By Wilhelm Haarmann and Oliver Dörfler, Haarmann, Hemmelrath & Partner, Frankfurt, Germany
In a long awaited decision, the German Supreme Tax Court has recently upheld that dividend stripping transactions with German stock cannot be considered abuses of legal forms (decision of 15 December 1999, docket-no. I R 29/97). The very first of its kind, the case is a landmark decision in this area of German tax law, one of the most controversial issues in German tax over the past decade. A 1992 report estimated annual revenue losses due to dividend stripping in the range of several hundred mio. DM each year. After years of inattention to the subject, the German tax authorities began to bear down hard on dividend stripping schemes in the early 1990’s. Of course, this caused considerable unrest in the banking community. For banks and brokers, who have not only come under pressure by the German SEC, but also by the German fisc, who promptly pronounced such structures abusive, the decision is a welcome relief. In essence, the German Supreme Tax Court fully rebutted the arguments made by the tax authorities and followed the posture taken by the taxpayer. Although provisions on dividend stripping have been tightened over the past years, the findings of the Court have a significant impact especially on cross border transactions.
2. The Problem
Under the current corporate tax system, German resident shareholders of German corporations are entitled to a tax credit on dividends received in the amount of the tax paid by that company on the distributed profits (except solidarity surtax). The corporate tax paid by the company therefore is more or less an advance payment on the German resident shareholder’s individual income tax liability. Shareholders residing outside of Germany have never been entitled to the imputation tax credit unless they do business though a permanent establishment in Germany that is deemed to be the owner of the shares in the German corporation.
3. Dividend Stripping Schemes
Since the introduction of the full imputation tax credit system in 1977 taxpayers have looked for ways and means to allowing non-German shareholders to utilize the imputation tax credit such as dividend stripping transactions. In its most straightforward form a non-German resident sells shares in a German corporation to a German resident before the record date ("cum dividend") at a price reflecting at least part of the imputation tax credit and repurchases those shares after the record date ("ex dividend"). The capital gain derived by the non-resident in general is not subject to German taxes, either in accordance with German domestic tax law (participation of less than 10%) or in accordance with the provisions of a tax treaty. The German resident receives the dividend including the underlying corporate tax credits, but can offset this income (at least partially) by the capital loss incurred on the repurchase by the non-resident (provided that he holds the shares as part of his business assets). The imputation tax credit is refunded (at least partially) to the German resident. The same effects can be achieved by a German resident acquiring shares cum dividend before the record date and (short-)selling new shares to be issued before the record date. Over the years taxpayers have become more innovative by using derivative financial instruments such as calls and puts, forwards and futures, swaps as well as security lending or repo transactions.
4. German Tax Authorities Attack and Rejection by the Supreme Tax Court
In the case under consideration, a German broker had purchased shares in a German corporation cum dividend before the record date and had sold those shares ex dividend after the record date. In addition, he had purchased German shares cum dividend before the record date and sold short new shares to be issued before the record date as well.
To avoid the utilization of the embedded credit by non-German residents sec. 50c German Income Tax Code (ITC) provides that inter alia sales losses incurred by a German resident taxpayer are non-deductible during a ten year period provided the shares have been acquired from a non-German resident or a German resident who was not subject to tax with a capital gain. In principle, the sales losses incurred were under these circumstances not tax deductible. However, in the years under dispute sec. 50c ITC effectively did not apply if the sale/repurchase was carried out over the stock exchange. Such stock exchange exemption was tightened with effect of 1994 (see 5. below). According to the tax authorities’ position this exemption only applies if the transactions were carried out anonymously (open outcry) invoking the objective of the law. Such posture was rejected by the Court arguing that the wording of the provision did not give rise to such conclusion.
The German tax authorities took the further position that, even if sec. 50 c ITC ultimately does not apply because of the stock exchange exemption for the years under dispute, the transactions constituted an abuse of legal forms in line with the general abuse clause of sec. 42 General Tax Code (GTC) which provides that the planning opportunities of civil law cannot be used to circumvent the tax law ("substance over form"-approach). This can be assumed if a structure is chosen which leads to tax advantages which using a straightforward structure could not be obtained and for which no valid business reasons can be presented.
