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German tax law contains a general anti-avoidance provision in § 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 purpose.

In a case recently heard by the Munich Tax Court (DStRE 2001, 138 - 29 August 2000) which grew out of the reorganisation of a major German corporate group some ten years ago, the tax authorities argued unsuccessfully that interest-free loans granted between affiliated companies were abusive in the sense of the statute and should be disregarded. At the time of the first interest-free loan in 1990, the borrower (referred to in the decision as "PVE") had amassed considerable loss carryforwards attempting to develop solar energy technology. The loan proceeds were invested in interest-bearing securities through the financial investments branch of the ultimate group parent. Such investments were made in PVE's name and on its behalf. The interest income earned was sufficient to offset all of PVE's loss carryforwards. Thereafter, PVE was merged into another group company. Had any loss carryforwards remained at the time of the merger, they would have been lost under the German tax reorganisation law in force through 1994.

The tax authorities argued that the entire scheme was designed merely to derive benefit from loss carryforwards which PVE could not otherwise utilise and which would have been lost upon merger. The tax authorities attributed the interest income on the loans not to PVE, but to the related-party lenders, and assessed tax accordingly.

On appeal, the Tax Court ruled in the taxpayer's favour. The court applied case law dealing with the transfer of income-generating assets between family members. In such situations, German courts have disregarded the transfer of funds where these were loaned back to the transferor, and have disregarded the transfer of real property where this was rented back to the transferor. In the instant case, however, the funds in question were invested at interest with unrelated party debtors. Hence, the court upheld the transactions.

The court also lent weight to the fact that interest-free loans are a common practice between affiliated companies, hence not an unusual or contrived transaction. The loans were supported by a sound business reason, namely restoring the net equity of PVE to the level it originally possessed at formation. The fact that tax considerations were also involved was not in itself damaging. Finally, the recipient of the loans was not a "mailbox" company without any economic function. PVE's solar energy technology operations were continued by the surviving corporation for roughly a year after the merger.

The tax authorities have appealed the case to the Federal Tax Court. In a purely domestic context such as that involved here, interest free loans have long been an accepted tax planning tool in Germany. One should therefore expect Germany's highest tax court to affirm the lower court decision.

Editorial cut-off date: 01 June 2001

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