Germany: German Tax & Legal News - September 2004

Last Updated: 20 September 2004
Article by Andrew Miles

PwC Reports

Mutual agreement on the terms of Pakistan treaty

Officials from the German and Pakistani finance ministries met on July 6 and 7 for a mutual agreement discussion on the interpretation of the double tax treaty under particular circumstances. The agreement reached is documented in a joint memorandum, published by the German finance ministry on September 8. The terms of this memo are:

  1. The treaty and its protocol shall take precedence over the domestic law of both countries.
  2. The construction site permanent establishment profit of a turnkey project shall be distinguished from the home country profit of the contractor from the supply of goods and services on the basis of the contract and how it was carried out. The split shall follow the arm's length principle.
  3. German companies shall have access to the Pakistani advance ruling system.
  4. German residents opting for taxation in Pakistan under the "presumptive" tax regime (withholding tax as a final burden) do so of their own free will and are therefore precluded from claiming relief under the mutual agreement ("competent authority") procedure.
  5. Transfer pricing in the pharmaceuticals industry is to be on the resale price method.
  6. The parent company in the pharmaceuticals industry may ask its own tax authority to certify that its transfer prices are in line with its prices charged to third parties in other, similar countries. If there are no such transactions, the certificate may refer to transfer prices to related parties in other, similar countries. Such certificates will be accepted by the tax authorities in the other state.

Stock options: two new OECD reports

The OECD has issued two reports on employee stock options, one on tax treaty issues and one on transfer pricing. Domestic issues are to be the subject of a further report to be issued later this year. The reports are intended for guidance in interpreting the commentary to the model treaty and, as such, are not binding. That on tax treaty issues concentrates on:

  • double-tax relief should be granted by the country of residence, regardless of the year of taxation in the country of source
  • employment income accrues up to the exercise of the option. Value accretions thereafter become part of any capital gain realised later
  • the employment in respect of which the options were granted is a matter of fact. If this employment was exercised in two or more states, the income should be apportioned by the time worked in each.
  • the same rules should apply to options granted to board members.

The report on transfer pricing covers:

  • the charge by the parent issuing the stock to the subsidiaries employing the beneficiaries
  • the effect on other inter-company transactions where these are based on, or influenced by, the costs of rendering a service or making a delivery
  • the effects on third-party comparables
  • the need for adequate documentation that the plan and its recharges are at arm's length and take due account of all relevant facts.

These two reports are to be released in a bound volume together with the third report in the series, on the purely domestic issues faced by a country's tax administration, once this latter is published. In the meantime, they are available from http://www.oecd.org/daf/ctpa

Official Pronouncements

Finance ministry decree on application of EU Interest and Royalties Directive to new members

The finance ministry has added to its decree of April 26 on the direct application of the EU Interest and Royalties Directive from January 1, 2004, not withstanding the still pending enactment into German law, by a further decree to embrace payments to the new member states from May 1, 2004. For the moment, the Directive's options are to be exercised as follows:

  • the two year qualifying period throughout which all conditions must be met is to be observed,
  • the qualifying shareholding of 25% is to be based solely on the capital held without regard to differing voting rights, and
  • the Directive is not to be applied to interest based on profits.

Exemption under the Directive of qualifying payments from Germany to the new member states is therefore immediate on accession on May 1. Transitional arrangements allow some of the new members to levy withholding taxes for up to eight years as follows:

  • Latvia and Poland - 10% on interest and royalties for the first four years followed by not more than 5% during the next four
  • Lithuania - 10% on royalties for up to six years; 10% on interest four the first for years followed by not more than 5% for the next two
  • Czech Republic - 10% on royalties for up to six years
  • Slovakia - 10% on royalties for the first two years.

Double tax treaty provisions must, however, be observed.

Finance ministry decrees exemptions from the duty to report investments

Under a provision of the Tax Management Act - Sec 138 (2) - domestic acquirers of foreign businesses, branches or partnership holdings, or of larger holdings in foreign companies, must make an immediate report of the investment to their local tax office. A larger holding is one leading to a total holding of 10% in the company (25% if the shares are held indirectly) or where the total of all investments is more than € 150,000. The finance ministry has now issued a decree exempting certain investments from this reporting obligation:

  • Quoted shares of less than 1%
  • Investments in partnerships may be reported centrally by the partnership if it has undertaken to filed a German return of partners' income.
  • Shares held by banks for trading, or by insurance companies as current assets.

