Germany has introduced measures to limit the deductibility of royalties paid by German resident taxpayers to related parties in certain circumstances. The new ‘royalty barrier’ rule, which targets royalties paid intra-group that benefit from a non-BEPS compliant intellectual property (IP) tax regime, will be effective as of January 1 2018. However, given the nature of the Irish tax regime, the royalty barrier should not impact royalties paid to a principal licensor resident in Ireland.
The royalty barrier
The royalty barrier is an attempt by Germany to tackle harmful IP tax practices identified in the BEPS Action 5 Final Report. However, it will apply to royalties paid or accrued after December 31 2017, three-and-a-half years earlier than the June 30 2021 deadline prescribed in the Action 5 report.
The royalty barrier operates to restrict the deductibility in Germany of a royalty paid directly or indirectly to a related party which is subject to low taxation that deviates from regular taxation resulting in an effective tax rate below 25%. However, where the low taxation applied to the royalty receipt results from the fact that the licensor’s income is taxed under a BEPS Action 5 compliant IP regime, the relevant royalty is not effected by the royalty barrier.
The extent to which the royalty barrier restricts the deductibility of a royalty payment depends on the effective tax rate levied on the royalty receipt. The royalty is restricted in proportion to the extent by which the tax rate applied to the royalty receipt falls below 25%. Therefore, the lower the tax imposed in the licensor’s jurisdiction, the lower the deduction available in Germany for the royalty.
Impact on royalties paid to Ireland
The application of the royalty barrier to a particular royalty payment ultimately depends on the tax treatment of the royalty in the hands of the recipient. For Irish corporation tax purposes, royalties are generally taxed as (i) passive income, (ii) trading receipts, or (iii) profits falling within Ireland’s knowledge development box (KDB) regime. The royalty barrier should not impact on the deductibility of royalties paid to a principal licensor in Ireland which are treated in any of the foregoing ways for the following reasons:
(i) Passive income: Royalties paid in Germany which are taxed as non-trading passive income in Ireland should not be restricted by the royalty barrier on the basis that they are not taxed in a manner which deviates from regular taxation and should generally be taxed at the royalty barrier’s threshold rate of 25%.
(ii) Trading receipts: Royalties paid in Germany which comprise the profits of a trade for Irish corporation tax purposes taxable at a rate of 12.5% should not be effected by the royalty barrier because that they are not taxed in a manner which deviates from regular taxation.
(iii) Knowledge development box profits: Royalties paid in Germany which comprise profits of a specified trade for Irish corporation tax purposes taxable at an effective rate of 6.25% under the KDB should not be effected by the royalty barrier on the basis that the KDB is a preferential regime which is in line with BEPS Action 5.
Ireland’s IP tax offering is not based on a ‘special IP regime’. The profits derived from the exploitation of IP in Ireland as part of a trade are taxed at a rate of 12.5% (or as low as 6.25% where KDB applies). The profits of such a trade are computed after deducting trade related expenses and qualifying depreciation and amortization. Qualification for the 12.5% (or 6.25%) corporation tax rate is inextricably linked to substance in Ireland, and always has been.
The effectiveness of the royalty barrier in practice remains to be seen. Nevertheless, the royalty barrier is further evidence of the international appetite to unilaterally implement BEPS measures and to erode the availability of non-compliant tax regimes. Ireland’s BEPS-compliant tax regime offers taxpayers a competitive and robust solution in the context of such unilateral initiatives.