German income tax on retained income of ‘controlled foreign companies’
Like the UK, Germany applies a ‘Controlled Foreign Company’ (CFC) tax regime to certain foreign entities with German-based shareholders [section 7ff of the German Foreign Tax Act (FTA )]. CFC rules serve to allocate a foreign entity’s income directly to its domestic shareholders for income tax purposes, even if the foreign Company does not distribute a dividend. The German CFC rules apply
- if the foreign company is located in a ‘low tax’ jurisdiction that levies an income tax of less than 25 per cent of the company’s income;
- if German-based shareholders hold more than 50 per cent of the foreign company’s capital or voting rights; in cases of passive capital Investment companies a share of 1 per cent or even less in the foreign company’s capital or voting rights may suffice;
- to the extent that the foreign company produces ‘passive’ income, eg income from typical investment activities or from royalties; income from an ‘active’ trade or business is not subject to CFC taxation.
Originally, German CFC rules did not provide for an exception for companies based in the European Union (EU) or European Economic Area (EEA). Following the judgment of the European Court of Justice (ECJ) of 12 September 2006, which struck down the British CFC rules as they did not exempt EU-based companies with a ‘genuine economic activity’ in the host EU Member State, German lawmakers enacted an escape clause from German CFC taxation (section 8 paragraph 2 FTA). This clause applies if:
- CFC is based in an EU/EEA Member State;
- its German-based shareholders can prove that the foreign company carries on a ‘genuine economic activity’; and
- the host EU/EEA Member State allows for a tax information exchange with Germany under Council Directive 77/799/EEC or a ‘comparable’ tax information exchange framework.
In case that the UK leaves both the EU and the EEA (‘hard Brexit’), the escape from German CFC tax rules will not shield German-based shareholders of UK companies receiving ‘passive’ income from German taxation anymore. As the UK government has announced plans for a tax reform that would reduce UK taxes significantly, there is some likelihood that the UK could soon qualify as a ‘low tax’ jurisdiction under German CFC rules. Since the German CFC regime applies to German-based individuals and parent corporations likewise, it poses a substantial threat to Anglo-German cross-border businesses and investments.
German income tax on retained income of foreign ‘family’ trusts and foundations
Analogous to its CFC regime, German law provides for semi-transparent taxation of German-based beneficiaries of foreign foundations and trusts if the foundation or trust primarily serves the interest of one family (section 15 FTA). For purposes of German taxation, the income of such a foreign ‘family’ foundation or trust is directly attributed to the settlor or the beneficiaries if they are German taxpayers. This semitransparent tax concept is even more severe than the German CFC regime as it does not require the trust or foundation to be based in a ‘low tax’ jurisdiction; furthermore, its scope is not limited to ‘passive’ income. To honour the right of free movement of capital under Article 63 of the Treaty on the Functioning of the European Union (TFEU), German law releases foreign-based ‘family’ foundations or trusts from semitransparent taxation if:
- the foundation or trust is based in a EU/EEA Member State;
- its German-based settlor or beneficiaries can prove that neither settlor nor beneficiaries have the legal or actual authority to dispose of the trust assets; and
- the host EU/EEA Member State allows for a tax information exchange with Germany under Council Directive 77/799/EEC or a ‘comparable’ standard of tax information exchange (section 15 paragraph 6 FTA).
In case that the UK leaves the EU and the EEA, the escape from German semitransparent taxation of foreign-based ‘family’ foundations and trusts cannot shield German-based settlors or beneficiaries of UK trusts from German taxation anymore. Therefore, the German semi-transparent tax regime on foreign-based ‘family’ Trusts poses a major threat to Anglo-German estate planning and will force tax and estate practitioners both in Germany and the UK to rethink the many existing arrangements involving UK trusts and German-based beneficiaries.
Continuing application of the EU/EEA escape clauses to UK companies and trusts?
According to the ECJ’s case law, a discrimination against non-EU/EEA companies and trusts is not generally permissible as the fundamental freedom of free movement of capital is applicable also to the movement of capital between EU Member States and third countries (cf Article 63 paragraph 1 TFEU). As long as the establishment of a company or trust in a non-EU/EEA jurisdiction or the existence of a German resident’s position as shareholder or beneficiary of such company or trust does not qualify as ‘direct investment’ under the standstill clause of Article 64 paragraph 1 section 1 TFEU, companies and trusts based in third countries should be entitled to the right of free movement of capital too. When a German-based shareholder or beneficiary of a non-EU/EEA company or trust cannot control this company or trust, a ‘direct investment’ should not be given. Therefore, the German EU/EEA escape clauses of section 8 paragraph 2 and section 15 paragraph 6 FTA should be read as if they did not require the company’s or trust’s seat or principal place of management to be in an EU/EEA Member State.
