German Tax & Legal News (Monthly Update For Inbound Investors Into Germany)

Edited by Christian Ehlermann and Dr. Andreas Kowallik

Originally published April 2005

Update on Tax Authorities' Discussions and Guidance

Thin capitalization rules – Uncertainties about guidance on back-to- back financing

A number of controversial issues remain unresolved with respect to the interpretation of the German thin capitalization rules. One issue, in particular, concerns third party debt with shareholder recourse. Third party loans with shareholder recourse are subject to the German thin capitalization rules only if the shareholder, or a party related to the shareholder, maintains liquid assets with either the financing bank or another party and that deposit is security for the debt financing of a subsidiary (true "back-to-back financing").

According to a Federal Ministry of Finance (BMF) decree dated 15 July 2004, it was commonly viewed that back-to-back financing followed the "legal" approach. That is, a back-to-back situation is presumed only if interest-bearing assets of the shareholder or a related party are used as direct collateral for the loan.

In discussions among the tax authorities, some Länder representatives want to take an "economic approach" in interpreting a back-to-back arrangement. According to this view, a harmful back-to-back situation may exist in almost any situation where a third party lender has recourse against the shareholder or a related party where the assets securing the loan even indirectly involve interest-bearing assets (e.g. in the case of a shareholder guarantee when the group owns interest-bearing assets or if a shareholder pledges the shares of a subsidiary which, in turn, owns interest-bearing receivables/bank deposits). A safe harbor for interest-bearing assets that are essential to the taxpayer's business (e.g. funds for pension plans) is under discussion.

Final guidance on this issue is not expected before June or July. Regardless of which view will prevail, taxpayers should not rely on the courts to rule against the tax authorities as the law itself is worded very broadly.

On 12 April 2005, the BMF issued a 76- page document that includes extensive administrative principles on transfer pricing documentation requirements.

These administrative principles, which are only binding on the tax authorities, emphasize that it is the obligation of the tax authorities to investigate the facts of a case and to try to discover facts that are beneficial for the taxpayer. In addition, the taxpayer does not have an obligation under German law to demonstrate the correctness of the transfer pricing methodology used. The administrative principles also include extensive cooperation and document maintenance obligations for taxpayers, although such obligations are limited by the legal or factual ability of the taxpayer to obtain the documents or information from other parties. This limitation is particularly relevant for a German subsidiary of a foreign parent because the subsidiary may have difficulties obtaining the documents from its parent or a related party.

It is interesting that the administrative principles accept the use of arm's length prices and gross margins when using the resale price method as well as net margins of comparable companies for different kinds of business transactions or aggregated business transactions. The use of the transactional net margin method, however, is subject to a number of restrictions.

It remains to be seen how tax auditors will apply the rules articulated in the administrative principles. Taxpayers should take the principles into account when preparing documentation to avoid transfer pricing issues from the outset.

The German Minister of Finance announced he will describe in the near future the tax law changes required to finance the reduction of the corporate income tax rate (from 25% to 19%) without further consultation with the opposition parties. The Minister of Finance also said the legislative procedure will be completed before the summer recess. This statement was preceded by an announcement by the opposition that they would only accept a more moderate rate reduction than the planned reduction. (For a discussion of the ideas to finance the rate reduction, see GTLN 03/2005.) In addition to the reduction of the corporate tax rate to 19%, the tax burden of partnerships is also intended to be reduced by increasing the tax credit available for trade tax paid at the level of a partnership against the individual income tax of its partners.

The Upper House will probably not consent to this bill on the grounds that the proposed revenue raising tax provisions will not fully compensate for the reduced revenue from the proposed rate reduction. Consequently, the future of the tax reform still seems rather vague.

According to information published by the German tax authorities, the German government has terminated the tax treaty with Brazil dated 27 June 1975 by giving written notice of termination through diplomatic channels to the Brazilian government. Under article 31, the treaty will generally cease to apply as from 1 January 2006. No new negotiations are currently taking place.

On 14 April 2005, Advocate General (AG) Léger issued his opinion in the CLT-UFA case (C-253/03), which deals with the taxation of permanent establishments (PE) of nonresident corporations under the old German imputation tax credit system. In the year under review, profits of a PE of a nonresident corporation were taxed at a rate of 42%, while the profits of a corporate subsidiary of a nonresident corporation were taxed at a rate of 30% (33.5% before 30 June 1996) if all profits were distributed to its parent. According to AG Léger, the choice between operating as a corporate subsidiary and a PE should not depend on the taxation of these entities. He, therefore, recommended that the domestic court make a comparison of the tax rate imposed on PEs of nonresident entities and the rate imposed on a corporate subsidiary of a nonresident entity that distributes all of its profits, and apply the lower tax rate to PEs.

