When it comes to corporate tax planning in Germany, the focus of multinationals has clearly shifted from offensive (or even aggressive) tax structuring to more robust structures and the reduction of risks and exposures (good corporate tax citizenship). The international tax initiatives against harmful tax planning, such as the BEPS project, and in its wake the EU anti-tax avoidance directives, have certainly contributed to this development, but it is also owing to domestic tax authorities becoming increasingly inclined to commence criminal tax proceedings in regular tax audits. Last but not least, the idea of tax planning as harmful caught full public attention through LuxLeaks and Panama Papers. As a result, multinationals must increasingly consider the reputational implications of their tax structures.
This chapter initially describes the general principles of corporate taxation and corporate tax planning in Germany (see Section II). The next section outlines some of the most important tax-planning developments in the German domestic market, such as the repatriation of German-sourced profits and the taxation of corporations holding German real estate (see Section III). Section IV deals with the status of German answers to international tax developments such as the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (MLI), the taxation of the digital economy and reporting obligations for cross-border tax planning. The chapter concludes with an outlook on what will likely be forthcoming hot topics.
II CORPORATE TAX PLANNING IN GERMANY
Corporate tax planning in Germany must necessarily take into account German corporate income taxation, and to an increasing extent German trade taxes as well, since after the reduction of the corporate income tax rate to 15 per cent in 2008, the overall tax burden is usually (depending on the local trade tax multiplier) almost equally split between corporate income and trade taxes. In structures involving German-situs real property, the German real estate transfer tax also requires careful attention.
i German corporate income taxes
For German tax purposes, a corporation that has either its seat or its place of management in Germany is subject to unlimited liability to corporate income tax as provided for in the German Corporate Income Tax Act, which in principle applies to its worldwide income (subject to limitations that Germany may have agreed on with respect to certain types of non-German source income in an applicable double tax treaty). Germany has applied a 'classical' corporate income tax system, pursuant to which corporate income tax is levied at the level of the corporation in combination with a preferential tax treatment for dividends and capital gains from the disposition of shares in a corporation at shareholder level. The corporate income tax rate amounts to 15 per cent (plus 5.5 per cent solidarity tax, resulting in an aggregate rate of 15.825 per cent). This rate applies both to resident and non-resident corporations to the extent their income is subject to German tax by assessment; for instance, to income derived through a German permanent establishment of a non-resident corporation.
Dividends received from German and non-German corporations are generally exempt from corporate income tax in the hands of a German corporation or a non-German corporation that holds the relevant shares as part of the assets of a permanent establishment maintained in Germany. This requires, among other things, that at the beginning of the calendar year the shareholding amounted to at least 10 per cent in the share capital of the distributing corporation (special rules apply to participations of at least 10 per cent that are acquired in the course of a calendar year). However, 5 per cent of any dividends received are deemed to constitute a non-deductible expense so that, as a consequence, only 95 per cent of any dividends received are exempt from corporate income tax.
Similar to a dividend received, capital gains from the disposition of shares in a German or non-German corporation are exempt from German tax in the hands of a German corporation, or in the hands of a non-German corporation holding the relevant shares as part of the business property of a permanent establishment maintained in Germany. In this case too, 5 per cent of any such capital gains are deemed to constitute a non-deductible expense so that only 95 per cent of capital gains from the disposal of shares are exempt from corporate income tax. However, unlike the tax exemption applying to dividends received, the exemption from corporate income tax applying to capital gains from the disposal of shares does not hinge on the selling corporate shareholder holding a minimum participation in the equity of the corporation whose shares are sold. Capital losses from the disposition of shares are not deductible. Similarly, no deduction is allowed for a write-down on account of a depreciation in value of shares in corporations.
