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In a judgement published in March of this year, the Federal Tax Court rebuffed challenges by the German tax authorities to dividend stripping schemes handled through a German broker firm (DB 2000, 600 - 15 December 1999). The transactions involved were of two types. In one case, foreign taxpayers holding shares in German corporations sold these shares to the German broker shortly before the dividend payment date and then repurchased the shares in a separate transaction after the dividend distribution at a correspondingly lower price. In the other case, sale and repurchase were effected on the same day. Also, instead of repurchasing the same shares, the foreign shareholders repurchased newly issued shares not entitled to participate in the impending dividend. In both cases, the sale and repurchase transactions were effected through intermediary banks over the stock exchange. The transactions at issue took place from 1989 to 1991.

At the root of such dividend stripping is the full creditability of corporation tax paid by resident corporations against the corporation or income tax of its dividend recipients. This credit is generally available only to resident taxpayers. (Non-residents qualify for the credit only if the shares are held in a domestic permanent establishment.) The purchase price paid by the broker firm, a German GmbH, passed this credit along to the foreign shareholder in large part. The GmbH received the dividend, claimed the corporation tax credit, and then reported a loss on resale of the stock. This loss plus the corporation tax credit allowed the broker to receive the dividend largely tax free.

The German tax authorities argued that, for tax purposes, the GmbH should not be recognised as the interim owner of the stock under the general rules respecting "economic" or "beneficial" ownership. Secondly, they sought to apply § 50c of the income tax act and to deny recognition of the GmbH's loss on resale of the stock. Thirdly, they tried to apply the general anti-abuse provision of Germany's Tax Procedure Act.

The court rejected all three lines of argument. The fact that the sale and resale of stock constituted two distinct transactions, albeit closely related, was sufficient in the court's view for the GmbH to bear the risk of stock market fluctuation and hence be the beneficial owner of the stock under the first type of transaction. As for the second type, where sale and resale arguably constituted a single contract, the court held that the beneficial ownership doctrine could not apply because two different assets were involved: "normal" stock and newly issued shares not entitled to share in the current dividend.

Application of § 50c of the income tax law failed because of an exception in the as law then in force for stock exchange transactions. Here the tax authorities contended that the exception should not apply because the legislature had only intended it to apply to anonymous stock exchange transactions, which those in question were not. The court implicitly criticised the legislature by holding that it should have written a law which reflected its intention. The so-called "stock-exchange exception" was held to cover all stock exchange purchases whether anonymous or not. This part of the opinion sends a message to the tax authorities that they cannot count on the courts to rescue them from their drafting errors.

The reader should note that the stock-exchange exception has since been tightened and in its present form would not apply to the transactions here at issue.

Lastly, the court refused to apply the general anti-abuse provision on the grounds that it had been pre-empted by the specific provisions in § 50c of the income tax law. This part of the decision tells the legislature that it should think twice before enacting legislation targeted at specific types of abuses. If the specific legislation misses its mark, the general anti-abuse clause will probably not be available as a fall-back.

The present German tax reform proposals (see articles nos. 195-199) would eliminate the corporation tax credit and hence put an end to dividend stripping with respect to German corporation tax. Dividend stripping for German dividend withholding tax would remain a problem, above all with respect to foreign shareholders not entitled to a reduced withholding tax rate.

The decision reported on is of fundamental importance and deserves careful study.

For further information, please send a fax or an e-mail stating your inquiry to KPMG Frankfurt, attn. Christian Looks: Fax +49-(0)69-9587-2262, e-mail cLooks@kpmg.com. You may also send an e-mail to KPMG Germany by clicking the Contract Contributor button on this screen.

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