Tax amnesty ignored

According to an announcement of the finance ministry of Saxony-Anhalt, 8,477 amnesty returns of previously concealed income were filed throughout Germany during the first six months of 2004. The terms of the amnesty are freedom from penalties against a full return of all undeclared income in the period 1993-2002 with immediate payment of 25% of 60% of the gross amount concealed.

The tax now paid was € 223 m, or € 26,300 per return, which seems to suggest that fewer people are taking advantage of the amnesty, and then for smaller amounts, than the authorities originally hoped for. Certainly, the federal budget projection of € 5 bn income from amnesty payments in 2004 appears at the moment to be something of an illusion. No official explanation of the shortfall has been offered. The amnesty lasts until March 31, 2005, although the rate rises to 35% for those not reporting until the last three months.

Baden-Württemberg anounces tax relief for those suffering storm damage

Baden-Württemberg has announced that victims of serious storm damage may apply to their tax office for interest-free suspension of payment of income and corporation taxes.

Supreme Tax Court Cases

No income adjustment re interest-free loan to finance foreign PE

Two local residents jointly held the share capital of a GmbH as well as that of a Swiss company. In the course of a reorganisation, the business of the Swiss company was sold to the GmbH which funded the transaction with loans from its shareholders. The business acquired was continued by the GmbH in its own name as a Swiss permanent establishment. The loans were granted informally, that is without written agreements. Interest was charged at 1% above the Bundesbank's prime rate, but only for the first year. Thereafter, it was waived altogether. The tax office maintained that the shareholders had no arm's length reason not to charge interest at the going rate and imputed additional income to them. There was no corresponding expense for the GmbH as its interest costs would have been attributable to its Swiss permanent establishment and so were not a matter for German taxation.

The Supreme Tax Court declined to deal with the substance of the case. Rather, it took the view that the transfer pricing rules calling for all transactions between related parties to be at arm's length were founded on Sec. 1 of the Foreign Tax Relations Act and so did not apply to transactions between two domestic parties. Here, lender and borrower were both domestic parties, and the fact that the borrower intended to use the loan to fund the purchase of assets for its foreign permanent establishment was not the concern of the lender. At any rate, it did not make the GmbH a "foreign" borrower.

This case may well have wider implications than immediately apparent, particularly in view of the not infrequent attempts by tax officials to apply the transfer pricing rules by analogy to domestic transactions. Interest income is not considered to be a "contributable asset", so there was no reason here for the tax authorities to try interpreting the transfer pricing rules as an abstract definition of "hidden capital" in the hope of founding a profit shift on domestic law. The same consideration applies, though, to the provision of most other services.

Pre-2002 VAT: "zero rule" allowed even if invoice questionable

Up to the end of 2001, a business with unrestricted rights to deduct input VAT was able to agree with its foreign service supplier to ignore German VAT altogether. This "zero rule" meant that no output tax was due and no input tax could be deducted. The rule was dependent upon adequate documentaion by both sides, failing which the tax authorities were able - in their view - to cover any risk of lost revenue by requiring the German recipient of the service to reverse charge the supply. The case before the Court was brought by the German customer of a foreign building contractor who had invoiced without VAT under the "zero rule". The tax auditors found contradictory evidence of the identity of the supplier along with only unclear evidence of the exact nature of the service rendered. They concluded that the documentation requirements had not been met and held the customer responsible for the inappropriate application of the "zero rule". He was to meet this responsibility by accepting a reverse charge for the supply. At the same time, his right to deduct the input tax was to be curtailed because the supplier's invoice was of questionable accuracy, or even veracity.

The Supreme Tax Court suspended procedings whilst it asked the ECJ whether the right to deduct the input tax from a reverse charged output was dependent upon a supplier's invoice being in the hands of the taxpayer. The ECJ replied that it was not, at least where the output and input tax were to be paid and deducted by one and the same business. The tax office then changed its argument to say that the ECJ had been asked, and had replied to, the wrong question; the German taxpayer had an invoice, clear as to amount but unclear as to the identity of the supplier or type of service. The Supreme Tax Court, though, followed the ruling of the ECJ and refused to burden the holder of an inadquate invoice where no invoice was necessary in the first place. The vague description of the service rendered was irrelevant in the present case, too, since all the possible choices led to the same conclusion of taxation in Germany because the service was performed here.