Dividends distributed are subject to a dividend withholding tax at a rate of 25 per cent (plus solidarity tax at 5.5 per cent thereon, resulting in a total withholding of 26.375 per cent). German-resident shareholders and non-residents who hold the relevant shares as part of the business property of a German trade or business are entitled to a refundable credit of such tax against their final tax liability determined by assessment. A non-resident corporation can request a refund of two-fifths of the taxes withheld under German domestic rules. In addition, non-residents may further be entitled to a full or partial refund under an applicable double tax treaty or the EU Parent-Subsidiary Directive. All refunds are subject to rather strict substance requirements, which recently came under scrutiny in light of their compliance with the fundamental freedoms under the Treaty on the Functioning of the European Union (TFEU).
To limit the deductibility of interest, Germany applies broad and highly complex interest-stripping rules. These rules apply to the deductibility of any interest payments made by a German-resident borrower to any related or unrelated recipient resident within or outside of Germany. Besides limiting the deduction of interest from the German interest payer's corporate income tax base, they may also affect the deductibility of debt interest from its trade tax base. Under the interest-stripping rules, deductions for interest payments are, in principle, subject to a cap at 30 per cent of the EBITDA (as adjusted for tax purposes) of the borrower. By way of exception, the interest-stripping rules do not apply if the net interest payment amount (interest paid minus interest received) remains below €3 million for the tax year (de minimis exception), if the German interest payer is a stand-alone company – i.e., it cannot be included in a consolidated financial statement prepared in accordance with IFRS principles (stand-alone exception) – and if the debt-financed entity can prove that its equity ratio as per the last balance sheet date was better or no worse than by 2 per cent compared to the equity ratio of the entire group (escape clause). Where none of the above exceptions apply, net interest paid in excess of the cap amount of 30 per cent of the borrower's EBITDA (as adjusted for tax purposes) is disallowed in the current year, but can be carried forward indefinitely to subsequent tax years (subject to restrictions that apply in the case of detrimental transfers of shares in which interest carry-forwards – as loss carry-forwards – fully or partially cease to exist). The same limitations apply in the carry-over year.
ii German trade taxes
A corporation with business activities in Germany is also subject to trade tax, a business tax whose revenue accrues to those local municipalities in Germany where the corporation maintains a permanent establishment. The tax is based on business income. The basis for the trade tax is the net income determined for corporate income tax purposes plus certain additions and minus certain deductions. This is intended to create steadier flows of trade taxes to the local municipalities, but actually makes the system rather complex and inconsistent. For instance, an add-back to the tax base would be required under the following circumstances. After applying the interest-stripping rules for corporate income tax purposes there will likely be amounts of interest that remain currently deductible. For purposes of computing the corporation's trade tax base, that remaining amount will also generally qualify as deductible. However, 25 per cent of any such interest will have to be added back to the trade tax base (i.e., it will not be deductible for trade tax purposes). This constitutes a definitive disallowance. For trade tax purposes, the disallowed interest amount is also not eligible for a carry-forward to subsequent tax years. Similarly, the 95 per cent exclusion for dividends received would generally not be allowable for trade tax purposes and 95 per cent of the dividend amount received would therefore be added back to the trade tax base. Only where the corporation derives the dividends from a 15 per cent or greater stake in the dividend-paying corporation (which deviates in various instances from the relevant 10 per cent threshold for corporate income tax purposes), the add-back is reversed (participation exemption for trade tax purposes). In the case of dividends paid by an EU corporation, a 10 per cent or greater stake qualifies for the participation exemption.
The basic trade tax rates are set by federal statutes and the 'local multiplier' is determined by the municipality and applied to the basic rate. As it is up to the municipalities to determine the local multiplier, no uniform rates exist. Effective rates for trade tax range from approximately 7 per cent to 17 per cent. Trade tax cannot be deducted from its own tax base or for corporate income tax purposes.
