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1. Introductory

The Greek tax code permits domestic corporations to reduce their corporation tax rate from 40 % to 35 % by meeting certain requirements, but denies this advantage to foreign corporations doing business in Greece through a permanent establishment. The European Court of Justice (ECJ) has now ruled that this discrimination is impermissible under Article 52 (now Article 43) of the European Treaty (Royal Bank of Scotland – ECJ Rs. C-311/97, decision of 29 April 1999 - DB 1999, 1197).

While the decision has no direct bearing on German tax law, it deserves careful study because of the various ways in which German tax law continues to discriminate against the domestic permanent establishments of foreign corporations (see article no. 101).

This article relies in part on the helpful comments of Saß on the recent ECJ decision (IStR 1999, 1199).

2. Facts and grounds of the decision

Greek corporate tax law permits a domestic stock corporation to qualify for a reduced tax rate of 35 % provided it issues no bearer shares not admitted to trading on the Athens stock exchange. Greek banks must by law be organised as stock corporations and are permitted to issue only registered shares. They thus invariably qualify for the reduced corporation tax rate. Foreign corporations, however, are taxed at a rate of 40 % even if organised in legal form equivalent to a Greek stock corporation and even if they issue no bearer shares not admitted to trading on the Athens stock exchange.

The ECJ decided the case under Article 52 of the European Treaty (now Article 43). This article deals with the freedom of EU citizens to do business in other EU countries through places of business established there. The freedom of establishment guaranteed by Article 52 is extended by Article 58 to companies organised under the law of a Member State and having their legal seat (registered office), their headquarters, or their principal place of business inside the European Union.

The treatment of EU banks doing business in Greece through a Greek permanent establishments was clearly less favourable than that of Greek banks, which of necessity qualified for the preferential corporation tax rate. The court thus asked whether objective differences existed which justified the unequal treatment. It noted that, under Greek tax law, both domestic corporations and the domestic permanent establishments of foreign corporations were taxed on their net income determined under identical principles.

The fact that foreign corporations were taxable in Greece only on their income from Greek sources while Greek corporations paid tax on their worldwide income, was not in itself regarded as a difference which would justify the higher tax rate for the permanent establishments of foreign corporations.

Apparently, no other differences were advanced in support of the distinction drawn under Greek law. Finding no objective grounds for the unequal treatment, the ECJ held it to constitute impermissible discrimination under Article 52 of the European Treaty.

3. Relevance for German law

It is not possible to conclude from the decision of the European Court of Justice that the German taxation of the domestic permanent establishments of foreign corporations is likewise in violation of European Union law. In Germany, the earnings of domestic corporations are taxed at different rates depending upon whether they are retained or distributed. The earnings of domestic permanent establishments of foreign corporations are, on the other hand, taxed at a single rate. Whether earnings remain in the permanent establishment or are withdrawn makes no difference. By contrast, the distribution of earnings by domestic corporations triggers 25 % withholding tax. This is, however, reduced to as little as 5 % under many German tax treaties and, since July 1996, is eliminated entirely for distributions to EU corporations under the EU Parent-Subsidiary Directive.

Effective 1999, a uniform rate of 40 % was introduced for the retained earnings of domestic corporations and the domestic permanent establishments of foreign corporations. The distribution rate remained unchanged at 30 %. Prior thereto, the rate for permanent establishments was intermediate between the two rates for domestic corporations: below the rate for retained earnings, but significantly above that for distributed earnings. From 1995 through 1998, the permanent establishment tax rate was 42 %, whereas the rates for the retained and distributed earnings of domestic corporations were 45 % and 30 % respectively.

From July 1996 to December 1998, the domestic permanent establishments of EU corporations were thus taxed at a rate 12 percentage points above that paid by domestic corporations on their distributed earnings. Prior thereto, when Germany was still entitled to collect 5 % withholding tax under a temporary exception to the Parent-Subsidiary Directive, the difference was still 8.5 percentage points. The rate changes which went into effect on 1 January 1999 leave the differential at 10 percentage points.

