German government publishes draft bill denying deductions for payments to “harmful” IP regimes

2017 Issue 1

German Tax & Legal Quarterly 1|17

On 25 January 2017, the German government issued a draft of an “Act against Harmful Tax Practices with regard to Licensing of Rights”. The purpose of the draft legislation is to introduce a new income tax code section, 4j Income Tax Act (EStG), restricting the tax deduction of royalties and similar payments made to related parties if such payments are subject to a non-OECD compliant preferential tax regime and are taxed at an effective rate below 25%. It is expected that the new rule will be enacted before the parliament’s summer break in 2017 and will be applicable to royalties incurred from 1 January 2018. In a recent pronouncement, the finance

Content

02 Legislation

04 German tax authorities

06 German court decisions

12 EU law

13 Spotlight

14 EY publications and events

committee of the German upper house (Bundesrat) asked the government to consider applying the new rule already for royalties incurred in 2017.

Under current German tax law, royalty payments are generally fully deductible for German corporate income tax purposes, provided that the payments meet the arm’s length principle. For German trade tax purposes, an add-back of 6.25% has to be considered, resulting in an effective tax deduction of 93.75%.

• Continued on page 2

Legislation

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Continued from page 1The new rule aims to restrict the deduction of royalties to the extent that

1. The royalty income is subject to a preferential tax regime that does not require substantial research and development activities carried out by the licensor and is, therefore, not in compliance with the so-called “Nexus Approach” of Action 5 of the OCED Base Erosion and Profit Shifting (BEPS) project,

2. The recipient of the royalty income qualifies as a related party, and3. The royalty income is effectively taxed at a rate below 25% in the jurisdiction of the recipient.

In line with the Nexus Approach, a royalty deduction is generally not limited as long as the recipient carries on substantial IP business activities. Substantial business activities are not deemed to exist if the recipient of the payments did not predominantly develop the rights in the course of its ordinary business activities. Hence, this exception based on substance does not apply if the IP rights were acquired or developed by another related party of the income recipient. Also, this substance exception shall not apply for the licensing of trademarks.

Both direct and indirect payments made to recipients with low-taxed harmful IP regimes may fall under the proposed rule. However, royalties that are low taxed at the level of the recipient, not because of a preferential IP regime but because the recipient’s jurisdiction generally applies a low tax rate for all kind of income, are not covered by the draft.

If the conditions of the rule are fulfilled, the percentage of the non-deductible amount of royalties is defined as ((25% - effective tax rate at recipient’s level in %)/25%). For example, if the effective tax rate amounts to 5%, 80% of the royalty payments would not be tax deductible.

Under Action 5 of the BEPS project, any jurisdictions with non-OECD compliant IP regimes have been granted time until 30 June 2021 to adapt their regimes to the OECD Nexus Approach. However, the rule proposed by the German government does not foresee any grandfathering rule for “old”, non-OECD compliant IP regimes. Therefore, the rule could already take effect in the period between 1 January 2018 and 30 June 2021. Against this background, existing IP structures should be reviewed and monitored to the extent the royalty income is subject to a low taxation under an IP regime which is not in line with the Nexus Approach.

Please refer to our Global Tax Alert dated 20 December 2016 for more details.

German government publishes draft bill denying deductions for payments to “harmful” IP regimes

For several years, the German tax exemption of gains from debt waivers in business restructuring/turnaround situations was based on an administrative decree only, and in each individual case had to be agreed with the tax authorities. In a landmark decision, the Federal Tax Court (BFH) held in 2016 (case reference GrS 1/15 – see below under tax court decisions) that without a legal basis and solely based on an administrative decree, such tax exemptions were unconstitutional. As the absence of a legal framework allowing a tax-neutral recapitalization through debt waivers is viewed as politically unacceptable by most stakeholders, tax politicians are now discussing options to avoid raising critical obstacles for restructurings using debt waivers. German state governments recently published a legislative proposal allowing businesses to request, if necessary, that restructuring profits caused by debt waivers be tax exempt, in return for foregoing any CIT/TT tax loss carry forwards that may exist. Further conditions for the application of the new rule would be that the debt waiver is necessary, appropriate, and intended to allow continuing the business. State governments address EU state aid concerns by requiring a formal approval by the EU Commission before the new provisions come into force. Considering widespread support for a new legal initiative to support business restructurings through debt waivers, a relatively quick adoption of the proposal in Germany may be expected, although approval by the EU Commission would in any event need to be awaited for the rule to become effective.

Initiative started to codify tax exemption for restructuring gains

Legislation

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On 10 February 2017, the German upper house of parliament (Bundesrat) commented on the draft law to combat tax avoidance (Steuerumgehungsbekämpfungsgesetz), published in November 2016 (see prior coverage in German Tax & Legal Quarterly 2016 Issue 4), which would introduce or reinforce disclosure obligations with respect to participations in foreign entities, and also extend these to financial intermediaries facilitating such investments. The Bundesrat supports the government’s initiative and makes a number of suggestions for other smaller tax law changes. Of potential relevance to inbound investors is a suggested change in the wording of the new German anti-double dip rule for debt-financed inbound partnership investments, which shall ensure that also “atypical silent” partnership investments would be caught by the rule – the wording of the rule at the moment is ambiguous on this point.