iii German real estate transfer tax
German real estate transfer tax (RETT) is imposed on all transactions with the purpose or effect of transferring title to German real estate (the term includes land, buildings, and inheritable building rights). The rates range from 3.5 per cent to 6.5 per cent depending on which state is in charge of levying the tax. The tax is also assessed when 95 per cent or more of the shares in a German or foreign corporation owning German-situs real estate are transferred to one acquiror, or when a shareholder owning less than all of the shares of such corporation subsequently acquires enough shares to bring his or her participation to 95 per cent or more. There is ongoing discussion as to whether this threshold should be reduced to, for example, 90 per cent, as suggested by proposed legislation. The tax is generally levied on the consideration for the transfer. Where there is no consideration, a consideration cannot be ascertained or there is a deemed transfer (which includes the transfer of 95 per cent of the shares to one person), the tax is levied on the tax value of the real estate, which, as a rule of thumb, is usually lower than the market value. Transferor and transferee are jointly and severally liable for the tax. However, in the case of the aggregation of 95 per cent or more of the shares in a corporation, only the person acquiring such shares is liable for the payment of the tax.
III RECENT LOCAL DEVELOPMENTS
The tax-efficient repatriation of German-source profits should benefit from recent decisions by the European Court of Justice (ECJ) on German substance requirements. With respect to transfer pricing, the ECJ again stressed that taxpayers must be provided with a fair chance to prove sound economic reasons for arrangements deviating from arm's-length terms in the case of corrections that apply in cross-border situations only. In both instances, it is, however, yet unclear how German tax authorities and the German legislator will react. Recent changes to the taxation of non-domestic corporations holding German real estate should be taken into account, but should ultimately not materially affect corporate tax planning.
i Tax-efficient repatriation of German-source profits
When it comes to inbound tax planning (i.e., investments by a non-German investor into Germany), one of the major tax-planning considerations is usually the tax-efficient repatriation of German-source earnings and profits. Often, such repatriation is structured through the disposal of shares in the German top holding company by the non-German investor, since such capital gains are tax-exempt under either German domestic rules (and not even subject to the 5 per cent claw-back taxation if the seller does not have a permanent establishment in Germany, as recently confirmed by the German Federal Fiscal Court) or an applicable double tax treaty. Such capital gains are also not subject to withholding taxes in Germany. Besides the disposal of shares to a third person, such beneficial capital gains treatment can also be achieved by way of share buy-backs that may often economically substitute a dividend distribution.
Dividend distributions are often not the preferred route for the repatriation of earnings and profits from German inbound investments, as such distributions are generally subject to German withholding taxes (WHT) amounting to 25 per cent, plus solidarity surcharge of 5.5 per cent thereof (i.e., effectively 26.375 per cent). WHT can be reduced to 15 per cent under domestic provisions, or lower or even to zero under an applicable double tax treaty or the EU Parent-Subsidiary Directive. To tackle abusive tax structuring on the basis of these reductions of WHT (treaty or directive shopping), the German legislator introduced quite harsh anti-abuse and substance requirements (Section 50d paragraph 3 of the German Income Tax Act). The provision excludes the reductions from WHT if, among other things, the ultimate parent would not qualify for the treaty or directive benefits and the interposed recipient of the dividend distribution was either not established for sound economic reasons or does not engage in general economic activities with sufficient substance (the German substance requirements). While tackling abusive treaty or directive shopping is obviously legitimate, the German substance requirements were discussed in a highly controversial manner owing to their broad scope, vague requirements, and because they raise concerns under EU and treaty law as they necessarily apply in cross-border situations only, and there is no equivalent provision for distributions to a domestic recipient.
Recently, the ECJ held in two sensational (but, in light of the dispute outlined above, not necessarily surprising) decisions that the German substance requirements violate EU law.2 Both decisions concerned dividend recipients who were resident in an EU Member State and held a controlling stake. Consequently, the ECJ applied the freedom of establishment as guaranteed under Article 49 TFEU, which is the ECJ's freedom of first choice (over the free movement of capital) when it comes to a controlling participation (whatever that means) of an EU (or EEA) Member State shareholder in a corporation residing in another EU Member State. The freedom of establishment is, however, limited to EU cases only whereas the free movement of capital according to Article 63 TFEU includes investments by third-country investors as well.
