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Simply put, a German resident corporation pays a constructive dividend to its shareholder by conferring on him a benefit for no consideration or inadequate consideration under the arm's length principle. A benefit in this sense may be conferred by failing to prosecute claims which the corporation has against its shareholder, as a recent case illustrates.
The case likewise illustrates the dual nature of a constructive dividend. On the one hand, the income of the corporation must be increased by the amount of the constructive dividend for both trade tax and corporation tax purposes. This occurs for the year in which its income is affected. On the other hand, upon receipt by the shareholder, a number of important distribution adjustments take place. The corporate tax burden is reduced to 30 % if the distribution comes out of higher taxed earnings and (usually) increased to 30 % if it comes out of earnings originally subject to a lower rate of tax. Furthermore, withholding tax is owing on the amount distributed and the shareholder (if a domestic person) is entitled to a credit for the corporation tax associated with the distribution.
The decision by the Federal Tax Court of 14 Sept. 1994 (DStR 1995, 94) involved a shareholder who, as general manager of his GmbH, had made significant gold purchases which, when the price of gold dropped, resulted in losses for the GmbH. The court below had held that, in making the purchases, the general manager had exceeded his authority and was thus liable to the GmbH for the amount of the loss. By failing to capitalise a damage claim against the general manager in its balance sheet for the loss year, the lower court considered that the GmbH had waived the claim and, in so doing, paid a constructive dividend to the general manager/shareholder.
The Federal Tax Court reversed and remanded the case to the lower court for further deliberation. Basically, the Court required answers to four questions the lower court had failed to address:
1. Had the other shareholders of the GmbH approved the gold purchase in advance? If so, no damage claim could arise under applicable GmbH law and hence there could be no waiver and no constructive dividend. (Approval after the fact would also seem to be sufficient provided it occurred before the loss was incurred, i.e. before the price of gold fell.)
2. If no adequate approval existed, could the GmbH have capitalised the claim on its balance sheet under applicable commercial law? This issue turns largely on whether the general manager acknowledges or contests his liability in damages. If a capitalisable claim existed, the Court implied that the GmbH's balance sheet should be corrected to include the claim, thus neutralising the loss but not leading to the distribution adjustments.
3. If the claim could not be capitalised, had the GmbH failed to bring suit in a matter in which it would have presumably received judgement in its favour? If so, would it presumably have been able to enforce the judgement? If the answer to these questions was affirmative, a constructive dividend would have occurred and the income of the GmbH would have to be corrected. Whether the distribution adjustments were necessary would, however, still turn on the answer to question 4.
4. Had the damage claim really been waived? Clearly, failure to capitalise can only be relevant if capitalisation was possible in the first place (question no. 2). Even so, the Court implied that mere failure to capitalise the claim did not constitute waiver and that waiver must be found in other circumstances. Absent waiver, no receipt of the constructive dividend by the shareholder could have occurred and no distribution adjustment of the corporate tax burden would be appropriate.
As a practical matter, the easiest way to avoid the constructive dividend dilemma in such situations is to be certain to secure formal shareholder approval in advance of risky or questionable transactions.
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