German Bundesrat comments on the draft law to combat tax avoidance

With the federal election scheduled for September 2017, the German legislator is working on wrapping up several open items by summer 2017.

In February, the governing grand coalition confirmed that the threshold for immediately deductible low-value assets of currently EUR 410 will be increased. This decision has been long overdue, as the threshold had been unchanged since the 1960s. Conversely, the pool depreciation of annually 20% for low value capital assets between EUR 150 and EUR 1,000 will likely be abolished. A final decision on the exact amount of the new threshold is expected in March. The Social Democrats are in favor of EUR 800 while the Conservatives recently proposed EUR 1,000.

Following a highly emotional public debate on remarkably high salaries for well-known board members of big corporations, the Social Democrats have published a bill to curb such “excessive” payments. The proposal combines restrictions of the tax deductibility of payments above EUR 500k with new rights for the general meeting of shareholders to limit board members’ earnings. The Conservatives are sending mixed signals. While high-ranking officials and even chancellor Merkel have stated some willingness to compromise on this issue, a significant number of their members of parliament are strictly opposed to the far reaching proposal.

State Finance Ministries are preparing an initiative to apply real estate transfer tax (RETT) even on share deals with a change in ownership of less than 95%. A proposal for a fundamentally new RETT approach regarding share deals will likely be the outcome of an expert working group report that has been requested for October. In the short term, first steps in this direction might be proposed in March and could be implemented by summer.

As discussed in the final report to BEPS action point 12, an initiative to introduce mandatory disclosure rules for aggressive tax planning strategies is expected to be launched in March. While in general the initiative has chances to be successful, it is unclear if a new regulation can realistically be agreed upon prior to the federal election in September 2017.

Latest German tax policy developments

On 22 December 2016, the German Federal Ministry of Finance (BMF) published the final version of its comprehensive circular concerning the allocation of profits between a head office and its foreign permanent establishments (PEs). The document only insignificantly differs from the draft issued on 18 March 2016. On 186 pages the BMF provides detailed guidance and examples with respect to its interpretation of the Authorized OECD Approach (AOA) and its separate legal entity concept for a PE, which Germany incorporated in the Foreign Tax Act in 2013.

In line with the AOA, it is stipulated that a PE is largely deemed a separate and independent enterprise in order to apply the arm’s length principle to the extent possible. The circular defines and explains specific steps for the PE profit determination. Following an initial analysis of general functions and risks, the individual people functions, assets, chances and risks as well as endowment capital and liabilities are to be allocated accordingly. Furthermore, since a PE cannot conclude legal contracts with its head office or other parts of the business, deemed business relationships (“dealings”) with other parts of the company are to be assumed and fictitious arm’s length remunerations have to be determined. Based on these methods, the PE income for financial years starting from 1 January 2016 must be calculated using a so-called auxiliary calculation on an annual basis, consisting of a PE balance sheet and a PE profit & loss statement. As a result, a PE can generally be profitable or loss making, irrespective of the overall income of the group it belongs to.

Following these general profit attribution principles, the circular contains a number of specific rules and examples with respect to the allocation of individual assets, liabilities, functions and risks. It also defines the dealings between a PE and its head office or other parts of the group and how they are to be identified and priced. Moreover, besides special regulations for banks, insurance companies and construction companies, the regulations also deal with a number of situations for which the separate legal entity concept of the AOA appears not to be practical and provides examples for further explanation.

The BMF clarifies that the PE profit attribution principles under the AOA do not apply to the determination of profits of a PE created through a partnership for its partners under a double tax treaty. However, the rules apply for PEs that a partnership itself operates in another jurisdiction. Moreover, the rules in principle apply to agency PEs as well.

Foreign companies with PEs in Germany and German entities with PEs abroad are advised to take action now and review whether their PE profit allocation complies with the specific German AOA rules as interpreted under the circular. Since Germany implemented the AOA with some deviating rules, e.g., asymmetric determination of endowment capital, the application of the AOA principles may result in double taxation scenarios. In such cases, the circular suggests resolving this via the application of a mutual agreement procedure. Since these procedures can be very time- and cost-intensive, upfront liaising with the German and/or foreign tax authorities as well as the preparation of substantial documentation in order to manage respective tax audit risks is therefore highly recommendable.

A Global Tax Alert with more details will be published shortly.

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German tax authorities

German Federal Ministry of Finance publishes circular on profit allocation to permanent establishments

Along with the amendments of the Investment Tax Reform Act, the German legislator has introduced new rules regarding the taxation of so-called cum/cum trades. Objective of sec. 36a Income Tax Act (EStG) is to stop certain tax arbitrage trades between domestic and foreign market participants around the dividend record date (cum/cum transactions). Such transactions have been used by foreign investors to avoid a definitive withholding tax burden by selling or lending German stock during the dividend season to German residents who are entitled to a withholding tax credit.

