Germany: 178. Withholding Tax: Withdrawal of Foreign Contractor Withholding Directive?

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Among the provisions added to the income tax code by the Tax Relief Act for the Years 1999, 2000, and 2002 was a new withholding provision for payments made to foreign contractors (§ 50a (7) EStG – see article no. 167 sec. X). The new rules went into effect on 1 April 1999 and require domestic and foreign persons to withhold 25 % of the gross amount of payments made from this date on to foreign contractors for certain work performed in Germany or perhaps simply used there. While the problem which provoked the new withholding rules involved non-compliance by foreign construction firms with their German tax obligations, the withholding provision actually enacted applies to all sectors of the economy.

The new withholding provision elicited a storm of protest and a flood of articles explaining why it places an intolerable and illegal burden on the operations of foreign contractors in Germany. However, the Federal Ministry of Finance nevertheless surprised everybody by issuing a press release on 26 July 1999 announcing the Government's intention to introduce legislation repealing the new withholding provision, effective retroactively to the day it went into force (1 April 1999). The press release further stated that the Federal Minister of Finance had addressed a letter to the senior tax authorities in each of the German States proposing that they immediately cease enforcing the new provision without awaiting passage of the repeal measure.

The press release goes on to say that the Federal Minister of Finance will launch an initiative at the European level to implement a compliance system for foreign contractors which does not distort competition, thus admitting by implication that the provision to be repealed would have unduly restrained competition.

The proposal of the Federal Ministry of Finance that tax authorities and taxpayers alike ignore a tax law in force conflicts with the principle of the rule of law, which has constitutional force in Germany. Objections based on these grounds are rumoured to have been raised by certain of the German States.

While the tax laws are federal law, they are administered by the States. Hence, it is not presently possible to rule out that at least certain States will continue to enforce § 50a (7) EStG until it is in fact repealed. The ultimate repeal of the statute does not presently appear doubtful as a political matter.

The recommendation of KPMG Germany as of early August 1999 was for payors owing payments subject to withholding to attempt to reach agreement with their payees (foreign contractors) to postpone payments due in the immediate future in the hopes that the situation will soon become more clear. If no such agreement can be reached, KPMG Germany recommended that the payor withhold tax as required by the law as currently in effect. However, it would not appear necessary to report and remit tax so withheld unless the tax office having jurisdiction over the payor in these respects insists on full compliance with the law. Taxpayers should secure a written statement from the tax office in question regarding its position. Once the tax office with jurisdiction has specifically waived compliance with regard to identified payments, it would appear safe to release the amounts withheld from the original payments.

The new withholding rules interfere both with the ability of foreign contractors to compete with domestic contractors and the freedom of contract awarders to choose foreign contractors to perform domestic work. It is in particular argued that the new rules violate Articles 59, 60 of the European Union Treaty (right of free traffic in services: active right for foreign EU contractors to compete on a non-discriminatory basis in Germany, passive right of contract awarders to select foreign EU contractors without discriminatory penalties). Since the new withholding provision applies to contracts entered into long before enactment of the statute, it may also be unconstitutionally retroactive or unconstitutionally require payors both to remit payment in full to their foreign contractors and at the same time remit tax to the tax authorities.

In late May 1999, the tax authorities issued a directive providing guidance on the operation of the new statute from their point of view (directive of 31 May 1999 IV C 1 - S 2303-196/99; hereinafter "the directive"). An unofficial English language translation of the directive can be downloaded from the website of the Federal Ministry of Finance (www.bundesfinanzministerium.de/steuersei.htm). Furthermore, KPMG Germany has prepared its own translation, which can be obtained from the tax partner-in-charge in our Frankfurt office:

The following comments on the statute and the directive interpreting it were largely prepared prior to the unexpected announcement by the Federal Ministry of Finance in late July 1999. Even if the new withholding rules are in fact repealed in the near future, as now appears likely, the rules still remain relevant, if only as a negative example for some future alternative solution to the problem which § 50a (7) EStG sought to address. Furthermore, continued application of the statute on an interim basis in at least certain German states can not presently be ruled out.

