Germany: German Tax and Legal News

OECD Proposes Clarification of Permanent Establishment Definition

The OECD working party dealing with permanent establishment questions arising in connection with the model tax treaty has proposed three amendments to the official commentary in respect of the definition of permanent establishment. The three changes concern:

• clarification that whilst any member of a multinational group may have a permanent establishment in another country where another group member is located, the determination of whether a permanent establishment actually exists must be done separately for each group company.

• stating that management services provided by one group company for another will not usually lead to a permanent establishment of the recipient in the country of the provider, since it will not be the business of the recipient that is carried on in the place where the facilities of the provider are located.

• emphasising that a PE by representation will not arise merely because a person from one group company has attended or even participated in sales negotiations of another group company in another country. However, the activity could be relevant in determining the exact functions performed by the person concerned on behalf of the whole group.

The OECD has called for comments by June 30. The details can be downloaded from http://www.oecd.org/dataoecd/34/9/31483903.pdf.

Other changes to the official commentary proposed recently refer to the employment income of staff hired out by a firm in another country and to the ancillary services such as maintenance and overhand provided by international airlines and shipping lines for their corporation partners under pooling arrangements.

German tax relations with Tajikistan are still governed by the double tax treaty of November 1981 with the Soviet Union. The ministry of finance has just published the text of a new treaty signed on March 27, 2003; the Bundesrat passed a motion of "no objection" to the ratification bill at its sitting of April 2. The new treaty will enter into force on the day the instruments of ratification are exchanged and will take effect for the tax year starting on the following January 1.

The text closely follows the OECD model with the following rates of withholding tax:

• Dividends to companies holding at least 10% of the share capital - 5%

• Dividends to all other shareholders - 10%

• Interest - including mortgage interest - nil

• Royalties - but not for equipment hire or leasing - 5%.

The business profits clause of the new treaty resolves the potential for qualification conflicts over partnership income by stating that income earned through a partnership shall be treated as the permanent establishment income of the partner; however, service fees, interest, rentals and royalties paid to a partner shall (only) rank as partnership profits if they are classified as such in the source state. This provision is reinforced by the avoidance of double taxation clause which substitutes the credit method for the exemption method wherever there is a conflict between the type of income or the identity of the taxpayer.

Apart from Tajikistan, the 1981 Soviet treaty remains in force in respect of the following states:

• Armenia

• Azerbaijan - new treaty under negotiation

• Belarus - new treaty initialled in November 1996

• Georgia - new treaty under negotiation

• Kyrgyzstan - new treaty under negotiation

• Moldavia

• Turkmenistan - new treaty under negotiation

• Uzbekistan.

US tax law treats a limited liability company (LLC) as a partnership unless the shareholders opt for its taxation as a corporation ("check-the-box" election). German tax law requires that a foreign entity's status be determined on the basis of a comparison with the legal properties of a German corporation. If the entity's legal structure - under its own charter within the context of its governing law - is closer to that of a German corporation (mostly an AG or GmbH) it will be treated as such for German tax purposes; otherwise it will be seen as a partnership or - if there is only one shareholder or owner - branch. The entity's tax status in its home country is irrelevant to the German determination, as is its exercise of any possible home country option, in this case "check-the box".

The ministry of finance published its decree of March 19 on March 26 giving guidance on its views as to the German tax status of a US LLC. Mostly, this is relevant to the German qualification of income from the LLC in the hands of a German shareholder, but it can also be of importance to the treaty protection from withholding taxes on income paid from Germany to a US LLC, or through the LLC to the shareholders.

The decree emphasises that each case must be decided on its own merits. It lists five specific criteria which, generally, will be sufficient to make the determination of status. Each criterion is to be seen in context with the others, that is, there is no particular order of preference:

centralised management typical of a corporation will be assumed if the LLC has a board of managers on which non-shareholders are potentially eligible for seats. Corporate shareholders with seats on their own boards potentially available to non-shareholders also suggest a centralised management of the LLC. Restriction of the board membership to shareholders with their own right to manage the LLC and to act in its name, on the other hand, will tend to indicate a partnership.

limited liability will be denied if any shareholder is personally liable for the debts of the LLC (for instance under a blanket guarantee).

free transferability of the shares presupposes that shares can be transferred to third parties without the approval of one or more of the existing shareholders.

distribution of profits by a corporation requires a shareholders' resolution, whereas for a partnership it is automatic. the share capital of a corporation must eventually be paid in, whereas a partnership may not require any capital contribution at all or satisfy itself with the provision of services.

