On November 9, 2006, the German Parliament passed the Annual Tax Bill 2007. It includes a significant tightening of the substance and activity requirements for non-German companies seeking benefits under a double taxation convention or under an EU directive (for example, the Parent-Subsidiary Directive) with regard to withholding tax exemptions or reductions. The new version of the anti-treaty/directive shopping provision went into effect on January 1, 2007.
The regulation mainly affects interposed holding entities receiving dividends, interest or royalties from German companies. For example, in private equity transactions, many groups create Luxembourg companies (LuxCo) that hold shares in a German subsidiary. According to the anti-treaty/directive shopping provision, the foreign holding company may not partake of certain benefits of the treaty or directive.
The bill is the government’s reaction to a German Federal Fiscal Court decision of 2005 stating that, according to the previous anti-treaty/directive shopping provision, treaty shopping cannot be assumed if the foreign company meets either the trade or business test or the business-purpose test.
Criteria for the Assumption of Anti-Treaty/Directive Shopping
According to the bill, authorities may assume treaty/directive shopping if the shareholder of the non-German company would not be able to claim the benefits through direct investment, e.g., because the shareholder resides in a country with less favorable treaty provisions. One of the following three criteria must also be met:
- The interposition of the foreign (non-German) company cannot be justified on grounds of an economic (business) purpose or other significant non-tax driven reasons (so-called “trade or business test”).
- The foreign company has not set up a business establishment with sufficient substance to conduct its business (business assets such as office space, personnel, etc., or the so-called “business purpose test”).
- The foreign company receives no more than 10 percent of its gross income from its own economic activities. These “active” activities are assumed to be missing as far as the interposed entity generates its gross income from the pure administration of assets.
The 10-percent-threshold criterion raises many questions and concerns and will quite likely become a hot topic with the fiscal authorities. It appears even active business outsourced to a managing company would not count toward the 10 percent threshold, and the bill does not provide a clear-cut definition of the term “gross income.” How can a German company apply the correct withholding tax rate on current payments to its foreign holding as only at the end of the business year of the holding it can be determined whether the 10 percent threshold has been met?
Moreover, according to explanatory notes, the new provision is intended to prevent passive holding companies, even those with substance and compelling business reasons, from abusing treaty and directive benefits. However, even an active holding will regularly have no substantial income other than that from its holding activities, such as dividends, interest on shareholder loans, royalties from group companies and capital gains. Therefore, these types of income may be deemed “passive income” from the administration of assets.
All of these criteria are applied solely to the interposed foreign company itself. Organizational, economic and other characteristics of related entities should not be taken into account. The anti-treaty/directive shopping provision is not applicable if the stocks of the interposed company are regularly and considerably dealt on an acknowledged stock exchange.
Once the interposed company has been qualified as passive in the sense of the new provision, it does not necessarily help if the direct shareholder of the interposed company could claim the same treaty/directive benefits on its own, e.g., the shareholder of the interposed LuxCo is another LuxCo. Supposedly, authorities will look through to all indirect shareholders. If only one of them would not be entitled to the treaty/directive benefits through direct investment, the provision might be applied.
Because the differentiation between active holding companies and passive companies administering only their own assets is vague and might be even challenged by the jurisprudence of the European Court of Justice, a proper structuring of holding entities will become much more difficult to achieve than it is today.
A non-German company might pass the 10 percent threshold only if it is not restricted to typical active holding activities but runs a considerable separate business as well. However, there is a debate whether this can prevent the application of the new provision as the fiscal authorities might regard the operative business as pure alibi activities, or they might argue that holding activities must be distinguished from the operative business as they are not directly connected to them. However, it may be sufficient to render services for other group companies such as controlling, internal audit, IT, legal and tax services, etc.
Possible Violation of European Law
Considering the recent Cadbury Schweppes decision of the European Court of Justice, it is doubtful whether the new provision complies with European law. The court confirmed that a restriction on the freedom of establishment can only be justified on grounds of the prevention of abusive practices, i.e., the objective of such a restriction must be to prevent wholly artificial arrangements that do not reflect economic reality. As the interposition of a management company that has sufficient resources to conduct its business should not be regarded as an artificial arrangement, the new provision might violate European law.