With a circular dated 22 October 2010 (DStR 2011, p. 175), the Regional Tax Office (Oberfinanzdirektion, OFD) Rhineland issued a short note in which it gave its opinion on the implications of the judgment of the Federal Fiscal Court (Bundesfinanzhof, BFH) dated 21 October 2009 (I R 114/08) regarding the application of double tax treaties (DTT) to income arising from a foreign permanent establishment (and to business assets of a foreign permanent establishment) under the switch-over clause of Sec. 20 (2) and (3) German Foreign Tax Act (GFTA) (old version).
Sec. 20 (2) GFTA (old version) contained a so-called switch-over clause under which the double taxation of income arising from the foreign permanent establishment of a resident taxpayer, deviating from the respective provision of the applicable DTT, shall be avoided by offsetting the foreign taxes levied on that income rather than by way of exemption. A prerequisite for this is that the income concerned would be subject to tax as controlled foreign corporation (CFC) income pursuant to Sec. 7 GFTA et seq. (old version) if the permanent establishment were a foreign corporation. Thus, Sec. 20 (2) GFTA (old version) is linked to the prerequisites of Sec. 7 GFTA et. seq. and, therefore, requires that the income qualifies as passive income and is subject to low taxation (corporate income tax burden of below 25%).
In the aforementioned judgment the BFH decided implicitly that the German CFC rules are not in line with EU law and, thus, in order to preserve its validity have to be construed in light of the EU law to the effect that they do not apply if the taxpayer is able to demonstrate that the foreign company is actually established and carries out genuine economic activities (so-called motive test). In addition, the BFH ruled that, due to the linkage to Sec. 7 GFTA (old version) et seq., Sec. 20 (2) GFTA (old version) should not apply in cases where a CFC taxation is not possible by virtue of the taxpayer passing the said motive test.
Since the European Court of Justice (ECJ) rendered its Cadbury Schweppes decision on 12 September 2006 (C-196/04), it had been obvious that the German CFC-rules (Sec. 7 GFTA (old version)) infringe EU law. Therefore, the German Federal Ministry of Finance (Bundesfinanzministerium, BMF) issued a circular in 2007 stipulating the motive test within the CFC taxation (circular dated 8 January 2007, IV B 4 – S 1351 – 1/07). Within the Annual Tax Act 2008, the legislator introduced Sec. 8 (2) GFTA (new version) which allows the taxpayer to show counter-evidence under certain conditions that the foreign company is actually established in its host state and carries on genuine economic activities there. However, at the same time, the legislator precluded such counter-evidence within the switchover clause (Sec. 20 (2) GFTA) since the ECJ decided in its Columbus Container Services decision dated 6 December 2006 (C-196/04) that a switch-over does not infringe EU law.
The OFD Rhineland now stated in its circular that for fiscal years beginning prior to 1 January 2008 the motive test for a foreign permanent establishment shall be based on the circular of the BMF dated 8 January 2007. However, for fiscal years beginning after 31 December 2007 the motive test of Sec. 8 (2) GFTA (new version) (so-called counterevidence) should be precluded within the application of Sec. 20 (2) GFTA (new version).
While, henceforth, the judgment of the BFH and its acceptance by the German tax authorities clarified that for fiscal years beginning prior to 1 January 2008 the switch-over clause is only applicable if the taxpayer fails the motive test, it is questionable whether the performance of the motive test shall be based exclusively on the respective circular of the BMF. This is because the circular imposes stricter requirements in several respects on the motive test than EU law, since, for instance, no counter-evidence is accepted with regard to income arising from a permanent establishment which is established outside the EU or with regard to special CFC income within the meaning of Sec. 7 (6) GFTA. Hence, taxpayers should scrutinize whether they could pass the – compared to the circular of the BMF – less stringent requirements for the motive test as imposed by the ECJ and invoke these, if need be. This holds true with respect to the CFC taxation pursuant to Sec. 7 GFTA (old version) et seq. as well as the switch-over clause of Sec. 20 (2) GFTA (old version).
With regard to CFC taxation, the same holds true for fiscal years beginning after 31 December 2007 since the requirements for counter-evidence pursuant to Sec. 8 (2) GFTA (new version) also go beyond the requirements of EU law regarding the motive test. Moreover, as to the switch-over clause it is currently not clear whether the legislator succeeded in effectively precluding the application of the motive test for foreign permanent establishments within the amended Sec. 20 (2) GFTA (new version). Also, the BFH indicated doubts in its aforementioned judgment in this respect. The taxpayer should therefore carefully consider keeping appropriate cases open.
As stated above, Sec. 8 (2) GFTA (new version) provides for a motive test in case of income of a foreign corporation. It is doubtful whether such test also applies to income generated through a foreign permanent establishment. Therefore, the use of a foreign corporation instead of a foreign permanent establishment might taxwise be preferable. More legal certainty can be achieved where the taxpayer is able to pass the motive test. Passing the motive test in case of the use of a foreign corporation means that the income of the foreign corporation is not subject to German taxation for corporate income and trade purposes.