Upcoming German tax law changes beyond transfer pricing

Court rulings have forced the German legislator to amend CFC rules relating to passive income

The respective "Act for the implementation of the amendments of the EU Administrative Cooperation Directive and of further measures to counter base erosion and profit shifting" passed the lower house of Parliament (Bundestag) on July 13 2016. Subsequently, the upper house of Parliament (Bundesrat) – representing Germany's Federal States – basically agreed with the draft act, but proposed some changes to some rules already contained in it and suggested some additions to the draft act.

The draft act is a first step of the German tax legislator to implement the outcome of the OECD's BEPS Action Plan into German domestic tax law. This article discusses the main changes and their impact on multinational companies.

In view of the relatively high effective tax rate in Germany and the territorial system with an exemption for corporate recipients of dividend income, German rules on controlled foreign companies (CFCs) play a significant role in the German tax system. These rules aim at subjecting income generated in a foreign country to German tax, provided certain criteria are met.

In brief, under §§7-14 FTA the criteria for the CFC rules to apply are significant shareholding by German taxpayers (in general >50%), passive income of the CFC and low taxation of the income in the foreign country.

This tax reduction has formed an interesting planning tool for multinational companies.

If these criteria are met, the income generated by the CFC is included in the tax base of the German shareholder(s). Technically, the income inclusion is made by way of allocating the income generated by the CFC to its German shareholder(s) in proportion of their shareholding. The German tax authorities used to hold the view that this income inclusion was to apply both for corporate income as well as trade tax purposes.

However, in its decision dated March 11 2015 the Federal Tax Court came to the conclusion that CFC income should be excluded from the trade tax base in Germany. The rationale for this conclusion was that despite the allocation of the income generated by the CFC to its German shareholder the income is still generated outside of Germany. The German trade tax, however, generally only applies to income generated within Germany. Consequently, CFC income is to be subjected to German corporate income tax and solidarity surcharge (total 15.825%), but not to trade tax (amounting between 7% and 17%).

Obviously, the German legislator did not like the outcome of the respective court proceeding. Therefore, the draft act includes an amendment of the CFC rules: In the future, any CFC income will be deemed to be derived within Germany despite its actual source, thus subjecting it to trade tax as well. In order to avoid this, structures would have to be adjusted to avoid German CFC rules.

In general, any income generated by a German company through a foreign permanent establishment (PE) is – under most of the double tax treaties (DTTs) – exempt from German taxation (exemption method). German tax laws contain some unilaterally applicable clauses (switch-over clauses) according to which this exemption is replaced by an inclusion of income combined with a crediting of foreign taxes (credit method).

One switch-over clause can be found in §20 (2) FTA. Under this rule the exemption method is not to be used if any income of a foreign PE was subject to CFC income inclusion (see above) had the PE been a CFC. In other words, it is assumed that the PE/partnership is a CFC to which §§7-14 FTA apply.

Under the today's laws, however, the switch-over clause does not have any effect on the determination of the trade tax base. The respective income, albeit passive in nature, is still to be seen as being derived in a non-German PE with the consequence that for trade tax purposes it is to be exempted. Technically, this exemption is done by way of abatement from the tax base either under §9 No. 2 TTA (profits of a partnership) or under §9 No. 3 TTA (profits of a non-German PE).

The ATAD will play a significant roles on the further development of German tax law

Again, the German legislator did not like this outcome and included a change in the draft act. In the future, CFC income derived in a non-German PE or partnership is deemed to be generated in a German PE with the effect that it is subject to trade tax. This applies regardless of the existence of any DTT, i.e. irrespective of whether or not a treaty provides for the exemption method. However, it is not supposed to apply in cases where the foreign PE or partnership meet the Cadbury Schweppes test by own genuine economic activities relating to the passive income (§8 (2) FTA).

The draft rules do not appear to be very well considered, and their application is likely to encounter some difficulty. This is because of the German taxation concept for partnerships: The tax base is not only formed out of the profits derived by the partnership as such, but also includes, for instance, any payments by the partnership to its partners for the use of assets owned by the partners or services provided by the partners to the partnership. In line with this, any compensation incurred by a partner relating to the respective assets and services as well as the investment in the partnership in general (i.e. interest from the refinancing of capital contribution) is deductible at partnership level. These so-called special business items are typically added back or deducted at a second-level profit determination.

In view of this, it is unclear how far the fiction under §20 (2) FTA and the application of §§7-14 FTA are supposed to go under the draft rules. Either the taxation concept for partnerships remains relevant – with the consequence that all expenses of a partner relating to the partnership are to be deducted from the profit subject to the draft rules; or for purposes of the draft rules the partnership is to be treated as company with the effect that any compensation by the partnership to its partners is to be deducted from the profits subject to the new rules.

Therefore, the Upper House has requested that it be analysed in the course of the further legislative process to tighten the draft rules such that the profit determination becomes clearer. The background for this request is that a number of German-headquartered companies have used non-German partnerships for IP optimisation. These structures may – without according adjustment – no longer lead to the desired result in the future. The same applies to some structures used for the avoidance of trade tax on the renting out of real property or finance income.

Dividend income of a German corporation is typically tax exempt in Germany. However, 5% of dividend income is treated as a non-deductible item which is added back to the income, leading to an effective tax exemption of 95% for both corporate income tax and trade tax purposes. The tax exemption for trade tax purposes follows a relatively complex approach. Generally, dividends are deducted from the tax base by way of specific abatement if certain prerequisites are fulfilled. However, the initial amount for the trade tax base is the income determined for corporate income tax purposes. In case of a stand-alone company, the 95% dividend income exemption for the determination of this income is already factored in. Therefore, for trade tax purposes, no (further) abatement occurs.