In discussing the directive, we generally use the terminology employed in our own translation, but also call attention to the terms used in the unofficial translation available from the website of the Federal Ministry of Finance where appropriate. The two translations are cited as the "KPMG translation" and the "unofficial FMF translation" respectively.

The statute provides for withholding by the payor (payment debtor) on payments to a foreign contractor for "the production of a work in Germany" (die Herstellung eines Werks im Inland; the unofficial FMF translation speaks of "contract work carried out in Germany").

As used in the statute and in the directive, "work" is a term of art referring to the "work" produced by the contractor under a "work contract" (Werkvertrag, defined and regulated by §§ 631 ff. of the German Civil Code or BGB; the unofficial FMF translation speaks of a "works contract").

The contractor under a work contract undertakes to produce a promised "work". The "work" (the subject matter of the contract) can be either manufacturing, constructing, or modifying a thing or achieving any other result by the performance of work or services. The cardinal feature of a work contract is the undertaking to bring about a specific result, e.g. to construct a building, not just to use best efforts to do so. The contractor breaches a work contract if the result achieved does not possess the contractually "assured characteristics" (another term of art) or if it contains defects which impair its value or suitability for the contractually assumed purposes (§ 633 BGB). The work contract is sharply distinguished from a "service contract" (Dienstvertrag – §§ 611 ff. BGB), another of the basic types of civil law contracts. The obligor under a service contract is obligated to perform services in accordance with the contract. He is not obligated to achieve any particular result and hence does not breach his contract merely because the results of his work are unsatisfactory. In short, the obligor under a work contract assumes the risk of failure, the obligor under a services contract does not.

Because the concept of a work contract is a broad one, the scope of the new withholding provision is correspondingly wide. While the perceived abuses which the new statute was primarily designed to redress involved construction work of the conventional sort, the statute as legislated covers repair and maintenance work, the transportation of passengers and freight, and a great deal of essentially "intellectual" work, for instance in the field of computer programming and computer systems, translation, architecture, engineering and design, agency and brokerage relationships, even training programmes and expert opinions. The operation of data transmission lines in Germany may also constitute a work contract under certain circumstances.

Since the dividing line between work contracts and other types of contracts, especially service contracts, is faint in many areas, analysis of the specifics of a contractual relationship may be needed in many cases to determine whether payments are subject to withholding.

Furthermore, with regard to mixed contracts having the production of a work as at least one of their "principal obligations," the directive provides for apportionment of the contract into a "work contract" and a "non-work-contract" part, with withholding on the "work contract" portion.

Application of the above principles will frequently be anything but self-evident. Compliance with the terms of the statute and the directive may then be almost impossible as a practical matter.

Under German civil law, a contract for the production of goods is a "work delivery contract" (Werklieferungsvertrag) if the producer provides the essential materials needed. The contract is not a sales contract because it does not relate to goods presently in existence, but rather to goods which have yet to be produced. This fine distinction is largely moot however, because contracts for the production of goods are subject to the provisions of the Civil Code which cover sales contracts as long as the goods in question are fungible (§ 651 BGB).

However, the law of work contracts applies (with slight exceptions) to contracts for the production of non-fungible "custom-made" goods.

The directive adopts the same distinction between contracts for the production of fungible and non-fungible goods, stating that the new withholding provision does not apply to the former, but does apply to the latter.

Whether the sale or licensing of software is covered by the new withholding rules is expected to depend largely on whether the software in question is pre-existing standard software or custom-made software produced to meet a client's specific needs.

The directive interprets the statutory language "production ... in Germany" as referring not to the place where work is actually carried out under the contract, but rather to the place where the contractually promised result is ultimately accomplished (the Erfolgsort; the unofficial FMF translation speaks of the "place of execution"). Under this view, it makes no difference where the work is actually performed as long as the benefit of the contract is conferred in Germany, e.g. because the work is delivered in Germany or used or exploited there.

The position taken by the tax authorities is controversial and by no means clearly supported by the statute. The concept of the Erfolgsort of a contract is furthermore vague and not established in German tax or civil law. The application of the concept is therefore bound to lead to confusion and uncertainty.

Withholding is only required on payments to non-resident (foreign) contractors. The statute speaks of payments to "non-resident [payment] creditors".

