StartTax lawInternational Tax LawControlled Foreign Corporation Rules

Controlled Foreign Corporation Rules

International Tax Law – Avoiding controlled foreign corporation rules according to the German Foreign Tax Act [AStG]

Taxation under controlled foreign corporation rules (CFC rules) is defined as the taxation on income of a foreign subsidiary of a shareholder based in Germany that can, in turn, be a natural or legal person or a partnership.

According to the fundamental position of the fiscal administration, taxation on controlled foreign corporation rules serves to protect the German tax substrate. The target is to tax German taxpayers holding an interest in companies in low-tax countries and, as a result, generate tax advantages. The income (intermediate income) of the foreign company (intermediate company) is added to the income of the fully taxable taxpayer in accordance with the amount of his/her interest in said company (attribution amount). Income from capital income is added as a so-called fictitious dividend payment (so-called distribution assumption). However, it also has to be remarked that both the Federal Fiscal Court (BFH) and the ECJ have repeatedly rejected provisions regarding the controlled foreign corporation rules and declared such as being incompatible with our basic freedoms. 

 

Taxation under controlled foreign corporation rules according to AStG – Background and historic development

In principle, a foreign subsidiary – provided it is a joint stock company – is considered an independent taxable company (the shielding effect of joint stock companies). The income of the subsidiary is subject to foreign tax law and is taxed abroad. Only the distributions made by the subsidiary to the domestic shareholder are subject to domestic taxation.

However, misuse is possible under these provisions. For example, a domestic taxpayer might set up a subsidiary in another low-taxation country and might use this foreign company to control both his/her entrepreneurial activities and shareholdings in other companies. The taxpayer would only pay (low) taxes on the profits collected provided he/she reinvests these profits rather than distributing them.

The shielding effect of joint-stock corporations has often been used by persons based in high-tax countries who set up foreign joint-stock corporations in low-tax countries. In the event of non-distribution, their profit was only subject to the low taxation in the country of residence or the management country. By moving passive activities involving high value generation – e.g. by granting a foreign loan to the domestic entity – profits could be transferred abroad. The legislator defined these foreign joint-stock corporations as base companies (or intermediate companies).

With the principles of 19th December 1970, the German federal government initiated the legislative procedure for the Foreign Tax Act Reform Law. At the time, the German legislator considered the establishment of base companies as a central problem of tax evasion.

The controlled foreign corporation rules were introduced in AStG in 1972. To this day, these provisions aim to prevent such “profit shifting”. The controlled foreign corporation rules break the shielding effect of the joint-stock corporation subject to low taxation abroad. A notional payment of the base company’s profit is directly and immediately attributed to the German shareholder.

 

Taxation under controlled foreign corporation rules according to AStG– Current practical relevance

In recent years, taxation under controlled foreign corporation rules has significantly gained in importance. Globalisation and international tax competition – with constantly declining tax rates – have contributed to a situation in which companies move their business activities abroad. Global activities force German group tax departments or German tax advisers to look critically into the provisions regarding taxation under controlled foreign corporation rules. In as far as the relevance of the individual matter and the submission of an assessment return are not recognised or recognised too late, a criminal tax law offence might, as a rule, be alleged – at the latest, in the framework of a company tax audit. Based on our counselling experience, we can report that, in criminal tax law cases, search warrants are also issued on the basis of the fact that the party affected by the search holds an interest in a domiciliary company (offshore company) that the party has failed to report so far (Please note: For this reason, reporting obligations under section 138 AO [German tax code] have to be complied with in all cases.). This acute criminal tax law issue is new and, in practice, it often leads to criminal investigation procedures.

 

Taxation under controlled foreign corporation rules according to AStG – Which conditions have to be fulfilled?

The following characteristics have to be cumulatively fulfilled to trigger taxation under controlled foreign corporation rules:

  • Fully taxable taxpayer as a shareholder (shareholding criterion);
  • Shareholding in a foreign joint-stock corporation;
  • Foreign company must be controlled by a domestic entity (control criterion);
  • Passive income;
  • Low-tax country;
  • No evidence to the contrary within the EU/EEA (motive test).

For example, taxation under controlled foreign corporation rules does not apply:

  • if the assets are attributed to another taxable entity (section 39 AO);
  • in the case of ineffective legal transactions or fictitious purchases (section 41 AO);
  • in the case of abusive structuring (section 42 AO);
  • if the investment tax law is applied (section 7 sub-section 7 AStG).

Moreover, special characteristics of permanent establishments and the required obligations have to be observed.

 

Applicable criteria for taxation under controlled foreign corporation rules: Fully taxable taxpayer as a shareholder (shareholding criterion)

According to section 7 sub-section 1 AStG, only fully taxable natural or legal entities can be considered as entities subject to taxation under controlled foreign corporation rules.

According to section 1 sub-section 1 EStG [German Income Tax Act], a natural person is fully taxable if he/she has a residence (section 8 AO) or is habitually resident (section 9 AO) within the country. Corporations are fully taxable according to section 1 sub-section 1 KStG [Corporation Tax Act] if their residence (section 11 AO) or the management (section 12 AO) are located within the country. In the case of partnerships, the shareholders involved have to be considered. According to section 7 sub-section 3 AStG, a proportionate shareholding in the foreign company is attributed to the co-entrepreneur. 

