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Changes to German withholding tax rules
In November 2006 the German Federal Government adopted the 2007 Tax Bill. It was published in the Federal Law Gazette before year-end and entered into force on 1 January 2007.
The purpose of this brief article is to deal with a specific provision of the Bill, which deals with anti-abuse rules in relation to German withholding taxes.
b) The essence of the changes
The new version of section 50d, paragraph 3 (dealing with anti-abuse provisions) of the German Income Tax Act (Einkommensteuergesetz) stipulates that a full or partial reduction of German withholding taxes will no longer be available in certain cases, as outlined below.
Though the provision relates to withholding taxes on dividends, interest (if any) and royalties (and certain other payments), we will only examine the impact on dividends below. The same also holds true for other payments (mentioned above) that are subject to withholding tax.
The domestic withholding tax rate for dividends (and royalties) including the 5.5% solidarity surcharge, is 21.1%. This tax is reduced to a zero rate in the event of qualifying holdings under the EU Parent-Subsidiary Directive, and to rates ranging from 5%-15% under tax treaties.
Entitlement to this reduction will no longer apply if the ultimate shareholder(s) of the payee company would not have been entitled to the same reduction had the income been received by them directly, unless the payee company meets all of the following three tests:
o there are business or other good reasons (other than tax reasons) for interposing the payee company and the payee company has business activities of its own; and
o the payee company derives at least 10% of its total gross revenues from its own business activities; and
o the payee company carries on a general business activity with sufficient substance.
Note that it will not be necessary to meet all of the above three tests in order to avoid such reduction being disallowed if the (main classes of) shares of the payee company are materially and regularly traded on a recognized stock exchange or if the payee company is subject to the Investment Tax Act.
c) Business activities
The rationale behind all of the above tests is to make sure that payments to a foreign company that has virtually no business activities do not qualify for any reduction in withholding tax(es). The effect is that, unless all of the three tests referred to above are met, the standard rate of 21.1% would apply instead of the treaty rate applied to the shareholders of the interposed company, had they received the relevant income directly.
A Japanese company owns 100% of a Dutch holding company, which fails one (or all) of the above three tests. In turn, The Dutch company owns 100% of a German subsidiary. Currently there would be no withholding tax on dividends paid by the German subsidiary to the Dutch company and onward payment to the Japanese company would be subject to 5% withholding tax. Under the Germany-Japan tax treaty the direct withholding tax would also be 5%. However, since a direct payment by the German subsidiary to the Japanese company would not attract a zero tax rate, the German subsidiary must charge the standard domestic rate of 21.1%. Thus, there will be an effective additional tax burden of approximately 20%.
Based on our comments on the new provision, any business activity generating more than 10% of gross revenues of the payee company must be carried on at the payee company itself and also in its country (or territory) of residence. An "active" business carried on by a foreign permanent establishment or a subsidiary forming part of the consolidated tax group cannot be taken into account. In principle, a business activity can take the form of merely providing services to only one customer, even if the customer is a related party. However, the holding of shares or securities, the leasing of property or rights and proprietorship of intellectual property do not in themselves constitute an "active" business. It would seem that active management of and control over more than one subsidiary may be regarded as an "active" business. However, even if they did, some doubt still remains as to whether dividend income, capital gains or interest and royalty income can be taken into account when determining whether more than 10% of gross revenues are derived from an active business. Chargeable management fees and administration fees would seem to qualify, but it is also unclear whether the 10% threshold would be passed if such revenues accounted for 10% or less of total gross revenues including dividends, gains and interest.
Typical mailbox companies and so-called base companies, would, however, not be regarded as carrying on an active business.
Furthermore, there must be sufficient substance. The company that carries on a business activity must have its own premises and sufficient qualified staff to engage in active business activities. It would seem that the staff would have to be on the company payroll.
d) Further information and regulations
It is expected that the German tax administration will issue further written guidance in late March. From what has transpired so far, although no official documents are yet available, the German tax administration is adopting a very narrow interpretation of the substance requirements. Not only would the immediate payee need to have its own business, but also there would (definitely in the case of dividends) need to be a sound and strong business connection between the foreign company and the German subsidiary. It would appear that valid reasons (i.e., non-tax reasons at parent company level or in relation to affiliates) would not be sufficient to argue that the business test is met. Thus, the argument that the German company is owned by, say, a Dutch operating and holding/financing company, because the Dutch company acts as European/regional holding company for all of the subsidiaries in the region, is not a sufficiently strong reason to pass the substance and business purpose tests. It would seem that in such case the Dutch holding company would need to have de facto influence over the business of the German subsidiary. Moreover, the taxpayer would have the onus of proving such involvement. Undocumented involvement will not be accepted. The holding company must be involved with more than one subsidiary, if managerial involvement is the only real connection between it and the German company. Individual business functions, such as treasury or coordination of purchasing would in themselves be insufficient involvement. The relationship must clearly go beyond the normal relationship of a shareholder.
Assuming that all tests, including the 10% test are met, a preliminary withholding exemption certificate will be issued. The burden of proof is on the party applying for the certificate to show that tests are met. If it becomes clear that a test will not be met, the applicant must inform the German authorities of this forthwith. Once the certificate has been issued, the German authorities will be entitled to demand further proof after the fact (i.e., in the years following the pertinent year). Furthermore, if circumstances change in the future, the certificate will be withdrawn. Based on currently available information, some leniency may be exercised if the 10% test has been met for a continuous period of three years, but is not in one year. Furthermore, it appears that in new cases, the certificate can even be applied for if in the first year the 10% test is not met but is likely to be met in each of the coming three years. Existing certificates for a reduction in withholding taxes will only remain valid to the extent that the taxpayer/beneficiary can prove that the three cumulative tests are met during the year of distribution.
Many issues are still extremely unclear. Similarly, no clarity exists as to whether or not the new rules (and the expected regulations) might conflict with EU law, especially as regards whether EU branches should be excluded from determining the existence of and the level of business activities.
Typical examples of groups that will be affected by these new regulations are groups whose ultimate shareholders are in China, Japan, Korea, the US, India and, obviously, places such as Hong Kong or Singapore.
e) Final comment
The new rule is not limited to related-party payments. Thus, particularly in the case of royalties, a situation can arise where 21.1% withholding tax suddenly becomes due despite it being completely beyond the control of the payor to (help) avoid the withholding. Only the payee will be able to reorganize its operations in order to meet the new tests.
NB: This submission has been contributed by Jan Kooi of the Dutch Taxand Member, Van Mens & Wisselink. Since neither Van Mens & Wisselink, nor Mr. Kooi are German tax specialists, the purpose of the note is simply to alert our readers to the issue and draw attention to the major international impact that the changes discussed here will have.