Global Tax Alert | 2 November 2017
Germany issues final guidance on classification of cross-border software and database use payments for withholding tax purposes
On 2 November 2017, the German Federal Ministry of Finance issued final guidance addressing the question of whether a German (withholding) taxing right exists on cross-border payments for software, cloud or database use transactions. The final guidance contains 16 examples and covers situations where a domestic (German) customer obtains the temporary use right for software or database applications from a foreign vendor/licensor and uses this right in its (domestic) business.
Under current German law, a cross-border “payment in consideration for the temporary use of a right”/“payment for a transfer of know-how” should give rise to withholding tax (WHT) in a business to business (B2B) situation. Business to consumer (B2C) transactions should not give rise to WHT. German royalty WHT amounts to 15% (plus solidarity levy of 5.5% thereon, i.e., effectively 15.825%), or 18.8% in a gross-up scenario.
Unchanged from draft guidance released in May 2017, the overriding principle that determines whether a software/database transaction leads to a German WHT obligation for the payer is that if the user is being granted rights to exploit the software/database that go beyond those rights that are typically granted for the intended use of the software/database, the transaction should be classified as a licensing transaction and hence be subject to WHT. Such additional rights can be copy, modification, distribution, or publication rights.
If the nature of the software/database use agreement is such that the functionality of the software/database and its intended use in the business is the core of the transaction, no WHT obligation should arise. In the latter case, no explicit upfront clearance by the tax authorities shall be necessary in order to allow the German customer to pay the consideration to the nonresident without deducting WHT.
It needs to be noted that the guidance states explicitly that it will only apply to the granting of rights to exploit or use software and databases. It will not govern other digital transactions (e.g., sale of image rights/pictures, online streaming, online gaming or cross-border sale of online advertising space), so uncertainty remains in these situations.
The guidance is a positive development as German companies and foreign software, cloud, or database vendors have been hoping for some time for a clarification surrounding cross-border payments from Germany for the use of software and databases.
The final guidance provides the following examples:
Example 1: German company receives the copy, modification, distribution, and publication rights in an image software from an information technology (IT) company in Singapore and adapts the software to the German market (i.e., translates it) and distributes it as part of a software package. Payments to the Singapore IT company shall be subject to WHT as the rights granted go beyond the mere use of the software.
Example 2: Cross-border payment for the use of word processing software with a right to create 5,000 copies to be used by employees of the German customer: No WHT obligation as no rights are granted beyond the intended use and the copying right is limited to own business.
Example 3: German company purchases (ready to use) software and adapts it to the specific needs of its business making use of specific adaptation features already embedded in the software by the developer for this purpose. There is no WHT on payment because the rights granted do not go beyond those needed for the intended use of the software. Adaptation by the client to the needs of its business constitutes intended use of the software.
Example 4: German IT-sourcing company purchases license to use word processing software in the group to which the sourcing company belongs (via sub-licenses): No WHT obligation as no rights are granted beyond intended use and the copying right is limited to own group.
Example 5: Foreign parent allows German subsidiary to further develop, copy and distribute the parent’s software products against royalty payments: WHT obligation as rights are granted that go beyond those needed for the intended use of the software.
Example 6: German subsidiary of foreign software developer is a reseller of downloadable software and pays a royalty for the right to distribute a defined number of software copies. A predefined number of copies can be physical units (e.g., on a DVD) or license keys which allow for a download of software. No right to copy or modify the software is granted. There is no WHT obligation as this is only a sales transaction. If the German subsidiary however obtained a copyright, a WHT obligation would arise.
Example 7: Foreign company provides “infrastructure as a service” (IaaS)-offering through a German subsidiary, and together with the right to use the IaaS, grants the German subsidiary the right to use and modify (for customer use) archiving software. This should be classified as a split transaction; the IaaS-related payment would not be subject to WHT (service, no grant of right), while the right to use and modify the software should be subject to WHT as rights are granted that go beyond those needed for the intended use of the software.
Examples 8 and 11: Cloud-based “software as a service” (SaaS)/”application service provision” (ASP) transactions where software remains installed on the service provider’s server, and beyond the use of software, additional services are agreed (software maintenance and updates, data storage, hotline service): No WHT as no rights are granted beyond intended use.
Example 9: Same as Example 8, but now the foreign cloud service company interposes a German ASP distributor who contracts with German customers. Payments by the German ASP distributor become subject to WHT as rights are granted that go beyond those needed for the intended use of the software (distribution rights).
Example 10: Foreign SaaS company distributes in Germany through a subsidiary, which is being granted copy, modification, distribution and publication rights to the software. Payments by the German SaaS distributor become subject to WHT as rights are granted that go beyond those needed for the intended use of the software (distribution rights).
Example 12: Payments for access to online scientific journal (only reading and printing rights): No WHT obligation as no rights are granted beyond the intended use.
Example 13: Foreign rating agency allows German bank through end user license to use financial market data online (access, reading, printing rights): No WHT obligation as no rights are granted beyond the intended use.
