The German government recently submitted an amended draft version of the domestic anti-treaty shopping rule in section 50d paragraph 3 of the Income Tax Act to the European Commission, which – if enacted in the current form – likely will result in the termination of the infringement procedure initiated by the Commission in March 2010. However, the language in the draft leaves room for interpretation, and it is possible that the government may further clarify the wording of the proposed rule during the legislative process.
Background
Germany levies a 26.38 % withholding tax (including the solidarity surcharge) on dividend distributions by a German corporation, although a lower rate frequently applies on distributions to foreign companies, either because the rate is reduced under a tax treaty or the distribution qualifies for the application of the EU Parent-Subsidiary Directive. Technically, the lower rate may be achieved by a refund of the withholding tax to the foreign recipient or by a (full or partial) exemption from withholding tax at the time of the distribution. Relief from the full withholding tax, however, is subject to Germany’s anti-treaty/anti-directive shopping rule in section 50d paragraph 3 of the Income Tax Act.
Under the current anti-treaty/anti-directive shopping rule, a foreign company that receives a payment subject to German withholding tax will be entitled to withholding tax relief only to the extent that (i) the company is owned by shareholders that would be entitled to a corresponding benefit under a tax treaty or an EU directive had they received the income directly; or (ii) if all of the following three tests are met:
- Business purpose test: There are economic or other relevant (i.e. nontax) reasons for the interposition of the foreign company;
- Gross receipts test: The foreign company generates more than 10 % of its gross receipts from its genuine business activities; and
- Substance test: The foreign company has adequate business substance to engage in its trade or business and engages in general commerce (mere administrative functions, outsourced activities or activities carried out by related parties in the same jurisdiction are not taken into account in determining business substance).
In principle, the relief mechanism (i.e. refund or exemption), as well as the anti-treaty shopping rule, apply equally to royalty payments and to certain interest payments (payments on profit-participating loans or convertible bonds). The withholding tax rate may be limited in those cases under the EU Interest and Royalties Directive (in particular, royalties) or under a treaty (royalties and interest). With the exception of profit-participating loans and convertible bonds, interest payments made on “regular” loans (including “regular” shareholder loans) are not subject to withholding tax.
Infringement procedure initiated with respect to gross receipts test
In March 2010, the European Commission initiated an infringement procedure against Germany and formally requested that the anti-treaty shopping rule be amended (reference no. 2007/4435 – see Deloitte Tax-News). The Commission emphasized that it was not challenging the objective of the anti-abuse measure, but rather the disproportionate requirements imposed on foreign companies to prove, in particular, the existence of a "genuine economic activity" (gross receipts test).
Draft of amended anti-treaty shopping rule
In response to the infringement procedure, the German government has submitted an amended draft version of section 50d paragraph 3 to the European Commission, which – if enacted as drafted – will likely result in the termination of the infringement procedure.
According to the draft, a foreign company that receives a payment subject to German withholding tax will be entitled to withholding tax relief to the extent that (i) it is owned by shareholders that would be entitled to a corresponding benefit under a tax treaty or an EU directive had they received the income directly; or (ii) if the foreign company’s gross receipts in the relevant year are generated from its genuine own business activities.
If the foreign company fails both tests (i.e. if the foreign company is not owned by shareholders that would have benefited from the same relief had they earned the income directly and if the company had not earned the gross receipts in connection with its genuine own business activity), the company would be entitled to withholding tax relief only if both of the following two additional requirements are met:
- Business purpose test: There are economic or other relevant (i.e. nontax) reasons for the interposition of the foreign company in relation to the mentioned receipts;
- Substance test: The foreign company has adequate business substance to engage in its trade or business and does not participate in general commerce.
Consequences of proposed changes
The wording of the proposed amendment is ambiguous and leaves room for interpretation. Even though from a technical and historic perspective, the terms “gross receipts,” “receipts” and “income” have different meanings, it appears that they are used synonymously in the draft law.
In practice, the issues relating to the language used in the proposed rule will become extremely relevant. Based on the actual wording of the draft and its explanations, the following tax consequences may ensue:
Example 1: Assume a Luxembourg management holding company has three German subsidiaries, two of which are actively managed. All three subsidiaries distribute dividends to the Luxembourg holding company. The Luxembourg holding company has limited substance and is held by shareholders in the Cayman Islands.
