In its 2013 "Action Plan on Base Erosion and Profit Shifting", the OECD clearly states that more and more sophisticated tax planning and legal arbitrage opportunities "have opened up opportunities to MNEs to greatly minimise their tax burden".
Furthermore, rules on international taxation have revealed certain weaknesses that create opportunities for BEPS. In certain cases, the interaction of domestic tax rules in connection with bilateral treaties leads to gaps and frictions.
Whereas it is principally acknowledged that the aim of a fair allocation of tax revenues, in the case of multinational groups, can only be achieved by a joint effort of the community of states, individual jurisdictions have started to close the most obvious loopholes.
The following sections will give an overview on recent measures implemented by German tax legislation in light of the above discussions. Particularly in the case of outbound investments by German based investors, the new regulations may have a significant cash tax impact as regards the flow of funds and the repatriation of capital.
Taxation of minority shareholders
As already announced in last year's volume, Germany has introduced a special regime with regards to the taxation on dividends received by so called "minority shareholders". In contrast to the generally accepted affiliation privilege, under which dividends received by a German resident corporation from a domestic or foreign corporation are principally tax exempted, this principle no longer holds true for minority shareholders.
Since March 1 2013, dividends from minority shareholdings qualify as taxable income at the level of domestic investors as well. In this context, minority shareholdings that are less than 10% at the beginning of the calendar year are defined as investments in a German corporation. Any acquisition of a 10% stake during the calendar year is treated as having taken place from the beginning of that calendar year. Under discussion is whether an add-on acquisition during the year of less than 10%, but leading to a shareholding of 10% or more in total, is also subject to the exemption rules. In case of a disposal of shares during the calendar year, leading to a shareholding of less than 10%, the dividend received in that year is still tax exempt.
Shares in a corporation, which are held via an investment fund/asset pool (Investmentvermögen) are deemed to be held directly (pro rata) by the owner of the fund share. In this respect, the exemption rules do not apply to public investment funds (Publikums-Investmentvermögen). However, as regards special investment funds (Spezial-Sondervermögen) and special investment corporations (Spezial-Investmentaktiengesellschaften), an exemption is still possible if certain requirements are met.
Particularly important for private equity and other investors is the 95% tax exemption on the disposal of shares in German corporations, which the conciliation committee agreed upon for foreign and domestic minority shareholders. Further, any costs in connection with the dividend received by minority shareholders are tax deductible.
With regards to M&A and private equity, the following shareholders in certain structures are affected: management participations, minority shareholders participating in a fiscal unity subsidiary and in old RETT-blocker models.
The regulation is currently only applicable to dividend distributions. It is likely that the application of the rule might be extended to capital gains resulting from a sale of shares in the future.
To receive a trade tax exemption for the dividend distribution as well, a minimum shareholding of 15% at the beginning of the calendar year is required. The 10% shareholding threshold which is necessary to avoid the corporate income tax is not sufficient for trade tax purposes.
Implementation of the correspondence principle for hybrid financing structures
The German Corporate Income Tax Act already included a corresponding taxation for hidden dividend distributions. Since the 2014 assessment period, the regulation has been extended towards all earnings resulting from (ordinary/hidden) dividend distributions or comparable payments. In particular, payments resulting from mezzanine financing are now included within the scope of the regulation to avoid so-called "white income". Thus, the 95% tax-exemption of dividend payments is only applicable to the extent that these payments are not deductible at the level of the distributing company. Since private equity acquisition structures in particular (but also other M&A structures) are often routed via Luxembourg where hybrid financing instruments are issued, this new regulation is of major importance for M&A deals. Other financing structures that are affected by the corresponding principle are typical and atypical silent partnerships, jouissance/participation rights as well as warrant-linked or convertible bonds.
Further, the exemption for shareholdings of less than 10% has to be considered (reference is made to above).
A corporation which is incorporated in Germany holds a 50% stake in a Luxembourg corporation. The Luxembourg corporation pays €100,000 ($1.4 million) towards the German company. The payment is, from a German tax point of view, qualified as dividend and would therefore generally be subject to the 95% tax-exemption for corporate income tax purposes. From a Luxembourg tax point of view, the payment is qualified as interest payment which is deductible for tax purposes at the level of the Luxembourg company. Without the extension of the material correspondence principle, the respective payment would not be subject to any taxes – neither in Luxembourg nor in Germany (exempt to 5% which is subject to corporate income tax). With the extension of the material correspondence principle, the 95% tax-exemption in Germany will be denied to avoid "white income".
The extension of subject to tax clauses in German treaty policy
The Federal Republic of Germany has concluded some 90 double taxation treaties, the majority of which provide for subject to tax, fall-back or remittance-base clauses. The problem of these policies is that neither the systematic approach nor the wording of these clauses is consistent in each treaty. As a consequence, there was a long history of decisions ruled by the highest federal tax court to interpret these clauses in the context of various different treaties. In fact also this diction in itself was not consistent but changed from time to time.
To overcome these deficiencies and to provide for security in applying the respective clauses, the German Ministry of Finance issued a decree as of July 2013, the aim of which is to clarify the point of view of the German fiscal authorities as regards the interpretation of the respective clauses.