Example 14: Facts as in Example 13, but now the German bank also has the right to grant its customers access to the database: WHT obligation as rights are granted that go beyond those needed for the intended use of the database (sub-licensing right).
Example 15: Facts as in Example 13, but now the bank also has the right to grant its customers access to data generated from the database (although not access to the database itself). There is no WHT obligation as no rights are granted beyond the intended use. The bank does not have the right to publish or copy material parts or the whole of the database content.
Example 16: A German university uses a database of US provider. On its premises, the university is entitled to grant free use of the database to employees and students and grant third parties access to the database against a cost-based, nominal consideration. There is no WHT obligation because the university does not economically exploit the rights granted because it offers database access for free or only a nominal consideration.
Navigating practical difficulties
From a procedural perspective, it will be important to distinguish between the following situations in the future:
Only right to intended use in the business is granted
- If the nature of the software/database use agreement is such that the functionality of the software/database and its intended use in the business is the core of the transaction, the remuneration should not give rise to taxable German source income (in absence of a German permanent establishment or a dependent agent of the nonresident software provider). Therefore, no WHT should be due under domestic law.
- No further clearance from the tax authorities should be required in order to pay out the remuneration to the nonresident software provider without deduction of WHT.
Comprehensive rights are granted
- If the user is being granted rights to exploit the software/database that go beyond those rights that are typically granted for the intended use of the software/database, the transaction should be classified as a licensing transaction and as German source income which is subject to WHT.
- Under German law, a customer cannot directly rely on the existence of a tax treaty/directive that gives the exclusive right to tax royalties to the country of the licensor’s residency; the customer may only refrain from levying withholding taxes (or withhold at a lower treaty/directive rate) if a transaction has been cleared with the Federal Tax Office (FTO) upfront and the vendor has presented a valid WHT exemption certificate issued by the FTO before payment is made. Otherwise the customer of the nonresident vendor can be held secondarily liable for withholding taxes if a tax auditor successfully argues that a payment should give rise to WHT.
- Such WHT exemption certificates are specific to the contract under which the remuneration is paid and to the counter-party to the contract. Essentially, this means that a WHT exemption certificate has to be obtained for each contractual relationship that triggers withholding tax. In situations where a nonresident digital business has a large number of clients in Germany, obtaining WHT exemption certificates can be challenging from a purely practical perspective.
It is expected that the principles set out in the guidance shall make the cross-border distribution of software to end-users in B2B transactions much easier. The guidance sets forth clear – and relatively easy to follow – criteria when WHT would need to be levied on cross-border payments. It can therefore be expected that in B2B transactions, German resident end-users will better understand when not to withhold tax in situations corresponding to the examples covered in the guidance so that no WHT exemption certificate from the German tax authorities should be needed in these cases.
Uncertainties may arise in the case of combined contracts. According to the guidance, the full remuneration should be subject to WHT where the granting of the comprehensive rights is the prevailing element of the agreement and a split of the remuneration is not possible. Based on the wording of the guidance, this should always be the case where comprehensive rights are granted to the customer and the software is adapted or developed for the customer by the software provider. No WHT has to be withheld where the rights granted account for 10% or less of the total remuneration.
In cases of doubt or disagreement between the software provider and the customer on whether the principles of their specific arrangement would be covered by the guidance or whether a portion of the remuneration would trigger WHT, it may still be possible to obtain a WHT exemption certificate to reduce the uncertainty.
As noted above, the guidance will only apply to remuneration for software and databases. Therefore, uncertainty remains e.g., for the cross-border sale of image rights/pictures in B2B transactions which customers may use for their business (e.g., for display in brochures, on webpages or similar). If, in these cases, WHT exemption certificates are not an option – e.g., because of the number of German customers – nonresident vendors should review whether they could take other measures to address the uncertainty resulting from the classification of payments received from their German customers. In very exceptional cases, it may be possible to discuss with the FTO the possibility of a blanket WHT exemption certificate (typically any such agreement would require the consent of the Federal Ministry of Finance). If this is not an option, vendors may consider contractual agreements shifting the financial risk to their customers to limit their own exposure – or serving the German market through a German resident distribution entity and thus avoiding the WHT obligation on customer payments completely.
Moreover, the guidance does not address other forms of digital transactions, e.g., sale of online advertising space, content streaming or online gaming so uncertainties can be expected to remain in these areas.
Nevertheless, the official guidance should be welcomed by taxpayers as it addresses the technical uncertainties in a pragmatic way. For the cases not covered by the guidance, however, the existing procedural difficulties remain. Elimination of these procedural difficulties is likely to require a change in law to fundamentally improve this process and make it easier to apply in cases where a nonresident has a large number of customers in Germany.
For additional information with respect to this Alert, please contact the following:
Ernst & Young GmbH, München
- Christian Ehlermann
- Katja Nakhai
Ernst & Young LLP, German Tax Desk, New York
- Tobias Appl
- Thomas Eckhardt
- Markus Schweizer
- Nicolai Huschke
- Valeska Schierle
- Ivo Schmohl
EYG no. 06234-171Gbl