Generally, German dividend withholding tax can be credited only against German tax payable by domestic taxpayers, while foreign taxpayers eligible for standard treaty benefits are generally charged with a definitive German withholding tax of 15%. Under a cum/cum transaction, a foreign taxpayer usually lends its shares to a German financial institution shortly before the dividend record

New rules introduced regarding the taxation of so-called cum/cum trades

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The German tax treatment of mergers involving non-EU subsidiaries of a German shareholder has been in dispute in German tax literature for a considerable time. Some representatives of the German tax authorities held the view that in certain situations, a side-stream merger of two non-EU subsidiaries that were directly held by a German shareholder could result in fully taxable income at the level of the German shareholder. With their circular issued on 10 November 2016 (IV C 2 – S 2761/0-01), the tax authorities revised this view and provide more certainty for such reorganizations.

Generally, the German Reorganization Tax Act does not apply to mergers of non-EU corporations. Therefore, in cases where non- EU corporations were directly held by a common German shareholder, a merger of such entities would basically be treated as a taxable event and any built-in gains in the shares of the transferor would have to be taxed at the level of the German shareholder. Some representatives of the tax authorities held the view that such a merger of non-EU entities would have to be treated as a liquidation from a German shareholder perspective and, if implemented tax neutrally in the jurisdiction of the transferor, would consequently result in a fully taxable deemed dividend at the level of the German shareholder under the German correspondence principle.

As an exception to this general rule, the Corporate Income Tax Act (KStG) allows a German shareholder to apply the Reorganization Tax Act and, therefore, carry out a merger of its non-EU subsidiaries at tax book value under certain preconditions. However, the necessary preconditions have been subject to intense discussions in the professional tax literature and among representatives of the tax authorities. Whereas there is no doubt that the merger in the foreign jurisdiction must legally correspond to a merger under German reorganization law in order for the exception to apply, it was particularly unclear from the wording of the law whether the transferor would need to be subject to limited taxation in Germany, i.e. would need to earn German income. In practice, these doubts were sometimes dispelled by creating German income at the level of the non-EU transferor prior to a merger, e.g. through the acquisition of German shares through which dividend income was generated.

The circular provides clarification in this regard and states that non-EU corporations do not need to be subject to limited taxation in Germany. This may significantly reduce the complexity and inherent tax risks of merging non-EU subsidiaries of a German shareholder and has practical implications in a number of international restructurings.

Unlike mergers, spin-offs are not explicitly covered by the wording of Sec. 12 KStG or by the circular. Consequently, it is still unclear whether spin-offs of non-EU subsidiaries of a German direct shareholder may also be implemented at tax book value at the shareholder level under similar conditions. In such situations, applying for a binding tax ruling prior to the restructuring steps remains advisable.

German tax authorities issue circular on the treatment of mergers between non-EU entities with German shareholders

German tax authorities

date. The institution then receives the dividend on the dividend payout date (usually the dividend-ex date — that is, the day after the dividend record date), claims a refund of the dividend withholding tax (usually 25% plus solidarity surcharge), returns the shares, pays the lending fee, and passes on a portion of the tax savings to the foreign counterparty.

Broadly speaking, German taxpayers will be eligible only for full credit if they have sufficient economic entitlement to the relevant stock or equity-like profit participation certificates within a 45-day window around the due date of the capital income.

In December 2016, the German Federal Ministry of Finance distributed a draft circular that addresses some of the many uncertainties arising under the new rule. German taxpayers who do not meet the new requirements will be entitled only to a credit of two fifths of the withholding tax — i.e. 10% if the withholding tax is 25%. The non-creditable portion (15%) corresponds to the tax treatment of ordinary non-residents (who frequently benefit from a reduced 15% rate under a tax treaty). Given that the rule applies retroactively from 1 January 2016, transactions as of start of 2016 should be reviewed and their tax treatment analysed.

It should be noted that cum/cum trades undertaken before the enactment of the new anti-avoidance rule are likely to be questioned by German tax authorities. Based on two recent Federal Tax Court decisions, tax authorities will likely examine whether the economic ownership of the stock was actually transferred to the German counterparty that claimed the withholding tax credit.

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German court decisions

On 28 November 2016, the German Federal Tax Court (BFH) ruled that the German tax authorities may no longer grant preferential tax treatment to “restructuring profits” of distressed businesses based on the so-called “Restructuring Decree” (Circular of the German Ministry of Finance dated 27 March 2003). The decree sets forth the conditions which need to be met in order to obtain tax abatement for corporate income tax and trade tax by way of an equitable measure. Generally, the German tax law foresees tax abatements where in individual cases the levy of a specific tax would establish a hardship in the individual case. Restructuring profits may occur where distressed companies obtain debt forgiveness of shareholders or third-party lenders. Such cancellation-of-debt income is neutralized for tax purposes where the debt waiver can be classified as a hidden contribution to the company. However, to the extent the waived loan was not fully valuable, such neutralization is not fully possible according to general tax principles and the difference between the face value of debt and the fair market value remains taxable income. Moreover, under German minimum taxation rules, an offset of such gains with loss-carryforwards is only possible up to a value of EUR 1 million; exceeding income can be offset only up to 60%. In the restructuring decree, the tax authorities set forth the conditions under which distressed companies undergoing restructuring may obtain tax abatement in order to facilitate the restructuring measures.