In German law, there is a basic principle that if both special and general provisions govern the same matter, the special provisions will have precedence. The German tax authorities have always taken the posture that notwithstanding a special misuse provision like sec. 50c ITC in the case under consideration, the general misuse clause in principle should still be applicable. Therefore, if loopholes in special misuse provisions became apparent, the German tax authorities could always argue that structures designed to make use of them constituted an abuse of legal forms. Interestingly enough, the Supreme Tax Court held in a clear and unambiguous manner that special misuse provisions will have precedence over the general misuse clause without any limitations. According to the Court’s opinion this holds true even if structures were designed with the sole purpose to make use of exceptions contained in general misuse clauses. Therefore, the Court did not regard it as abusive if the sale/repurchase transactions were carried out over the stock exchange with the sole purpose to make use of the stock exchange exemption of sec. 50 c ITC. In the past the Court has never been that unequivocally clear on the relationship between special and general misuse clauses so that taxpayers can only welcome the Court’s findings.
Moreover, the tax authorities argued that the German resident could not be regarded the beneficial owner of the acquired shares so that he could not claim the imputation tax credit. Based on former decisions of the Court, beneficial ownership is not transferred to the acquirer if the seller has an option (e.g. call) for retransfer and it can be expected that under normal circumstances such option will be exercised. According to the Court’s findings, there has even been an obligation for retransfer in the case under consideration. However, as the sale and repurchase transaction were on different assets (i.e., old shares cum dividend and new shares to be issued), this was not of relevance here and hence, beneficial ownership was transferred. The important point is that the Court rejected an overall approach in accordance with the wording of the law and therefore restricted the popular thinking of the tax authorities to apply an overall "economic" perspective whenever they deem the wording of a law to be insufficient.
In summary, the Supreme Tax Court fully rejected the arguments presented by the tax authorities, a major victory for the taxpayer. This means that the German Revenue has definitely failed in attacking dividend stripping schemes in the courts.
5. Tightening of the Rules
Apart from taking perceived dividend stripping cases to court the respective provisions in the tax code have been tightened with effect of 1994.
In particular, the stock exchange relief no longer applies if
- The repurchase of the acquired or similar shares takes place within ten days after the acquisition and the dividend resolution falls within that period;
- The acquired or similar shares are directly or indirectly sold back under conditions leading either alone or in context with other agreements to a limitation of the share price risk;
- The consideration for the acquisition of the shares lies wholly or partly in the obligation to transfer shares either not ranking, or not ranking fully, for dividends.
In addition, the introduction of sec. 36 para. 2 no. 3 sent. 4 lit. g ITC with effect of 1994 aimed to curtail the use of security lending and repo transactions in dividend stripping schemes.
While all this sounds good in theory, it is fair to say that the application of those provisions encounter major problems in practice, as capital market transactions are becoming more and more complex.
6. The Way Ahead
Notwithstanding the tightening of the law the findings of the Supreme Tax Court have a significant impact on a number of areas.
6.1 Proposed Repeal of the Imputation System for Dividends
As proposed under the draft of a Company Tax Reform and Tax Reduction Act published by Germany’s Federal Ministry of Finance on January 10, 2000 the imputation credit system for dividends will be repealed with effect of 2001 and replaced by a classical double taxation system (for details see Bogenschütz/Wright, TNI of 14 February 2000, p. 710).
One of the main reasons for such profound change is the extensive use of dividend stripping techniques. Many tax practitioners hold the opinion that in view of today’s increasingly complex capital market transactions it will hardly be possible to get hold of the problem even after a tightening of the laws in the past years. If some members of the parliamentary opposition still favoured the imputation credit system, their resistance to the tax reform proposals should disappear after the decision of the Supreme Tax Court. Hence, it has to be strongly expected that the imputation credit system will be repealed in the near future.