The decree mentions other criteria - continuity of life, or profit distribution in the ratio of capital contributed - but does not ascribe great importance to them, largely because of the many exceptions in German law and practice. Similarly, formation formalities are also not a relevant criterion, since these are the same for any LLC.

If natural persons as private individuals sell property in the course of managing their estates, the gain on the sale is subject to income tax if the property was held for up to 10 years. If the property was owned for longer, the gain will be free of tax altogether. If, however, the sale is seen as being by way of trade, the gain will be charged to both trade and income taxes regardless of the period of ownership. The broad distinction between the two concepts is found in the so-called "three item rule", that is, up to three sales over five years are asset management whilst four or more qualify as trading. The ministry of finance has now issued a detailed decree based largely on the relevant Supreme Tax Court cases since 1990, when the three item rule was first formulated, to give specific guidance in borderline cases. In particular, it deals with the exceptions, where the circumstances of the case clearly indicate an intention to deal by way of trade even though fewer than four properties were actually sold. It also deals with the converse case of more than three items being sold without the activity necessarily losing its qualification as asset management. This latter is especially the case where a property had previously been let for more than ten years, or with owner-occupied housing.

Businesses from non-EU countries have the right to claim a refund of their German VAT on the same terms as businesses from other EU countries if the ministry of finance is satisfied that German businesses enjoy reciprocal treatment in the foreign country. The ministry has now updated its list of favoured states by adding to it Brunei-Dar es Salaam, Cyprus, the Czech Republic, Guernsey, Jersey, Latvia, Lithuania, Macedonia, and Slovakia. Malta is now the only acceding country to the EU not on the list, although this also applies to the three candidate countries, Bulgaria, Romania and Turkey.

The 2004 Budget Accompanying Act extended the VAT reverse charge principle on certain domestic sales to all VAT-able sales of real estate subject to real estate transfer tax, and to sales within the building trade. According to the statute, the new rules take effect on April 1, but the ministry of finance has just issued a decree allowing those affected to delay their application of the new rules until July 1, provided that both parties to the transaction agree on a common treatment, and subject to the condition of correct taxation by the supplier.

The decree also clarifies, and expands on, some of the terms used in the statute. VAT-able sales of real estate broadly mean those sales of land and buildings subject to real estate transfer tax, in respect of which the parties have opted for VAT. This option must now be declared in the conveyance itself, or in a notarized supplement or amendment thereto. If the sale is by public auction at the behest of a mortgage creditor, the exercise of the option must be declared before calling for bids, though otherwise the rules for reverse charge on forced sales by auction have not changed.

Sales within the building trade are those for building work, or for all but insignificant repairs and maintenance of buildings, by one builder to another. The customer ranks as a builder if more than 10% of his turnover the previous year was from building work, or if he shows the supplier a valid exemption certificate for his own services from building withholding tax. The supply in question does not have to be in connection with any particular output of the customer; it could, for example, be the installation by a builder of a heating system in the office building of another business which also does building work. The customer must, though, actually invoice as such the building work done; a property developer that "only" sells completed housing free of VAT does not rank as a builder.

In an effort to curb the merry-go-round type of VAT fraud, the government introduced a provision into the VAT Act for 2002 to make the customer liable for the premeditated failure of the supplier to account for the VAT shown on the invoice. The liability presupposes that the customer knew - or, with the exercise of due care, should have known - of the supplier's intention when he placed the order, and hence that the two were in collusion. This, though, can be difficult for the authorities to prove, so the statute was enhanced for 2004 with a further sub-section deeming knowledge on the part of the customer wherever his buying price was less than the current going rate, or was below that paid by a supplier higher up the chain. The customer can, however, redeem himself and so escape liability if he can show a good business reason for the price he paid. The ministry of finance has now issued a decree stating how it intends to apply the new rules:

• the provision does not apply to VAT incorrectly shown on an invoice, as the input tax deduction for the customer would in case be excluded.