4. Analysis by Saß

Noting that the reduced corporation tax rate of 30 % is not available under the German tax system until a dividend is distributed, Saß (IStR 1999, 1199) asks whether the repatriation of earnings from a domestic permanent establishment to a foreign home office is comparable to a dividend distribution. It may not be, because under the German corporation tax system the reduction in tax upon distribution is not definitive until a dividend is paid to a non-corporate shareholder. Payment of a dividend to a corporate shareholder, e.g. to a 100 % German parent company, leads to a reduction of corporation tax for the distributing subsidiary, but taxation at the higher rate for retained earnings is restored at the level of the parent (since 1999, 40 %; prior thereto, 45 %). In other words, as long as earnings are retained inside a German corporate group, the higher tax rate applies.

The repatriation of earnings from a domestic permanent establishment to a foreign home office may bear more similarity to a dividend paid from a domestic subsidiary to a domestic parent than it does to payment of a dividend to a non-corporate shareholder, i.e. to a shareholder outside the corporate group. If this analogy is persuasive, then denial of the lower distribution tax rate to the domestic permanent establishments of EU corporations may be justified.

However, the reduction in German corporation tax is also definitive upon payment to any foreign shareholder, corporate or otherwise. Noting this, Saß points out that foreign corporate groups doing business in Germany through subsidiaries enjoy a tax advantage over German corporations, because a dividend paid by a German subsidiary to its foreign EU parent benefits from the reduced distribution tax rate (30 %; no withholding tax applies) without any re-imposition of tax at the level of the parent in countries which use the exemption method to avoid double taxation. Even countries using the credit method typically do not have a corporation tax rate of 45 % (though some have rates near 40 %). Hence, foreign groups may obtain a reduction of German corporation tax, often to 30 %, while still retaining control over the earnings, whereas purely German-based groups cannot.

Saß apparently regards this so-called "foreign shareholder effect" as an additional reason why the repatriation of earnings from a domestic permanent establishment to a foreign home office may not be comparable to a dividend paid to a non-corporate shareholder. It is unclear, however, why an advantage enjoyed by EU foreigners doing business in Germany through a German subsidiary is relevant for the treatment of EU foreigners who do business through a German permanent establishment.

If, at any rate, one concludes that the repatriation of earnings is not analogous to the payment of a dividend to a non-corporate shareholder, the question arises as to whether the EU foreign corporation is entitled to a reduction in German corporation tax paid when such an event occurs. Naturally, this event will occur in another EU country.

Saß sees a parallel here to the Royal Bank of Scotland decision. The tacit basis of the decision, he argues, may be that the registration of stock on a stock exchange in another EU country must be treated as analogous to the registration of stock in Greece. In other words, Saß sees grounds in the decision for the principle that tax benefits attaching to the fulfilment of economic criteria in one EU country may have to be accorded by that EU country even if the economic criteria are fulfilled in another EU country.

This seems to be reading too much into the ECJ's Royal Bank of Scotland decision. The ECJ does not state that non-Greek banks must be granted the preferential Greek corporation tax rate if they have no bearer stock not registered on an EU stock exchange. Instead, the court rests its decision on the lack of plausible reason for denying foreign EU banks the tax preference enjoyed by all Greek banks.

Nevertheless, Saß may be right that the extent to which economic criteria fulfilled in one EU country must be accorded, so to speak, "full faith and credit" in another EU country will be important in upcoming ECJ decisions in pending tax matters.

Saß notes that a case challenging Germany's taxation of the domestic permanent establishments of EU foreign corporations is currently pending before the Cologne tax court (cf. Günkel/Hörger/Thömmes DStR 1998, 1864) and that the outcome of the Hoechst and Metallgesellschaft cases, which are already pending before the ECJ, will probably decide the more important issue of whether denial of the German corporation tax credit to foreign persons not holding stock in domestic corporations in a domestic permanent establishment is consistent with EU law. Whether EU countries may, consistent with EU law, continue to attach different tax consequences to the fulfilment of the same economic criteria depending on whether fulfilment occurs on their territory or on that of another EU member is but one issue posed in these cases.

5. Concluding remarks

The decision of the European Court of Justice in Royal Bank of Scotland increases the likelihood that the German taxation of the domestic permanent establishments of European Union corporations is incompatible with EU law.

Doubts whether the current German system of corporate taxation is compatible with EU law are one reason, Saß states, why abandonment of the split-rate imputed corporation tax system is a key element in the Brühl tax recommendations and the Government's next round of business tax reforms (see article no. 165).

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