In the context of subject to tax clauses, one must differentiate between clauses that apply in the source country and clauses that apply in the country of residence. Furthermore, you will find respective regulations in the "Methods of Elimination Article" (Art. 23 of the OECD model treaty), as well as clauses in the respective income articles. Moreover, certain clauses are expressively defined as subject-to-tax clauses. Others, such as the protocol to the Italian German treaty, nearly define the term "income stemming from another country" as income that has been taxed in that respective state (so called "definition of source regulation").
The so-called "remittance-base-clauses" also apply to the above mechanism. Certain states –for example the UK – only tax the income of non-residents in cases such as when income is remitted to that state. German treaties provide for a fall-back clause in case the other state does not utililse their right of taxation which is granted under the treaty.
Switch over clauses
Germany is principally known to be a state that applies the exemption method as the preferred system to avoid double taxation in its treaties. However, an increasing number of treaties provide for a regulation under which this exemption method is replaced by the tax credit method. This especially applies to certain so called "passive incomes" and other activities not accepted by the German tax authorities.
Provisions under the new decree
By confirming the recent decision of the highest federal tax court, the decree states that all kinds of clauses described in the above outlined system qualify as effective subject-to-tax clauses. Thus, in case a taxpayer cannot prove that the respective income is effectively taxed in the other state, the right of taxation falls back to Germany. Only in cases where non-taxation in the other state is based on general exemption thresholds, compensation with existing tax losses, the application of a tax credit system or permanent as well as timing differences, such lack of taxation will not result in the reallocation of the taxation right to Germany. As a consequence, the following criterions particularly result in harmful non-taxation:
- the income is not taxable
- the income is tax exempt for personal or factual reasons
- the income is effectively not taxed due to release or waiver of taxation right
In addition, pursuant to the strict wording of the decree, the fact that the other state also has no knowledge with respect to such income and therefore does not impose taxes thereon would result in the application of this subject-to-tax clause.
The most dramatic change, however, that has been enacted via the above decree is a new interpretation of the term "income" by the German authorities. As a general rule that is also supported by the interpretation of the double taxation treaties, income has to be defined as the net amount stemming from gross income minus expenses. However, under the new interpretation, as stipulated in the decree, isolated gross income streams (such as dividends or licenses) that are not taxable under the foreign jurisdiction will also be subject to the tax clause. This is a fundamental change in light of the "net principle" (Nettoprinzip) that normally is respected under German tax law. In addition, it must be seen as a kind of treaty override. Two contracting states agree under a treaty that the income from permanent establishments is taxable in the PE state, whereas the other state grants a tax exemption on such income. Further, there is a mutual understanding that PE income is the remainder of income minus expenses. If one state applies the subject to tax clause to a certain income portion that – on an isolated basis – is tax exempt in the PE state, then this would violate the treaty.
A German corporation maintains a PE in another treaty country. This PE holds investments in various portfolio subsidiaries. PE generates a profit of 300 which is taxed at a regular rate in the PE state. From one of the companies PE receives a dividend of 100 which is tax exempt under the local holding privilege of the PE state. Germany would then apply its subject-to-tax clause and tax the dividend income of 100. Exemption is only granted to the remaining 200. In the case of a minority investment, taxation would be at the full German tax rate (see Chapter II).
The ridiculous impact of this scheme becomes evident, if it is assumed, that the PE makes a loss:
PE in Example 1 suffers a loss of 400 – including the income from the portfolio dividend. Also, in this case – where the foreign PE does not pay any tax due to an overall loss – Germany would tax the income element "dividend", since such income is tax exempt in the PE state.
It is evident that, especially in the case of German multi-tier outbound investments, this new interpretation may result in dramatic adverse tax implications.
Cash tax cost
Within the EU and the OECD there is a consensus that the community of states should jointly prevent aggressive tax planning and avoidance schemes that result in unfair allocation of income streams and misallocation of national tax revenues. However, isolated measures taken on a unilateral basis by one state bear the risk of jeopardising existing tax harmonisation. The above outlined regulations/decrees enacted by German legislators, not only repair certain inconsistencies, but go far beyond what should have been regulated. In addition, it partly qualifies as harmful treaty overriding and jeopardises the well-established affiliation principle originally implemented in German tax legislation. Especially for German based out-bound investments, the changes may impact the cash tax cost for certain income streams and cash repatriations.
Tel: +49 (0)40 6378 1363
Claus is leading the Hamburg M&A tax team of PwC and holds a part-time chair on international tax law at the University of Lüneburg.
He has more than 20 years' experience in advising on cross border M&A transactions as well as international reorganisation. In his role he serves a number of private equity houses as well as corporate investors on the buy side, and works on due diligence projects on the sell side. In addition he specialises in tax-efficient financing structures and post-deal integration projects.
Tel: +49 40 6378 1318
Alke Fiebig is a PwC M&A tax senior manager based in Hamburg. She is a certified tax adviser (steuerberater).
In 2001 Alke joined PwC. Since then her focus has been on advising financial and strategic investors in tax due diligences (buy side/sell side) and acquisition structuring as well as on corporate group taxation of multinational businesses and (cross-border) corporate restructurings. Further, Alke is specialised in management participation taxation matters.