In Germany, anti-avoidance provisions can be divided into two sub-divisions. The first seeks to prevent the use of foreign/offshore mechanisms for tax avoidance purposes in respect to German commercial activities whilst the second seeks to prevent wealthy individuals from changing their residence/nationality for the same reason. Nevertheless, German law like its British counterpart specifically allows resident companies and individuals to arrange their affairs in such a manner that would be most fiscally beneficial (see the decision of the Federal Tax Court - the Bundesgerichtshof - 17/04/74). Therefore, provided no specific German legislation is breached there are no de jure restrictions. However, in general terms traditional and normally non-treaty partner tax haven countries should be avoided, as they are very likely to be investigated and subject to a reverse burden of proof. For individuals, there must also be careful planning with perhaps the use of relatively high tax jurisdictions, such as the United Kingdom and Ireland, offering the best 'legitimate1 advantage.
Specific Tax Provisions
- German Related Transactions: In general, German law seeks either to set-aside any transaction which could be deemed an intentional abuse of the tax system (see S.42 of the General Tax Act or Abgabenordnung below) as if such transaction has never existed or, where passive income is redirected to a favourable tax jurisdiction*, to ascribe such income to the German resident (see Aussensteuergesetz S.7 -S.14 08/09/72below). In respect to S.42 it should be noted that this provision is universal in application and is not merely restricted to either passive activities or to German residents. However, it is clear that /^K there must always be an intention to abuse the German tax system. In respect to the Aussensteuergesetz sections the main protection seems to be afforded by being able to establish genuine foreign management and control. Where there is an overlap between the two possibilities, i.e that either S.42 or Aussensteuergesetz sections could apply, it will normally be the latter which takes precedence since it is specific to a certain type of situation
- Thin Capitalisation: Since 1 January 1994, Germany has thin capitalisation rules that deny interest deductions on shareholder loans that are deemed to be equity. However, the rules for deductibility are reasonably clearly defined providing operating companies with a so called 'safe haven1within a 3-1 debt-equity ratio (so long as less than 20% of its shares are held by a holding company) whilst holding companies have a more generous 9-1 debt-equity ratio. Holding companies for this purpose must have at least two investment in resident or non-resident corporations that exceeds 20% of the subsidiaries' nominal capital and either i) more than 75% of the holding company's gross income is dividends and interest from subsidiaries (based on a 3 year average) or ii) more than 75% of its assets (excluding its assets (excluding receivables) as equity holdings in other corporations. Debt covers all loans from foreign shareholders (or parties related to them) owning more than 25% of a corporation and includes debt with unrelated third parties (e.g. banks) if that third party has any recourse against a foreign 25% shareholder (or party related to that shareholder). The advantageous treatment for holding companies has led to many multinational corporations reorganizing their corporate structures to benefit from the 9-1 debt-equity ratios…
The Application of the General Tax Act
S. 41(2) - This section allows a tax inspector to disregard any 'sham' transactions for tax purposes. However, the definition of the word 'sham' is very literal, allowing the section to be ignored if there is any veracity to the disputed transaction. For example, if a German firm claimed to have sent € 10,000.00 to a Bahamian IBC and actually did so forward the sum to a real Bahamian company this section could not be implemented. In fact, only if there was no such company could it be relied upon with any degree of confidence. The point being that whether malfeasance exists or not does not matter only that some kind of legitimate structure has been established. For obvious reasons, therefore, this provision is hardly employed. S.42: Section 42 is far more commonly employed than S. 41(2) since it concentrates on the intention to evade German taxes and is not fettered by the mere veracity of the structure. Under this section the intention to evade taxes will normally be satisfied if it can be shown that the transaction has no commercial reason other than the saving of tax. The factors that will normally be considered in deciding whether there is a bona fide commercial reason and the requisite intention would include:
- Would the format and structure of the transaction be in keeping with what would normally be expected of a like business - For example, a car manufacturer purchasing components from a West Indian intermediary would be a prima facie cause for concern and;
- Are the fees/charges being invoiced consistent with the nature of the goods/services provided. Again, using the example in (a), are the costs of the components 'reasonable' by industry standards and;
- Are the jurisdictions involved deemed 'low tax' by German standards i.e. subject to a 30% or less tax liability and;
- Would it have been possible to purchase similar goods and/or services in Germany or another high tax-area on similar terms and conditions and;
- Is there evidence of any control or influence over the other transacting party (ies) and;
- Is there evidence that the other transacting party (ies) were not genuine and did not have bona fide management and control in the applicable jurisdiction? It should be noted that the use of serviced office address facilities and/or passive local administrators, managers or directors would not suffice as a defence. Of course, other variations on the above could be developed but the simple crux of the matter is that the transactions must be real and carried out in the normal course of business. If not, there is a strong possibility that the transactions could be open to an attack under S.42
The Application of S.42 to Non-Residents
One of the most important benefits of this section, at least from the point-of-view of the tax authorities, is that it does not appear to discriminate between residents and non-residents of Germany. Therefore, non-residents investing or receiving income from Germany could be subject to S.42 if they try and insert some sort of intermediary vehicle to mitigate their German tax obligations. However, on a practical level 'attacks' on non-residents are relatively rare especially if sensible precautionary measures are taken. For example, if the tax benefiting jurisdiction was located in the European Union, such as Ireland, or if the ostensible local tax was over 30% (as in Malta) the proverbial 'red flag1 is unlikely to be raised and even if so raised such jurisdictions will normally afford genuine defences.
