The CFC Regime in Germany

AuthorSteffen Lampert - Jan-Niklas Bittermann - Bastian Harms
Pages20-33

Ver notas 1 y 2

1. General remarks

The German CFC legislation is found in sec. 7 to 14 of the German Act on External Tax Relations 1972 ("Außensteuergesetz" or "Foreign Tax Act", hereinafter "FTA"). The last update of the CFC regime took place in 2013. The existence of the CFC legislation can be explained by the fact that legal entities that have neither their registered office nor their place of management in Germany are not subject to comprehensive taxation in Germany. This provision made it attractive to transfer assets from German to foreign companies and thereby escape comprehensive taxation in Germany, and this "shielding effect" means that profits made by the foreign entity are only taxable at the level of the shareholder who is subject to comprehensive taxation in Germany if the shareholder receives dividends from the foreign entity. Sec. 7 to 14 FTA address such asset-transfer constructions that take advantage of intergovernmental tax differentials and lead to a distortion of competition (see "Steueroasenbericht" 3 ["report on tax havens") and an avoidance of the taxation of income at the (comparatively high) German tax rates. 4

2. How the system works
2.1. Deemed Distribution System

The underlying idea of the German CFC regime is quite simple: it assumes that comprehensive taxpayers shift profits to a foreign legal entity and refrain from distributing those profits to the German-based shareholder. Consequently, under certain circumstances, the CFC regime deems that there is a distribution of profits. 5 The rules are primarily applicable in the case of a passive-income-generating foreign company (non-German entity) that is controlled by a domestic individual or corporate shareholder (German resident). Due to the German CFC rules, the passive income of the foreign company is deemed to be distributed to domestic shareholders in proportion to their share (sec. 7 para. 1 FTA). This attribution of income takes place irrespective of whether the foreign company actually distributes the profits or not. As a result, the certain amount of income - the so-called inclusion amount ("Hinzurechnungsbetrag") - is included in the taxable income of the German resident and consequently subject to taxation in the form of German income tax, corporate tax and trade tax. 6 According to sec. 10 para. 2 s. 1 FTA, the distribution is simulated immediately after the closure of the relevant fiscal year of the foreign company. 7

Double taxation resulting from the income tax provisions modified by the CFC rules can be almost completely avoided by the exemption in sec. 3 No. 41 ITA. 8 Pursuant to this provision the inclusion amount that has actually been distributed is entirely tax-exempt when the taxation according to CFC rules took place in the year of distribution or in the previous seven years.

2.2. Application Conditions

In order to apply German CFC rules, it is necessary to satisfy three conditions according to sec. 7 para. 1 and sec. 8 para. 3 FTA. First, there has to be an individual or corporate German resident taxpayer with unlimited German tax liability who is required to hold more than 50% of the share capital of a foreign corporation (known as the controlled foreign company). 9 Second, the foreign entity must earn passive income. All revenues that are not included in the exhaustive enumeration of active income in sec. 8 FTA are classified as passive income. 10 Third, this passive income needs to be subject to an effective income tax burden of less than 25% (sec. 8 para. 3 FTA). 11

2.2.1. Relevant Participation in the Foreign Company
2.2.1.1. General rule

The definition of a foreign company is provided in sec. 7 para. 1 FTA and sec. 1 CITA. 12 According to these rules, the CFC provisions are only applicable in the case of an entity whose registered office and place of effective management and control is in a foreign country. In addition, the entity needs to have a structure that leads to a classification as a corporation in accordance with the German entity-characterization rules (so-called "Typenvergleich"). 13

The foreign company is controlled by a shareholder (group of shareholders) if he (they) hold(s) at least 50% plus one vote of the shares of the foreign corporation or of the voting rights (sec. 7 para. 1, 2 FTA). In the case that the foreign entity does not have nominal capital or any voting rights, the proportion of the assets of the corporation is decisive (sec. 7 para. 2 s. 3 FTA). 14 In the calculation of the 50% threshold, even shares and voting rights of a mediating entity have to be considered proportional to the holding of the domestic shareholder in the mediating company (sec. 7 para. 2 s. 2 FTA).

A similar consideration of holdings is applicable in the case of intermediate partnerships (sec. 7 para. 3 FTA) as partnerships are not regarded as taxable entities with regard to corporate or personal income tax.

Thus, all shares that are at least indirectly held by domestic shareholders have to be taken into account, irrespective of the size of the stake or the number of interconnected entities.

2.2.1.2. Income of an Investment Nature

The CFC regime usually only applies if domestic taxpayers hold more than 50% of the shares of a controlled foreign company. However, if the company generates passive income of an investment nature 15 according to sec. 7 para. 6, 6a FTA, a 1% share is sufficient for the CFC regime to be applied with respect to this type of income. The provision offers a de minimis limit in sec. 7 para. 6 s. 2 FTA. The threshold is not applicable, and thus the shareholder is not subject to the CFC rules according to this provision if the passive income of an investment nature represents a maximum of 10% of the gross passive income of the foreign company and if this excluded amount does not exceed 80,000 euros. 16

However, a stake that does not reach the threshold of 1% also leads to an application of the CFC provisions pursuant to sec. 7 para. 6 s. 3 FTA if the foreign entity generates almost exclusively passive income (about 90%) of an investment nature. 17

2.2.2. Determination of Passive and Active Income

Sec. 8 FTA contains an exhaustive enumeration of revenues that can be qualified as active ("good" or "harmless") income and are therefore not subject to the CFC regime. All revenue that cannot be subsumed under one of these categories must be classified as passive ("bad" or "harmful") income. 18 Referring to the application of sec. 8 FTA, each economic activity of the foreign company has to be investigated separately. 19 The determination takes place by way of a functional approach. 20

According to sec. 8 FTA, revenues are active, subject to certain exemptions, if they derive from agriculture and forestry, the manufacturing of property, the generation of energy, exploration and exploitation of natural resources or if they refer to the operation of a banking or insurance business for which commercial business establishments are pursued. 21 The same applies to income that is generated by trading, the provision of services, letting and leasing, and the borrowing and lending of capital under certain further conditions. 22 Finally, also classified as active income are dividends distributed by corporations, gains from corporate shares and revenue resulting from corporate reorganization. 23

In the decision of the Court of Justice of the European Union (CJEU) in the Cadbury-Schweppes case, 24 the British CFC rules were declared to be not in line with the freedom of establishment. According to the Court such anti-avoidance rules could be justified; however the taxpayer must be granted the option to refute the charge of tax evasion by proving the pursuit of an economic activity. German authorities quickly realized the relevance of this decision for the German CFC provisions. The German Federal Ministry of Finance reacted promptly and issued a circular 25 that restricted the taxation to such cases that were solely artificial by allowing the taxpayer to provide counterevidence. Later in 2008 the German legislator introduced a complementary activity test in sec. 8 par. 2 FTA. 26 According to this test, a company that has its registered office or place of effective management or control in a member state of the European Union or the EEA that provides administrative assistance is excluded from the German CFC rules if the pursuit of an economic activity can be proven. 27

According to the explanatory memorandum of the provision, several criteria have to be taken into account to produce evidence that an economic activity exists. 28 One indication is a fixed establishment set up for an indefinite period in the foreign state. Also of significance are actual commercial operations and the presence of business premises and staff. Equally a continuous participation in general economic transactions leads to the assumption of an economic activity. However, occasional capital investments as well as merely administrative shareholdings without any executive functions do not provide sufficient evidence. 2...

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