The directive does not comment on the concept of "non-residence," which is not defined by domestic tax or civil law. The term "resident person" is used in German tax treaties, where it is generally defined from a German perspective as meaning individuals with either their domicile or their habitual abode in Germany and corporations with either their legal seat (registered office) or principal place of management in Germany. These are the criteria which, under German domestic tax law, distinguish persons subject to German tax on their worldwide income from persons subject to tax only on German-source income. Applying this to the present context, a foreign or non-resident contractor is one not subject to German tax on his worldwide income.

The directive does provide in its sec. 3.3 that, with respect to partnerships and other non-corporate collective entities (associations), withholding is determined for each partner individually. The directive does not explain what to do when the contractor is a partnership, the partners of which are also partnerships. Presumably, such partnerships are also treated as transparent, so that one looks to their partners.

Even when the contractor is a partnership, the partners of which are all individuals or corporations, it may be anything but simple as a practical matter to determine which share of the contractual payment is allocable to each partner. Such allocation is necessary, however, when the partnership includes domestic and foreign partners, since withholding is only required for the share owing to foreign partners.

In practice, the payor may have little choice but to over-withhold when partnerships are involved and the partners to whom the payments are ultimately allocable cannot be determined with adequate certainty.

Withholding is at a rate of 25 % on the gross amount owing under the contract including VAT. VAT is included in calculating the withholding amount even if the "zero procedure" is applied to the supply for VAT purposes (directive sec. 3.4). Solidarity surcharge must be withheld in addition to the basic income tax withholding. The current rate is 5.5 % of the basic withholding amount.

The statutory rate of withholding can be reduced pursuant to written certification issued by the tax authorities if the contractor can make an adequate showing that his actual tax liability based on net income will be less than the sum which would be withheld at the normal rate (directive sec. 3.7). Since the statutory rate of 25 % of the gross payment is based on the assumption of a tax rate of 50 % and a 50 % profit, many contractors should qualify for reduced withholding.

In fact, the return on sales assumed by the new statute appears ludicrously exaggerated compared to the profit margins actually earned in the construction industry, at least. Hoffmann (DStR 1999, 1061, 1062) estimates the average return on sales in the German construction industry to be around 1 %.

While profit margins may differ on other types of work contracts and a reduced rate of withholding is available on a showing that the statutory rate will lead to withholding in excess of the probable tax liability, the statutory withholding rate itself nevertheless appears abusively high, particularly when one considers that considerable effort and expense may be required to obtain a reduced rate of withholding.

Withholding is required whether or not the foreign contractor has German tax liability on the payment under domestic tax law and, if such liability exists, whether or not Germany's right of taxation is excluded under tax treaty law. (The non-official FMF translation contains an error here – first sentence of sec. 2.) However, if there is in fact no tax liability under domestic law or the German right of taxation is excluded by tax treaty, an exemption from withholding will be granted on request.

In addition, the directive also provides that the tax authorities may grant exemptions simply on the grounds that the foreign contractor is registered for tax purposes in Germany and may be expected to pay any tax owing in due course (directive sec. 2.1.2).

In many cases, domestic tax liability and tax treaty exemptions will depend on the duration of the foreign contractor's domestic permanent establishment (with six months and one year being the crucial lengths of time for construction and assembly contracts under domestic law and most tax treaties respectively). However, it may be difficult to obtain exemptions on these grounds as long as the permanent establishment is still in existence because of uncertainty as to its ultimate duration (cf. directive sec. 2.1.3).

The directive permits a foreign contractor to obtain a single exemption which is valid for several work contracts ("blanket" or "global" exemption). Such exemptions are valid until revoked and may be issued for work of the same nature for a single contract awarder (principal) or for multiple specifically identified contract awarders. Blanket exemptions for multiple unnamed contract awarders are also possible, but such exemptions will be limited in duration to six months (directive sec. 2.4).

Tax withheld will be refunded if no tax liability exists or if the tax withheld exceeds the actual tax liability (determined with respect to net income). While only the contractor is able to apply for and receive any refund, the contractor can contractually authorise his contract awarder (principal) to file an application and receive the refund on his behalf.

