Germany: 040. Foreign Corporations in Germany - Legal Identity and Tax Status

Last Updated: 17 January 1996
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1. SEAT OF MANAGEMENT AND APPLICABLE LAW
2. RECENT CASES APPLYING THE SEAT-OF-MANAGEMENT THEORY
2.1 Entry of foreign corporations in German Land Records
2.2 Tax clearance for entry in the Land Records
2.3 Liability of persons acting for foreign pseudo-corporation
3. TAX STATUS OF FOREIGN CORPORATIONS
3.1 General
3.2 Foreign corporations with foreign seat of management
3.3 Foreign corporations with German seat of management
3.4 Position of the German tax authorities
4. TRANSFER OF THE PRINCIPAL PLACE OF MANAGEMENT

For disclaimer and copyright see end of this article.

1. SEAT OF MANAGEMENT AND APPLICABLE LAW

Germany's choice of law rules provide that the issue as to whether an entity has separate legal identity and legal capacity is determined with respect to the law at the entity's "seat of management", not with respect to that at its place of formation or incorporation. The term "seat of management" (Verwaltungssitz) is synonymous with, or at least very close to, that of the principal place of management.

Applied to foreign corporations, i.e. to corporations organised under non-German law, this choice-of-law approach means that a corporation formed in Country A having its seat of management in Germany is, from a German perspective, subject to German corporate law, not to the law of Country A. If, however, the corporation has its principal place of management in a third jurisdiction (Country B) which itself determines the applicable law with reference to the place of incorporation, Germany's conflict of law rules respect this referral onward and its courts would apply the law of Country A, because it is the law of choice in the jurisdiction where the place of management is located.

If the seat of management of a foreign corporation is located in or transferred to Germany, this conflict of laws approach can have dramatic consequences. Applying German substantive law, a German court would conclude that a foreign corporate entity has no separate legal personality because it has not been formed in accordance with German statutes, in particular has not been entered in the German Commercial Register as a duly organised corporation. Without moving the seat of management, re-incorporation in Germany is the only means of curing this defect. Even if incorporation in Germany is intended, the entity generally cannot qualify as a corporation in the formation stage because its articles of incorporation will not meet the German requirements. The result is a denial of legal identity and consequent personal liability on the part both of the shareholders and of the persons acting for the foreign entity (application by analogy of sec. 128 HGB as to the shareholders and of sec. 11 par. 2 GmbHG, sec. 41 par. 1 AktG as to its representatives).

It should be noted, however, that bilateral treaties sometimes modify these consequences. Such treaties have been concluded with the United States and with Spain. Furthermore, a draft EU treaty on the subject has been in existence since 1968 but not yet entered into force. Germany has ratified this treaty.

2. RECENT CASES APPLYING THE SEAT-OF-MANAGEMENT THEORY

German courts have recently applied the seat-of-management theory to foreign corporations in several interesting contexts. In each instance, the court affirmed the validity of this uncodified conflict of law rule and reaffirmed German rejection of the place-of-incorporation theory prevalent above all in Anglo-Saxon countries.

2.1 Entry of foreign corporations in German Land Records

The Hamm Court of Appeals (OLG Hamm 18 Aug. 1994 - DB 1995,137) was called upon to decide whether a Liechtenstein corporation could be entered in the land records as owner of a piece of German real estate. The Land Records Office (Grundbuchamt) had refused to enter the company on the grounds that its seat of management was in Germany and hence the entity lacked corporate existence for the reasons set forth above. The court held that, as a factual matter confirmed by experience, an entity generally has its seat of management in the jurisdiction in which it is incorporated. It stated that the Land Records Office must likewise proceed on this assumption and was therefore not entitled to deny registration to an entity which established its valid incorporation in a foreign jurisdiction, except in cases of "concrete and pervasive doubt" as to whether the entity's seat of management was in fact located at the jurisdiction of incorporation. According to the court, the Land Records Office also lacked authority to investigate this question. Unless the fact of a German seat of management has become public knowledge by some means or other, it thus seems unlikely that any foreign entity will find itself rejected by Land Records Offices which follow the decision of the Hamm Court of Appeals. (Each of the 16 German States has at least one Court of Appeals; some have as many as three.)

