Drafting "watertight" license agreements from the perspective of tax law presents challenges, especially where cross-border contractual relations are concerned. It happens in practice that international tax implications are often overlooked by the parties – in some cases with severe consequences. Following a field audit, for example, a German party owing remuneration in cross-border license relations can be confronted by substantial belated tax demands. Yet agreements which fail to take tax particularities into account can also lead to a rude awakening for foreign remuneration recipients.
When drawing up international license agreements under which foreign licensors (whose residence or registered office or place of habitual abode is not in Germany) receive payments (so-called inbound license), it is important to examine whether the licensor will be liable for tax in Germany (limited tax liability). This will be affirmed if the license fees are so-called "domestic income" according to the German Income Tax Act (EStG). This includes, for example, license fees for permission to use patents or individual software as well as remuneration paid for the right to advertise using a symbol or emblem.
If a foreign licensor has limited tax liability in Germany for domestic income, this may mean that the income is subject to double taxation since the licensor still has to pay tax on the remuneration together with his other income in his country of residence.
The first pitfall arises here, since contracting parties often operate under a false sense of security where double taxation treaties exist between the countries in which the parties owing remuneration and the recipient reside, which has the aim of avoiding double taxation. For example, according to Art. VII of the double taxation treaty between Germany and the UK, license fees from Germany that are received by a person residing and liable for tax in the UK are only taxed in the UK. However, the fact that this requires a contractual clause is often overlooked. Where a British remuneration recipient with an inbound license agreement realizes that of the 80,000 Euro in remuneration agreed for the grant of rights, a payment of only 67,340 Euro is received, or where in a different case the German tax authorities demand a sixfigure amount in belated tax from the party owing remuneration, for license payments made to the UK many years ago, the parties concerned who did not obtain tax advice when drawing up the agreements are very unpleasantly surprised. How could this happen in view of the double taxation treaty?
Tax Deduction "At Source"
According to Sec. 50a Income Tax Act (Einkommensteuergesetz, EStG) in numerous cases where cross-border licenses are granted the party owing remuneration is under an obligation to deduct the tax payable on the remuneration and to pay it directly to the tax office. As a rule, the tax rate in this respect is 15.825 percent. This obligation arises even where an evidently applicable double taxation treaty does not attribute a corresponding taxation right to Germany.
If the foreign recipient of the remuneration places trust in the double taxation treaty and relies on full payment of the agreed remuneration and is not secured by a socalled "gross-up clause" in the agreement, there will be considerable surprise when the party owing remuneration complies with its statutory obligation and deducts the tax from the remuneration.
Avoiding Deduction of Tax
If there is an applicable double taxation treaty, this unpleasant surprise can be avoided. In that case there are two possible procedures which can provide relief from the tax deduction under Sec. 50a of the EStG.
The party owing remuneration does not have to deduct tax in accordance with a double taxation treaty if the Federal Central Tax Office provides confirmation to the recipient that the relevant requirements have been met. However, this requires filing of a corresponding request in good time (i.e. at least three months before payment of the remuneration).
Alternatively, the creditor can apply for reimbursement of the tax amounts withheld and deducted.
Certain prerequisites and procedural rules have to be observed in both procedures (form of request filed, deadlines etc.). If necessary a detailed catalogue of questions has to be answered in the German language.
Consequences of Failure to Deduct Tax
It is important to note that the party owing remuneration is under an obligation to deduct tax unless it has received confirmation of a tax exemption by the date of payment. If that party fails to comply with the obligation, it will be liable for the tax amount and may be called upon accordingly by the tax office. If the party owing remuneration has already paid the full amount to the foreign licensor at the time, this can result in a substantial additional financial burden unless the former can obtain reimbursement of the tax amount.
It is also important to point out that confirmation of a tax exemption is never issued with retroactive effect, but that actual payment of the tax is an essential prerequisite for the reimbursement procedure. Furthermore, only the remuneration recipient may file a corresponding request or at least has to issue corresponding authorization – hence the party owing remuneration is dependent upon the recipient's cooperation. Should it emerge during the reimbursement procedure that there is no protection under a double taxation treaty (e.g. in case of socalled "treaty shopping"), a reimbursement will not be granted and, in the absence of an adequate contractual clause, the full financial burden will be placed on the party owing remuneration.
The above explanations also apply vice versa: a party liable for tax in Germany who receives remuneration for the grant of rights abroad (outbound license) can be liable for tax (limited liability) on those payments. Since many countries deduct source tax at high rates (especially south-American countries, e.g. Brasil at the rate of 25%) which cannot be deducted from the German tax burden in full, this issue should not be neglected when negotiating and drawing up crossborder agreements which – if only in part – are based on the grant of rights, for there are more than enough pitfalls in this area.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.