Within a fiscal unity the income determination for corporate income tax purposes takes place individually at the level of each entity of the group, but the dividend income tax exemption is (cumulatively) applied at the level of the parent. Hence, at subsidiary level the dividend income is fully included in the initial trade tax base. Therefore, on 17 December 2014 the Federal Tax Court decided that dividend income is to be fully deducted from the trade tax base; hence, no 5% add-back for non-deductible items is to be made for trade tax purposes. As a result, dividends can be derived in a fiscal unity with an effective tax rate of approximately 0.8% (as opposed to 1.6% – depending on the trade tax multiplier applied by the municipality where the recipient's residence is situated). Bearing the high amounts at stake, this (albeit small) tax reduction has formed an interesting planning tool for multinational companies.

Again, the German legislator did not like the outcome of the court proceeding. The draft act therefore includes a change of the German Trade Tax Act in order to also subject the dividend income derived by a fiscal unity subsidiary to the 5% add-back. The rules are difficult to read and lack clarity as to their concrete scope and mechanics. Therefore, the Upper House requested that the respective rules be redrafted. Nonetheless, the German legislator's goal remains unchanged: that in the future it should no longer be possible to benefit from the trade tax loophole for dividends received by a fiscal unity subsidiary. In order to achieve a similar trade tax benefit, other structuring alternatives will need to be chosen.

The German tax laws, inter alia, contain a unilateral switch-over clause relevant for DTT cases where, under the provisions of the treaty, German income is to be exempted from tax but – due to a different interpretation of the respective DTT – in the source country likewise is tax exempt or taxable at a reduced tax rate only. In these cases of qualification conflict, the laws prescribe, by way of treaty overriding, that the exemption method be replaced by the credit method in order to avoid double taxation.

The German tax authorities used to hold the view that this switch-over ought to apply if the entire income was subject to the qualification conflict, but also if only items of the income remained untaxed or taxed at a low rate. However, in two recent decisions (both dated 20 May 2015) the Federal Tax Court refused to apply the switch-over to items of income only.

In order to counter these decisions, the draft act includes a clarification that the switch-over clause applies even if only parts/items of the income are not subject to tax or subject to a low tax in the source country. The same is supposed to apply to switch-over clauses provided in DTTs.

As mentioned above, Germany follows a specific taxation concept for partnerships; business expenses of a partner may, under certain circumstances, be deductible at partnership level. This fact has often been used for German inbound planning in order to create deductions without inclusions in a foreign country or double deductions. In its reply to the draft act presented by the Lower House, the Upper House included a draft rule aiming at a prevention of double deduction situations. In view of the recently proposed adjustment of the European Anti-Tax Avoidance Directive (ATAD) it is not clear whether this rule will actually be included in the final tax act. Furthermore, given the limited scope of the draft rule, there appears to be sufficient leeway to identify structuring approaches not affected by it.

Finally, the Upper House included in its recommendations that a further tax event be incorporated into German tax laws covering any capital gain in case of a disposal by a non-German taxpayer of shares in a German company that predominately (more than 50%) owns domestic real property. This proposal is in line with an according allocation of taxation rights under the DTTs recently concluded by Germany, and is in line with the OECD model tax treaty. Historically, Germany's domestic tax laws lacked the taxation of such gains with the result that the allocation of taxation rights under an according DTT was without effect.

In the future, therefore, foreign taxpayers investing directly or indirectly in German companies which own real property should bear in mind that German taxes might be triggered in case of a disposal. While corporate investors should benefit from a tax exemption of (effectively) 95%, the remaining 5% may be subject to German tax. It should be considered to structure the investment in a way to avoid that the 50% threshold is passed.

As mentioned, the draft act constitutes a first step of the German tax legislator towards implementation of the BEPS Actions into German domestic tax law. It is quite clear that the draft act covers only a part of the measures proposed by the OECD. In particular, the European ATAD and its implementation into local laws will play a significant role on the further development of the German tax law. While many measures included in the ATAD are already generally covered by the German tax laws, an incorporation of anti-hybrid mismatch rules will be a particularly important additional measure. German tax laws continue to be on the move.

Claus Jochimsen DLA Piper Tel. +49 89 2323 72 190 Email: claus.jochimsen@dlapiper.com Claus Jochimsen is a tax principal and leader of the German tax group at DLA Piper in Germany. He has a broad experience in international tax projects, in particular in planning and implementation of cross-border reorganisations. He advises international clients (both German and foreign headquartered) with respect to their inbound and outbound investments. Claus studied economics at the Freie Universität in Berlin and was on a tour of duty in the US from 2004 to 2006, based in New York. He is a frequent author and speaker on various matters related to German and international taxation.

Christoph Imschweiler DLA Piper Tel. +49 89 2323 72 194 Email: christoph.imschweiler@dlapiper.com Christoph Imschweiler is a tax counsel in DLA Piper´s Tax Practice. He has broad experience in international M&A tax projects, in particular in tax due diligence and international tax structuring projects as well as cross border reorganization and refinancing projects. He advises Private Equity Clients as well as large Corporate Clients on international M&A tax projects. Christoph studied law at the University of Passau and Munich. He holds a doctor degree in law and qualifies as a certified tax lawyer and certified tax accountant. Christoph was on a tour of duty in UK in 2011, based in London. He is a frequent author on German and international taxation matters.