The fact that a foreign corporation maintains no significant facilities and employs no significant personnel at its place of incorporation is, according to the court, insufficient to raise "pervasive doubt" as to the location of its seat of management. The court justified its decision by express reference to the need to permit foreign corporations to participate without undue impediment in transactions involving entries in the German Land Records Offices.

Voices in the literature have advocated extending the approach of the Hamm Court of Appeals to all other contexts and in effect treating the fact of foreign incorporation as a sort of prima facie evidence that the seat of management is located in the jurisdiction of incorporation. It would then be up to the party arguing otherwise to raise serious doubt as to whether this was in fact so in the case at hand (burden of production), whereupon the burden of proof on the issue might then fall on the foreign corporation as the litigant best able to produce evidence on point (Bungert DB 1995, 963).

2.2 Tax clearance for entry in the Land Records

A decision by the Federal Tax Court on 20 June 1995 (DB 1995, 2413) likewise involved entry of foreign corporations in the German Land Records. German tax law prohibits the entry of a purchaser of real estate as owner of record unless he produces a clearance certificate from the tax authorities, which they are required to issue if real estate transfer tax owing with respect to the transaction has been paid or if payment is assured (sec. 22 GrEStG). The tax authorities refused to issue this certificate to two Dutch corporations on the grounds that, as their seats of management were in Germany, they were not validly organised and could not be entered as owners of record. The two corporations then posted bond in the amount of the tax potentially owing. The Tax Court decided against the tax authorities and its judgement was upheld on appeal by the Federal Tax Court. It was in the court's opinion for the Land Records Office, and not the tax authorities, to decide whether the foreign corporations were entitled to register their title. For tax purposes, it was enough that bond had been posted to cover the real estate transfer tax and the foreign corporations had made a prima facie showing (Glaubhaftmachung) that their seats of management were in the Netherlands, not in Germany.

Following the court's ruling, the tax authorities acquiesced by issuing a directive stating that the clearance certificate was to be issued when bond had been posted for any tax owing. The directive makes no mention of the necessity for a factual showing by the foreign corporation as to the location of its seat of management.

2.3 Liability of persons acting for foreign pseudo-corporation

The outcome of the third case we wish to discuss, heard by the Duesseldorf Court of Appeals (OLG Duesseldorf 15 Dec. 1994 - RIW 1995, 508) stands in opposition to the above decisions. It involved a suit by creditors of a corporation formed in Delaware, U.S.A. against a director of the corporation who had acted for it in creating a substantial corporate liability under a broker agreement with an American broker firm. The Delaware corporation apparently conducted all of its business from Germany. When the corporation defaulted on its obligations, the U.S. firm assigned its claims to its German subsidiary, which brought suit against the director in his personal capacity, alleging that the Delaware corporation had its seat of management in Germany and moreover that no "genuine link" existed to the State of Delaware (or, apparently, to any other State of the United States). In the plaintiff's view, German corporate law governed the question of the status of the Delaware corporation, with the consequence that corporate existence must be denied, causing all persons active on behalf of the corporation to have personal liability for its debts (application by analogy of sec. 11 par. 2 GmbHG, sec. 41 par. 1 AktG).