Sections 7-14 of Aussensteuergesetz
The principal distinction (as already inferred) between S.42 and the aforementioned is that they apply only to passive income being paid to a foreign undertaking in which a German resident holds an equity stake of 10% or more. It is not necessary, though often the case, that such a person has an intention to mitigate his or her tax position. The reason behind this is that it may not be possible for a minority equity holder to 'force' the other interested parties, who may not be German residents, to use an alternative structure. Nevertheless, where benefits do accrue to a German resident the modis operandi of these Sections is to place such a person in a position as if full German tax obligations were met They do not, however, seek to set-aside the veracity of the whole undertaking only to balance the German equity holders tax position. Notwithstanding the provisions contained in the said Sections, it is important to realise that they will only apply where the structure in question cannot demonstrate genuine foreign management and control and/or that there are no applicable tax treaty protections. Therefore, once more, the legitimate tax mitigator will not be denied the right to manage his or her affairs in a fiscally advantageous manner. In regards to the criteria considered in the application of the Sections there is considerable overlap between S.42 (see above) but in particular the following will be given special emphasis:
- Whether genuine foreign management and control can be established. As with S.42 serviced office facilities or foreign 'nominee' officers will not be sufficient. (b) That the basic requirements of 10% ownership and passivity exist. (c) That no specific tax treaty provisions apply. (d) That the recipient jurisdiction has taxes below 30%. If this cannot be satisfied it may not be possible to rely on Sections 7-14;
- Whether the German resident, or residents, can or may be able to exercise control over the operations of the foreign company from Germany, creating a 'boomerang' effect for tax purposes. If the answer to this is yes then, even if there may also be legitimate foreign management and control, difficulties could arise. S.42 may also apply in these circumstances since the activities may no longer be 'passive’
SPECIFIC TAX PROVISIONS
EXTRATERRITORIAL POWERS: In order to prevent the departure of long-term German residents and citizens to more fiscally beneficial territories, the authorities have introduced legislation penalizing wealthy individuals leaving Germany for solely tax reasons. Of course, the effectiveness will be fettered by the choice of alternative residence and if any, the provisions of the applicable tax treaties. In general terms, significant benefits can be achieved by moving to countries like the United Kingdom and Ireland given their distinction between domicile and residence and the existence of favourable tax treaties than, for example, to traditional havens such as Monaco The principle extraterritorial provisions are S.2 and S.6 Aussensteuergesetz (Foreign Tax Act) 08/09/72 and S.16 Einkommensteuergesetz 19/02/90 (Income Tax Act):
S.2 Foreign Tax Act
S.2 of the Foreign Tax Act, 1972, is by far the most powerful piece of extraterritorial legislation and basically applies to German citizens who have been 'resident' in Germany. Importantly, the term resident for the purposes of this act is substantially broader than normally applicable. In fact, a German citizen will be potentially liable to this legislation if he or she has been resident for 5 out of the 10 years preceding migration. Once liable, subject to the qualifying criteria, the said individual could face special German taxation, basically seeking to equalise for a further 10 years. The qualifying criteria, both of which must be satisfied, are as follows:
- That the individual has migrated to a tax haven jurisdiction. This for the purposes of S.2, subject to tax treaties, equates with the aforementioned receiving a taxable income of over €75,000.00 and being taxed on that income at a level amounting to less than two thirds of the then prevailing German income tax rate or that special schemes or dispensations are available which could result in a lower tax liability than prima facie may seem the case. An example being Cyprus, which will often tax non-nationals at half the rate of indigenous citizens (approximately 20%). Alternatively, if the tax haven rules cannot be satisfied and the German citizen has not established any new jurisdiction of residence, he or she will probably fall foul the 'perpetual traveller* caveats and be treated in the same manner as if he or she had taken up residence in a tax haven with zero taxation;
- That there exist, after the departure, significant economic interests in Germany. This second qualifying criteria being necessary to ensure the jurisdiction of the German fiscal authorities. Under the Foreign Tax Act, an individual will have a significant economic interest if:
- He or she plays an active managerial role in a German undertaking, including a partnership or;
- Where no such active role exists, that he or she holds at least, a 25% equity interest in a German undertaking or receives a distributed income which equivalent to the aforementioned or,
- The former German resident receives foreign source income constituting either 30% of his or her total income or €60,000.00 in a given financial year (whichever applies first) which, if he had remained resident, would have been subject to German taxation or;
- The former German resident receives income from net assets which, if he had remained resident in a given financial year, would have been subject to German taxation, such income constituting 30% of his or her total income or €150,000.00 (whichever applies first).
S.6 Foreign Tax Act
The principle objective of S.6 of the Foreign Tax Act is to automatically infer a capital gain on residents* leaving Germany who have, at least, a 25% equity interest in a German company. If this is the case, the fiscal authorities will charge 50% of the normal taxes applicable to a capital gain S.16 Income Tax Act
The modis operandi behind S.16 of the Income Tax Act and S.6 of the Foreign Tax Act is very similar save that the former applies to previously resident sole proprietors leaving Germany whilst the latter applies to investments held in German companies. However, unlike S.6 a sole proprietor will be subject to tax on all of the imputed capital gain. This is logical since, by definition, if such a person leaves his or her business must have ceased if not sold. The fact that the business in continued elsewhere is irrelevant.
For more information on the German Tax System please contact one of our tax planning consultants.