Contract awarders may agree to make full payment to the contractor and then collect the refund themselves (for instance, because the foreign contractor threatens to stop work if his payments are reduced, and no exemption can be obtained). Those who so agree should consider carefully all the ramifications. Even if the refund is justified as a substantive matter, the foreign contractor may later fail to cooperate in applying for the refund. When the refund depends on a tax treaty, the tax authorities in the contractor's home country have to countersign the refund application. If the contractor has not reported the income in question to his own tax authorities, he may be reluctant to request such countersignature.

Careful planning and a well-drafted agreement with the foreign contractor would appear desirable for arrangements under which the contract awarder is supposed to collect a refund. Regarding refund timing, see sec. 14 below.

Sec. 2.2 of the directive contains a list of tax offices with jurisdiction to issue exemptions. These tax offices are not necessarily the ones to which any tax withheld should be remitted nor those to which requests for refunds should be addressed.

Sec. 3.2 of the directive states that foreign payment creditors are also required to withhold on payments to foreign contractors for the production of a work in Germany.

Multi-tiered foreign contractor/subcontractor contracts would thus appear to result in multiple withholding. For instance, if Domestic Contract Awarder hires Foreign Contractor to erect a building in Germany, and Foreign Contractor subcontracts the work in question to Foreign Subcontractors A, B, and C, both Domestic Contract Awarder and Foreign Contractor would have to withhold on the payments each makes. Foreign Contractor and Foreign Subcontractors A, B, and C would then have tax credits for tax withheld. Foreign Contractor could probably apply for reduced withholding on the grounds that, because the work has been subcontracted, its profit will be less than the assumed 50 % (see sec. 8 above).

If full withholding occurs, Foreign Contractor will receive only 75 % of the gross contract amount from the contract awarder. Foreign Contractor will then probably have to remit more than the net amount received to its three subcontractors and the German tax authorities, which could cause serious cash-flow problems. Foreign Contractor would be made whole by the refund ultimately received from the German tax authorities.

In cases in which no tax liability exists, no refund will be made until after the end of the assessment period at the earliest (directive sec. 4.1 and § 50a (7) sent. 4 EStG). In cases in which tax liability depends on the duration of a permanent establishment, the tax authorities may wait until the permanent establishment has actually been abandoned before refunding tax withheld. Where tax liability exists, credit of the tax withheld and refund will take place within the context of the normal tax return and assessment procedures, i.e. not until a return has been filed and processed for the year in question.

The delays which result from these refund procedures can therefore be quite considerable.

Expedited refunds are available under a special transition provision created by the directive (directive sec. 4.2). This provision, which was included for equitable reasons in light of the short notice on which the new withholding provision was legislated, permits immediate refund on the basis of certificates of exemption or reduced withholding submitted no later than 30 September 1999 with respect to payments already made. Normally, such certificates must be provided to the payor (payment debtor) prior to the payment. Under the transition regime, they may also be submitted after the fact to the tax office to which the payor remitted tax. The tax office can make an immediate refund without waiting for the end of the assessment period.

Expedited refunds are otherwise available only in situations in which withholding was improper under the statute as a matter of law, e.g. because the contractual relationship was erroneously treated as constituting a work contract or the contractor was erroneously considered to be resident in a foreign country (directive sec. 4.3).

There is a de minimis exception for work contracts (or allocable shares thereof) on which the withholding base (in which VAT must be included) does not exceed DM 5,000.

The issue of how to react to the statute appears in an entirely new light since its repeal now appears imminent (see sec. 1 - 3 above). The comments in this section were prepared on the assumption that the new withholding provision would remain in force for the indefinite future.

There is no shortage of articles which seek to demonstrate that the new withholding provision violates domestic and/or European law. Still, it is not possible to challenge the new law without assuming some risk. A payor (contract awarder) who complies with the new provision by remitting tax in the proper amount may lack standing to challenge the withholding provision because the tax remitted is for the account of the payee (foreign contractor). If the payor fails to comply with his statutory withholding obligations and the tax authorities take collection action against him, he then may contest this action in court. Before the recent statements by the Federal Ministry of Finance and the proposed non-enforcement of the statute, one had to assume that the tax courts would decide in the favour of the tax authorities and compel payment from the taxpayer. In light of the new situation, it is more difficult to say what the courts would do. In particular, the chances of persuading a court to stay execution of any withholding tax assessed would appear to have improved dramatically as a result of the recent developments.