Dissolution balance sheet of a partnership does not bind successor

The Reconstructions Tax Act allows corporate reorganisations and similar transactions at any value between the book and the (higher) market values of the assets, provided the same option is exercised on both sides of the transaction. In other words, deferral of an inherent gain is permitted, as long as the successor corporation does not seek to base its future depreciation or other expense on more than the old book values of the assets taken over. The Supreme Tax Court has now held that this principle does not apply (by analogy) to the dissolution of a partnership with distribution of the assets to the partners in kind for subsequent reinvestment in a different partnership or other business. The case was brought by a member of tax consultancy partnership who brought his share of the partnership assets on dissolution into a successor partnership with a new partner. Dissolution was at book value with distribution to the partners of the partnership assets in kind. This included in particular the (substantial) goodwill embodied in the client base. The partner decided to continue in practice with a new partner and brought "his" clients into the new partnership at the market value of the inherent goodwill. The other, new partner had no existing clients and so contributed cash. The Court confirmed that there was no legal succession between the old and new partnerships and that the validly exercised option of the first did not bind the second.

This case went against the interests of the taxpayer, since the difference between the dissolution and contribution values of the goodwill necessarily became chargeable by the partner as his business income. A capital gain on dissolution of the partnership would, at the time, have been chargeable at only half rates. However, if the assets had been held privately (inconceivable for goodwill, but not impossible for other intangibles), the differential could well have gone to the taxpayer's advantage.

Minimum value shareholding in Russian tax treaty is nominal value

The German/Russian tax treaty reduces the withholding tax on dividends to 5% if the recipient is a corporation holding at least 10% of the share capital with an investment amounting to at least DM 160,000 (now just over € 81,800) or the equivalent value in Roubles. In all other cases, the dividend withholding tax may not be more than 15%. The Supreme Tax Court has rejected an argument brought by a Russian shareholder in support of a claim for the lower rate of withholding tax that the absolute amount of € 81,800 be interpreted as referring to the market, or current value of the investment, rather than to its nominal value. The Court rejected all the various justifications put forward by the shareholder for his point of view and chose to rely on such objective evidence of the intent of the treaty partners as was actually available. It saw this evidence in the long established consistent practice of the administrations of both countries and in the lack of any agreement to take any other value than the nominal amount despite an opportunity of doing so (a mutual agreement on the effects of the exchange rate on the corresponding Rouble amount). In the view of the Court, the nominal value was both the simplest and most obvious interpretation, so that if anything else had truly been meant, there would have been an attempt at specification. Conclusions from the OECD treaty commentary were also to be rejected as not relevant, because the OECD model convention does not have such a clause.

Foreign company's expense deduction limited to direct costs - court turns to ECJ

The case was brought by a Portuguese company in the business of horse racing. It attended eleven German meetings in a year in which it made an overall loss. It was unable to claim a refund of the withholding tax deducted from its German gate money because German law only allows refunds of amounts exceeding 50% of the difference between the gross gate and the "directly related business costs". In this case, its direct costs were less than 50% of its gross German income, although, fully costed, it had made a loss in Germany as elsewhere. The Supreme Tax Court turned to the ECJ for a preliminary ruling on whether this effective exclusion for non-residents of general expenses and other indirect costs from tax deduction was not equivalent to discrimination of other EU companies in breach of the basic freedom to provide services throughout the EU.

Non-deductibility of tax consultancy costs for EU non-residents - court turns to ECJ

The case was brought by a Dutch tax resident earning trading income as a non-resident member of a German partnership. His German income from all sources was less than 90% of his total income: thus he was not entitled under German law to claim the privileges accorded to resident taxpayers. One of these, the point at issue here, is the relief for tax consultancy costs granted by allowing resident taxpayers to deduct them without limitation, and without specific linkage to income earned, as "other" expenses. The taxpayer claimed that his exclusion from the deduction was a breach of the freedom of establishment article of the European Community Treaty - Art. 43 in the current, Amsterdam version of 1997.

