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By its ruling dated 30 June 1997 (Saint-Gobain - IStR 1997, 557 with insightful commentary by Dr. Martin Lausterer), the Cologne Tax Court requested the European Court of Justice (ECJ) to decide whether various sorts of tax discrimination against the German permanent establishment of a foreign corporation resident in the European Union are permitted under Article 52 of the EU Treaty (freedom of establishment). The case relates to foreign dividend income received by the German permanent establishment of a French S.A. in 1988. While certain of the forms of discrimination complained of have since been eliminated by changes made in the German tax law effective from 1994 onwards, others still remain.
Foreign dividend income in general
German domestic tax law allows a credit for foreign taxes paid on dividends received from foreign subsidiaries (direct FTC) and for taxes paid by the foreign subsidiary itself on the earnings distributed (indirect FTC). To qualify for the indirect FTC the parent must have held a 10 % share in the foreign subsidiary for 12 consecutive months or more. The indirect FTC extends to taxes paid by a second-tier subsidiary if the parent's indirect shareholding through the first tier subsidiary is at least 10 %.
Instead of the FTC, many German tax treaties exempt dividends received by German corporations from foreign subsidiaries in which the parent holds a share of 10 % or more. While most tax treaties require a higher shareholding for this so-called "participation privilege," German domestic law reduces the minimum to 10 % (provided all other requirements under the particular tax treaty are met). Since 1994, dividends paid by the German parent which are deemed to come out of tax-free dividends received may be redistributed tax-free to another German corporation, but not to a resident individual. Redistribution to foreign persons triggers withholding tax only. Such withholding is reduced under tax treaties and eliminated entirely under the EU Parent-Subsidiary Directive.
Gains by German corporations on the sale of shares in foreign subsidiaries are likewise generally free of German tax under German domestic law subject to a 10 % holding requirement. Such tax free gains may be redistributed in the same manner as tax-free foreign dividends received. Furthermore, interest expense incurred to finance the purchase of shares in foreign corporations is at present deductible for tax purposes subject only, for shareholdings yielding tax-free dividends, to the requirement that the annual deduction be reduced by any dividends received in the same year (see article 54). [QQ]
Status of corporate permanent establishments
Since 1994, the German commercial permanent establishments of all foreign corporations (i.e. not just those of EU corporations) qualify for certain of the above benefits when shares in foreign corporations are part of their business property. Essentially, they now enjoy the following benefits on the same basis as German corporations:
- Direct and indirect FTC (non-treaty and credit method treaties)
- Exemption for dividends received from foreign corporations (tax treaty)
- Exemption for gains on sale of shares in foreign corporations
- Deduction for interest expense to finance shares in foreign corporations
However, domestic permanent establishments are still treated differently from foreign corporations, as detailed in the four points below. The first two points are at issue in the case before the ECJ. Points one to three are peculiar to situations in which a German permanent establishment (PE) holds shares in a German intermediate corporation which in turn holds shares in a foreign corporation:
i. Distribution of tax-exempt foreign dividend income received by a German intermediate corporation to its German "parent" PE triggers tax, whereas such distribution to a German corporate parent would not.
ii. Where a German intermediate corporation is consolidated for tax purposes under a German PE, the participation privilege is (arguably) lost on the foreign dividend income received by the intermediate corporation, whereas it would still apply if the intermediate corporation were consolidated under another German corporation.
iii. Where a German intermediate corporation is consolidated for tax purposes under a German PE, the indirect FTC on the foreign dividend income received is limited to the first tier subsidiary of the German intermediate corporation, whereas the FTC would extend to second tier subsidiaries if the German intermediate corporation were consolidated under another German corporation.
iv. Permanent establishments of foreign corporations pay corporation tax at a flat rate of 42 %; there is no withholding tax on transfer of earnings. German corporations pay corporation tax of 45 % on retained earnings and 36 % on distributed earnings. While distributions trigger withholding tax of 25 % under domestic law, this is eliminated on dividends to EU parent companies (and generally sharply reduced under tax treaties). The tax rate for German permanent establishments of EU parents is thus considerably higher than that applying to earnings distributed by their German subsidiaries.
The chances appear good that the ECJ will decide in the taxpayer's favour.
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