The Great Senate of the BFH has now ruled that the tax authorities may no longer base tax abatement measures on the restructuring decree. Under the constitutional principle of the legality of the tax authorities’ actions, a tax abatement for the restructuring of ailing companies shall not be possible. Setting forth general principles for the restructuring of distressed companies would require legislative action and may not be based on a mere administrative decree of the tax authorities. Instead, tax abatements may only be granted under the general rule which requires individual hardship.

The order of the Great Senate of the BFH renders a key element of the German rules on restructurings inapplicable and may impede restructurings of ailing entities. As a consequence of the BFH decision, political action is now likely (see above comments on an already issued proposal for a codification of a debt waiver income exemption).

German Federal Tax Court suspends application of “Restructuring Decree”

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German court decisions

On 28 September 2016 (3 K 2206/13), the lower tax court of Cologne characterized as royalties for domestic tax purposes the payments made by a German TV channel for a so-called total buy-out of TV coverages from an Australian reporter. The TV channel appealed against the decision before the German Federal Tax Court (BFH, case reference I R 83/06).

While under German law outbound royalty payments are subject to 15.825% withholding tax at source, payments for the permanent transfer of rights are not subject to source taxation. The court’s reasoning for recharacterizing the total buy-out contract as a license contract was as follows: (i) Copyrights (“Urheberrechte”) themselves are not transferable, but only the right to exploit them; (ii) for tax purposes, only the economic substance of the contract is decisive; (iii) from an economic standpoint, there is no permanent transfer of rights if the transferred rights may revert to the seller without the consent of the acquirer – it is immaterial whether the reversion right is established by law or contractually; (iv) in the case at hand, the parties could not exclude reversion and withdrawal rights stipulated under German law; (v) the following facts are not sufficient to characterize a permanent transfer of rights: the right of the German TV channel to edit the Australian TV coverages; the contractual possibility of the German channel to transfer the acquired rights to third parties and to exclude the reporter from exploiting his rights until they are in the public domain.

The court further ruled that the double tax treaty Germany-Australia was applicable. Hence the German source tax rights should be limited to 10%. This court decision is in line with the understanding of the tax authorities so far. It is worth mentioning that on 25 August 2016, the lower tax court of Cologne ruled in a similar case (13 K 2205/13) that a contract on the total buy-out of film rights from the UK should be considered as a license contract for tax purposes. An appeal before the BFH is pending (case reference I R 69/16).

Foreign individuals and enterprises selling or licensing IP rights to Germany should therefore be aware of the German withholding taxes when drafting their contracts in order not to be caught by surprise. German-resident taxpayers acquiring IP rights from abroad should double-check whether they should withhold taxes on the payments they make.

On 12 October 2016, the German Federal Tax Court (BFH) decided on a case with regard to fiscal grouping for VAT purposes (XI R 30/14). In this decision, the court reduced its very strict demands for an organizational integration into a VAT group.

The general requirements for forming a VAT group are the presence of a financial, economic and organizational integration between the parent company (the head of the VAT group) and the controlled entity. The organizational integration is generally accepted where identical persons act both in the board of managers of the parent company and the controlled entity.

Furthermore, according to previous BFH decisions, the organizational integration into a VAT group could also be established where employees of the parent company are at least part of the management board of the controlled entity.

The BFH has now accepted an organizational integration into a VAT group even in cases where the managing director of the controlled entity is neither a managing director nor an employee of the parent company, but where the parent company has institutionally approved direct intervention options into the core business of the controlled entity. According to the recent decision of the BFH, these requirements are met in case the managing director of the controlled entity is required to comply with the instructions issued by the parent company acting as shareholder through the shareholders’ general meeting and the board of directors of the parent company. In the past, the BFH used to deny an organizational integration only based on intervention rights or reporting obligations in favor of the general meeting of the shareholders.

Outbound consideration for total buy-out of TV coverages characterized as taxable royalties

Federal Tax Court rules on the requirements for organizational integration into a VAT group

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German court decisions

According to the decision of the German Federal Tax Court (BFH, case reference V R 31/15), supplies via a consignment stock located in Germany may qualify as direct supplies to the customer if the recipient of the supply is known at the beginning of the shipment to the warehouse.

This is good news for companies not established in Germany. In the past, according to the German tax authorities, foreign suppliers had to register with the German tax authorities for VAT purposes in case they dispatch goods from another EU member state into a warehouse located in Germany and keep goods in storage ready for a particular customer. The supplier had to account for an intra-Community acquisition for the movement of the goods into the warehouse and for local VAT when the customer calls for (“calls off”) goods when the goods are needed. If the new approach of the court is accepted, the obligation to register for VAT purposes accompanied by filing VAT returns in Germany may become obsolete.