• it is up to the tax office to take the initiative in demanding payment from the customer, but before doing so, it must give the customer an opportunity to state his case and in particular to show that there was a valid business basis for the price charged.

• if the customer satisfies the authorities of the business basis for the transaction, they must investigate whether the customer nevertheless knew of the attempt to defraud.

• the tax office may withhold its approval of any VAT return of the customer, and may suspend any refunds due back to him, until they have completed their investigations

• if the customer is unable to satisfy the authorities of his probity, they may have recourse to him for the VAT without waiting for the attempts to collect it from the supplier to fail.

• if various customers are jointly liable, the responsible tax offices are to coordinate their actions.

Following an ECJ ruling, the finance ministry has issued a decree effective for all open cases extending the reduced rate of VAT charged by drama and musician groups to solo performers. VAT charged at the standard rate will still be acceptable as input tax for the invoice recipient for solo performances up to June 30.

The case before the Supreme Tax Court was brought by a sole proprietress whose Organschaft GmbH had made a gain from the sale of one of its operating branches. She maintained that an Organschaft subsidiary was "merely" a branch of the parent and that the income should be taxed by the parent as though the parent had earned it direct. For her, this should mean that the sale of the branch should be free of trade tax under the rules exempting from trade tax the gains of sole proprietors on relinquishing their trade or business, and that her income tax on the gain should be levied at the favourable rates relevant to large amounts of non-recurring income.

The Court accepted neither contention. In this case, it emphasised that an Organschaft subsidiary had a separate tax and legal personality from that of its parent, and that this distinction applied to corporation tax as it did to income tax. The gain was made by the GmbH, for whom it was trading income by statutory definition. The GmbH surrendered trading income to its Organschaft parent, the proprietress, who could not afterwards requalify it, merely because it would have had a different tax character had she earned it directly. Trading income was not favoured under either of the two relief provisions quoted. There was also no offence against the "equal treatment" provision in the Constitution, especially as she had not been forced into the Organschaft or compelled to continue with it once it had been accepted by the tax office.

The income of a corporation from all sources is trading income by definition. It is therefore subject to trade tax. The Income Tax Act mirrors this with a provision for a "partnership hallmarked as a trader". It defines this as a partnership with only companies as general partners and where the management is in the hands of the companies or of outsiders. There is also a rule stating that a partnership hallmarked as a trader shall rank as a company in respect of any partnership in which it is itself a member. Thus partnerships for which no natural person ultimately bears unlimited liability and which are run by employed managers (directors) all qualify as traders whatever their actual activity. Their entire income ranks as trading income.

The Supreme Tax Court has now confirmed for a GmbH & Co. KG that these rules qualify its income from managing the assets of one of its partners (real estate rented out to third parties) as income from trading. The GmbH & Co. KG is therefore subject to trade tax on its entire income from the moment its asset management started. This is a matter of statutory definition and is independent of any actual trading done or appearance thereof.

In the case before the Court, the sole shareholder and managing director of the general partner GmbH in a GmbH & Co. KG changed his personal status in the KG from that of a limited to that of a general partner by partnership resolution shortly before year-end, but "with immediate effect". This resolution was not entered into the trade registry until the following year. The change was clearly prompted by the realisation that the year was going to close with a large trading loss that would not rank for offset by the limited partner, except against later profits from the partnership.

The Court held that the resolution removing the limitation from a partner's liability "with immediate effect" was legally valid, and there was no reason not to recognise it's tax effect. The entry into the trade register was not a condition for validity, even if it was only then that the resolution became apparent to the outside world. The fact that there was ultimately only a single individual behind the GmbH & Co. KG also did not invalidate, or change, the legal forms. The change in status would entitle the new general partner to an immediate offset of the entire loss for the year against his other income, but always provided the resolution really had been passed in the old year. This, though, was a question of fact to be determined by the lower court. In its referral back, the Supreme Tax Court made the point that in tax law the onus of proof lay on the party making a claim to his own advantage; thus if the lower court were unable to determine in which year the resolution was passed, it would, in effect, be obliged to rule in favour of the tax office.