- Dividend distributions from the two actively managed German subsidiaries should qualify for withholding tax relief provided it can be demonstrated that the Luxembourg entity acts as a true management holding company. This outcome would be based on an interpretation of the proposed amendment, according to which a foreign company that has treaty-protected shareholders or that earns income from its own business activity is entitled to relief.
- Dividend distributions from the German subsidiary that is not actively managed should qualify for withholding tax relief only if it can be demonstrated that there are business reasons for the interposition of the Luxembourg entity and there is sufficient substance in relation to the business purpose of the Luxembourg company.
Based on this interpretation, the situation for the actively managed subsidiaries should be similar to that under the current rule because such entities typically meet the gross receipts test (i.e. the dividends they receive qualify as “good income” for purposes of that test). Discussions with the tax authorities are likely to be ongoing and will center on the question of whether the activity of the management holding is sufficient to qualify as a genuine own business activity.
Example 2: A German company that is part of a multinational group develops patents and transfers them to a Swiss related party, which centrally manages the IP for the group. The Swiss company is directly held by the group parent company resident in Canada. The German company subsequently pays royalties to the Swiss company for which the Swiss company wants to obtain withholding tax relief (0% under the Germany-Switzerland treaty). The applicable treaty rate on royalties from Germany to Canada is 10 %.
- The Swiss IP company is not held by shareholders that would qualify for a corresponding benefit and the royalties are not earned in connection with a genuine own business activity (according to the German tax authorities’ view of what constitutes a genuine own business activity).
- The Swiss IP company, therefore, would only enjoy full withholding tax relief if it can show that there are business reasons for its interposition in relation to the royalties earned (e.g. because there are synergies from a centralized IP structure) and that it has sufficient substance for its activity as an IP management company. In all other cases, the 10 % withholding tax rate under the treaty with Canada should apply.
For this group of companies, the amendment would be an improvement because currently, withholding tax relief for royalties received by pure IP companies whose activity is deemed to generate passive income under the anti-treaty shopping rule would not be available because it usually would be impossible to meet the 10% of gross receipts from own business activities test without adding additional substance to these entities.
Example 3: An operating entity in France holds shares in a German subsidiary. The German subsidiary is not actively managed by its French parent, but the parent is active in the same line of business and coordinates the distribution of the group’s products on a worldwide basis. The French parent company wants to obtain withholding tax relief for dividends received from its German subsidiary. The French parent is held by the Japanese head of the group.
Alternatively, assume there are no business or other relations between the German subsidiary and its French parent.
- Based on the wording of the draft law, it is unclear whether the dividends received would qualify as receipts that result from own genuine business activity in the absence of a management holding activity in France.
- If the dividends were not deemed to be earned in connection with a genuine own business activity, the French parent company would have to show that there are business reasons for its interposition, as well as sufficient substance at its level.
In this case, the situation of the taxpayer would remain unchanged or may potentially even become worse as compared to the current situation.
Under the current rule, the gross receipts test, as well as the business purpose and substance tests, must be met. Based on the facts in the example, the gross receipts test would be met since the French parent company’s active business should be sufficient to produce more than 10% of the total gross receipts. In addition, past experience has shown that in these situations the tax authorities often do not scrutinize closely the business purpose of the interposition of the holding company. Thus, it generally should be possible to obtain withholding tax relief in the base case of Example 3 (e.g. because of the supporting nature of the parent company for the subsidiary’s distribution) and in many cases in the alternative fact pattern as well.
Under the draft, “reasons for the interposition of the foreign company” will have to be proven “in relation to the mentioned receipts,” i.e. presumably in relation to the dividend income. It will remain to be seen whether the tax authorities will – with reference to the mere new wording – ask for non-tax reasons for the interposition of the French company as a holding of the German subsidiary or whether it will be sufficient that the foreign and the German business complement one another. Irrespective of which view will be supported in future, it appears unlikely that full withholding tax relief will be granted in the alternative fact pattern (but only a refund to the treaty rate with Japan).
Burden of proof on foreign company
In addition to the changes in the wording of section 50d paragraph 3, a new sentence would be added, which would codify the tax authorities’ view that the burden of proof would be on the foreign company to demonstrate that there are economic or other relevant (i.e. nontax) reasons and adequate business substance.
Enactment
The amended version of the anti-treaty shopping/anti-directive shopping rule is likely to be enacted with the law by which the Directive on the EU Recovery of Tax Claims will be implemented into national law. It will become effective on 1 January 2012.
Contact
Katja Nakhai | Munich
Dr. Thomas Wagner | Düsseldorf
