On 13 October 2010 the Federal Fiscal Court held that a foreign subsidiary has a business organization equipped in a commercial manner within the meaning of the activity clause of Sec. 8 para. 1 no. 3 FTTA, even if the subsidiary’s insurance business is operated by another company based on a management agreement (outsourcing).
The ruling has a high degree of practical relevance not only for the FTTA, but also for other provisions — such as Sec. 42 General Tax Act (Abgabenordnung - GTA) and Sec. 50d para. 3 Income Tax Act (Einkommensteuergesetz — ITA) — setting minimum requirements for foreign companies with regard to their technical and human resources, as the ruling’s underlying principles should also be applicable to these rules.
The ruling was based on the following facts: A German insurance company (Plaintiff) established a subsidiary (Ltd.) in Ireland. With its income derived from entering into reinsurance agreements, the Ltd. was subject to a reduced income tax rate of 10 percent in Ireland. By way of a management agreement the Ltd. assigned all activities essential for the conduct of the reinsurance business to a subsidiary. This management company had fully equipped offices and was sufficiently staffed. The German tax authorities regarded the Ltd. as a controlled foreign company (CFC) within the meaning of Sec. 7 et seq. FTTA. Consequently, the Plaintiff’s income was subject to taxation as provided by Sec. 10 FTTA irrespective of dividend distributions by the Ltd.
In accordance with the fiscal court of first instance, the BFH held that the Ltd., despite being subject to a low rate of taxation, was no CFC within the meaning of Sec. 7 et seq. FTTA, as it derived active income from insurance business within the meaning of Sec. 8 para. 1 no. 3 FTTA. According to the BFH the Ltd. maintained a business organization equipped in a commercial manner irrespective of the Ltd.’s business activities being delegated under the management agreement.
A business organization equipped in a commercial manner does not require the insurance activity of the foreign subsidiary to be performed exclusively “on the market” by the foreign subsidiary itself. Moreover, in accordance with the general income tax rules — which are also decisive for the FTTA — the activities of the management company are attributable to the Ltd., since the Ltd. directly obtains rights from and is bound by all reinsurance contracts agreed by the management company.
In contrast, the fiscal authorities hold the view that a foreign subsidiary does not maintain a business organization equipped in a commercial manner within the meaning of Sec. 8 para. 1 no. 3 FTTA, if substantial business functions are delegated to another company. According to the tax authorities, outsourcing of substantial business functions shall be equally harmful in respect of the substance requirements provided by Sec. 50d para. 3 ITA and Sec. 42 GTA. It should be noted though, that this rigorous approach has been softened in recent publications by the tax authorities.
However, as the BFH assumes the foreign company’s business organization to be sufficiently equipped and staffed for the purposes of Sec. 8 para. 1 no. 3 FTTA even in cases of outsourcing, such construction should also be applicable with respect to Sec. 50d para. 3 ITA and Sec. 42 GTA, since the purposes of Sec. 7-14 FTTA, 50d para. 3 ITA and 42 GTA are comparable: All these rules aim at preventing foreign companies lacking sufficient business activities and substance from being abusively interposed in order to benefit from tax advantages.
The aforesaid ruling can be viewed as indication for the treatment of outsourcing for the purposes of Sec. 50 d para. 3 ITA — at least as far as companies situated in the European Union (EU) are concerned. Under the Annual Tax Act 2007 the legislator introduced Sec. 50d para. 3 sent. 3 ITA stating explicitly that the delegation of substantial business activities to third parties is not recognized as own business activity of the foreign subsidiary for purposes of the substance requirements of Sec. 50d para. 3 ITA. However, with a view to the case law of the European Court of Justice (see ruling dated 12 September 2006, C-196/04 Cadbury Schweppes) there are serious doubts about the compliance of this new rule with EU Law, as Sec. 50d para. 3 sent. 3 ITA does not allow for proof of the contrary. Similarly, the Federal Fiscal Court stated in its ruling, that a rule of law would violate the freedom of establishment under the EU Treaty, if it would deny a company an “activity” under the circumstances provided by the case in dispute. The German legislator will have to consider this view, as they did with respect to the European Court of Justice’s ruling in the Cadbury Schweppes case by introducing Sec. 8 para. 2 FTTA in order to comply with this ruling.