It has to be emphasized that the other criteria required by law to escape German CFC/semi-transparent Taxation should be sufficient to protect Germany’s legitimate fiscal interests. A 2015 court decision demonstrates that German courts take the requirement of a tax information exchange standard that is comparable to Council Directive 77/799/EEC very seriously. According to the court, the tax information exchange provisions contained in the double tax convention between Germany and Liechtenstein, although the latter being an EEA Member State, are not sufficient to release German-based beneficiaries of Liechtenstein foundations from semitransparent taxation in Germany even though the convention’s tax information exchange provisions do not deviate from the OECD model. In contrast, if a third country
- has ratified the International Convention on Mutual Administrative Assistance in Tax Matters dated 27 May 2010 and the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information dated 29 October 2014, which in combination come very close to the tax Information standard set out by Council Directive 77/799/EEC; and
- provides tax information to the German revenue service not just upon request but also automatically under the Common Reporting Standard as well as spontaneously under the Convention on Mutual Administrative Assistance in Tax Matters,
there is no need for Germany to apply its CFC rules and the semi-transparent tax regime for foreign foundations and trusts. It is, however, doubtful whether the German revenue service will subscribe to that view. German lawmakers should amend section 8 paragraph 2 and section 15 paragraph 6 FTA to make clear that the escape from German CFC/semi-transparent trust taxation may apply to companies and trusts worldwide, provided the host Country complies with the high international and EU standards of tax information exchange.
As long as the scope of German CFC/semi-transparent taxation of companies or trusts based in non-EU/EEA countries is not clear, practitioners should obtain a private letter ruling in Germany before setting up such structures or file precautionary CFC tax returns with the German authorities and appeal any tax assessment that disregards the tax information exchange standard offered by the company’s or trust’s host country.
Specific inheritance and gift tax exemptions only for certain EU/EEA-based businesses
German inheritance and gift tax law allows for tax exemptions of up to 100 per cent of the fair value of certain ‘active’ trade or business companies if they are located in the EU or the EEA (section 13(a)ff German Inheritance and Gift Tax Act ). With tax rates of up to 50 per cent, the German inheritance and gift tax can place a heavy burden on the successors of family-owned businesses. Therefore, the tax exemptions for ‘active’ business assets are pivotal for every estate planning strategy when either the business, its owner, or a potential successor has a nexus to Germany.
If the UK were to leave the EU and the EEA, Anglo-German cross-border successions would not be eligible for the existing German inheritance and gift tax cuts for businesses any more. British heirs of German enterprises as well as German heirs of British enterprises could face severe inheritance tax levies since Germany and the UK have not entered into a double tax convention for inheritance and gift tax purposes; in addition, European and German Courts have consistently held that European law does not oblige the UK and Germany to arrange for the avoidance of multiple taxation of estates and gifts.
In recent German business successions ‘Brexit’ is already casting its clouds over the German inheritance tax: to what extent the tax exemptions for ‘active’ business assets are granted depends, among other factors, on the successor’s ability to reach a certain percentage of the transferred company’s average payroll expenditures during the last five years prior to the transfer in a period of five or seven consecutive years following the transfer. If this ‘minimum payroll test’ is not met within five or seven years after the transfer, inheritance or gift tax is retroactively levied on the transfer.
The relevant payroll expenditures include all wages paid to the company’s employees anywhere in the EU or the EEA. Since many German businesses hold UK subsidiaries with employees in the UK, the German payroll test can lead to an absurd outcome: when the average payroll expenditures for the five years prior to the transfer are determined, the UK payroll expenditures must be included as the UK to date is still a member of the EU. When the seven-year control period ends and the UK then is not a member of the EU and the EEA anymore, the UK payroll expenditures must not be included in the payroll expenditures reached during that period. The successor thus can fail the ‘minimum payroll test’ even if he does not lay off his UK employees or dispose of the UK subsidiary.
Two approaches exist to avoid that successors pay increased German inheritance or gift taxes solely for the fact that the UK has left the EU: either the UK payroll expenditures are already excluded today from the average payroll expenditures during the five-year period prior to the transfer, or the UK payroll expenditures even after ‘Brexit’ are included in the payroll expenditures during the seven-year control period after the transfer. The German Revenue service has not yet issued a ruling in this regard.
As long as it is unclear when ‘Brexit’ will happen and what consequences it will have on the ‘minimum payroll test’ under the German inheritance and gift tax practitioners should address this issue in all relevant tax filings and, if necessary, appeal any unfavourable tax assessment.
Several provisions of German tax law require that the persons or entities affected are based in the EU or EEA to be eligible for preferential tax treatment. When the UK happens to leave the EU and the EEA the existing preferential tax rules for EU/EEAbased companies, foundations, and trusts will cease to apply to British entities and trusts. Anglo-German tax and estate planning will become a lot more challenging than today; many cases already planned are likely to end up in a German tax trap if not revised to address the expected changes.
This article was first published in Trusts & Trustees, Volume 23, Issue 6, 1 July 2017, Pages 664–668.