Against this background, will the ECJ hold the German substance requirements in violation of EU law in case of a third-country (i.e., non-EU or EEA) investor that would be tested under the free movement of capital? The answer should clearly be yes. The ECJ confirmed its previous jurisprudence, according to which generally both fundamental freedoms are applicable on the German substance requirements. The freedom of establishment blocks the application of free movement of capital (and hence excludes third-country cases from protection under EU law) only if the domestic provision that constitutes the unequal treatment or the limitation requires a controlling stake. The German substance requirements, however, do not impose such requirements. Benefits granted under the EU Parent-Subsidiary Directive or under an applicable double tax treaty may require a certain participation (e.g., 10 per cent), but this is clearly below what the ECJ considers as a controlling stake. Even if the ECJ's view on this is not entirely clear, control can hardly be established below 25 per cent and clearly not with a 10 per cent stake.
As a result, the German substance requirements should no longer be applicable to third-country investors so that the repatriation of profits by way of German-source dividends is less burdensome. However, the German tax authorities have so far taken, not surprisingly, a different, narrower view. In April 2018, the German Federal Ministry of Finance issued guidelines on the further application of the German substance requirements in light of the first decision of the ECJ (Deister/Juhler). It remains to be seen how tax authorities and the German legislator will react on the second ECJ decision. German tax courts must apply the jurisprudence of the ECJ and can do so based on the acte clair doctrine in third-country cases.
In the context of a tax-efficient repatriation of German dividends, it should also be noted that the German Federal Fiscal Court recently held3 that dividends that are received through a German partnership (which can even be a low-substance partnership with deemed trading activity) will be subject to tax assessment, which effectively means that WHT are refundable at the level of the partnership assessment. This refund by assessment would not be subject to German substance requirements (even if still applicable). While this obviously provides for tax-planning opportunities, the structures should be carefully planned and monitored as the refund by assessment requires that the shares in the distributing corporation can be attributed to the partnership, which might be challenged in case of a low-substance partnership.
ii Transfer pricing
German tax laws apply the arm's-length principle in quite a strict sense. The ECJ had to decide a case in which a German corporation issued a letter of comfort for its two Dutch subsidiaries and the German tax authorities increased the corporation's income in the amount of a deemed consideration for such letter of comfort in accordance with arm's-length principles. While the ECJ held the relevant provision in line with fundamental freedoms, the court also stressed the fact that a taxpayer must be given a fair chance to provide economic reasons that may justify arrangements that are not at arm's length. German tax authorities, however, apply the decision in an extremely narrow sense (i.e., only in distressed situations). Any other intra-group financial assistance a German corporation provides to its foreign subsidiaries is still under scrutiny if the parent, even for sound economic reasons, provides such assistance on a free-of-charge basis.
The case decided by the ECJ4 concerned Hornbach-Baumarkt, a German-resident stock corporation holding, inter alia, a 100 per cent stake in two Dutch companies. Hornbach had guaranteed the repayment of a third-party bank loan that had been taken out by the Dutch subsidiaries, but did not charge them any remuneration for the guarantee. The tax authorities therefore increased Hornbach's income in accordance with Section 1 paragraphs 1 and 4 of the German Foreign Tax Act by a deemed remuneration for such guarantee in accordance with arm's-length principles. In the subsequent proceedings, the regional fiscal court5 referred the question to the ECJ as to whether Section 1 paragraphs 1 and 4 of the German Foreign Tax Act complies with EU law. The regional fiscal court considered Article 49 TFEU (freedom of establishment) violated because the relevant provisions do not allow the taxpayer to prove that the terms and conditions had been agreed on for valid economic reasons.
