Withholding Tax Health Check – identifying risks and checking processes

Withholding Tax Health Check – the benefits to you at a glance

• Identification of agreements and cash flows relevant to withholding tax
• Review of existing processes and responsibilities
• Reduction of liability and back payment risks
• Optimisation of collaboration between the specialist and tax departments
• Improved preparation for tax audits

What is it about?

In an ever more digitised and globalised world, for many businesses cross-border licensing and use of rights agreements are part of day-to-day business. Use of rights agreements are mostly for trademarks, copyright or patent rights or for know-how.

Tax deduction here for non-resident taxpayers in accordance with section 50a of the Income Tax Act is one of the most underestimated risk areas in international tax law. Whenever a company based in Germany pays fees for the temporary use of such rights to a foreign contractual partner, as a rule 15% in tax deduction plus solidarity surcharge (15.825% in total) is to be withheld.

Depending on the issue, this can include fees for performances and the financial exploitation of them in Germany (section 50a(1) nos. 1 and 2), such as for public appearances or advertising services. Payments made to recipients in tax havens may also be withheld (section 10 of the Act on Combating Tax Avoidance and Unfair Tax Competition [StAbwG]).

At first glance the basic principle looks simple. But in practice many stumbling blocks await:

• A lack of knowledge of the relevant issues: The agreements are concluded in the specialist departments – purchasing, marketing, IT, research & development or licence management – and frequently don’t reach the tax department at all, or only when payment has already been made. The actual challenge is therefore not primarily to assess them legally but to identify issues of relevance to withholding tax at all.
• Copyrights: Concerning licences for copyrights (mostly related to creative services or trademark or personality rights, such as arising from collaborations with well-known people or influencers), it often goes unrecognised that tax also must be withheld on a total buy-out of all rights.
• Software and contract development: The conditions for selling rights without withholding tax are often inadequately documented in contracts with foreign contractual partners.
• Mixed and intercompany agreements: Agreements that combine services and licensing elements, and intercompany service offsetting with a “hidden” licensing aspect are particularly prone to error. Without clearly identifying the object of the service and breakdown of the tax base, the liability to withhold tax is overlooked or the wrong amount is applied.
• Barter deals: The tax authorities’ view is that barter deals for cross-border licensing, i.e. non-monetary consideration (payments in kind, reciprocal use of rights) for use of rights agreements, are also typically subject to withholding tax. This is often particularly inadequately considered when drafting the contracts and in dividing up the tax burden.
• Contractual security: Foreign contractual partners often assume that there is no liability to withholding tax where there is a double taxation agreement. This fails to recognise that an exemption for this must be formally applied for and the German licensee is liable for withholding tax until the process is concluded. If tax clauses on withholding tax are missing or if the licensee accepts a gross-up clause too quickly, the German company could well end up bearing the burden of the withholding tax.

Erroneously withheld tax may make the German licensee liable and result in penalties or even in prosecution. Whether or to what extent the licensee can be held harmless with respect to its contractual partner is determined by the contractual provisions and the statute of limitations under civil law.  Particularly if the errors are only uncovered several years later during a tax audit, the company can end up with the withholding tax.

What is a Withholding Tax Health Check?

As already shown, withholding tax comes with numerous uncertainties and liability risks. This is precisely where the Withholding Tax Health Check comes in and brings clarity – before an audit uncovers the tax issues and risks. It identifies risky processes in an ordered way, points out potential for process optimisation and reduces costs and liability risks.

But at the same time it does not need to be an extensive examination according to a tax control framework. It is much more expedient to start off with a small solution than to keep pushing the launch of an organised risk assessment into the future. The best starting points is to focus on the topics that are of particular relevance to your business.

Why carry out a Withholding Tax Health Check?

Liability risk of the licensee
It is the German licensee that must withhold tax. If it does not, the German company will be liable for the tax that was not withheld or paid (section 50a(5) Income Tax Act in conjunction with section 73g of the Income Tax Implemention Regulation [EStDV]). Since the tax rate is to be applied to the gross fee, the burden (particularly for on-going licences over several years) can quickly add up to considerable sums.

