Draft tax bill covers the issues

In 2007, the legislature introduced rather groundbreaking changes to the German tax framework in form of the 2008 Corporate Tax Reform Act. The reduction of tax rates was accompanied by other significant highlights, such as the new earning-stripping rules, changes to the trade tax system and significant changes to the loss limitation rules. Therefore, the activities of the legislature in 2008 can be regarded to have been calm compared to the volcanic eruption of last year. However, in June 2008 the cabinet adopted the 2009 Annual Tax Bill and the courts have also made notable decisions in the area of international tax. In addition, it remains to be seen how the German legislature will react to the financial crisis. There is already legislation underway to start initiatives that should stimulate the German economy to avoid a greater recession. This may also lead to tax law changes. However, though now (early November) the only significant changes proposed are in connection with reduced amortisation periods and two-year tax holidays for new cars, it is not unrealistic to expect other changes.

2009 Annual Tax Bill

In the 2009 Annual Tax Bill, a multiplicity of measures was enacted for the achievement of policy aims, to adjust to European Court of Justice (ECJ) judgments and other European developments and to curb perceived abuses. The main changes in the international area are as follows.

Business losses incurred abroad are only deductible against German income if the conditions of an active business are met. Other losses are frequently only deductible in Germany against current or future income of the same type from the same country. These restrictions are now to be lifted in respect of losses from other EU countries and from Iceland and Norway in response to various recent ECJ cases and to an approach from the European Commission. Deduction will continue to be denied where a double tax treaty frees corresponding positive income from the same state from German taxation. This new rule is effective retroactively for all cases that are still open.

Tax-free foreign income (positive or negative) is generally to be taken into account when determining the progressive scale rate to be applied to the taxable income of domestic source. This provision is no longer to be applied in respect of land and forestry income, business income from a non-exempt permanent establishment, property income, ship charters and for losses and write-downs on property and ships where the income stems from another EU country or from Iceland or Norway.

Until 1998, losses incurred in treaty-protected foreign permanent establishments could be deducted from German income against a recapture provision against treaty exempt permanent establishment income of later years from the same country. This recapture provision expired 10 years after the effective abolition of the deduction (in 2008) on the assumption that all recapturable amounts would, by then, have been settled. Because this was not the case, the Annual Tax Act 2008 contained a provision extending the recapture provision for an indefinite period. The present bill supplements this with a similar extension in respect of pre-1990 losses deducted under a different legal provision.

Foreign tax credit is limited to the lower of the foreign tax actually paid and the unrelieved German tax payable on the same income. The German tax is an apportionment by source of the unrelieved tax to be levied on the entire income. However, partial relief is also available from 2008 onwards for profits retained in unincorporated businesses and the foreign tax credit calculation is now to be amended to take this further relief into account.

At present, dividends to banks are paid gross of withholding tax. This exemption is to be extended to all dividends paid to corporations or to unincorporated recipients on shares held as business assets.

The catalogue of the domestic sources of income subject to German tax when paid to non-resident recipients is to be extended to remove anomalies. Income from artistic and sports performances is to include income from appearances to divert or amuse. Talk show appearances have been quoted as an example. Income from property let by way of trade is to be treated as trading income, even if the trading establishment is abroad. This makes the property income of an unincorporated foreign entity subject to trade tax, but also brings the taxation of current income into line with the taxation of the gain on disposal. Pensions paid to non-residents are to be taxed in Germany to the extent they were funded from tax-exempt premiums.

The rules for assessing non-residents are to be revised to accord with European law, particularly as expounded by the ECJ. Various other concerns regarding conformity with community law are also to be addressed. Thus the restrictions on expense deductions for non-residents are to be relaxed and the flat rate of 25% on business or similar income is to be reduced to the scale rate applied to an amount equivalent to the income plus the general allowance of (at present) €7,664 ($9,576) per annum. Because of their community law origin, the revised rules are to apply mainly to residents or nationals of other EU/EEA countries.

The rules governing the deduction of tax at source on the incidental income of non-residents (not employment, investment, property or business income) are to be amended in line with the changes to the rules on assessment. The general rate is to be reduced from 20% to 15% (30% on directors' fees) and rentals of moveable assets, together with a few other income items, are to be exempted altogether.