The primary defence raised was that the 1954 German-American Treaty of Friendship, Commerce, and Navigation provided in its Article XXV par. 5 that the parties mutually recognised all corporations duly formed under the laws of the other party. This clause was, however, interpreted by the court to mean that, as regards U.S. corporations, applicable law was to be determined under the place-of-incorporation theory (instead of the seat-of-management theory). The court stated, correctly if somewhat diffusely, that the place-of-incorporation theory was subject to certain ordre public limitations in the United States in cases where a minimum nexus was not present between the State of incorporation and the State where business was conducted. Labelling the lack of a minimum nexus or genuine link an "abuse of law" consistent with neither the American nor the German ordre public, the court held that, for want of a genuine link to Delaware, German law was to be applied. Despite comments in the German literature to the effect that the "genuine link" (or "pseudo-foreign-corporation") doctrine in the U.S. was only invoked to justify the application of local protective legislation and never resulted in a denial of the legal existence of the foreign corporation (Bungert DB 1995, 963, 966), the court proceeded to do just this and held the director personally liable since he had acted in the name of an unincorporated entity.

Although the reasoning of the court seems questionable, the decision was not appealed. The decision fails to confront the diversity of American law on the issue of recognition of foreign corporations, each State having its own approach to the matter. The facts of the case decided appear to have been extreme and/or the defence very weak.

3. TAX STATUS OF FOREIGN CORPORATIONS

Two questions arise with respect to foreign corporations (and other foreign associations) which are seldom problematic for domestic ones: Is the foreign corporation an entity subject to German corporation tax and, if so, does this entity participate in the German corporate tax credit system? If the foreign entity is not subject to corporation tax, it will be taxed in Germany as a partnership.

3.1 General

The first three sections of Germany's corporate tax law govern which entities are subject to corporation tax, either as resident entities on their worldwide income or as non-resident entities on certain German-source income. The tax liability of an entity subject to corporation tax encompasses its worldwide income (so-called "unlimited" tax liability) if either its legal seat (registered office) or principal place of management (Ort der Geschaeftsleitung) are in Germany. "Principal place of management" and "seat of management" are theoretically distinct concepts, but they in practice rarely, if ever, fail to coincide. The former is determined with respect to the place from which the person or persons charged with overall management responsibility exercise their functions. The seat of management is commonly defined as the place at which fundamental management decisions are effectively translated into externally recognisable actions, generally the place at which the management body and its members are located. The location of the dominant or sole shareholder is, however, not relevant unless the shareholder intervenes in the management of the company's ordinary or day-to-day business (cf. Ebenroth/Auer RIW Beilage 1 1992 pp. 5, 14, 15; Debatin BB 1988, 1155, 1159).

3.2 Foreign corporations with foreign seat of management

Foreign corporations with their principal place of management in the jurisdiction in which they were organised are treated in Germany as corporations or as partnerships depending on their degree of resemblance in legal structure and economic role to the typical German corporate forms listed in sec. 1 par. 1 no. 1 KStG. This is not in theory entirely different from the U.S. approach under sec. 7701 (a) (3) and Reg. sec. 301.7701-2 IRC, but is applied on an "all facts and circumstances" basis without rigid rules such as have been articulated in America. The results reached under this approach are often difficult to predict (for instance, the status of the relatively new American limited liability company is at present unclear). Generally speaking, foreign legal forms with separate legal identity, a corporate management structure, and a corporate capital and profit distribution structure are classified as entities subject to German corporation tax. Conversely, foreign partnership entities are seldom treated as corporations for German tax purposes, largely because German partnership entities are likewise hardly ever reclassified as associations taxable as corporations.

3.3 Foreign corporations with German seat of management

Under a fairly new line of cases decided by the Federal Tax Court, the tax status of foreign entities having their seat of management in Germany is decided according to the same principles. This issue was largely undecided until mid-1992 when the 9th Chamber of the Federal Tax Court held that a Liechtenstein AG (= Aktiengesellshaft or stock corporation) was subject to German corporation tax as a resident entity because the place of management of the Liechtenstein corporation was in Germany. The court acknowledged that, by virtue of having its seat of management in Germany as well, the Liechtenstein AG lacked separate legal identity under the choice of law principles described at the outset of this article. Although the court did not stress the point, the lack of legal identity meant that German courts would have held the company's managers and shareholders personally liable (see sec. 2.3 above). Nevertheless, the AG was declared subject to corporation tax because of its general corporate structure under Liechtenstein law and because German corporate tax law subjects to corporation tax certain entities which likewise lack separate legal identity (sec. 1 par. 1 no. 5 KStG).

