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German tax law contains a general anti-abuse provision in sec. 42 AO (tax procedure act). This section reads as follows:
The tax laws may not be circumvented by abuse of legal structuring possibilities. In case of [such] abuse, the tax claim [of the tax authorities] is the same as that arising under a structure appropriate to the economic transaction.
The vagueness of the statute makes it difficult for taxpayers and tax authorities alike to know when it will apply. Obviously, a structure cannot be "abusive" in the sense of the law just because it was preferred over another structure which would have resulted in greater tax liability. Over the years, the courts have tended to regard structures as abusive if they are unusual (artificial, contrived) and serve no sound business reason.
1. Recent decision on abuse provision
A recent Federal Tax Court decision involved a Dutch pension fund (with separate legal identity) and its two wholly owned Dutch subsidiaries. The two subsidiaries purchased a German office building in late 1979 using funds borrowed for this purpose from the pension fund. They rented the office building to an unrelated third party and had no permanent establishment or permanent representative in Germany. The subsidiaries were typical "mailbox" companies with minimal equity and no employees or independent economic function of their own. They were managed by the pension fund and had the same mailing address and telephone number. While apparently at an arm's length rate, the interest payable on the loan from the pension fund greatly exceeded the foreseeable net rent from the office building. By the end of 1980, the two subsidiaries owed hfl 624,000 in back interest. By 1985, this figure had risen to just under hfl 5 million. Because of the interest expense, the two subsidiaries reported a loss on their German rental activities. The Dutch pension fund received interest payments free of tax in Germany under the tax treaty and in the Netherlands as well under Dutch domestic law.
On audit, the tax authorities denied the deductibility of the interest in computing rental income subject to German tax. Treating the two subsidiaries as a partnership, the tax authorities issued a formal determination of partnership income. (The income of a partnership is generally determined in an initial separate procedural step under German tax law (sec. 180 (1) no. 2 AO) before being allocated to the individual partners.)
The two corporations contested this determination. The case went up to the Federal Tax Court on appeal, was remanded to the tax court in 1994 (BFHE 176, 571 - 21 December 1994), and decided by it for the second time in 1997 (EFG 1997, 538). The second time around, the tax court held that the loan of funds by the pension fund to the two corporations was abusive under sec. 42 AO. It therefore upheld the determination of partnership income as if no loan had taken place (in effect, denial of the interest deduction). The two corporations appealed again, resulting in the decision here reported on.
The Federal Tax Court overruled a second time, holding that the tax authorities had assessed tax against the wrong person. The court found that the only reason for interposing the two corporations was to siphon off the German rental income in the form of interest on the shareholder loan. It rejected, somewhat summarily, the argument that the corporations were also interposed for the legitimate non-tax reason of limiting liability. The structure selected by the Dutch pension fund was therefore regarded as abusive within the meaning of sec. 42 AO. As a consequence, tax liability arose as it would have under a reasonable, non-abusive structure. This in effect meant disregarding the two interposed corporations. The rental activities were therefore attributed to the Dutch pension fund.
This holding was disastrous for the tax authorities. The determination of partnership income for the two corporations was quashed because the income was attributable to the Dutch pension fund. In view of the time elapsed since the litigation marathon began, it was no longer possible to issue an assessment notice against the pension fund because the statute of limitations had run.
Unlike the tax court, the Federal Tax Court saw nothing abusive about the fact of the loan as such. On the contrary: the high court reaffirmed its consistent position that a shareholder is free to finance his subsidiaries with debt or equity as he sees fit. It was in the court's view only logical for corporations with little equity to borrow funds to finance a purchase they wished to make.
The abuse lay not in the loan, but in "the merely formal transfer of the rental activity from the pension fund to the taxpayers for the sole purpose of avoiding recognition of positive rental income by the pension fund" (court's decision at page 114/2).
2. Grounds of the abuse of law
Like many of the decisions under sec. 42 AO, this one is hard to understand and it is hard to see how it should apply to other cases. Abuse of tax structuring possibilities may be in the eye of the beholder. The tax court struggled with this case for a decade without being able to discern the abuse now identified by the Federal Tax Court. The tax authorities are in the same boat, and out of their money, because they issued their assessment against the wrong person.
Why the court believed the Dutch pension fund did not obtain the non-tax benefit of limited liability from the chosen structure is unclear. The court at one point implies that the two corporations acted "in fiduciary capacity" for the pension fund (p. 114/2). Apparently it did not mean this in a strict sense, however, because it did not rest its decision on sec. 39 (2) AO, which reads in pertinent part, "property held in fiduciary capacity is to be attributed to the principal". The casenote thus speaks of a "quasi-fiduciary" relationship. At another point the court stresses that the Dutch pension fund bore the economic risk (p. 115/1) of the venture (since only its funds were committed) and that it was economically impossible for the corporations to discharge their obligations under the loan agreements because the rental premises could not possibly generate enough income (p. 114/1). This coupled with the complete lack of substance or function in the interposed corporations is probably the grounds of the decision.
It should be noted that the Federal Tax Court had hitherto applied sec. 42 AO only to justify disregard of functionless companies (mailbox corporations) interposed by domestic taxpayers (BFH BStBl II 1982, 150 "Monaco decision"). It overrules its prior decision and holds the anti-abuse provision to be equally applicable to mailbox companies interposed by foreign taxpayers.
3. Other aspects of the decision
The decision confirms an earlier decision (BFH/NV 1990, 161 - 30 August 1989) with regard to the character of the income earned by the two foreign corporations, or rather, the foreign pension fund. The pension fund, which was subject to corporation tax on its German source income, derived rental income (Einkuenfte aus Vermietung und Verpachtung), not commercial business income (Einkuenfte aus Gewerbebetrieb), from the rental of the German office building. This is because only its German activities are relevant for characterising the type of income it earned and these included no commercial business activity. Such income is also not deemed to be commercial under sec. 8 (2) KStG. If the income from the office building had been commercial business income, it would have been tax free for want of a permanent establishment or permanent representative in Germany to which to attribute it. As rental income, however, it was taxable by virtue of the situs of the property (sec. 49 (1) no. 1 (a) and no. 6 EStG). The tax treaty assigns to Germany the right of taxation for income from German real property.
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