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In its tax treaties, Germany typically uses the exemption method to avoid double taxation on certain sorts of income, including capital gains, business profits, and dividends received by a German corporation from a qualified participation in a corporation in the other treaty state. The tax exemption in Germany for such dividends is known as the "participation exemption". Under German domestic law, a 10% direct shareholding is sufficient to qualify for the participation exemption even if a particular tax treaty establishes a higher limit. Moreover, in 1994 sec. 8b KStG was added to the German corporate income tax law to permit German corporations to sell tax-free their shareholdings in foreign corporations to which the participation exemption applied.

The Federal Tax Court has recently reaffirmed its 1971 decision that interest expense incurred to finance the purchase of shares in foreign corporations remains deductible in Germany within certain limits even when the dividends flowing from such a participation are exempt from German tax (BFH IStR 1996, 336 - 29/05/1996). In addition to the cited decision, two unpublished decisions with the same tenor were handed down on the same date. From the decisions, it appears to make no difference whether the year in question is prior to the effective date of sec. 8b KStG or not.

The cited decision had been awaited with great interest after state tax authorities in certain German states had secured a lower court judgement categorically denying the deductibility of interest expense or other expenditure in connection with shareholdings qualifying for the participation exemption. The legal basis of these judgements was sec. 3c EStG, a provision applicable to corporations as well which denies a deduction for expense "with direct economic relation to tax-exempt revenue". Prompted by the adverse reaction to this decision from German industry and the positive reception by German state tax authorities, the German Federal Ministry of Finance issued a draft public letter ruling reaffirming the principles of the 1971 Federal Tax Court decision. However, this ruling was blocked by the majority of the German States Ministries of Finance and never took effect.

In its 1971 decision, the Federal Tax Court had held that an analogous provision precluded a deduction of interest and other expense related to a shareholding qualifying for the participation exemption only to the extent of dividends actually received from the shareholding in a particular tax year. A deduction was therefore allowed to the extent of the excess of expense incurred over dividends received in a tax year. This led to development of the so called "ballooning technique" under which dividends from foreign corporations were not paid to their German shareholders for several fiscal years, causing the expenses in Germany to be fully deductible for the respective fiscal years. Then, a large dividend was paid in a single year, preferably one in which the expenses had been quite low or even nil. By this means, it was possible to deduct most, if not all, expenses relating to tax free foreign participations for German corporation tax purposes.

Since the deductibility of the excess of expense incurred over dividends received has now been reaffirmed, such tax planning structures remain possible in the future. There appears, however, to be a distinct possibility that the tax laws will be amended as desired by a majority of German states to deny the future deductibility of expenses incurred in connection with tax exempt foreign shareholdings. Such an amendment is unlikely to take effect before January 1998.

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