The lawyer fighting the case claimed that the rules requiring him to document in detail his business entertainment clashed with his duty to keep his clients´ affairs confidential. In his view, he was unable to follow the tax rules without committing an offence. The Supreme Tax Court did not, however, accept his contention and held him to be obliged to follow the general rules of recording the names of the persons entertained and the reasons for the entertainment if he wanted to deduct the expense from his taxable income. He must give at least sufficient details for a tax auditor to be able to see for himself that the entertainment was business and not private. The Court also made the points that:

• Giving the required details was not an offence against any penal provisions as the lawyer could assume that his business client had agreed to his disclosing the fact and circumstances of the entertainment when accepting the invitation.

• General reasons such as a business meeting, practice development or client meeting were too vague to be of value.

• Meetings with colleagues or other non-clients were often not covered or affected by a lawyer's duty to remain silent, since that duty only applied to his professional work for clients.

• Information disclosed on client affairs would only go to tax officials who were themselves bound to secrecy by a strict set of rules. These were of greater weight than a lawyer's professional duty of secrecy when one took other important factors, such as the public interest in a fair and orderly system of taxation into account.

• Even if the tax secrecy rules could not be relied upon in the circumstances, such as when the subject at issue was an as yet undiscovered tax fraud, the Court held that the lawyer would be able to follow the rules without disclosing that fact. "A less concrete disclosure would be sufficient, as long as it was enough to enable verification that the entertainment was for a business reason". Unfortunately, the Court did not expand further on what it meant by that remark.

In June of last year the ECJ held that the flat rate German tax of 25% on the performance fees paid to non-resident artists and athletes did not offend against community law as long as the amount of the tax did not exceed the German standard scale rate taxation on the same income net of expenses plus the basic personal allowance built into the rate scale - the Gerritse case. The ministry of finance has reacted in the meantime with a decree ordaining a simple refund procedure until the law can be changed.

The Supreme Tax Court has now ruled in the same vein in the slightly different case of a non-resident earning fees to be taxed as income from professional services. In this case the 25% is a minimum tax, rather than a flat rate. The self-employed income earner must file an income tax return and face an additional liability if the scale rate amount exceeds the 25% minimum. The German scale has the basic personal allowance (in 2004 of € 7,664) built in, whereas the 25% is calculated on the total net income. The self-employed fee earner was now claiming that the 25% should be calculated after deducting the basic personal allowance from the net income received so that he would have equal treatment with a salary earner.

The Court sided with the tax office. Employment and self-employment income are not the same and there are good reasons for the differences in taxation. In Gerritse, the European Court of Justice had pointed out that the purpose of the basic personal allowance was to shelter the bare subsistence level of income from taxation and that there was no need to give this shelter a second time, in a member state where the taxpayer was not resident. Since the Court was now following Gerritse, there was no need to turn to the ECJ anew. There was also no need to turn to the Constitutional Court in view of the possibility in the Income Tax Act of opting for taxation as a resident where the German income is high and that in the state of residence is low.

A private individual agreed with an insurance agent to purchase a policy on condition that the agent passed him part of the commission due on the deal. The tax office tried to tax this commission as "other income" but the Supreme Tax Court found it to be nothing more than an agreed rebate off the premium. As the Court emphasised, the insured person had performed no service to earn the commission beyond buying the policy for himself. The amount paid was thus nothing more than a partial refund of the purchase price, the premium. However, the Court did not go into the implications of the case for insurance tax, which is based on the premium paid by the insured person.

The European Commission has proposed that the Czech Republic, Latvia, Lithuania, Poland and Slovakia be allowed partial exemptions from the Interest and Royalties Directive for up to six years. The transitional relief was requested by the new member states concerned because of the losses of tax revenue they, as capital importing countries, would suffer from immediate application of the Directive. The Commission has previously agreed to similar requests from Greece, Portugal and Spain. The relief granted takes, among other things, the existing tax treaties with EU member states into account; thus the Czech Republic, Poland and Slovakia have not been granted a derogation for interest in view of the nil rate of withholding tax in most of their treaties. The concessions proposed:

The Czech Republic and Poland: a royalty withholding tax of not more than 10% may be levied for up to six years.