Each payor should examine carefully the available alternatives before deciding not to comply with the withholding statute and to take his chances in court. Some payors may believe themselves to be in a situation in which they have nothing to lose, because as a practical matter they find themselves compelled to disburse the full amount owing under the contract to their foreign contractors. However, even here thought should be given to possible criminal liability under the general tax fraud provisions of the Tax Procedure Act. The tax fraud investigation units of the tax authorities have reportedly sent letters to a number of contract awarders advising them of their responsibilities and may be prepared to instigate criminal proceedings against those who intentionally disregard their withholding obligation. However, the recent announcement by the Federal Ministry of Finance should make it much harder to obtain criminal convictions, at least with respect to taxpayers who have not been specifically informed that their local tax authorities will insist on compliance in spite of the announcement by the Federal Ministry of Finance.

There are various legal grounds on which the statute might be challenged (aside from the expectation of repeal and non-enforcement created by the recent top level announcement). In addition to the controversial interpretation of the term "production of a work in Germany" which has been adopted by the tax authorities (see sec. 6 above), the new statute may be impermissibly retroactive with respect to contracts in existence when the law took effect. The withholding required of the payor as a matter of tax law may also conflict with the payor's contractual payment obligations, thus exposing the payor to an impermissible double liability.

With respect to European Union law, the new statute imposes a burden on foreign contractors seeking to do business in Germany and on contract awarders seeking to hire foreign contractors for work in Germany. The statute thus both prevents foreign contractors from competing on an equal basis and creates an incentive for contract awarders to prefer domestic contractors over foreign contractors when awarding contracts.

While it is true that securing compliance with domestic tax law may justify discrimination against foreign taxpayers in certain circumstances, the German legislature is probably obliged as a matter of European Union law to resort to compliance measures which interfere with competition to the least necessary extent. A reporting obligation for payments to foreign contractors might have been adequate in the present case.

Even conceding that a withholding system is justifiable on compliance grounds, the specific system instituted may still be unnecessarily and excessively discriminatory. The scope of the statute, which covers all work contracts, is both sweeping and at the same time poses a myriad of definitional problems in the numerous unclear cases. This alone may make the statute unworkable as a practical matter. The rate of withholding bears no reasonable relation to actual tax liability in the one area in which compliance problems appear to have arisen in the past (the construction industry). The refund mechanisms will of necessity inflict a cash-flow penalty on foreign contractors (or on contract awarders who use foreign contractors). The administrative burden is in general excessive.

On the other hand, the new directive offers some relief from the more onerous aspects of the new withholding system. Not only can the rate of withholding be reduced if a reasonable showing is made that the statutory rate is excessive, but withholding can be avoided altogether with respect to foreign contractors registered for tax purposes in Germany and posing no tax collection risk. Furthermore, the tax authorities have in effect been instructed to take account of the existence of bilateral mutual assistance agreements in the tax enforcement area when deciding whether to grant exemptions. Most such agreements are with European Union countries.

The European Court of Justice would weigh all of these considerations, in particular the degree of interference with competition and the need for improved tax compliance measures. However, it might take five to ten years before its ruling could be obtained.

KPMG Germany is pleased to advise on a specific course of action appropriate to particular circumstances. Here as well the general principle applies that no action should be taken except pursuant to the advice of tax counsel.

In the event of continued enforcement of the statute, taxpayers should remember that some relief from withholding is available under the statute. Exemptions from withholding or certificates of reduced withholding can be applied for where such relief is merited. Possibilities for blanket exemptions (directive sec. 2.1.3) also exist. These provide relief from the administrative burden of continually applying for exemptions in each specific instance.

It should also be recalled that an exemption may be granted under the directive on the grounds that the foreign contractor is registered for tax purposes in Germany and in compliance with his tax obligations, so that no tax collection risk exists (directive sec. 2.1.2).