The Court agreed that he might have a point and referred the matter to the ECJ for a preliminary ruling. In its referral, the Court pointed out that the "other expense" deduction of tax consultancy costs is granted because of the complexity of German tax law necessitating professional advice, and not because of any personal circumstances dependant upon residency, and in the days when taxpayers where allowed to deduct interest on tax charges as "other expenses" there was an explicit extension of this deduction to nonresidents; thus there is no systematic reason for restricting relief for "other expenses" to residents only.

Input tax deduction not until invoice received

The Supreme Tax Court has held - following a preliminary ruling from the ECJ - that input tax may not be deducted - also in retrospect - until the supply has been made and the invoice has been received.

No export draw-back for beef exported after run-out date

The Supreme Tax Court has held that beef no longer fulfils the EU norm of "commercial quality" set as a pre-condition of agricultural export draw-back if its run-out date is already past on export.

From Europe

Imputation tax credit must be granted on dividends received from abroad – ECJ

The case was brought by a resident of Finland with dividend income from shares held in Swedish companies. Finland levied income and corporation tax at the same rate - 29% - but avoided a double charge by granting a resident shareholder a 29 point credit for the corporation tax paid. If, for any reason, the company had not paid corporation tax on the income distributed as dividend, it was required to make good the deficiency on distribution. The payment by the company thus always equalled the credit to the shareholder, so preserving the "cohesion" of the system. However, dividends of foreign source did not rank for credit, so the Finnish shareholder in a Swedish company was effectively taxed twice, once through the Swedish corporation tax on his company, and a second time through his unrelieved Finnish income tax. The shareholder saw this as a hindrance to the free movement of capital and sued before a Finnish court for an order that he be allowed the same credit that he would have enjoyed on a domestic dividend.

The ECJ agreed with the taxpayer. If the system was designed to ensure that domestic profits were taxed only once, it must also ensure single taxation on profits from other member states. The Court pointed out that this did not have to be at Finnish expense; for example there would be no objection to an unrelieved Finnish income tax of 29% on dividends from a country that only taxed undistributed earnings. Similarly, the Finnish credit could be restricted to the combined Swedish burden of corporation tax and treaty-rate dividend withholding tax, if lower than the 29%. On the other hand, it dismissed arguments from the Finnish (and UK) governments based on the practical difficulties of determining the actual rate of payment of corporation tax in another country when the rate had changed and the dividend declared did not correspond in each year with the net after-tax income. Here, it took the view that the credit could be based on the general rules for computing corporation tax in the other member state, and followed up with the remark that "possible difficulties in determining the tax actually paid cannot, in any event, justify an obstacle to the free movement of capital such as that which arises from the legislation at issue". It also made the point that a reduction in tax revenue (for Finland if she were to be required to refund Swedish tax) "cannot be regarded as an overriding reason in the public interest .... to justify a measure which is in principle contrary to a fundamental freedom". "Cohesion" of the tax system is therefore to be seen more from the point of view of the taxpayer than from that of a government.

This case can be expected to have a direct impact on any EU member state with an imputation system of relieving domestic double taxation on investment income. In Germany this was the case up to 2000 for calendar year-end companies. Natural person shareholders receiving foreign dividends in 2001 or earlier, or even to some extent in 2002 if the dividend payer had a non-calendar year-end, would now seem to be able to demand a German corporation tax credit of up to 30/70 (43%) of dividends received from other EU countries. Whether they can do so in practice depends, of course, on whether their assessments are still open. This could lead to the ironic result of the tax office' being forced to grant a large additional and unexpected credit because of their insistence on holding assessments open for audit.

Belgian coordination centre regime approved by EU with modifications

The European Commission has announced its approval of a modified version of the Belgian coordination centre tax regime. Agreement in principle was reached on May 6 with the Belgian finance minister at "a very constructive meeting" to allow the coordination centre system to continue, provided its tax privileges are extended to other companies in Belgium. As an exception, the exemption from the withholding tax on equipment rentals continues. The exemption from the 0.5% capital duty on formation is to be replaced by a reduced rate of 0.25% or 0.30% to be enjoyed by all companies. The Commission has promised to reply to the Belgian government's request for a more precise description of its attitude to the Belgian application of the cost plus method in a separate letter. This letter has not - or not yet - been published.

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.

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