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. 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 held 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 ECJ 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 court 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. 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.