Furthermore, in granting exemptions, the directive permits the tax authorities to give weight to the fact a treaty for mutual administrative assistance in tax matters is in force between Germany and the foreign contractor's home country (directive sec. 2.1.4). Such agreements currently exist with Belgium, Denmark, Finland, France, Italy, Luxembourg, Norway, Austria, [and] Sweden, and an agreement with Holland is imminent, so that the tax authorities will already assume it to be in force.

Situations are conceivable in which selective non-compliance may be a viable alternative under the new withholding system. The expected retroactive abolition of the statute may mean that few taxpayers, if any, will need to consider such courses of action, however.

The withholding tax represents a payment on account of the ultimate tax liability of the foreign contractor. In situations in which there will be no such liability, because liability does not exist under German domestic law or the German right of taxation is excluded under a tax treaty, the payor (payment debtor) may consider the option of making a full payout to the foreign contractor without remitting any tax to the tax authorities.

Without the expected legislative changes, failure to withhold and remit despite the lack of an exemption certificate would pose the risk of action by the tax authorities to collect from the payor. If no tax liability exists on the part of the foreign contractor under domestic tax law, the payor may be able to raise this as a defence.

Where domestic tax liability exists, but the income in question is exempt from German taxation under a tax treaty, the situation is more complicated. While the foreign contractor still has no German tax liability, the payor is precluded by § 50d (1) sentence 4 EStG from raising the treaty rights of the foreign contractor in defence against an action to collect.

While collection of tax under § 50a (7) EStG would appear improper if the foreign contractor has been determined to have no tax liability, this determination will be made in a separate proceeding which will probably be subsequent to action taken by the tax authorities against the payor. As long as the domestic tax liability of the foreign contractor has not been determined, the withholding tax could probably be collected from the payor.

If collection from the payor was enforced and then the foreign contractor subsequently received an assessment notice showing no tax owing by reason of the tax treaty, this would lead to a refund to the foreign contractor, not to the payor. It is, however, conceivable that the payor could enter into a contractual arrangement with the foreign contractor to act as the agent of the foreign contractor for purposes of receipt of such a refund.

In many cases, however, the payor will not be in a position to reliably assess the German tax situation of his foreign contractor. The foreign contractor may, for instance, have a permanent representative or other permanent establishments of which the payor is unaware. Furthermore, cooperation from the foreign contractor in obtaining a refund may not be forthcoming (see sec. 11 above).

Thoughts along the above lines can be found in Hoffmann's article in DStR 1999, 1061, 1063-1064. In the event the foreign contractor has domestic tax liability, Hoffmann suggests that the payor (payment debtor) can remit (or set aside) tax at a reduced rate even without a certificate of reduced withholding because the actual profit on the contract will at worst (that is, assuming no cooperation from the foreign contractor) ultimately have to be estimated at no more than 5 % to 10 % of the gross contract amount.

Aside from the fact that the tax authorities may arrive at a much higher estimate of profits in the event of total non-cooperation from the foreign contractor, the order in which events occur may make a big difference. If the tax authorities first take action to collect tax under § 50a (7) EStG from the payor, it is not at all clear that the payor can raise the issue of the ultimate total tax liability in such a proceeding. When ultimate tax liability was finally determined, presumably by estimation, the excess of tax collected from the payor over tax owed by the foreign contractor would be refunded to the foreign contractor, barring other contractual arrangements of the sort mentioned above (see also sec. 11 above).

When the payor is dealing with an affiliated company, certain of the above problems may become more manageable.

Again, we emphasise that the expected retroactive abolition of the withholding provision may obviate the need for most taxpayers to even consider the courses of action outlined above.

As of this writing (early August 1999), it appears that the new withholding regime will soon be abolished retroactively. Nevertheless, interim enforcement of the statute cannot be ruled out, nor is it inconceivable that repeal of the statute will not occur promptly, in the form expected, or at all. Taxpayers should be certain they have the latest information available before deciding what course of action (or inaction) they will adopt. KPMG Germany is of course prepared to advise in this area.

For further information, please send a fax stating your inquiry to KPMG Frankfurt, attn. Christian Looks +49-(0)69-9587-2262 or an e-mail using the button appearing below. Please state your name and organisation in all inquiries.

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