Germany: 094. Tax Consolidation Under Dual Resident Corporations

Last Updated: 10 December 1997
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In article no. 40, we dealt at length with the status in Germany of corporations organised under the law of another country (foreign corporations). The article covered both tax questions and issues under civil and company law, including in particular Germany's conflict of law rules.

Under German corporation tax law (sec. 1 KStG) and tax treaty law, a corporation is "resident" in Germany, i.e. subject to tax in Germany on its worldwide income (so-called "unlimited" or "comprehensive" tax liability) if either its "legal seat" (Sitz, a term resembling that of "registered office") or its principal place of management (Geschaeftsleitung) is in Germany.

In our previous article, we reported the Federal Tax Court's holding that a corporation organised under foreign law (a foreign corporation) with its principal place of management in Germany cannot qualify as the lead or dominant company in a consolidated tax group for corporation tax purposes even though it is "resident" in Germany by reason of having its principal place of management here (13 Nov. 1991 - BStBl II 1992, 263). Such a corporation would in effect have dual residence: in Germany by reason of its place of management and in its country of incorporation by reason of such incorporation. In our previous article we stated that, notwithstanding the decision of the Federal Tax Court regarding tax consolidation for corporation tax purposes, such dual resident corporations should still qualify as the lead company in a tax consolidated group for trade tax purposes.

In an as yet unpublished decision, the Tax Court of Rheinland-Pfalz has now upheld our position (FG Rheinland-Pfalz case no. 5 K 2307/95 - 9 June 1997). The tax authorities have appealed the judgement to the Federal Tax Court (docket no. I R 102/97).

1. Factual background

The (slightly simplified) facts of this important case are as follows:

Q Holding Inc. (hereinafter: the dual resident company or DRC) is the parent company of a worldwide group which manufactures and sells machine tools and related products. The DRC was organised in 1988 under the laws of the state of Delaware, U.S.A., where it had its registered office. From the company's inception, its principal place of management was located in Germany, where it maintained offices with some 25 employees. On 6 March 1989, these offices were registered in the local Commercial Register as a branch establishment (Zweigniederlassung) of the DRC pursuant to sec. 13d ff. HGB.

The DRC had two German subsidiaries, one profitable and one which produced losses, in which it held virtual 100 % interests in the years at issue. The structure met the integration requirements for corporation and trade tax consolidation of both subsidiaries under the DRC. This is to say, both subsidiaries were integrated organisationally, financially, and economically into the German principal place of management of the DRC. Formal agreements of domination and profit and loss assumption (Beherrschungs- und Gewinnabfuehrungsvertraege - required only for corporation tax consolidation) were also in place between the DRC and each of its subsidiaries.

The tax authorities refused to permit trade tax consolidation of the two subsidiaries under the DRC and the two subsidiaries filed suit after rejection of their administrative appeals.

2. Tax consolidation for corporation tax purposes

Tax consolidation for purposes of corporation tax was not directly at issue in the case. We nevertheless discuss this controversial point because it is implicated in the case on which we are reporting and noteworthy in its own right.

2.1 Provisions of corporate tax law

The Federal Tax Court held in its ruling of 13 November 1991 (BStBl II 1992, 263) that consolidation for corporation tax purposes was impermissible on the facts set forth in section 1 above. In particular, it ruled that a foreign corporation with its principal place of management in Germany was precluded from being the lead company in a consolidated group (i.e. the company to which the gains and losses of the group's members are attributed) because sec. 14 no. 3 KStG applied by its terms only to corporations with both their principal place of management and their "legal seat" (Sitz) in Germany.

Whether or not one analogises a registered office to a legal seat in the German sense, the DRC in the case we are discussing had no legal seat in Germany. To acquire one, it would in effect have had to reorganise under German law.

Sec. 18 KStG does permit consolidation of German corporations under the domestic registered branch establishment of a foreign corporation. However, in its ruling, the Federal Tax Court construed this provision as applying only to foreign corporations with neither their legal seat nor their principal place of management in Germany. While the statute was not explicit on this point, it did assume the foreign corporation to be subject to tax in Germany only on its German source income ("limited" tax liability). Since a corporate entity is subject to tax in Germany on its worldwide income ("unlimited" or "comprehensive" tax liability) if it has either its legal seat or its principal place of management in Germany, the Federal Tax Court held sec. 18 KStG not to apply to situations such as that presented in the case under discussion.

The nexus between the DRC and Germany was thus too strong for it to qualify under sec. 18 KStG (because of its German principal place of management), but at the same time too weak to fall under sec. 14 KStG (because it lacked a German legal seat).