The BFH came to the same conclusion as earlier the Hessian lower tax court (case 1K 2519/10) as well as other lower tax courts (lower tax court of Düsseldorf - case 1 K 1983/13; lower tax court of Lower Saxony – case 5 K 225/14). The BFH ruled that the supply of goods to the customer already takes place at time of the beginning of the shipment to the warehouse under the condition that the customer of the supply is already known at this point in time due to an existing binding legal agreement between the parties. The court explicitly mentions in its decision that an interim storage of the goods in the warehouse for a short period of time is irrelevant. Thus, a period of several weeks should meet these requirements. As a consequence, the suppliers perform zero-rated intra-community supplies of goods from their home country instead of local supplies to their customer and, consequently, do not have to register for VAT purposes in Germany. Only in cases where a binding contract (e.g. binding purchase order) is not yet in place at the time of the beginning of the shipment to the warehouse, does the supplier need to register for VAT purposes in Germany and perform local supplies from the warehouse (see also German Tax & Legal Quarterly 2016 Issue 4).

In any case, agreements in place with regard to supplies via a consignment stock need to be reviewed in the light of this new BFH decision. The court decision is to be welcomed given the fact that the generalized approach of the German tax administration with regard to consignment stocks was abandoned. Foreign businesses who faced VAT assessments and sanctions for late registration in the past should now consider invoking the principles applied by court and appeal against such assessments.

German Federal Tax Court disagrees with fiscal authorities on the VAT treatment of consignment stocks

A company performing VAT-exempt intra-Community supplies is required to record the foreign VAT-ID of its customer. Furthermore, in order to treat supplies as Intra-Community supplies, the supplier must take reasonable measures to ensure the validity of the VAT-ID of its customer.

If at a later point in time the VAT-ID of the customer turns out to be invalid, e.g. as it has been cancelled by the competent tax authority or as it was only valid as of a date after the execution of the supplies, tax authorities of the supplier tend to deny the VAT exemption for the supplies and levy VAT. Such VAT may become a cost for the supplier, because the customer may not be willing to accept a corresponding onward charge.

In this regard, recent jurisdiction strengthens the position of the supplier. In particular, the European Court of Justice (ECJ) held in its decision “Euro Tyre 2” dated 9 February 2017 (C-21/16) that the tax authority of a Member State may not refuse the VAT exemption of an intra-Community supply on the sole ground that at the time of that supply the purchaser did not provide a valid VAT-ID even though the customer was undoubtedly an entrepreneur in terms of VAT. In the light of the principle of proportionality, no refusal of the VAT exemption is acceptable even where the vendor was aware of these circumstances, but was convinced that subsequently the purchaser would apply for a valid VAT-ID.

Similarly, the BFH ruled in its decision dated 2 November 2016 (V B 72/16) that a cancellation of the VAT-ID of the customer with retrospective effect (this was initiated by the local competent tax authority) may not infringe upon the VAT exemption applied by the supplier, where the supplier took reasonable and sufficient measures to check the validity of the VAT-ID at the date of supply.

In summary, these decisions show that a valid VAT-ID of the customer is important from a practical perspective and should carefully be checked and recorded by the supplier. However, where tax authorities deny the VAT exemption of the supplier based on potential deficiencies of the customer’s VAT-ID, the supplier should not accept such assessments and invoke the above described principles of the courts, according to which the formal requirements cannot undermine the vendor’s entitlement to exemption from VAT where the substantive conditions for an intra-Community supply are obviously satisfied.

The relevance of a correct VAT-ID of the customer

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German court decisions

The German Federal Tax Court (“BFH”) in case IV R 8/14 had to decide how to treat a partnership which in turn had “atypical” silent partners from a trade tax perspective. The question is relevant, as trading partnerships are not tax-transparent for trade tax purposes, and are not able to become tax group subsidiaries, i.e. are taxed on a stand-alone basis.

Even though the atypical silent partnership as an undisclosed, internal partnership is not itself liable to trade tax, the court held that for tax purposes, it nonetheless creates a separate trade-taxable partnership, and hence the principal partnership (in this case a KG) had to actually file two trade tax returns – one for itself, and one for the income share allocable to the atypical silent partnership. In such a case, no netting was possible for trade tax purposes between e.g. losses in the principal partnership, and profits in the atypical silent partnership.

German Federal Tax Court rules on trade tax treatment of partnership with “atypical” silent partners

On 7 December 2016, the lower tax court of Münster decided on a – very common – case of inter-company financing. The tax court casts doubt on the applicability of rating-based bond search analyses to determine inter-company interest rates. The decision also contributes to the international discussion concerning implicit group support and the delineation of inter-company loans versus inter- company services. At the basis of the court’s decisions are the following:

1. The comparable uncontrolled price method was rejected on the grounds of incomparability of group financing companies with banks

2. Evidence created with credit-rating software was dismissed because the rating algorithm inherent in the software was unknown3. Due to the lack of better evidence, the tax court estimated the income of the foreign financing company based on a cost-plus

method. The determination of the cost mark-up is similar to well-known approaches used for pricing back-to-back financing involving Luxembourg or Dutch pass-through financing companies.

A German-based corporation took out various loans from third parties and an affiliated Belgian finance company. Throughout the tax audit period, the inter-company interest rates were higher than the external interest rates. The taxpayer explained this observation with the existence of group guarantees towards the third-party lenders for which the taxpayer did not pay. The taxpayer defended the inter-company interest rates with reference to a rating-based bond search and yield curve analysis, which is quite common among German and international taxpayers.