This withholding rate is to be doubled to 30% for income paid to natural person residents in other EU/EEA countries who claim that it is to be deducted only from the net amount of related expenses. Payments to corporations making this claim remain subject to the 15% rate.

The anti-avoidance rules making treaty or directive relief from dividend withholding tax dependent on the demonstration of a proper business establishment and purpose of a corporate recipient owned by shareholders without their own treaty entitlement are to be applied to claims from foreign corporations for reduction of the 25% withholding tax rate to 15%. Such claims are independent of any treaty and are based on the 15% domestic rate of corporation tax. This measure is intended to thwart attempts by foreign natural person shareholders to gain withholding tax rate reductions through sham incorporations.

Foreign tax credit

The procedures for establishing the maximum amount of foreign tax that can be credited against the tax on foreign investment income are to be simplified to take account of the fact that the German rate is always 25%.

Accounting records abroad

The present rigidly applied restriction on keeping accounting records abroad is to be replaced with a general acceptance of electronic accounting records prepared and stored in any other EU country, Norway or Iceland. The relaxation applies to all electronic records subject to the tax rules on accounting, and therefore includes records such as lists of export transactions and intra-community deliveries kept for VAT purposes only. However, it does not include manually prepared records or paper documents, such as the original invoices. The permission of the tax office is required and is to be dependent on the taxpayer allowing the office online access to the records and on its obtaining the consent of the local tax authority for that access. Permission will be refused to taxpayers known to have failed in the past in their duties of cooperation with the tax authorities. From the wording of the bill, this could be a problem for taxpayers who already do keep their books abroad but without permission. The explanatory notes to the bill suggest that the finance ministry is proposing this concession with international groups of companies sharing their accounting service functions primarily in mind.

Trade tax to the fore

Businesses in Germany generally pay two income taxes: trade and corporation tax. The total burden is some 30% from 2008 onwards. Half of this is the standard 15% corporation tax, but the other half comes from the trade tax levied at local rates.

These range from 7% in Norderfriedrichskoog to 17.15% in Munich. The rates for both taxes have been significantly reduced for 2008. However, this has been partially compensated for by broadening the scope of the interest add-back to the extent that all but the smallest businesses can expect to report a higher income for trade tax than that chargeable to corporation tax. Because trade tax is no longer deductible as an expense, it now rivals corporation tax in tax planning importance.

The trade tax base is still derived from the regular taxable income. However, the traditional add-back of half of the long-term loan interest has been replaced by a general disallowance of a quarter of all interest over €100,000. The definition of interest has been extended to include the implicit interest in leasing, rental and royalty payments. Therefore, the 25% interest add-back is accompanied by 5% of the leasing costs for moveable assets, 16.25% of property rentals and 6.25% of the royalty and licence fees. A decree of July 4 2008 addresses many of the qualification issues in detail and in doing so excludes expenses for car hire, hotels, interest swaps, employer pension fund payments and other items where the service element predominates. On the other hand, dividend income will now be added back if the holding does not exceed 15%.

The changes make certain common business transactions, such as the sale and lease back of assets, costly. Even companies with losses risk paying trade tax. Apart from the cost, there is a severe additional compliance and accounting burden because of the need for additional information, such as the lease payments for copying machines. It will be necessary to enhance the IT systems so that the new requirements can be met.

New protocol to the US-German tax treaty entered into force

The 1989 tax treaty with the US was amended by the protocol of June 1 2006. Unfortunately, US procedural difficulties prevented ratification of the protocol in the same year and at one stage seemed likely to delay the process for more than another 12 months. However, the ratification instruments were exchanged on December 28 2007, with the consequence that the withholding tax provisions take effect retrospectively to all payments made on or after January 1 2007. By contrast, the provisions relevant to taxes levied by assessment are not effective until the 2008 tax year.

The main withholding tax provision concerns dividends: payments to corporate shareholders with an interest of at least 80% in the company's share capital for the 12 months up to the date of the dividend resolution are to be exempted from withholding tax. Dividend recipients in 2007 will be able to claim a refund of the 5% withholding tax deducted under the provisions then in force. Correspondingly, German branches in the US will no longer be subject to branch profits tax, though this exemption will only apply from 2008.