The decision is dogmatically complex and has been the subject of criticism (see e.g. Ebenroth/Auer, RIW 1992, 998, 1005). Another chamber of the Federal Tax Court, however, reached similar results on slightly different reasoning for a Swiss AG (BFH 1st Chamber 1 July 1992 - BStBl II 1993, 222; cf. the 1st Chamber's decision of 23 June 1993 regarding a Spanish S.A. - BFH/NV 1994, 661).

3.4 Position of the German tax authorities

The tax authorities have abandoned their previous refusal to treat foreign corporations with seat of management in Germany as subject to corporation tax. Instead, the tax authorities now endorse the position taken by the Federal Tax Court (see coordinated directives e.g. FM NRW of 4 Oct. 1993, OFD Hannover of 17 Jan. 1994).

The directives issued by the tax authorities establish two requirements for corporation tax liability of a foreign corporation with seat of management in Germany:

- Comparability with one of the entities listed in sec. 1 par. 1 no. 1 - 5 KStG, whereby the chief focus appears to be on the German corporations listed in sec. 1 par. 1 no. 1 (this is largely a legal question involving comparison of foreign law with German law); and

- Attribution of the income earned to the entity and not to its members (this is largely a factual question turning on whether the entity has, in dealing with third parties, acted like an entity or like a partnership).

If a third condition is fulfilled, namely

- Membership rights similar to those of German corporations,

the entity is, according to the directives, also to be integrated into the German corporation tax credit system. This means that it is taxed like a domestic corporation at the split rates of 45 % / 30 % for earnings retained and distributed respectively, instead of at the flat rate of 42 % generally applicable to foreign corporations on German source income. Furthermore, it must organise its equity into the equity accounts (baskets) required for such purposes. And it would in theory be entitled to the corporation tax credit and withholding tax credit on dividends received from German corporations.

It thus appears that a corporation organised under foreign law with principal place of management in Germany can be treated for certain tax purposes as a domestic corporation even though, for civil law purposes, its separate legal existence is not recognised by the German courts. The tax treaty status of such a corporation might well be unclear. Many of Germany's tax treaties contain tie-breaker clauses for corporate entities which determine residence for treaty purposes with respect to the principal place of management. In other treaties, the matter is left open, which creates a potential for double taxation.

There are, however, also tax differences between a foreign corporation with principal place of management in Germany and German corporations. The Federal Tax Court has held that such foreign corporations cannot qualify as the lead or dominant company in a consolidated tax group for corporation tax purposes (13 Nov. 1991 - BStBl II 1992, 263). In our opinion, this should not prevent consolidation under a foreign corporation with principal place of management in Germany for trade tax purposes. It is, however, doubtful whether such foreign corporations, in the event they hold shares in other corporations, can claim the participation exemption for net worth tax purposes (sec. 102 BewG).

4. TRANSFER OF THE PRINCIPAL PLACE OF MANAGEMENT

As a final point, it should be noted that transfer by a foreign corporation of its place of management into or out of Germany can have considerable tax consequences. Transfer of the place of management into Germany would, as explained, likely cause the corporation to become subject to tax in Germany on its worldwide income. Depending on the applicable tax treaty, there could be double taxation problems or significant changes in the scope of taxation in the jurisdiction of incorporation. Transfer by a foreign corporation of its seat of management from Germany to another country (e.g. back to the country of incorporation) would cause the foreign corporation to move from resident to non-resident status ("unlimited" to "limited" tax liability). This event is treated as a liquidation leading to realisation of all hidden reserves (unrealised appreciation) under sec. 11, 12 KStG.

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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