Taxpayers with a restricted tax liability are not covered by section 7 sub-section 1 AStG. In contrast, taxpayers with an extended full tax liability according to section 1 sub-section 2 EstG or taxpayers with a notional full tax liability according to section 1 sub-section 3 EstG are considered in the framework of the examination of the conditions for application.

According to section 7 sub-section 2 AStG, the full tax liability must apply as of the end of the financial year of the intermediate company.

 

Criteria for taxation under controlled foreign corporation rules: Foreign joint-stock company

Another precondition is that the intermediate company must be a corporation, partnership or assets with neither registered offices nor the management body in the country and which is/are not exempt from national corporation tax according to section 3 KStG. It is irrelevant if the joint-stock corporation is considered as being based abroad according to the tie-breaker rule (section 4 sub-section 4 OECD-MA 2014) of the respective double taxation agreement.

The question of whether the foreign company is a corporation has to be resolved following a comparison of the type of rights. In cases of doubt, the German fiscal administration uses the document regarding the tax classification of limited liability companies set up in accordance with the laws of the federal states of the USA (so-called LLC decree of 19th March 2004) for definition purposes.

 

Criteria for taxation under controlled foreign corporation rules: Control by a resident (control criterion)

The fact that one or several (total of the parties involved) fully taxable persons hold an interest of more than 50 percent in a foreign joint-stock company – with passive income with low taxation – constitutes one criterion for taxation under controlled foreign corporation rules.

The amount is only added for the individual parties involved (also in the case of free float holdings) to the amount of the share in the nominal capital of the foreign joint-stock company. In the case of foreign companies without nominal capital, the income is divided according to the benchmark of profit distribution in accordance with section 7 sub-section 5 AStG.

If a foreign company (parent company) holds an interest in another foreign company (subsidiary company) alone or together with a fully taxable taxpayer, the passive income of the subsidiary company is attributed to the parent company pursuant to section 14 sub-section 1 AStG (transferring attribution). This applies accordingly if there are further foreign companies downstream of the subsidiary company (section 14 sub-section 3 AStG). In the event that the shareholding is held via one or several partnerships, the direct attribution is effected via section 7 sub-section 2 AStG. In addition, section 7 sub-section 4 AStG expands the scope of application of attribution to shares subject to directions.

According to section 10 sub-section 2 sentence 1 AStG, attribution is effected after the end of the intermediate company’s financial year (deadline-specific consideration). For attribution to apply, the significant shareholding must apply at the end of the intermediate company’s financial year. If the significant shareholding is acquired after the end of the intermediate company’s financial year, the attribution of passive income does not apply to this financial year.

 

Criteria for taxation under controlled foreign corporation rules: Income of a capital investment nature

Section 7 sub-section 6 AStG expands the scope of application of taxation under controlled foreign corporation rules with income of a capital investment nature within the meaning of section 7 sub-section 6a AStG.

According to section 7 sub-section 6 sentence 1 AStG (in deviation from section 7 sub-section 1 AStG), only fully taxable persons who hold, at least, 1 percent in the foreign capital company are covered. Section 7 sub-section 6 sentence 1 AStG does not apply if the gross income on which the intermediate income of a capital investment nature is based does not exceed 10 percent (relative threshold) of the entire intermediate income and if the amounts not to be considered for an intermediate company or a taxpayer do not exceed a total of EUR 80,000 (absolute threshold). However, taxation under foreign corporation rules can also apply to a shareholder holding less than 1 percent. This applies if the foreign company exclusively or almost exclusively generates its gross income from intermediate income of a capital investment nature (90 percent according to the BMF letter dated 14th May 2004, sub-section 7.6.2). By way of exception, this also does not apply to foreign companies whose shares are essentially and regularly traded at an approved exchange (exchange clause) (section 7 sub-section 6 s. 3 AStG).

Intermediate income of a capital investment nature is generated from holding, managing, maintaining or increasing the value of means of payment, receivables, securities and shareholdings (with the exception of income referred to in section 8 sub-section 1 no. 8 and 9 AStG) or similar assets (BMF letter of 14th May 2004, sub-section 7.6.4).

 

Criteria for taxation under controlled foreign corporation rules: Passive income

In section 8 sub-section 1 AStG, the legislator established the material scope of application of taxation under controlled foreign corporation rules. The active income referred to in section 8 sub-section 1 AStG alone is exempt from taxation under controlled foreign corporation rules. The complicated system of principle – exception – reverse exception and, if applicable, a further reverse exception is no longer up to date in view of the globalised world of business and changed business models.

A foreign company that carries out active operations can generate income which – if considered on its own – constitutes income from a passive acquisition. Commercially connected activities then have to be uniformly subsumed (functional consideration; BMF letter of 14th May 2004, sub-section 8.0.2).

Every individual activity of the intermediate company has to be examined with the help of a catalogue of activities. This income is only subject to the further preconditions of taxation under controlled foreign corporation rules (segmentationin as far as this income has to be considered as passive income.

Agriculture and forestry (No. 1): Income from agriculture and forestry is considered active income without exception.

Industrial activity (no. 2): The production, handling, processing or assembly of products, the generation of energy as well as the exploration and extraction of natural resources are also considered as active activities.

If the foreign company has purchased, handled or processed and resold goods, this is considered as forming industrial (active) activities to the full extent if, according to the prevailing opinion, handling or processing has created an object of other marketability and if the good was only treated by the foreign company to a minor degree; a separation between industrial activity and trading (section 8 sub-section 1 no. 4 AStG) is not applicable. