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1. Background and facts
The Federal Court of Justice recently rebuffed attempts by the German tax authorities to use the general anti-abuse provision in the German tax code to challenge structures involving the formation of Irish International Financial Service Centre (IFSC) companies (decision of 19 January 2000 - DB 2000, 651). In Ireland, IFSC companies enjoy a preferential 10 % corporation tax rate. The reduced rate of taxation constitutes a government subsidy authorised by the European Commission under Article 87 (3) of the European Community Treaty.
The case involved income earned in 1990 prior to the 1992 changes in the German rules on controlled foreign corporations (CFC rules). Two German corporations formed an Irish corporation with registered office and principal place of management in the International Financial Service Centre in the former docks area of the city of Dublin. The German shareholders contributed capital totalling some DM 70 million to their Irish subsidiary, the business purpose of which was the passive management of its assets. The Irish tax authorities recognised the Irish subsidiary (hereinafter the IFSC) as an IFSC company entitled to a 10 % tax rate. The IFSC had no employees or premises of its own. It engaged a Dublin corporation to handle its investment transactions, reserving to itself certain consultation rights. The asset management company had 17 employees and was 75 % owned by a German bank. The IFSC's funds were invested in German bonds. The IFSC had a board of directors which met in Ireland.
Under German law in effect for the year 1990, the IFSC's low-tax passive income was in principle taxable to its shareholders when earned by the IFSC as a "supplemental income amount" (look-through taxation subject to a correction for actual distributions). However, the CFC rules treated supplemental income amounts as tax exempt where actual dividends would be exempt under the participation privilege of an applicable treaty (§ 10 (5) AStG). Since the Irish-German tax treaty contains such a participation privilege, the CFC's income could be retained indefinitely in the CFC subject only to the preferential 10 % Irish tax rate.
The CFC rules were not changed until 1992 to deny tax treaty protection to designated types of passive income earned by CFC's in low-tax jurisdictions. The tax authorities therefore challenged the structure under the general anti-abuse of § 42 AO (tax procedure act). This reads as follows:
"The tax laws may not be circumvented by abuse of legal structuring possibilities. In case of [such] abuse, the tax claim [of the tax authorities] is the same as that arising under a structure appropriate to the economic transaction".
The position of the tax authorities was that the interposed CFC should be disregarded for tax purposes and its shareholders treated as having directly earned pro rata shares of the CFC's income.
2. Federal Tax Court holding
The highest German tax court reversed a lower court ruling in favour of the tax authorities. The Federal Tax Court held essentially that § 42 AO was preempted by the more specific CFC rules except where the interposed foreign corporation is a mere "mailbox company" without any economic function. The court noted that a mere mailbox company would not have qualified as an ISFC eligible for the low preferential tax rate and stated that passive asset management constituted an economic function. The court gave weight to the fact that the company had a board of directors which exercised final responsibility for the CFC's investment decisions with the consent of the shareholders. The delegation of responsibility for handling the actual investment transactions to a management company was not seen as damaging because such delegation was considered common practice in the passive asset management field.
The fact that the CFC rules then in effect explicitly respected tax treaty exemptions (§ 10 (5) AStG) and permitted passive asset management earnings to be shielded from German taxation was viewed by the court as "unqualified [legislative] acceptance" of structures such as that involved in the instant case. The 1992 changes in the CFC rules to override tax treaty protection in specific instances were cited as further evidence that the prior legislative intent was to permit passive asset management companies to operate under the shield of tax treaties. Furthermore, the detailed CFC rules on the handling of "supplemental dividend amounts" differed substantially from the more sweeping rule of § 42 AO. Under such circumstances, foreign passive asset management companies were governed by the CFC rules and could not be disregarded as abusive in the sense of § 42 AO.
The principle behind the Federal Tax Court's holding in Dublin Docks thus resembles that in its recent dividend stripping decision (see article no. 202): Where specific legislation is enacted in response to a particular type or class of tax planning structure, there is – barring extreme circumstances – no scope for application of the general anti-abuse clause of § 42 AO in addition to the specific legislation.
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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