Further tax law changes proposed to be included in the Annual Tax Act

The Finance Committee of the Upper House of Parliament made recommendations for various amendments during consultations on the draft Annual Tax Act 2013 which may affect corporate taxpayers.  

The Finance Committee of the Upper House of Parliament made recommendations for various amendments during consultations on the draft Annual Tax Act 2013 on 22 June 2012, and the Upper House is expected to make a final decision on the recommendations on 6 July 2012. The government will then review and forward the recommendations of the Upper House and its own comments to the Lower House of Parliament.

Given this provisional stage of the legislative procedure, it is unclear whether the Upper House will pursue part or all of the recommendations; some of the comments are merely in the form of a “request for review” as to whether change to existing legislation should be made. Nevertheless, it can be reasonably expected that some of the recommendations will be enacted.

The main changes/requests for review that are relevant for corporate investors are as follows:

A. Overview of most relevant proposed changes

Changes to Corporate Income Tax Act:

• The most significant change concerns the possible elimination of the 95 % exemption for dividends and capital gains derived from portfolio investments (i.e. less-than-10% shareholdings in subsidiaries). The proposed change is combined with a number of other proposed modifications to the loss carryforward rules and the calculation of EBITDA for purposes of the interest deduction limitation rule relating to dividends which are taxable under the new rule. According to these proposals, taxable dividends received from less-than-10 % shareholdings would not increase the relevant tax EBITDA for purposes of the interest deduction limitation rule and any expenses and losses resulting from a less-than-10% shareholding could be offset only against income from other portfolio investments. 
• A general principle of corresponding treatment is proposed for all dividends, i.e. dividends generally eligible for the 95 % exemption would enjoy the exemption only if they were not treated as deductible expenses at the level of the payor subsidiary. This would result in the extension of the scope of the current principle, which only provides for corresponding treatment in the case of deemed distributions. 
• The Finance Committee proposes to limit the application of the “held-for-trading” exception to banks and financial institutions within the meaning of the Banking Act. Under this exception, dividends and capital gains realized by a financial institution are not entitled to the 95 % exemption if the participation is held with the intention to engage in short-term trading activities (and losses are fully deductible in these situations). According to recent jurisprudence of the German courts, regular holding companies also fall within the scope of this rule, which is the reason why the Finance Committee decided to propose restricting the scope of the rule. 
• The Finance Committee is requesting a review of the rules on tax groups to make their application less prone to formal errors in practice.

Request for review of RETT rules

• The Finance Committee has formally asked the government to review the Real Estate Transfer Tax (RETT) rules and propose an amendment to eliminate “RETT blocker structures” (discussed in more detail below), which are used by taxpayers to minimize their RETT liability in share acquisitions. 
• There is no proposed language for the change, so it is difficult to anticipate what steps the government will take.

Proposed changes to taxation of investment funds

• Following the postponement of a major reform to the Investment Tax Act by the Finance Ministers of the federal states at their conference on 1 June 2012, the Finance Committee has proposed changes to the Act, including changes to reflect the amendments to the participation exemption in the Corporate Income Tax Act (for a comprehensive overview of the proposed changes, see below).

B. Further details - request for review of RETT rules

Background  
A RETT blocker structure is often used to avoid the RETT due on a transaction, specifically to prevent the unification of shares due to share transactions of real estate holding companies. The diagram below shows a typical RETT blocker structure in which 94.9 % of the real estate holding company (Target) is acquired by AcquiCo, with the remaining 5.1 % acquired by RETT Blocker KG.

AcquiCo can acquire up to 99 % in RETT Blocker KG (94.9 % is also common). Because there is a second partnership interest in the KG held by a third party, the 5.1 % holding is not attributed to AcquiCo, meaning there is no 95 % unification of the shares in Target and, hence, no RETT liability. 

Proposal 
The Finance Committee has recommended that the government come up with measures to address these types of structures. The explanation for this approach is that the possibility of RETT avoidance is only available for high volume real estate transactions due to the resulting structuring costs, with the effect that smaller real estate purchases are unfairly discriminated against and these structures lead to a considerable loss of tax revenue. Due to the increasing RETT rates in most federal states, the RETT blocker structure has become more attractive.
The Finance Committee proposal is rather vague and does not include any concrete suggestions on how the tax law should be amended to prevent RETT blocker structures. It remains uncertain whether the recommendation to attack such structures will be included in the Upper House’s official comments to the Annual Tax Act 2013 and, if so, whether the recommendation would be pursued in the next legislative session. Given that no specific wording is available, it is unclear how future structures would be affected if legislative measures were adopted.