6.2 Anti-Treaty Shopping Rules
Over the past years Germany has introduced a considerable number of provisions designed to curtail perceived misuses, in particular in cross border transactions. In a typical treaty shopping situation a shareholder resident in a tax haven who holds shares in a German corporation may interpose a corporation resident in a treaty country to make use of lower withholding taxes on dividends. Under these circumstances, sec. 50d para. 1a ITC provides that such treaty benefits cannot be claimed to the extent that the shareholder – had he held the shares in the German corporation directly - could not receive the same benefit, and the interposition is not justified by business or other reasons or the interposed corporation did not exercise own business activities. The tax administration felt that special misuse clauses were necessary as the tax courts have often been reluctant to apply the general misuse clause of sec. 42 GTC. As many of these provisions have been drafted in an overhasty manner, it was not overly surprising that many loopholes became apparent soon after such provisions had been enacted. Before that background the German Revenue tried to close those perceived loopholes by arguing that notwithstanding a special provision the general misuse clause of sec. 42 GTC should still be applicable. In a major pro-taxpayer break through, the Supreme Tax Court rejected that argument. Rather, the Court held in a clear and unambiguous manner that the general misuse clause does not apply if there is a special provision in place irrespective of any perceived or de facto existing loopholes. Apparently, the Supreme Tax Court has become increasingly unwilling to "save" sloppily crafted laws and hence, taking over the legislator’s job by applying the general misuse clause.
A similar problem arises in cases where German corporates use foreign corporations to shelter passive income. If properly structured, the German CFC rules did often not apply so that passive investment income could be taken "offshore". As a prerequisite, the country of residence of the foreign corporation had to be a treaty country and the participation exemption for foreign dividends did not have to have an active trade or business test. In line with the above findings the Supreme Tax Court held in a not yet published decision (decision of 19 January 2000, docket-no. I R 94/97) that the CFC rules had precedence over the general misuse clause.
Generally speaking, the decision will make life more difficult for the German Revenue as they can no longer apply the general misuse clause of sec. 42 GTC as a method of last resort provided there are special misuse clauses in place.
6.3 Dividend/Interest Stripping with Foreign Securities
The decision has also an impact on dividend/interest stripping schemes with non-German shares or bonds. A resident of country A, who holds shares in a company resident in country B with which no tax treaty exists, may take advantage of the lower withholding tax rates under the tax treaty between Germany and country B by selling those shares before the record date to a German resident at a price reflecting the lower withholding taxes and repurchase those shares after the record date. The German resident will offset the dividend income received by the capital loss incurred on the repurchase (provided he holds the shares as part of his business assets) and claim a refund of any withholding taxes deducted in excess of the treaty rate. The German tax authorities treat those schemes as an abuse of legal forms (sec. 42 GTC) provided that no valid business reasons can be presented.
In contrast to dividend stripping with German stock there is no special misuse provision like sec. 50c ITC available. Hence, the tax authorities in principle may still try to invoke on the general misuse provision of sec. 42 GTC. However, it has to be taken into account that in line with the case law on interposed foreign corporations it has to be regarded as sufficient if any business reason can be presented. An abuse of legal forms can be assumed only if the transaction has been entered into for no business reason at all, except for the reason to save taxes. In addition, it has to be noted that the Supreme Tax Court has already held in a preliminary proceeding (resolution of 3 February 1993, docket-no. I B 90/92, Federal Tax Gazette 1993, part 2, p. 426) that a certain transaction may constitute a misuse for one party, but not for the other depending on whether the other party receives an unjustified benefit out of the transaction or not. In case of dividend stripping with foreign shares this should not be the case with regard to the German resident as it is the foreign resident who transforms dividend payments into (tax free) capital gains. Provided that under these circumstances the general misuse provision of sec. 42 GTC is not applicable, the German resident has to be regarded as the beneficial owner in line with the Supreme Tax Court’s decision so that he can claim a refund of withholding taxes and utilize potential capital losses to offset the dividend income received.
7. Closing Remarks
The first decision of the Supreme Tax Court on dividend stripping is a major victory for the taxpayer. It has shown that the German Revenue will not get hold of dividend stripping schemes. This makes it even more likely that the imputation credit system will be abolished. The decision has major importance for other areas as well. Taxpayers may in particular welcome the Court’s clearcut posture that special misuse clauses have precedence over general rules without any limitations. Therefore, loopholes in special clauses cannot be closed by applying the general substance over form provision. This has to be understood as a clear hint to the legislator to improve the quality of the laws in future. The German Revenue should also give up his negative posture on dividend/interest stripping schemes with foreign securities.
This article appears with the permission of Tax Notes International