Germany’s tax avoidance regulations
von Peter Scheller
Germany’s tax avoidance regulations are far reaching and cover a lot of different situations. There are certain measures which are treated as a tax avoidance scheme although involved companies or individuals do not realise that their business activities may be treated as harmful tax practice.
Shielding effect of corporations
Like in most other states the taxation of corporations and their shareholders are treated as two different tax subjects in Germany. A German based company is subject to corporation income tax plus additional taxes such as solidarity surplus charge and trade and business tax. The total tax rate will vary between 28 to 32 % of the profits. If the shareholder is an individual resident in Germany he or she will be subject to Income tax plus solidarity surplus charge. However, income tax is only due if the corporation distributes profits to its shareholders. As long as the company does not distribute profits (dividends) there is no actual taxation on behalf its shareholder. This concept is known as shielding effect of corporations.
It is obvious that the shielding effect can be maximised if the corporation is based in a low tax jurisdiction and profits can be transferred to this foreign entity. As long as this entity does not distribute its profits there will be no tax implication on behalf of its shareholders. It is obvious that the German government has imposed measures to stop German companies and their shareholders to shift profits to low tax jurisdictions such as the Channel Islands, Gibraltar, Liechtenstein or the Cayman Islands. Companies in other countries with special tax regimes or low tax rates such as Switzerland, Malta, Cyprus and others will be threatened by Germany’s tax avoidance regulations as well. Over the years Germany developed a large number of respective regulations. The regualtations tackle different scenarios and vary technically speaking a lot.
Foreign corporation as German tax subject
Subject to German corporation tax is every company or other corporation which is tax resident in Germany. Tax resident is a corporation if it has its statutory seat or its place of management in Germany. The term place of management refers to a place where the management takes decisions and activities of major importance in regard to legal, organisational and economic transactions of the enterprise. The term fixed place does not require premises of the enterprise. This place of management can be in the private home of the managing director.
Example: A British Limited Company has its statutory domicile in Manchester. Its only shareholder and managing director relocates to Germany. This person gives up his residency in the UK and the Ltd. has no office in Great Britain. All day-to day decisions will be taken in Germany. Therefore the place of management will be in Germany.
The foreign company is tax resident in Germany although its statutory seat is situated abroad. Business profits will be taxed in Germany at an overall tax rate between 28% to 32%. The foreign based company has to fulfil more or less the same obligations and has the same rights as any other German based company.
The fact that the “official” director is a trustee or nominee abroad is irrelevant if the actual management is carried out in Germany. German tax authorities are always suspicious if directors of a company are lawyers or solicitors situated in a low tax jurisdiction.
The rules in regard to “base” or “post box companies” are not regulated in law codes. They are based on rulings and decisions of Germany’s High Fiscal Court.
A base company is a corporation based abroad which is formed to avoid German taxation, has no own economic or other reason and does not carry on an own business activity. These rules are predominately applied on companies without any business functions situated in tax havens.
The profits of these corporation will be taxed directly on the level of the shareholders as it would be their own income. The foreign entity is totally ignored for tax purposes.
Germany has as many other countries in the industrialised world special CFC (Controlled Foreign Company) rules. They are more restrictive than in most other countries. Furthermore they are complicated and in practice not easy to handle.
A foreign company is considered as an “intermediate company” if the following applies:
- It has to be a foreign company which legal structure in general is comparable to the one of a German company.
- More than 50% of the share capital is in the hand of persons who are tax resident in Germany. Please be aware of the fact that these persons do not have to be related.
- The foreign entity realized “passive income”.
- The effective tax rate abroad does not reach 25%. The income is calculated by following German accountancy and tax rules.
The catalogue of income which is considered to be passive is extensive. Trading activities for example will only be considered as “active” if the foreign entity is capable to carry out these activities. This requires sufficient personal and technical resources. Beside this the activity is only to be considered active if no shareholder or any other person related to the shareholder is involved in the trading activity.
Example: A German company has a subsidiary in the UK (100% of the shares) which is acting as a distribution company. The UK-company has an own office and sales personal. The German mother company is providing for all foreign subsidiaries a marketing strategy and respective marketing support.
Most preconditions for a “passive” income are fulfilled. The UK-company is 100% owned by a German company. The income will be taxed at a tax rate of under 25%. The corporation tax rate in the UK is 20%. Whether the income is considered as “passive” depends only on the fact whether the marketing support will be considered as a tax harmful activity by the mother company.
If the foreign entity qualifies as an intermediate company the passive income will be taxed at the level of the German company. The foreign company will be treated as such but its passive income will be deemed to be distributed as a dividend. A foreign tax levied on the passive income will be credited against the German tax (plus solidarity surplus charge) on this part of the income.