The ECJ first stated that a national provision, such as Section 1 paragraphs 1 and 4 of the German Foreign Tax Act that seeks to prevent the transfer of profits realised in an EU Member State to another jurisdiction without being subject to taxation is appropriate to secure the balanced allocation of the power to tax between the EU Member States. The Court then addressed the question whether the taxpayer must be allowed to prove valid economic reasons for such a transfer of profits. The regional fiscal court had originally asked for clarification if the mere interconnections between the parent company established in the concerned EU Member State and its subsidiaries established in another Member State can represent such economic reasons. The ECJ, however, focused on the fact that the Dutch companies had negative equity and that the financing bank had demanded the guarantees by Hornbach for loans that were necessary for the continuation and expansion of the business operations of the Dutch companies. The Court concluded that in such situations of need for additional equity there may be commercial reasons for a parent company to agree to provide capital on non-arm's length terms. The judgment clearly demands a possibility for the taxpayer to prove valid economic reasons, as domestic provisions without such possibility must be considered incompatible with EU law. Furthermore, it seems to result from the ECJ's reasoning that at the same time such proof of valid economic reasons must not be subject to excessive requirements.
Following the decision of the ECJ, the German Federal Ministry of Finance issued a decree limiting such valid economic reasons to distressed situations only – namely measures taken by the company to preserve the existence of the group or persons related to the taxpayer, especially to prevent insolvency. On the one hand, this guideline provides certainty for the taxpayers as it refers to terms known in German tax law, jurisdiction and literature.6 On the other hand, the tax administration limits the possibility to prove economic reasons to said insolvency cases. All other cases of intra-group support regarding the financing of subsidiaries without a liability remuneration remain unclear.
iii Third-party transactions
In respect of third-party transactions, the German legislator has recently focused very much on non-domestic corporations holding German real estate. While most of the relevant German double tax treaties would allow Germany to tax the gains from the disposal of the shares in such foreign corporations holding predominantly German real estate, Germany has until recently not taxed these profits according to a limited scope of its domestic tax provisions. Germany has now closed that loophole. The practical impact on corporate tax planning is nevertheless limited. Such profits are usually still tax-exempt in Germany and even a taxation of 5 per cent of the profits under the German participation exemption will usually not apply, according to very recent jurisprudence of the German Federal Fiscal Court.
IV INTERNATIONAL DEVELOPMENTS AND LOCAL RESPONSES
Germany will implement the MLI in a limited fashion and its practical impact on international corporate tax planning remains to be seen.
Any adviser on international corporate tax planning with a German or more general EU nexus (i.e., an intermediary) has to deal with the mandatory reporting requirements under the amended EU Directive. While the rules enter into effect in mid-2020 and Germany has recently only published preliminary draft legislation (which is expected to be further amended), any intermediary must already be aware enough of the reporting requirements to at least be prepared and anticipate the new rules in terms of documentation and collection of information to be reported.
While there are not yet concrete proposals on what is referred to as the taxation of the digital economy, German tax authorities are increasing efforts on tax audits performed jointly with the tax authorities of other countries when it comes to multinational companies.
i Implications of the MLI in Germany
The MLI was signed by Germany on 7 June 2017. However, signing the MLI does not directly amend double tax treaties. Instead, such a change requires (1) national ratification of the MLI and (2) a congruent selection of changes to the double tax treaty by both jurisdictions involved.
Germany has named only 35 of 90 possible German double tax treaties to be amended via the MLI and will implement only a few points of the MLI. The reduced number of treaties chosen is mainly because Germany is currently revising double tax treaties with more than 30 states. Germany plans not to implement rules addressing hybrid mismatches, and to implement only Action 7 with regard to the proposals for permanent establishments. To tackle treaty abuse, Germany will implement the principal purpose test, but will not introduce limitation-of-benefit clauses. However, Germany will implement amendments to:
- Article 10 paragraph 2 and Article 13 paragraph 4 of the OECD Model Agreement for double tax treaties;
- permanent establishments in third countries; and
- rules for dispute resolution and compulsory arbitration.
ii EU proposals for mandatory reporting of tax planning
On 5 June 2018, amendments to the Directive on Mutual Administrative Assistance 2011/16/EU were finally issued, according to which intermediaries, who help taxpayers set up cross-border arrangements (which include in particular advisers on international corporate tax planning), are obliged to report this arrangement to the tax authorities of their country within quite a strict time frame. An arrangement must be notified if one of the characteristics of Annex IV to the Directive is fulfilled. Annex IV further distinguishes between a Main Benefit Test and specific Hallmarks that shall indicate a tax benefit (either in connection with the Main Benefit Test or on their own). Regardless of the details of the provisions, it is questionable how such a mandatory reporting can adequately be implemented in jurisdictions without precedence for reporting standards to tax authorities (such as Germany).
