by Thomas Sauter and Dr. Tobias Eckerle, KPMG Frankfurt

The following article first appeared in International Tax Review, September 2002, p. 64

For editorial cut-off date, disclaimer, and notice of copyright see end of this article.

In a decision that may mean less than meets the eye, Germany's highest tax court has handed down its first decision on a provision added to the tax code in 1994 to combat treaty shopping (Federal Tax Court judgement of 20 March 2002 – IR 38/00 – published only electronically so far). The treaty shopping statute read as follows in 1994, the year at issue:

A foreign company has no right to tax relief (tax exemption or tax reduction under ... [Germany's implementation of the EC Parent-Subsidiary Directive] or under a convention for the avoidance of double taxation) to the extent it is owned by persons who would not be entitled to such tax relief if they derived the income directly, and there are no economic or otherwise valid reasons for the company's interposition and it engages in no economic activity of its own.

The provision was slightly revised in 2001 and moved from section 50d (1a) to section 50d (3) of the Income Tax Act, but remains in force substantially as set forth above and applies to both individuals and corporations.

The case before the court involved the first and second tier subsidiaries of a Bermuda-based television and film production and licensing group. The group's Bermuda holding corporation owned various Dutch subsidiaries, including a wholly owned B.V. which in turn held all of the shares in a German GmbH. The Dutch B.V. had no personnel of its own besides its general manager, who also managed other Dutch members of the same corporate group. The B.V. shared the premises and the telephone and fax numbers of one such group member. The Bermuda holding company belonged to three individuals: a Bermuda resident with an 85% stake, a U.S. resident with a 7.5% stake, and an Australian resident, also holding 7.5%.

The German GmbH paid a dividend to the Dutch B.V., which the B.V. presumably received free of tax in the Netherlands. In Germany, the B.V. requested a refund of 4/5 of the 25% withholding tax under Germany's implementation of the EC Parent-Subsidiary Directive. A full refund was not available because of a transition arrangement allowing Germany to levy a 5% withholding tax on EU dividends paid on or before 30 June 1996. Citing the treaty shopping statute, the German Federal Office of Finance denied the refund request and rejected the taxpayer's administrative appeal.

The B.V. filed suit. Both the lower court and the Federal Tax Court (FTC) decided in favour of the tax authorities, holding that the refund could be denied both under the treaty shopping statute and under the general anti-avoidance provision in section 42 AO (Tax Procedure Act):

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.

One line of cases under section 42 AO relates to interposed foreign corporations (so-called foreign base companies) located in low-tax jurisdictions. The courts have disregarded interposed foreign base companies where no economic reason or other valid reason for the structure was discernible and the interposed corporation engaged in no business activity of its own. The 1994 treaty shopping statute was modelled after this line of cases.

Until 1997, when the FTC overruled its 1982 Monaco decision, section 42 AO was considered inapplicable to non-resident taxpayers. Furthermore, the statute had only been applied against foreign base companies in low-tax jurisdictions. Hence, the drafters of the 1994 treaty shopping statute assumed that section 42 AO could not be used to combat treaty shopping of the sort involved in the March 2002 judgement.

In this judgement, the FTC reaffirms both its abandonment of Monaco and its 1998 holding that an interposed corporation without economic substance can be disregarded under section 42 AO even if not located in a low-tax jurisdiction. In light of this shift in the case law, the court raises, but does not resolve the question whether the treaty shopping statute has any significance independent of section 42 AO.

The legal consequence of section 42 AO is to disregard an interposed corporation that lacks sufficient substance. Under section 42 AO, the Bermuda holding company is treated as the dividend recipient. Since Germany has no tax treaty with Bermuda, no reduction of withholding tax is permitted. Had a tax treaty existed, the Bermuda company would probably have had to file a refund request.

The legal consequence of the treaty shopping statute is to treat the Dutch B.V. as the dividend recipient, but deny a reduction of withholding tax because its sole shareholder would not be entitled to a reduction had it received the dividend directly and the Dutch B.V. lacks the required substance.

Irrelevant in the court's view was the fact that the U.S. and Australian shareholders in the Bermuda corporation would have been entitled to reductions, albeit of lesser magnitude, had they derived the dividends directly. There had been support in the literature for an alternative reading of the treaty shopping statute under which one looked to the ultimate shareholders of the interposed corporation and their entitlement to treaty protection. The Federal Office of Finance at first followed the alternative approach in the instant case by initially granting, then later revoking, the refunds to which the minority shareholders in the Bermuda corporation would have been entitled by virtue of direct shareholdings in the German GmbH.

The FTC rejected the taxpayer's attempts to portray the Dutch B.V. as a managing holding company that played an active role in financing and managing the German GmbH. The court did not reach the issue of whether shares in more than one subsidiary are necessary to qualify as a managing holding company in the first place. The court also dismissed arguments that the group's other Dutch subsidiaries were actively engaged in a trade or business, and that this was a valid reason to locate the interposed B.V. in the same country.

Finally, the FTC held that denial of a refund does not violate the Parent-Subsidiary Directive. While acknowledging that different anti-avoidance law in every EU member state could lead to undesirable non-uniform application of the Parent-Subsidiary Directive, the court considered the case at hand to involve a "classic" mailbox company, that is, an entity with so little substance that it must be disregarded under any conceivable implementation of the anti-abuse clause found in Article 1 (2) of the Parent-Subsidiary Directive. Referral to the European Court of Justice was considered unnecessary under such circumstances.

The instant case is of limited utility for future tax planning. While a zero-substance entity cannot claim the benefits of a tax treaty or the Parent-Subsidiary Directive, it remains unclear just how much substance is needed to do so. With regard to the Parent-Subsidiary Directive, EU law limits the discretion the German legislature and courts otherwise enjoy. In Germany, some experts contend that a "pure" EU holding company with minimal substance and just one subsidiary is entitled to the protection of the Parent-Subsidiary Directive, whereas others reserve this privilege to managing holding companies that play an active role in financing, controlling, and running multiple subsidiaries. The issue is crucial in light of the large number of international groups that have rearranged their European structure to take advantage of the Parent-Subsidiary Directive.

Editorial cut-off date: 13 August 2002

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