Other changes include a new set of provisions to protect pension plan members from taxation of contributions made in the other state, an arbitration clause should a mutual agreement procedure fail and a revised and tightened limitation of benefits article with the express intention of curbing treaty-shopping.

Treaty abuse criteria up to 2006 to be applied cumulatively

Under the law in force up to December 31 2006, the treaty (or EU directive) relief from withholding tax on dividends paid to foreign residents was refused for dividends abusively paid to foreign companies, to the extent that the recipient was owned by shareholders without their own relief entitlement had they received the dividend directly. The payment was abusive where there was no good reason for interposing the immediate dividend recipient, and where that recipient had no business activity of its own.

The Supreme Tax Court has now confirmed an earlier case in which it held that this provision must be taken literally: that is, success in meeting any one of the three tests is sufficient to ensure entitlement to treaty relief (Supreme Tax Court judgment I R 26/06 of January 29 2008, published on April 23). The case was brought by a Luxembourg SA, apparently beneficially owned by an individual who specialised in providing an accommodation address for so-called letterbox companies. The SA had no office facilities, staff or business establishment of its own. However, it did hold 70% of the shares in the dividend payer, a German GmbH, as well as other majority holdings in Germany, Switzerland and various other countries. The Supreme Tax Court saw the dividend from the GmbH as ranking for relief from withholding tax under the Germany-Luxembourg treaty, if the SA could indeed be seen to have exercised overall management control, as claimed, over the companies in which it held shares.

The SA maintained no office or communication facilities, its verbal instructions to its subsidiaries being communicated by its presumed beneficial owner. It was for the lower court to determine whether, as a matter of fact, that person was acting on behalf of the SA or in his own interests, using the SA as a mere conduit. However, the Supreme Tax Court tempered this by mentioning the outsourcing of services to third parties and remarked on a possible lowering of the requirement to demonstrate business substance where little was typically needed to perform the duties involved.

For 2007, the statute was revised to deny treaty relief to the extent that the foreign company is held by shareholders who would not have been entitled to treaty relief had they received the dividend directly and where either there is no good reason for the foreign company as intermediary shareholder, the foreign company earns less than 10% of gross earnings from its own business activity or the foreign company does not have a business presence commensurate with its business purpose.

Therefore, the activity criteria have become individually, rather than cumulatively, exclusive, so the present case loses some of its value as a guide for the future. However, the remarks of the court regarding the demonstration of business substance by reference to the office facilities, communication equipment and staffing remain relevant.

These can be seen as a selection of the highlights of 2008. There are other tax developments, particularly following the discussion and interpretation of the rules enacted in the 2008 Corporate Tax Reform Act, as well as eventual tax reform plans in connection with government reactions to the financial turbulence. Furthermore, the impact of recent and pending EU court decisions needs to be monitored very closely. Germany remains a fast-moving place tax-wise, and taxpayers need to stay tuned to be up-to-date in order to avoid surprises and to make use of the new rules.

Stefan Ditsch
		PricewaterhouseCoopers Tel: +49 69 95 8561 81 Email: stefan.ditsch@de.pwc.com Stefan Ditsch is a tax partner in the international tax group of PricewaterhouseCoopers, Frankfurt, advising multinational companies on taxation issues relating to Germany and the European Union. Stefan studied business management science at the University of Mannheim and joined the tax department of PricewaterhouseCoopers in 1991, qualifying as a tax adviser (steuerberater) in 1994. He started a two-and-a-half year tour of duty in the US in January 1997, during which he was based at the Washington national tax services office of PricewaterhouseCoopers for the first eight months of his tour, transferring to the New York office in August 1997. Stefan's main practice area is tax consulting on international business transactions and structuring international operations, as well as reorganisations and M&A consulting. Stefan is a member of the German Institute of Tax Advisers and of the European-American Tax Institute. He is a frequent author and speaker on various matters relating to German and international taxation and teaches international tax law at the University of Applied Science in Wiesbaden.