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Included in the Draft 1996 Tax Act published by the German Government on 31 March 1995 is a provision permitting the retroactive reversal of constructive dividend distributions under certain circumstances. Following please find a short description of the problem of hidden dividend distributions in general and the most important facts to be taken into account if hidden dividend distribution treatment is to be retroactively avoided.

Under German corporate tax law, an agreement between a corporation and its shareholder or related parties which is not at arm's length, and is disadvantageous for the German corporation, results not only in an increase in the taxable income of the German corporation, but also in a constructive dividend distribution made by the German corporation to its shareholder. This procedure is best illustrated by an example. Let us assume that a corporation with no retained earnings reports a tax loss for the year of DM 100,000 but has deducted excessive interest payments made to its sole shareholder in reaching this result.
Loss initially reported						(100,000)
Increase in income due to non-arm's length agreement	+ 50,000
Taxable income							 (50,000)

Constructive dividend: 
net dividend								  50,000
+ corporation tax (30/70 of net dividend), rounded	  21,400
gross dividend							  71,400

In the above example the corporation has to pay corporate income tax even though its net income after adjustment for the constructive dividend is still negative. Moreover, it would have to pay withholding tax on behalf of its shareholder at a rate between 5% and 25% on the net dividend (DM 2,500 to DM 12,500 in the above example).

Under the existing legislation it is not possible to avoid this result even if the shareholder repays the amount of the constructive dividend either voluntarily or as a matter of contractual obligation. Any amount repaid is treated as an additional shareholder contribution and does not affect the taxable income of the German company.

The draft 1996 legislation would allow a retroactive correction providing the shareholder is obligated to repay any benefits from a non-arm's length agreement and actually does so in fact. The repayment obligation can arise either under corporate law or by virtue of a contract. It must, however, already be in force at the moment at which the constructive dividend distribution is deemed to occur (e.g. at the time of payment of an excessive price for goods delivered by a shareholder). Retroactive reversal would mean in effect that the tax paid by the corporation as a result of the constructive dividend is refunded to it by the tax authorities in the year in which the shareholder repays the constructive dividend to the corporation. The shareholder must also repay any corporation tax and withholding tax credited to him on his tax return.

It could therefore make sense to add a clause to contracts between related parties requiring repayment of sums received to the extent they are treated as constructive dividends for tax purposes. However, in situations involving foreign shareholders, it must be considered how the country of the non-resident shareholder would treat such an agreement. Moreover, it is uncertain whether the provision discussed will ever be enacted into law in the first place.

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This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.