German banks have issued "Genussscheine" qualifying as tier two banking capital. Such Genussscheine have been subscribed by UK corporate investors. Under the German/UK Tax Treaty, Genussscheine are named in the dividend article providing for a 15% German withholding tax. For many years, the German Federal Fiscal Office therefore rejected applications for the full refund of the German taxes withheld. In the judgement of December 11, 2003 the Lower Fiscal Court of Cologne now decided that income from certain Genussscheine constitutes interest income subject to a zero rate for German withholding tax purposes.
In the judgement of December 11, 2003 the Lower Fiscal Court of Cologne decided the long controversial tax issue whether income of an UK corporate investor from certain German Genussscheine constitutes dividend or interest income under the Double Taxation Convention between Germany and the United Kingdom of Great Britain and Northern Ireland (DTC Great Britain).
Only in the case of dividend income the Federal Republic of Germany has the right to impose German withholding tax.
Facts Of The Case
The UK corporate investor obtained income from German Genussscheine i.e. convertible profit participation certificates issued by a German bank and qualifying as banking equity under the German Banking Act. From these earnings, statutory 25% German withholding tax plus 5.5% solidarity surcharge thereon was retained by the issuer.
The UK corporate investor applied for a zero rate by reference to the interest Art. VII of the DTC Great Britain.
The German Federal Fiscal Office rejected the full refund of the German taxes withheld as in its view the earnings from the Genussscheine constitute taxable dividends under Art. VI (4) of the DTC Great Britain and not zero rated interest. Accordingly, the Federal Fiscal Office only refunded German withholding tax in the amount of 10% of the earnings plus the solidarity surcharge. This left the UK corporate investor with a final German withholding tax of 15%.
The UK corporate investor appealed against the rejection of the full refund of the German taxes withheld. The appeal was accepted by the Lower Fiscal Court of Cologne in the judgement of December 11, 2003 which is now final.
The Genussscheine in question were those frequently issued by German banks to German or non-German investors and qualifying as banking equity of the issuer under the German Banking Act. Due to this, they had the following features:
- A fixed annual return, which was cumulative.
- Reduction of this annual return to the extent the return otherwise due results in an annual deficit of the German bank as issuer.
- Repayment generally at nominal value (no participation in hidden reserves or goodwill).
- Full participation in losses of the German bank which could result in a lower repayment amount to the Genussschein investor.
Arguments of the Federal Fiscal Office
The Federal Fiscal Office held that the income from these Genussscheine needs to be seen as dividends subject to German withholding tax of 15% under the DTC Great Britain:
- The Genussscheine have certain characteristics qualifying them as shares rather than debt.
- The owners of the Genussscheine participate in losses of the issuer.
- Such loss participation may result in receiving less than the nominal value at the end of the term of the Genussscheine (shareholder risk).
- The qualification as banking equity under the German Banking Act speaks in favour of treating the income from the Genussscheine as taxable dividends rather than zero rated interest.
Judgement of the Lower Fiscal Court
The Lower Fiscal Court based its view on the overall picture of the case at issue. It held in its comprehensive judgement, that the income from the Genussscheine needs to be considered as interest under the DTC Great Britain. The result is a full refund of German withholding tax based on the following reasons:
- Although the Genussscheine are directly listed in the dividend article in the DTC Great Britain, a case by case consideration of the individual features of such securities is required for proper taxation.
- Only if the securities in question have prevailing characteristics of equity rather than debt, it is justified in the view of the Court to treat the income arising from such securities as dividends under the DTC Great Britain.
- Although in principle there are two arguments to treat the income from the given Genussscheine as dividends, namely, (a) the possibility of a capital loss due to participation of the Genussschein owner in the annual deficit of the issuer and (b) the qualification of the Genussscheine as banking equity, all other features of the given securities indicate a loan arrangement according to the Court.
- Especially, the recognition of the Genussscheine as banking equity under the German Banking Act is not relevant for German tax purposes, as there is a different qualification of equity for banking purposes versus equity for tax purposes.
Based on the further features of the Genussscheine, the Lower Fiscal Court held, that the UK corporate investor has the entitlement to a full refund of German withholding tax on the earnings:
- There is neither participation of the owner of the Genussscheine in liquidation proceeds nor in hidden reserves or goodwill of the issuer.
- There is an explicit exclusion of any shareholder rights in the terms and conditions of the Genussscheine.
- There is a fixed return and a fixed life of the Genussscheine.
- As explicitly ruled in the terms and conditions of the Genussscheine, their owners need to be satisfied prior to any shareholders of the issuing company.
Therefore, the Lower Fiscal Court qualified the Genussscheine as loan instruments. As the Court acknowledged that this case is of fundamental importance it allowed an appeal with the Federal Fiscal Court.
The fundamental importance of this case was seen by the Lower Fiscal Court in the issue, that there is no Federal Fiscal Court decision available yet whether or not the non-participation in hidden reserves and liquidation proceeds is sufficient for recognition of the Genussscheine as a loan instrument despite a residual risk of the investor that he may receive less than the nominal value of his investment at the end of the term of the Genussscheine due to his participation in losses of the issuer, if any.
However, the Federal Fiscal Office did not appeal to the Federal Fiscal Court. Therefore, the above decision of the Lower Fiscal Court is now final.
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