvantage and still deduct your expenses for the license.

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§ 4j EStG declares licensing expenses at the domestic licensee not or only limited deductible. They cannot therefore reduce the tax burden. The licensor is liable to a lower taxation rate of less than 25 %, which differs from the standard taxation in the licensor where the licensee and the licensor are related parties. Low taxation is also known as preferential taxation. However, the licensing barrier does not apply exceptionally if the licensing income is subject to a substance regulation that corresponds to the Nexus approach according to capital 4 of the 2015 Final Report on Action Point 5, OECD (2016). The regulations on the Nexus approach are explained below. If you want to know exactly what consequences the license barrier has and how it works, please read our other article on the license barrier.

In Capital 4 of the 2015 Final Report on Action Point 5, OECD (2016), the OECD sets out when licensing income from intellectual property rights benefits. This is a further development of the substance law that the OECD already developed in 1998. At a first stage, it will be examined whether the preferential regime is potentially harmful. But even then it is only really harmful if it meets the criteria of actual harmfulness at the second stage.

2.1.1. Potentially harmful

At that time, 4 criteria were decisive for the question of whether a harmful regulation existed. This was used to determine whether the tax regime is potentially harmful. Accordingly, it was potentially harmful if the licence income is taxed low or not at all, this tax advantage applies only to foreigners and therefore does not apply to purely national arrangements. Moreover, the tax regime was not allowed to be transparent and there was no effective exchange of information. This catalogue has been modified and extended by the OECD. A low or absent taxation is replaced by the tax reduction by means of a preferential tax rate in relation to the standard taxation, so-called preferential taxation. This criterion is therefore met for any deviation from the regular tax rate. In addition, another, fifth main criterion was the substance test in the form of the Nexus approach. This criterion is met if the preferential scheme favours taxpayers without sufficient business activity in the State.

2.1.2. Actually harmful

If these four criteria are met, a second step is to check whether the tax regime is actually harmful. It is examined whether the preferential taxation leads to a relocation of activities to the low-tax country, whether the licensor’s business activity is proportionate to its licensing revenues and whether the tax advantage was the decisive reason for licensors to establish themselves there. The decisive factor is therefore whether tax revenue is artificially shifted between states. Therefore, the low taxation alone is not harmful, but only an indication.

The licensor has substance if he has developed the IP rights himself and at his own expense. The licensor must therefore be economically active and have activities on site. A distinction is made between qualified and non-qualified expenses. Under the Nexus approach, a tax break may be granted only to the extent that the licensor has qualified expenses.

The 2015 Final Report distinguishes three categories of “good” IP rights: patents and similar rights, copyrighted software and other intellectual property.

In addition, there are “bad” IP rights. These are marketing-related intellectual property rights, such as trademark rights. Therefore, under the Nexus approach, they can never meet the conditions for tax breaks by an irrefutable presumption.

According to the OECD, trademark rights do not serve to promote and support research and development, but only the Group’s own marketing activity. This is not eligible, so that licenses for it should not be tax deductible. Marketing-related IP rights (trademark rights) therefore occupy a special position.

§ 4 j EStG, on the other hand, classifies preferential taxation as harmful if licensors without substance are favoured and their licensing income comes from related parties. If the two main criteria of the preferential tax rate and the lack of substance in the sense of the nexus approach are met, and if the licensing income also comes from related parties, then there is not only a potentially harmful, but a genuinely harmful preferential regime. The license expenses are then not deductible or only deductible to a limited extent.

There is therefore no two-stage examination in national law in terms of potential and actual harmful. It is therefore not necessary to examine whether the harmful preferential regime actually has negative economic effects in the sense of an artificial shift in tax revenue. In addition, only two main OECD criteria are applied. These are the Nexus and preferential taxation. In contrast, it is irrelevant for the OECD criteria whether licensors and licensees are related. Therefore, irrespective of whether licensors and licensees are related parties, the OECD criteria determine the harmfulness of the licences. Therefore, § 4j EStG covers only part of the harmful regulations, since it knows of a further restriction.

The OECD approach has a gap in which the sole determinant of preferential taxation is whether IP rights are tax-advantageous. In the tax havens there are no or only very low income taxes. Licensors therefore tax their licensing income at the regular, low tax rate. However, § 4j EStG is not a low tax burden per se harmful, but the deviation from the regular taxation in the specific country.

The OECD has recognized this gap, but has only acted to the extent that a modified substance test is applied for licensors in tax havens despite a lack of preferential taxation and regardless of the property as bad IP law. Therefore, it depends on whether the licensor has created the licensed rights himself with his own resources and own personnel, whereby the necessary research and development work must be carried out by the licensor himself. Despite this change, tax havens are better off than other countries because they are free to prove that they have sufficient substance in trademark rights.

However, it remains to be clarified whether this advantage for tax havens can also be recognized in § 4j EStG. The decisive factor is whether the OECD regulation on the scope of the substance test – i.e. the exclusion for marketing-related IP rights – is adopted. These are subject to the above-described, developed by the OECD only after 2015, own substance test only if the licenses are paid to a licensor in a tax haven. It could be understood as referring solely to the concept of the nexus approach, but the German legislature itself determines to which preferential systems and which licensed rights it applies this concept. Therefore, the Nexus approach would apply to all trademark rights and would also be subject to licences for trademark rights in non-tax havens. Then they would also be able to withdraw.

This has not yet been clarified, so the meaning must be determined by means of interpretation. The OECD examines whether a system of preferences is harmful. In the preliminary question of whether there is a potentially harmful license at all, the Nexus test is a criterion of five main criteria. Even if the tax regime does not comply with the Nexus approach, it is only potentially harmful. This does not necessarily mean that the licence is classified as harmful. Rather, it is checked at the second level whether the license is actually harmful. Therefore, a license may be classified as harmful by the OECD, although the licensor implements the Nexus approach correctly, but does not meet other criteria.

In contrast, § 4j EStG stipulates that a licence is harmless solely because a tax regime has correctly implemented the Nexus approach. The Nexus test therefore receives a different weighting within the framework of the OECD than within the framework of § 4j EStG. It is therefore necessary to determine the scope of the Nexus test differently. Consequently, the regular Nexus audit also applies to marketing-related IP regulations. If the Nexus is effectively justified, the expense is not harmful for this reason alone.

According to §4j EStG, licences are not deductible if they are paid to a foreign licensor who is subject to lower taxation than the standard taxation there, even though the licensor has no substance in the State and licensors and licensees are related parties. A substance test is also applied to trademark rights, contrary to the view of the OECD, and it is not irrefutably assumed that they have no substance there. Substance testing is therefore also possible for trademark rights.