Latvia and Lithuania: withholding taxes on royalties may be not be more than 10% for six years. On interest, the maximum is 10% for the first four years, followed by 5% for the next two.

Slovakia: will not have to apply the Directive to royalties for the first two years (Slovakia did not ask for a longer period).

The Commission's suggestion includes a clause allowing for extension of the transitional relief. It emphasises that the existing treaty exemptions and reliefs must be respected and provides for credit of the withholding tax in the country of the interest or royalty creditor.

The European Commission has approved the system of rebates on minaral oil tax and electricity tax granted to high energy manufacturers from 2003 - 2006. Even with the rebates, the German energy tax is still within EU norms.

The e-Privacy Directive is seen by the European Commission as of central importance to its efforts to protect private homes as well as businesses, from spam, unwanted cookies, spy-ware and other forms of electronic harassment. Under its own terms, it should have been transposed into national law throughout the EU by October 31, 2003, but eight states, Belgium, Finland, France, Germany, Greece, Luxembourg, the Netherlands and Portugal, have so far failed to fulfil their obligations or to furnish the European Commission with a satisfactory explanation. Accordingly, the Commission has now moved to the second stage of its infringement proceedings, to serve "reasoned opinions" on the member states named. Those addressed now have two months in which to take action, failing which, the way will be open to the Commission to take them to the European Court of Justice.

In one of the few instances of departure from the opinion of the advocate general on the case, the ECJ has held that a German customer of a service from abroad which he was obliged to reverse charge, does not require a fully detailed invoice from the supplier as a precondition of his right to deduct the charge as input tax.

The case was brought by a German building firm which had purchased services from abroad. The services were depicted as sub-contracted building work - at the time potentially exempt from VAT under a now defunct provision - although they were, in fact, almost certainly nothing more than the loan of staff. The name of the supplier was vague; it purported to be a British company and gave two alternative London addresses and one in Holland, but was not listed in any local phone books. A company with a rather similar name was registered at the British Registrar of Companies under one of the two London addresses given, but there the similarities ended. After audit, the German tax office took the view that neither the identity of the supplier, nor the nature of the services rendered had been properly documented and thus subjected the supply to reverse charge VAT whilst denying the input tax deduction.

Ultimately, the appeal went to the ECJ on questions as to whether the German provisions on which the tax office based its position were in accordance with community law. After listening to the arguments of both sides, and of the European Commission in support of the German government, the advocate general on the case suggested in his opinion of October 23, 2003 that the Court find that the recipient of services to be reverse charged may exercise his right of deduction of the input tax "only if he is in possession of an invoice issued in accordance with Article 22 (3)" of the Sixth Directive. The advocate general then went on to list the invoice details required and to conclude that member states are allowed "to refuse the recipient a right to deduct if those particulars are absent or materially incorrect". As a slight let-out, he did make the point that it was up to member states to determine the consequences of difficulties in establishing whether the supplier of the services was the same person as the issuer of the invoice, but cautioned that the input tax deduction should not be made impossible or excessively difficult in practice.

The Court took the unusual step of departing fundamentally from the advocate general's opinion. It answered the questions of the referring court (the German Supreme Tax Court) with a blunt, "A taxable person who is liable, as the recipient of the services, for the value added tax relating thereto ...... is not obliged to be in possession of an invoice in accordance with Article 22(3) of that directive in order to be able to exercise his right to deduct."

In the write-up of the case, the Court does make the point that member states may establish their own formalities governing the input tax deduction of reverse charged VAT, but quickly qualifies this apparent licence with the demand that these formalities should not make the deduction impossible or excessively difficult in practice. This is further explained as meaning that the formalities for deduction "should not exceed what is strictly necessary for the purposes of verifying the correct application of the reverse charge procedure concerned". In other words, the deduction right is the equal and opposite of the charging obligation.

These articles are intended as general information for our clients. Concrete action should not be taken without reference to the specific sources given or advice from your usual PwC office. No part of this publication may be copied or otherwise disseminated without the written permission of the publisher. The opinions expressed reflect the views of each author.