Germany is obliged to implement the changes by 31 December 2019 and proposed legislation was published already in September 2018, which is now being discussed both inside and outside the parliament.
From the perspective of intermediaries, who must fulfill the relevant reporting obligations in the very near future, the main expectations are: (1) that the new legislation on the mandatory reporting of cross-border arrangements will provide guidelines as precise and practicable as possible (in particular, on non-reportable standard tax planning); (2) that the deadline for making such reporting will be more generous than the suggested 30 days; and (3) that German lawmakers will not go beyond what must be implemented according to the amended Directive.
iii EU proposals on taxation of the digital economy
So far, the German Federal Ministry of Finance has not provided draft legislation to implement the European Commission's proposals on taxation of the digital economy. However, German commentators are already voicing concerns regarding the European proposals, focusing especially on a possible double taxation of income by the Digital Services Tax (DST) and value added tax, as well as by DST and corporate income tax. Such double taxation can arise because the proposed directives themselves do not provide exemption or deduction rules.
iv Joint tax audits
The German tax authorities are increasing efforts to realise more and more joint tax audits (i.e., tax audits involving two jurisdictions carried out on the premises of multinational companies). So far, around 70 joint tax audits with German involvement have taken place. While such coordinated, cross-border tax assessments can offer advantages to the taxpayers (such as avoidance of double taxation and certainty for future tax planning in general), many aspects still await clarification. Nevertheless, the growing number of (unsolved) mutual agreement procedures, especially pending in Germany, underlines the necessity for alternative dispute resolution approaches. Joint tax audits may offer such alternative ways to deal with international double taxation.
V OUTLOOK AND CONCLUSIONS
It should be expected that the requirements for a tax-efficient repatriation of profits from Germany into the investor's jurisdiction will remain in focus and be subject to proposed legislation in the near future.
Share deals involving German-situs real property might be subject to amended provisions as well. The German legislator plans to expand the German RETT regime by lowering the threshold for harmful shareholdings in the company with the real estate from 95 per cent to 90 per cent, prolonging the holding periods from five to 10 years, and introducing a new provision regarding the transfer of shares in corporations that so far were not subject to German RETT. Whether the German lawmakers will in fact implement the proposed tightening of the taxation of real estate transfers is unclear. If the amendments become effective as proposed, the impact on corporate tax planning involving German real estate would be substantial.
In respect of international tax developments, the mandatory reporting requirements for cross-border arrangements is probably the hottest topic. The tax-planning community in Germany is excited to see how the German legislator will implement the respective EU Directive.
Another major topic in 2019 will very likely be changes to the German rules on controlled foreign companies based on Sections 7 to 14 of the German Foreign Tax Act (add-back taxation). It is expected that this will result in stricter rules for foreign licensing companies, holding companies, and purchasing and distribution companies.
1 Markus Ernst is a tax counsel at Hengeler Mueller. The author would like to thank Isabella Zimmerl for her assistance.
2 See ECJ of 20 December 2017, C-504/16, C-613/16 – Deister/Juhler Holding; ECJ of 14 June 2018, C-440/17 – GS.
3 BFH of 29 November 2017, docket no. I R 58/15.
4 ECJ of 31 May 2018, C-382/16 – Hornbach-Baumarkt.
5 Fiscal Court of Rheinland-Pfalz of 28 June 2016, docket No. 1 K 1472/13.
6 See especially Section 3a para. 2 German Income Tax Act and Section 8c para. 1a German Corporate Tax Act.