Approach your next tax audit with certainty
A proactive health check reduces risks and brings clarity. With clear lines of responsibility, reliable processes and a clear paper trail, you will create a solid position for yourself for your next tax audit.

Optimise internal processes and interfaces
A key question is how can the tax department get hold of all the relevant contracts and information on time?  At the heart of a Withholding Tax Health Check is the question whether transactions subject to withholding tax are even uncovered.  That’s why we firstly start by looking at the process and clarify the following with you:

• Where are agreements that are relevant to withholding tax concluded – and which departments initially receive them (purchasing, marketing, IT, R&D, licence management, legal)?
• Which person or department is the first point of contact? And is a reliable process in place to ensure that agreements related to foreign countries are forwarded to the tax department?
• What are the criteria for potentially classifying an agreement as subject to withholding tax – as a reliable trigger for further checks?

Typical classification criteria include payments to a foreign recipient, use of rights, IP, software or know-how, buy-out or right-of-use clauses, mixed contracts with a licensing aspect and intercompany offsetting. We consider a clearly defined threshold for action that has been communicated within the company the most effective lever for controlling withholding tax risks early.

How does a Withholding Tax Health Check work?

A Withholding Tax Health Check follows a structured, multi-step process – similarly to our other Health Checks, which it can be combined with as required.

1.   Kick-off and defining the scope
Together we will set the goals, scope and focuses (such as intercompany licences, software and IT connections or media and advertising rights) and agree which types of agreements and cash flows should be prioritised.

2.   Recording agreements and cash flows
Depending on the scope, internal policies, example contracts and evaluations of the payments made to foreign recipients (accounts payable, intercompany) are requested and viewed.

3.   Analysis of processes and interfaces
The focus is on the question how agreements with a foreign connection can reliably reach the tax department. We examine responsibilities, data flows and criteria for action – and uncover discontinuity between media and manual workarounds.

4.   Risk assessment
We assess the identified issues and associated risks, including taking into account potential relief, exemptions and simplifications under section 50c of the Income Tax Act.

5.   Results report and recommendations for action
You will receive a clear, practical summary – and you can choose from an executive summary, risk report, short- or long-term measures and a prioritised roadmap for implementation. 

Combined health checks – interfaces with other types of tax

Starting from the Withholding Tax Health Check, interfaces to other types of taxes should be checked. The same cross-border supply connections that trigger withholding tax under section 50a of the Income Tax Act also often lead to VAT liability for the recipient in the reverse charge mechanism (section 13b VAT Act [UStG]). Barter deals are to be correctly recorded for VAT. Intercompany licensing relationships are at the same time a topic for transfer pricing – the amount of the licence fee must pass the arm’s-length principle and match value added (DEMPE). Domestic events with foreign collaborators are also affected by income tax aspects – such as flat-rate taxation in accordance with section 37b of the Income Tax Act, the restriction on the deductibility of gifts under section 4(5) no. 1 of the Act and the social insurance contribution for artists [Künstlersozialabgabe]. 

Since these issues mostly concern the same responsible parties at the business, we only involve contacts once and consider several risk areas at the same time. In this way we conserve resources and interface risks become apparent that are often overlooked when considering matters individually.

The value to you at a glance

You can identify issues with relevance for withholding tax early – before payment has been made and liability risks arise – set up clear responsibilities and reliable processes at the interface with the tax department and thereby become more robust for tax audits, while reducing the risk of fines or prosecution at the same time.

We’re looking forward to hearing from you!

We combine professional expertise in withholding tax law with practical experience in implementation – from targeted health checks all the way to implementing reliable tax control framework structures for withholding taxes. If you would like to assess your current risk exposures, improve your processes or review your existing contracts and cash flows, we’ll be glad to talk to you.

Also read: 

Our health checks so far and the health check hub.