Alarming audit trend in Germany
German tax auditors have recently started to treat payments made by German companies to nonresidents offering online advertising services as royalties. In the auditors’ view, cross-border payments are made for the use of undisclosed know-how in the form of advertising algorithms. Although the auditors justify this practice by the application of the withholding tax regime on royalties, it functions as a digital advertising tax or digital service tax.
This practice is not yet commonly accepted among the German tax authorities. Rather, it is a controversial interpretation of German tax rules by various tax auditors. Given the public attention paid to this audit practice, the matter is on the agenda of the Federal Ministry of Finance in order to form a uniform position nationwide. A concerted statement from the tax authorities can be expected in the near future.
No legal justification for pseudo-digital advertising tax
In the majority of cases, no advertising algorithm or other know-how is disclosed by nonresident advertising providers to German companies. Advertising algorithms are a critical success factor for MNEs offering online advertising and give them a competitive advantage. Consequently, no legal basis exists for treating cross-border fees on online advertising as royalties for the use of know-how. These fees in general do not trigger any withholding tax or pseudo-digital advertising tax in Germany.
Various tax auditors also argue that the conclusion of mere advertising contracts is covered under the term of legally protected intangible assets. This has to be analyzed on a case-by-case basis. Some auditors also take the view that services rendered automatically or electronically cannot be classified as a service within the meaning of German tax law. This opinion is not in line with German court decisions. These services should likewise regularly not trigger any German withholding tax.
Withholding tax on royalties for the use of IP
Royalties for the use of know-how are subject to statutory withholding tax at a rate of 15.825% if paid to nonresidents. The current audit practice has led to fees for online advertising also becoming subject to this withholding tax according to the auditors, although there is no withholding tax on fees for the provision of mere service under German tax rules. And again, there is no pseudo-digital service tax in Germany.
This withholding tax rate can be further increased to 18.8% if a gross-up clause was agreed between a German company and a nonresident service provider. This type of gross-up clause is common practice and depends on the negotiating power of the contracting parties. It means that any withholding tax ultimately has to be borne by the German company, although the nonresident service provider is the taxpayer under German tax rules.
If a German company fails to levy the withholding tax on cross-border payments for online advertising to nonresidents, that company becomes liable for the withholding tax because of noncompliance. As a result, that online advertising becomes significantly more expensive for German companies if the service provider is a nonresident.
Avoidance of withholding taxes in a tax treaty situation?
Nonresident advertising providers often have their country of residence in a country with which Germany has concluded an income tax treaty. These treaties typically provide for a lower withholding tax rate than 15% or 18% or preclude withholding tax completely.
However, a payer of royalties may apply the lower treaty withholding tax rate only if the nonresident advertising provider presented a valid withholding tax exemption certificate at the time of payment. Nevertheless, treaty benefits are often barred by domestic anti-treaty shopping rules. The application thereof is assessed in the procedures for obtaining the exemption certificate from the competent authority. In addition, a subsequent refund of the withholding tax requires the cooperation of the nonresident advertising provider and the resident company.
Trade tax implications?
For German trade taxes, a certain portion of expenses incurred by German business taxpayers for the temporary use of intellectual property rights is not deductible. These intellectual property rights are subjective rights for intangible assets, which are legally protected and contain rights to use and to defend. For instance, copyrights within the meaning of the German Copyright Act, trademarks within the meaning of the German Trademarks Act, and patents within the meaning of the German Patents Act.
German tax courts have repeatedly confirmed that legally unprotected intangible assets are not intellectual property rights for German trade tax purposes. In particular, these assets contain technical, scientific or managerial knowledge (know-how). Therefore, royalties for the use of know-how are not covered by the partial limitation of deductibility for trade taxes. Consequently, these royalties are fully tax deductible for the calculation of a payer’s taxable trade income.
In the – highly controversial – view of German tax auditors, fees for online advertising are deemed as royalties for the use of know-how, but not of intellectual property rights. So these fees are – even in the view of the German tax auditors – usually fully deductible for trade taxes at the level resident payer/advertising service recipient.
Recommended actions for MNEs offering online advertising
In anticipation of the current audit practice in Germany, MNEs offering online advertising to German companies can take the following action to pre-empt an outcome as outlined above:
- Careful examination and observation of developments in Germany, as a concerted statement by the tax authorities is to be expected in the near future.
- Apply for the issuance of withholding tax exemption certificates if they take the view that treaty benefits apply and the requirements of the German anti-treaty shopping rule are met. This could also be done as a precaution, i.e. such a certificate might even be issued if it is unclear whether the received cross-border payments are subject to withholding tax at all.
- Prepare supporting documentation to demonstrate that there is no withholding tax obligation, which can be handed over to the German companies and the German tax authorities.
- Agree on gross-up clauses to shift the financial impact of any withholding tax to the German companies paying fees for online advertising. In this case, the German companies will ask the MNE for assistance in obtaining withholding tax refunds, depending on the rights and duties agreed on. It is obvious that the German companies have a strong incentive to avoid gross-up clauses.
- Restructure the way of providing online advertising by interposing a German subsidiary as the direct contracting partner for German companies receiving online advertising services. The spillover effect here is any new intercompany transactions are subject to transfer pricing rules and could also be subject to withholding tax. Nevertheless, the number of cross-border payments can be significantly reduced and managed internally within the MNE.