Scheuten Solar Technology and other developments affecting the trade tax add-back of interest

Two recent court decisions – one by the European Court of Justice (ECJ) and one by the German Federal Tax Court (BFH) – may have an impact on the application of the add-back of interest expense under German trade tax rules in both EU and third country situations.

Trade tax is a tax on business profits levied by the municipalities in Germany. The basis of the trade tax is computed in a way similar to the corporate income tax, but with certain adjustments, one of which was the add-back of 50 % of interest (reduced to 25 % under the 2008 tax reform) paid on long-term loans (extended to interest on all debt as from 2008), so that 50 % (25 %) of the interest expense was nondeductible. 

Scheuten Solar Technology  
The ECJ issued its decision in the Scheuten Solar Technology case (case reference: C-397/07) on 21 July 2011, concluding that the (old) rules requiring the add-back of interest in the Trade Tax Act are compatible with the EU Interest and Royalties Directive (IRD). The ECJ followed the opinion of Advocate General Sharpston (delivered on 12 May 2011).

The IRD provides for a source-state tax exemption for interest and royalty payments in certain intragroup situations, regardless of whether the tax is levied by way of assessment or withholding. The main issue in Scheuten Solar Technology was whether the German rule that limits the deductibility of interest payments at the level of the paying entity is in line with the IRD. The BFH had requested a preliminary ruling from the ECJ in 2009 and voiced concerns from an EU law perspective.

Scheuten Solar Technology, a German company, obtained a long-term loan from its Dutch parent company. Under the rules governing the determination of the trade tax base in the year at issue, 50 % of the interest payment on long-term loans had to be added back to the trade tax base of the debtor (i.e. were treated as nondeductible). Scheuten Solar Technology brought the case to court arguing that the increase of its trade tax base due to the interest expense paid to its direct EU parent is not in line with the IRD, because the tax burden resulting from this increase in the tax base constitutes taxation of the interest payment, which is prohibited by the IRD.

The ECJ disagreed, concluding that the limitation on interest deductions under the trade tax rules is compatible with the IRD. The ECJ held that the IRD only applies to tax imposed on the interest payment itself and that the exemption from any taxes imposed on interest payments in the source state “concerns solely the tax position of the interest creditor.” The ECJ further noted that legislation, such as the add-back of interest payments under German trade tax rules, relates only to the determination of the tax base of the debtor. “The method of calculating the basis of assessment of the payer of the interest and the elements to be taken into account for that purpose, such as the taking of certain expenditure into consideration when performing that calculation,” are not covered by the IRD.

The Scheuten Solar Technology case had attracted considerable attention (with nine EU Member States and even the European Commission submitting observations supporting the position of the German tax authorities) because a decision in favor of the taxpayer potentially would have had far-reaching consequences. For example, a taxpayer-favorable decision also could have affected other rules limiting the deductibility of interest expense throughout the EU (e.g. rules in Italy). The ECJ decision is short and (unlike Advocate General Sharpston) does not address various systematic and historic arguments raised by the taxpayer that indicated that the IRD should apply to rules relating to the determination of the tax base. Because of the number of Member States that submitted observations and the potentially far-reaching ramifications of a decision in favor of the taxpayer, one may speculate that the decision may have been political.

BFH decision

The ECJ decision in the Scheuten Solar Technology case needs to be viewed in conjunction with a landmark decision of the BFH (case reference: I R 54, 55/10) in a case dealing with the nondiscrimination principle in tax treaties and their impact on the trade tax add-back of interest expense which was published in 2011. Under German rules, interest payments within a tax group for trade tax purposes are not subject to the add-back rules. In the case decided by the BFH, a German taxpayer argued that it should be able to create a tax group with its nonresident parent company to which interest was paid because the rules in the Trade Tax Act, which limit tax groups to domestic cases, violated the nondiscrimination article in the applicable tax treaty (i.e. the Germany-U.K. treaty).

The BFH agreed with the taxpayer, holding that the inability to form a tax group with a nonresident parent company violates the nondiscrimination principle in the Germany-U.K. treaty. The BFH, however, went a step further and indicated that the subsidiary cannot be deemed to be subject to trade tax at all in Germany because of the tax technical interaction between the domestic trade tax rules and the tax treaty rules.

Because the case decided by the BFH involved the old trade tax rules where a trade tax group could be formed even if no profit and loss pooling agreement (PLPA) was concluded (and provided certain other requirements were met), it is unclear whether the court’s conclusions would apply under current law. The main difference between the old and new tax group rules for trade tax purposes is that, under the amended tax group rules in place since 2002, a formal PLPA is also required for trade tax purposes. The PLPA must be concluded between the parent company and its subsidiary, be registered in the commercial registry of the subsidiary and is subject to strict formal requirements. If a PLPA is in place, however, the reasoning of the BFH generally would not be limited to trade tax but would have to be extended to corporate income tax as well.

The fact that German corporate law does not allow a formal corporate law PLPA to be concluded with a nonresident parent company likely will not be sufficient to justify the restriction of tax groups to purely domestic situations. Based on previous case law (case reference I R 79/09 and I R 16/10), however, the question remains open as to whether it would be necessary for the German subsidiary and nonresident parent company to conclude a civil law agreement similar to a formal corporate law PLPA in order to argue that the German subsidiary and its nonresident parent company are in a comparable situation.

Recommendation for taxpayers

German taxpayers with parent companies located in EU/EEA Member States or in third countries where the tax treaty with Germany includes a rule similar to article 24(5) of the OECD model treaty that have kept their trade tax assessments open in light of the Scheuten Solar Technology case, or a similar argument based on the freedom of establishment or the free movement of capital principles, should review their situations carefully to determine whether they would be in a position to benefit from the BFH decision in light of the applicable tax treaty. This will be especially relevant for pre-2002 cases where a PLPA was not required for trade tax purposes.

For years from 2002, taxpayers should review the relevance for their situation on a case-by-case basis. Arguably only a limited number of taxpayers will have concluded civil law agreements similar to a PLPA with their nonresident parent in the past. Even though the BFH has not yet specifically addressed this issue, it is likely that the court would take a restrictive view when determining whether a situation comparable to a German tax group exists in the absence of a PLPA simply because a taxpayer acted as if a tax group had been concluded in fact and transferred all profits to its nonresident parent (or where the parent had actually compensated all losses of the subsidiaries). Therefore, the decision mainly may be relevant for future periods.

At this juncture, however, it does not appear that taxpayers should actively plan into a situation similar to a tax group only to achieve the effects described above because the tax authorities are likely to request that the law be amended given the potentially significant amounts of revenue at stake. Reactions of the German legislator could, for example, involve a retroactive treaty override excluding the group taxation rules from the scope of the nondiscrimination clause.

Even without resorting to the nondiscrimination principles under EC law or an applicable tax treaty, a similar outcome may be possible where a German partnership with nonresident partners only acts as the head of a German tax group but the shareholdings in the tax group subsidiaries cannot be allocated to the partnership for tax treaty purposes because the functional connection to the permanent establishment created by the partnership is insufficient. As with the case above, the tax technical interaction between the domestic tax rules and the tax treaty rules may prevent Germany from taxing the profits of the tax group subsidiaries in Germany.

If you have any questions, please contact the authors of the article at gtln@deloitte.de or your regular Deloitte contact.