If the foreign entity is situated in the EU the taxation of passive income will not be taxed at the level of German shareholders if the foreign company carries out real business activities in this country and provides respective evidence. Companies from non-EU/EEA member states do not have this possibility.
The German CFC-rules are over 40 years old. Therefore they are out of line with modern concepts such as the OECD-initiative of BEPS (Base erosion and profit shifting) and the EU Anti Tax Avoidance Directive (ATAD). Therefore it can be expected that the rules will be amended in the next years.
The German CFC-rules are also under the threat of court rulings. There are various cases still pending before the European Court of Justice (ECJ) in regard to the question if certain provisions of the CFC-rules are in line with EU freedom rights
A very important issue is the German trade and business tax. The German tax authorities take the view that passive income is also object to the German trade and business tax. This issue is of special significance since foreign taxes cannot be credited against the German trade and business tax. However, the Highest Fiscal Court ruled that for trade tax purposes the foreign income has to be reduced because it is connected to a foreign establishment. The trade and business tax is only due on income which is realized by the activity of a German based establishment.
Considering this decision the CFC-rules loose financial importance if the foreign country imposes a relevant tax. The German corporation tax rate plus solidarity surplus charge is levied at a total tax rate of about 16%. In our above mentioned example this would lead to no German tax burden since the UK tax rate on profits is 20%. Therefore the British corporation tax could be credited against the German tax. However, there are situations where special tax treatments abroad reduce the effective tax burden to a rate under 16%. For example: This is the case if the foreign company uses the “patent box” in the UK which entitles to a reduced corporation tax rate of 10%.
Restriction in refunding German withholding taxes
This regulation is applicable to German withholding taxes especially on dividends and interests. Foreign companies are normally entitled to receive dividends from German subsidiaries without any German withholding tax or at a reduced tax rate if the following applies:
- The foreign company is resident in a country which has a Double Taxation Convention (DTC) with Germany.
- The provisions of the DTC restricts the tax rate on dividends or interests to a reduced rate (0% to 15%). The normal overall withholding tax rate in Germany is 26,375%.
If a notice of exemption has been issued by the Federal Central Tax Office (Bundeszentralamt für Steuern) before the date of profit distribution (or the payments of interests), the payment can be made at the reduced rate. Otherwise the foreign company can apply for a refund of the unjustified amount afterwards.
This possibility is not valid if the following applies:
- Shareholders of the foreign company would not be entitled to above mentioned reductions if they would receive dividends or interests directly.
- For the interposition of the foreign entity no economic or other reason exist and the company does not carry on any own business activity.
This provision is designed for situation were the shareholders are not tax resident in Germany and would not be entitled for a reduction of the withholding tax rate (because of an absence of a DTC) by themselves. This unpleasant effect cannot be avoided by interposing a company in a country which has agreed a DTC with Germany and provides covering provision in regard to withholding taxes.
In general the effects of these regulations can be avoided if the foreign company possesses its own offices abroad, employs its own staff and has its own means of telecommunication. It should also participle in the general economic life. However, the request on business activities can be relatively low if the foreign company is acting as a holding or financing company.
For companies and persons who are affected by Germany’s tax avoidance regulations it is very important to know which of above mentioned rules are applicable. It is important to understand that the application of one set of rules eliminates the application of other rules.
As can be seen from the following table the main difference are:
- Whether the foreign company is in general accepted as an independent entity or ignored for tax purposes.
- If the corporation is accepted as such it is of importance whether it has its tax residence in Germany or abroad.
All this has a different tax implications.
|Regulation||Acceptance of the corporation||Tax residence of corporation in Germany||Tax implication for shareholders in Germany|
|Effective Management in Germany||yes||yes||Taxation of dividends|
(is ignored altogether)
|Income taxation of the corporation’s profits
|CFC-rules||yes||no||Income taxation of the corporation’s profits (as “fictive” dividends)|
The correct classifications may have far reaching consequences on the taxation in Germany, for example:
- Tax treatment of the current income of company and shareholders (e.g. trade and business tax)
- Tax treatment of dividends
- Taxation if the foreign entity or one of its subsidiaries are sold
- Exit taxation if one of the shareholders is leaving Germany (often the case if expatriates return to their home countries)
- Restructuring of a company group (e.g. foreign company or one of its subsidiaries will be merged with another group member in Germany or abroad)
- Applicability of the EU Merger Directive or Interest and Royalties Directive
- Possibility of the foreign company to act as parent company in regard to Germany’s special rules for tax groups
Author: Peter Scheller, Steuerberater, Master of International Taxation, Fachberater für Zölle und Verbrauchsteuern