The court rejected the comparable uncontrolled pricing method and argued that neither the cost structure, nor the business purpose of the group financing company was comparable with that of banks. The data that the taxpayer presented as comparable data was rejected on the basis that it did not allow any conclusions concerning the interest rates at which the taxpayer could have borrowed from third parties that are fully aware of the taxpayer’s affiliation to a multinational enterprise.

On this basis, the tax court decided that a cost-plus based transfer pricing method would be the most reliable method to estimate the interest expense for inter-company borrowings. The determination of the cost mark-up is similar to a capital return method relying on weighted average costs of capital.

The court’s decision has been admitted to appeal by the German Federal Tax Court.

It is likely that this tax court decision provides additional momentum to the attempts of German tax authorities to challenge the pricing of inbound inter-company loans. However, a more detailed analysis of the court’s arguments and method to estimate inter-company interest rates raises a lot of questions. For instance, the tax court has not provided any arguments under which circumstances the inter-company provision of funds constitutes a service or a loan. Furthermore, it is not clear whether the court considered any adjustment calculations of the third-party data provided by the taxpayer. Last but not least, the estimation method ultimately suggested by the tax authorities but largely accepted by the court raises a number of conceptual inconsistencies and misunderstandings that upon correcting would have mostly avoided the need for any income adjustments.

Tax court decides on applicability of rating-based bond search analyses to determine inter-company interest rates

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German court decisions

According to the German Reorganization Tax Act, a downstream merger of two German entities can, in principle, be carried out at book value. Assets may be recorded at book value to the extent that the following three conditions are fulfilled: First, it needs to be ensured that the assets which are transferred in a merger are later subject to corporate income tax at the level of the transferee. Second, Germany’s right to tax at the transferee’s level any gain on the sale of these assets must not be precluded or restricted. And third, no consideration may be provided, or if consideration is provided, such consideration consists of shares.

In this regard, it is questionable whether the term “assets transferred in a merger” comprises also the shares in the transferee. Issues can arise when the merged entity is owned by a foreign treaty-resident shareholder since Germany might lose its taxing rights in such shares. According to a decree of the German tax authorities (which binds the authorities, but not the courts), a book value treatment for the shares in the surviving entity in a downstream merger should only be available where the shares in the merged entity in turn are still subject to German tax. Then, according to the general rule, assets transferred in a merger shall be stated in the closing tax balance sheet of the transferor at fair market value. This means that the merger would have to lead to gain crystallization in the shares of the surviving entity previously owned by the merged entity.

Based on several voices in German tax literature, the tax court of Rhineland-Palatinate contested the view of the tax authorities (12 April 2016 – 1 K 1001/14 and 6 K 1947/14). The court is of the opinion that the downstream merger should not result in a tax burden because the shares in the transferee cannot be considered as assets transferred in a merger. Therefore, a continuance of book values would be possible.

The question is now pending before the Federal Tax Court (BFH, case reference I R 35/16 and I R 31/16). Should the BFH decide against the tax authorities, it is possible that the German legislator will quickly and prospectively repair the law and close what could be viewed as a loophole in the German Reorganization Tax Act, so that similar downstream mergers after that law change would likely be taxable.

In German companies, the works councils have extensive rights of co-determination (“betriebliche Mitbestimmung”). For example, if a company wants to monitor its employees through the use of technical devices, this is subject to operational co-determination. When a company runs a Facebook page, it is in principle not subject to the co-determination of the works council. This changes, however, if the employer grants other Facebook users the possibility to comment on the Facebook page on the performance and behavior of individual employees. Therefore, if a company decides to set up an interactive internet presence, it must take into account the potential co-determination rights of the works council. This should also be applicable to other providers of social networks that work like Facebook and enable interaction between employees and third parties.

In the case decided by the German Federal Labour Court (Bundesarbeitsgericht, BAG) on 13 December 2016 (case reference 1 ABR 7/15), the defendant was an operator of blood donation services. During the blood donation sessions, several employees wearing nametags were present. In 2013, the company set up a Facebook page for group-wide marketing purposes. Registered Facebook users have the opportunity to post on this Facebook page. After third parties posted critical comments about the behavior of individual employees, the works council claimed that the set-up and operation of the Facebook page was subject to co-determination, arguing that the employer could monitor the employees because users had the possibility to publicly comment on the behavior or the performance of employees. According to the works council, this created considerable monitoring pressure.

The BAG decided that the employer’s decision to run a Facebook page and to enable the immediate publication of postings was subject to co-determination. It argued that as far as these postings were related to the behavior or performance of employees, this would lead to the monitoring of employees through a technical device, which is subject to co-determination.

Tax court allows tax-neutral downstream merger

German Federal Labor Court (BAG) rules on co-determination right of works council in connection with a company’s Facebook page

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Social networks are playing an increasingly important role in different areas of labor law. Facebook, Twitter etc. enable their users to reach large groups of individuals within a short time frame. This can lead to far-reaching consequences from a labor law point of view. If employees criticize their employers via social media, the employers’ reputation can suffer considerably in very short time and much faster than during a personal confrontation or through traditional media. This triggers the question as to the extent to which employees can still rely on their constitutional rights to freedom of speech.