2.2 Rationale of the law

The irony of result reached by the Federal Tax Court raised the issue as to whether it was in fact intended by the legislature and supported by a rational legislative purpose. The taxpayer argued that the intention of sec. 14 KStG was to permit any corporate entity subject to tax in Germany on its worldwide income to be the lead or dominant company in a consolidated group because the income of the member companies attributed to it would then remain within the German tax sphere. Likewise, the taxpayer saw the purpose of sec. 18 KStG as allowing the domestic branch establishment of foreign corporations to be the lead or dominant company because attribution of the income of the member companies to a domestic branch establishment would likewise keep the income within the German tax sphere under the permanent establishment principle. In both cases, the only concern was that the income of the members of a consolidated group remain subject to German taxation. These requirements are doubly fulfilled in the case of a foreign corporation with a domestic branch which is also the sole place of management. Hence, the taxpayer believed that no rational purpose was served by refusing to permit consolidation in such a case.

The Federal Tax Court could adduce no tax policy reason in support of its reading of the law. Instead, it stated that the legislature's purpose was to prevent entities which lack separate legal existence under German conflict of law rules (discussed at length in article no. 40) from acquiring the benefits of tax consolidation. Since Germany determines the company law applicable to a corporate entity with respect to its "seat of management" (Verwaltungssitz), a corporation organised under foreign law with a German principal place of management is as a rule not recognised as having separate legal existence because it has not been formed in accordance with German law. Exceptions can apply under bilateral treaties, however (see section 3.2 (iii) below). Notwithstanding this denial of civil and company law recognition, such corporations are recognised as entities subject to corporation tax (for details see article no. 40).

3. Consolidation for trade tax purposes: the legal arguments

3.1 Argument of the tax authorities

The tax authorities argued essentially that, as regards the status of the entity under which consolidation is to take place, the conditions for consolidation for trade tax purposes were identical to those for corporation tax purposes. In this view, consolidation was possible under a corporation with both its principal place of management and its legal seat in Germany or under the registered domestic branch establishment of a foreign corporation with neither its principal place of management nor its legal seat in Germany, but not under a corporation with only its principal place of management, but not its legal seat in Germany.

3.2 Taxpayers' arguments

The two plaintiff subsidiaries of the DRC advanced three separate arguments in favour of tax consolidation for trade tax purposes.

(i) Firstly, they attacked the reasoning of the Federal Tax Court's ruling of 13 November 1991 as lacking any basis in policy (section 2.2 above). They urged the Tax Court to refuse to follow the logic of the higher court and in effect to hold that the relevant requirements for corporation tax consolidation were fulfilled, hence that trade tax consolidation was permitted even if the trade tax requirements mirrored those of corporation tax in the respects at issue.

(ii) Secondly the taxpayers called attention to the failure of the controlling trade tax provisions (sec. 2 (2) sentences 2 and 3 GewStG) to incorporate by reference all of the corporation tax requirements in question. In effect, the taxpayers urged the Tax Court to construe the trade tax law differently from the corporation tax law and to permit consolidation as long as the trade tax income of the members of the consolidated group remained subject to German taxation in the hands of the lead or dominant group member.

(iii) Lastly, the taxpayers sought to rely on the anti-discrimination clause of the 1954 German-American Treaty of Friendship, Commerce, and Navigation (German-American Friendship Treaty). Article XXV (5) of this treaty provides for mutual recognition by both treaty states of corporations duly formed under the laws of the other treaty state, and Article XI (1) prohibits German discrimination against U.S. corporations. Since a German corporation with a German principal place of management could qualify as the lead or dominant member of a tax consolidated group, the argument ran that it would conflict with the anti-discrimination clause not to permit a U.S. corporation with a German principal place of management to so qualify. (The Federal Tax Court had rejected this argument as well in its ruling of 13 November 1991, discussed in section 2 above.)

4. Decision of the Tax Court

The Tax Court refused to follow the taxpayers' first argument and instead affirmed the position taken by the Federal Tax Court with respect to the requirements for consolidation for corporation tax purposes.

The Court nevertheless decided in the taxpayers' favour based on their second argument. It agreed with the taxpayers that the requirements for trade tax consolidation differed from those for corporation tax consolidation based on the different wording of the trade tax law on point. In the Court's opinion, the trade tax law divided commercial enterprises into only two categories: "domestic commercial enterprises" and "foreign commercial enterprises". It construed the term "domestic commercial enterprise" so that the DRC fell into this category and so qualified as the lead company in a consolidated group.

The Court did not address the taxpayers' argument based on the German-American Friendship treaty.

5. Outlook

The appeal filed by the tax authorities means that the Federal Tax Court will review the decision here reported on. This will give the taxpayers the opportunity to present their first and third arguments as well to Germany's highest tax court and will give this court the opportunity to reconsider its 1991 ruling on these arguments.

Disclaimer and Copyright

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. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. 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.

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