Because the imputation tax credit system was replaced by a classical income tax system in 2001, a decision by the ECJ will only be relevant for cases that took place before 2001 and that are still open.

On 17 February 2005, the tax court of Baden Württemberg found that the German implementation of the exchange of shares provisions in the EC Merger Directive was not in compliance with the Directive. Under the German rules, the value that the receiving company uses to record the shares acquired will be deemed to be the sales price of the person contributing the shares. Therefore, a cross-border exchange of shares without realization of a capital gain is possible only if the other country also permits the recording of the shares at book value. If that is not the case, a capital gain would have to be realized in Germany. The tax court of Baden Württemberg concluded that this rule is not in compliance with the Merger Directive, holding that the Directive should be directly applicable in these cases. The case is now pending before the Federal Tax Court (BFH).

In a series of recent decisions, the Federal Civil Court (BGH) has shaped the concept and applicability of "destructive intervention." Under this concept, the shareholders of a GmbH may become personally liable if they – disregarding the earmarking of funds of the relevant GmbH and without appropriate consideration – deplete assets of the GmbH by open or concealed withdrawals where the GmbH requires such assets to meet its debt.

In a decision of December 2004, the BGH more narrowly laid down the prerequisites for the concept of a destructive intervention to apply. In the court's view, a destructive intervention requires the concerted depletion (serving a purpose other than a business purpose) of assets required by the company to meet its obligations. The court expressly stated that a mere failure by the managing directors or, respectively, wrong decisions made with respect to the company's business operations, is not sufficient to constitute destructive intervention. While, in principle, the court's decision should be followed because it limits the applicability of the concept of destructive intervention to cases of severe depletion of assets, the ruling leaves uncertainty as to its interpretation on a case-by-case basis.

In two recent decisions, the OLG Düsseldorf and the High Regional Court (OLG) of Frankfurt a.M. ruled differently on the validity of departure clauses in management participation agreements. In the cases under review, both courts had to decide on the validity of a departure clause after local managers participating in the same program in different branches of a group enterprise had left the company. (A departure clause, in essence, provides for the re-transfer of a participation previously granted under a management participation program if the target's management decides to leave the target before an IPO or a trade sale).

Relying on prior case law of the BGH relating to shareholder termination clauses by way of ejection (which are valid only if supported by good cause), the OLG Düsseldorf held that the relevant departure clause was supported by good cause and, therefore, confirmed its validity. The OLG Frankfurt a.M., however, concluded that good cause was lacking and held that both the clause and the entire management participation program (including its implementation) were invalid and, therefore, had to be annulled. The OLG Frankfurt a.M. justified its decision by pointing out that, in its view, the departure clause was contrary to public policy and its invalidity on that basis infected the management participation program.

Although both decisions concern specific fact patterns, the conflicting decisions lead to substantial uncertainty as to the validity of departure clauses in Germany. Until a final decision is rendered by the BGH, it will be critical to include specific language in a management participation program, as well as in a departure clause, that could provide good cause within the meaning of the OLG Frankfurt a.M.'s decision.

Deloitte Germany's annual two-day seminar on outbound investments and developments in international tax law will take place in Königstein (near Frankfurt) from 31 May to 1 June 2005. The focus of the seminar will be tax issues and planning opportunities for German companies investing abroad and will include an update on recent tax developments with relevance to outbound investment in Germany and in major target jurisdictions (e.g. the United Kingdom, United States, Russia, China, Austria and Central and Eastern Europe). One-on-one meetings with target country participating tax partners can be arranged. Please note that parts of the seminar will be conducted only in German. If you are interested in attending, please contact Ebru Özüaydin (eoezueaydin@deloitte.de).

From 13-17 June 2005, IIR Ltd. will be hosting an International Tax Seminar in London that addresses current tax practice and planning opportunities in the U.K., Germany, U.S., France and Italy. The seminar also provides an overview of European holding and financing regimes. Practitioners of Deloitte Munich will give a presentation on 14 June 2005 on the key features of the German tax system with a particular emphasis on corporate taxation and transfer pricing in Germany. To register, or for more information, please contact Sindi Chong with IIR Ltd. (schong@iirltd.co.uk or www.iir-conferences.com/ITS). For a special discount on all registrations through Deloitte, contact Lolita Blankenstein (lblankenstein@deloitte.de).

In June 2005, Deloitte Germany will be hosting an English-language afternoon seminar on the German and the U.S. tax systems. Tax practitioners from both countries will discuss similarities and differences between the two tax systems. The seminar will take place in the following locations:

For more information, contact Lolita Blankenstein (lblankenstein@deloitte.de).

This article is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter. This bulletin should not be relied on as a substitute for such advice. While all reasonable attempts have been made to ensure that the information contained in this bulletin is accurate, Deloitte Touche Tohmatsu accepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

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