Existing structures 
Existing RETT blocker structures should not be affected by any potential change to the law due to the constitutional prohibition on laws having retroactive effect in Germany.

However, if the final Annual Tax Act 2013 does amend the RETT Act, RETT blocker structures could be affected as early as 1 January 2013 or even as from the date of the final resolution of the Lower House of Parliament. In the interim, implementation of blocker structures should be carefully considered. According to jurisprudence of the Federal Constitutional Court, it may be possible for new legislation to be effective on a retroactive basis. However, the earliest date for this retroactivity would be the date of publication of the draft legislation by the Federal government. Thus, it seems unlikely that the legislature gives the law change retroactive effect beyond the date when the proposed new rules take a more definite form.

C. Further details - Proposed changes to Investment Tax Act

Amended cost allocation 
The Finance Committee is recommending changes to the rules relating to the allocation of “general costs”, i.e. costs that are not directly attributable to a particular income source of the investment fund, for purposes of the German investment taxation. Under current rules, it is possible to allocate general costs predominantly to taxable ordinary income (e.g. interest) and thus reduce the investor’s taxable income derived from the fund investment.

The new rules would provide for a fixed ratio of 50 % for the allocation of general expenses between ordinary income and capital gains. The rule to qualify 10 % of the indirect costs as nondeductible expenses might be abolished. However, there will be no changes to the allocation of direct costs, i.e. costs that are directly attributable to a particular income source.

Binding order to use fund income for distributions  
The Finance Committee recommends introducing a binding order to use fund income for distributions to investors for German tax purposes. Any distribution would be deemed to have been sourced from (1) all ordinary income of the current financial year or the previous financial year if the distribution is made within four months after the financial year-end; (2) deemed distributed income (i.e. already taxed ordinary income) from previous financial years; (3) income not included in the current or previous financial year’s deemed distributed income; and finally (4) substance and other income. The proposed new regulations do not seem to affect interim distributions.

The rule primarily aims to restrict the ability of foreign investment funds to distribute substance, i.e. effectively repay investor capital, even though the fund accumulates realized capital gains. A decree issued by the Ministry of Finance on the application of the Investment Tax Act contains an interpretation in this respect, but the Finance Committee is recommending a legal provision since there is a lower finance court case pending on the issue.

Anti-abuse rules regarding dividend withholding tax 
The Finance Committee favors the introduction of regulations to ensure Germany’s ability to levy income tax and withholding tax on German-source dividends received via investment funds.

Dividend taxation currently can be avoided for certain investor groups by redemption of the investment fund units. Although the recommendations do not propose any specific wording, the new regulation may correspond to the taxation of interim profits for untaxed interest income. Undistributed dividends (i.e. dividends that have not been subject to deemed distributed income taxation at investor level in previous financial years) would become taxable upon the redemption of the fund units.

Anti-abuse rules applicable to bond-stripping structures 
The Finance Committee has requested new regulations to prevent certain structures involving the change-in-ownership rules, known as “bond-stripping structures”. In essence, these structures have been used to generate taxable income from the disposal of stripped interest coupons at the fund level, which can be used as deemed distributed income to be offset against other taxable income of the investor. Future losses from the disposal of the fund units can be offset against other taxable income and, hence, circumvent the full or partial forfeiture of the investor’s tax losses in the event of a harmful change in ownership.

Reaction to ECJ decision in Santander case 
On 10 May 2012, the European Court of Justice (ECJ) held that French withholding tax levied on French-source dividends paid to nonresident investment funds violates the EU fundamental freedoms of both EU resident and nonresident funds (combined cases C-338/11 and C-347/11 FIM Santander).

Although no specific wording has been suggested, the Finance Committee recommends changing the existing withholding tax system on German dividends distributed to investment funds to mitigate the risk that Germany will be obliged to refund the withholding tax in the future.

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