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German tax treatment of royalties regarding software license and database licenses

– Draft guidance of German Federal Ministry of Finance released for discussion purposes

Explaining ideaYesterday the German Federal Ministry of Finance (Bundesfinanzministerium) released a draft circular on the German tax treatment of royalties paid for software and database licenses granted by non-resident licensors (the draft can be found here).

The draft is highly important to clients (i) having licensed software and databanks to German customers or using German distributors, or (ii) paying royalties for licenses to foreign licensors with regard to software or databases.

Background and impact

Pursuant to Sec. 50a para. 1 no. 3 of the German Income Tax Act (Einkommensteuergesetz) a licensee being resident in Germany is obliged to withhold German tax at a tax rate of 26.375% from a consideration payable for the usage of an intangible asset, e.g. patent, or the usage of scientific findings, experiences or anything comparable. Such withholding tax will, however, only apply, if the non-resident licensor is subject to German (corporate) income tax liability with regard to the royalties received.

Whether a German tax liability exists and, as a consequence, a royalty is subject to German withholding tax, has been discussed intensively with the German tax authorities for decades. In the case of end-users, the distinction is mainly based on the question of whether software has been modified to fit the individual needs of the customers (individual software: withholding tax) or not (standard software: no withholding tax). If a license was granted to a resident distributor, case law of the German Federal Tax Court exists pursuant to which a royalty paid by a resident distributor to non-resident licensor is subject to German withholding tax – if the distributor also has the permission to modify/reproduce software.

A number of tax audits are ongoing in which the withholding tax treatment of royalties paid to foreign licensors or database providers are under scrutiny of the German tax auditor.

Core statements of the draft

The core statement of the guidance affect:

  • Software

A German tax liability will exist if a customer receives comprehensive (umfassende) rights regarding the use of the software, including but not limited to reproducing, modifying, distribution or publication rights.

The simple granting of rights to use the software for the purposes for which the software was created or to distribute copies without any rights to modify or reproduce the software is not deemed to be sufficient to constitute a limited tax liability in Germany, irrespective whether the software is provided on a medium or as a download.

The justification of a German tax liability is apparently based on the understanding that reproducing and modifying the software allows the licensee to generate its own economic benefit by selling the software, i.e., a utilization of the software in excess of the mere usage of the software for the purposes for which the software was created. In this regard, it is not relevant whether the software is provided on a medium or by means of a download.

A limited tax liability does not exist if no reproducing or modifying rights are granted to a resident distributor, irrespective whether the software is provided on hard copies or by way of download. In cases of distribution contracts which allow, inter alia, reproduction / modification, but which include other elements being in excess of 10% of the overall activities, the right to reproduce and modify should not result in a tax liability of the foreign licensor.

With regard to ASP and SaaS (Software as a Service (i.e., Cloud services)) the same principles apply, i.e., a German tax liability only exists if rights of use are granted which are aimed at a further utilization (i.e., reproducing and modifying).

  • Databases

The same principles shall apply if databases are provided from non-resident providers.

A German tax liability exists only if the database provider grants the right to use the database, i.e., the permissions to access the database, and to read and print the content.

However, if for example the respective customer is allowed to provide a sublicense to third parties, e.g. his own customers, the royalties paid to the foreign providers are subject to German tax and, consequently, to German withholding tax.

Action points and conclusion

The draft circular is of utmost importance for everyone who is involved in the cross border licensing of software and databases involving Germany.

The circular will give guidance to customers and distributors of software and database services in Germany. Even thought the draft provides room for clarification in certain details, e.g. a more precise definition of own financial use and the impact of (auxiliary) services such as training, emergency services and update services, it appears that the tax authorities are trying to find a practical solution for the market.

Customers should review whether respective license agreements contain tax gross-up provisions, which might not apply anymore because the services rendered should not result in a German tax liability of the non-resident licensor.

In the case of an ongoing tax audit involving questions on German withholding tax on royalties, taxpayers should carefully review whether the statements of the tax auditors are in line with the draft circular. A suspension of the tax audit should be requested if not.

The Federal Ministry of Finance has asked to receive comments by 7 July 2017 from interested parties. It can be assumed that the final version will be released after the summer break. We will keep you updated!