If an employee posts critical comments regarding the employer, the employer may have the right to dismiss the employee properly and effectively without notice. A German labor court decided that the extraordinary termination of an apprentice was considered effective after the apprentice had listed „human oppressor and exploiters” under the employer section of his Facebook profile. The court argued that Facebook is a public platform so that the apprentice’s comments were available to a large number of people.

While employers may be able to obtain information about applicants and employees from publicly accessible sources, research on social networks is in principle not acceptable since the data is not accessible to the general public and cannot be retrieved without registration. However, professional and leisure-oriented networks are treated differently. A search in career-oriented networks such as LinkedIn or Xing, in which the employee can provide information for potential future employers, should in general be permissible.

German court decisions

The German Federal Tax Court (BFH) recently published a decision (IX R 43/15) which significantly impacts the structuring of management equity participation programs (MEPs).

The BFH confirmed recent jurisprudence of the Cologne lower tax court that typical leaver provisions (i.e. rules that stipulate what happens to the manager’s equity investment if she/he leaves the company) should not necessarily lead to adverse tax implications. In particular, the BFH clarifies that leaver provisions as such do not justify a re-qualification of exit proceeds into ordinary employment income for managers participating in a MEP.

All of the underlying facts and circumstances need to be taken into account to determine the type of income received (i.e. capital income at beneficial tax rates vs. employment income at ordinary income tax rates). Generally, the MEP participation can be classified as a separate (shareholding) relationship between the employer and the managers for German tax purposes. There is not necessarily a connection of MEP participation with the existing employment. In addition, according to the BFH, leaver conditions are rather an integral part of the shareholding as opposed to being caused by the employment – as argued by the German tax authorities. Considering the BFH’s decision, exit proceeds received by managers should qualify as capital income as long as there are no other provisions besides the leaver clauses leading to a significant link between the MEP and the employment relationship.

The BFH’s decision is to be welcomed. It confirms that the tax authorities’ interpretation of previous jurisprudence was too narrow and the conclusion that leaver provisions per se are harmful was not in line with German tax law. In addition, the BFH confirmed its previous jurisprudence that offering the MEP participation to a limited group of employees should also not necessarily lead to a re-qualification of exit proceeds into ordinary employment income for the participating managers.

It is crucial to ensure an appropriate wording of the underlying MEP documentation. In addition, applying for binding wage tax rulings with the tax authorities is recommended – the chances of successfully arguing that exit proceeds qualify as capital income have been substantially increased by the BFH’s decision.

Management Equity Participation – breakthrough concerning leaver conditions

EY German Tax & Legal Quarterly 1.17 | 12

EU law

The German Trade Tax Act (GewStG) contains autonomous participation exemption rules deviating from the corporate income tax participation exemption provision and from the participation exemption rules in the German double tax treaties (DTTs). In particular, the GewStG requires in its Sec. 9 No. 7 for non-EU-participations “active income” at the level of the subsidiaries and imposes in case of sub-holdings further requirements with regard to the activities, the group structure and the timing of the distributions. For domestic and EU-based subsidiaries, less severe requirements apply.

The local tax court of Münster, by order of 20 September 2016 (9 K 3911/13 F), has now referred a case to the European Court of Justice (ECJ) where the taxpayer received dividends from a third-country subsidiary which did not meet the strict requirements for the trade tax participation exemption. In the referring court’s view, the free movement of capital principle of the Treaty of the Functioning of the European Union (TFEU) was applicable and the requirements set forth by Sec. 9 No. 7 GewStG cannot be classified as an (in principle permitted) anti-abuse provision. The court further stated that the stand-still clause which protects national rules being in place on 31 December 1993 does not apply in the case at hand as the rule had undergone several law changes since then.

The case is pending before the ECJ (case reference C-685/16). In cases where the dividends received are not protected by DTT participation exemptions and where in a purely domestic situation the exemption would have been granted, taxpayers may therefore now file objections for still open trade tax assessments and apply for suspension of proceedings until the ECJ has rendered its decision.

German local tax court refers trade tax participation exemption rule for third-country participations to the European Court of Justice

EY German Tax & Legal Quarterly 1.17 | 13

Spotlight

The cross-border merger of companies has become a more or less common practice in the European Union. The relevant legal framework has been set for company law and tax by European directives which had to be implemented into domestic law many years ago. The harmonized rules provide a safe basis for group-internal reorganizations, entity reduction programs and integrations after acquisitions. But mergers are often not as tax-neutral as initially expected, even if assets are not shifted between different jurisdictions. Each merger entails a transfer of assets and liabilities between the entities which are part of the merger transaction. And such transfers may e.g. trigger real estate transfer taxes, can cause breaches of minimum holding periods from prior reorganizations, extinguish tax losses or cause reversals of tax adjustment items accrued within fiscal unities. For all those adverse and costly events identified in the context of envisaged merger transactions, a new but very efficient alternative should be considered – a cross-border conversion of the relevant entity.

In contrast to a merger, a conversion does not entail a legal transfer of assets and liabilities between different entities. The preservation of the company’s legal identity is the key to a maximum of tax neutrality.

Interestingly this reorganisation possibility lacks a basis in European directives and domestic legislation. It is purely based on case law of the European Court of Justice (Vale Case, C 378/10) and in Germany on the decision of the higher regional court of Nuremberg (decision of 19 June 2013, 12 W 520/13). In line with this case law, an EU company can move its seat from one EU-member state to another without liquidation and wind-up in its departure jurisdiction and without being regarded as newly established in the arrival jurisdiction.

This means in practice that a Dutch B.V. can move its statutory seat from Amsterdam to Berlin - leaving as a Dutch B.V. and arriving as a German GmbH.

Notwithstanding the fact that the departure country shall not regard and treat the converted company as being liquidated, local provisions for protection of creditors apply. This means for the Netherlands example that the conversion (respectively the deletion) of the entity from the commercial register in Amsterdam has to be announced at least two months prior to the implementation of the conversion. After this period, a Dutch notary issues a clearance certificate, which is one of the documents required for the registration of the company with a German commercial register.

Cross-border conversion is rather new and local implementation requires proper preparation, which also involves qualified conversations with the competent courts that require experience in such transactions. Therefore, working with experienced legal advisor teams capable of efficiently collaborating across borders is crucial for the success of this type of reorganisation. EY Law is one of the first law firms in Germany to have successfully advised on cross-border conversions into Germany.

Conversion is sometimes better than a merger

EY publications and events

Please find pdf-versions of the EY publications listed below by clicking on the related picture. The free EY Global Tax Guides app provides access to our series of global tax guides. www.ey.com/GL/en/Services/Tax/Global-tax-guide-app

Upcoming EY events

Worldwide corporate tax guide (2016 edition) The worldwide corporate tax guide summarizes the corporate tax systems in 162 jurisdictions.

Worldwide personal tax and immigration guide (2016-17 edition)The worldwide personal tax guide summarizes personal tax systems and immigration rules in more than 160 jurisdictions.

Worldwide VAT, GST and sales tax guide (2016 edition) Inside this guide you will find extensive details of value-added tax, goods and service tax and sales tax systems of 115 jurisdictions.

Deutsches Transfer Pricing Forum

• In-depth analysis of recent transfer pricing developments from various points of view• Special focus on the BEPS initiative and digitalization due to current regulatory changes and developments

Language: GermanEvent contact: Katharina Beckfeld, katharina.beckfeld@de.ey.comDate and location: 23-24 March 2017 in Mainz

Worldwide Personal Tax and Immigration Guide2016–17

EY German Tax & Legal Quarterly 1.17 | 14

EY German contactsCities in alphabetical order

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Arnulfstraße 5980636 MunichPhone +49 89 14331 0Telefax +49 89 14331 17225

Am Tullnaupark 890402 NurembergPhone +49 911 3958 0Telefax +49 911 3958 550

Gartenstraße 8688212 RavensburgPhone +49 751 3551 0Telefax +49 751 3551 550

Heinrich-Böcking-Straße 6–866121 SaarbrückenPhone +49 681 2104 0Telefax +49 681 2104 42650

Flughafenstraße 61 70629 Stuttgart Phone +49 711 9881 0Telefax +49 711 9881 550

Max-Planck-Straße 1178052 Villingen-SchwenningenPhone +49 7721 801 0Telefax +49 7721 801 550

EY German Tax Desks

LondonPhone +44 20 7951 4034

New YorkPhone +1 212 773 8265

ShanghaiPhone +86 21 2228 6824

TokyoPhone +81 3 3506 2238

EY German Tax & Legal Quarterly 1.17 | 15

EY | Assurance | Tax | Transactions | Advisory

About the global EY organizationThe global EY organization is a leader in assurance, tax, transaction and advisory services. We leverage our experience, knowledge and services to help build trust and confidence in the capital markets and in economies the world over. We are ideally equipped for this task – with well trained employees, strong teams, excellent services and outstanding client relations. Our global purpose is to drive progress and make a difference by building a better working world – for our people, for our clients and for our communities.

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© 2017 Ernst & Young GmbHWirtschaftsprüfungsgesellschaftAll Rights Reserved.

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This publication contains information in summary form and is therefore intended for general guidance only. Although prepared with utmost care this publication is not intended to be a substitute for detailed research or the exercise of professional judgment. Therefore no liability for correctness, completeness and/or currentness will be assumed. It is solely the responsibility of the readers to decide whether and in what form the information made available is relevant for their purposes. Neither Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft nor any other member of the global EY organization can accept any responsibility. On any specific matter, reference should be made to the appropriate advisor.

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PublisherErnst & Young GmbHWirtschaftsprüfungsgesellschaft Flughafenstraße 6170629 Stuttgart

Editorial TeamChristian Ehlermann, christian.ehlermann@de.ey.comJoerg Leissner, joerg.leissner@de.ey.comMartina Ortmann-Babel, martina.ortmann@de.ey.com

About this quarterly reportThis quarterly report provides high-level information on German tax developments relevant to foreign business investing in Germany.

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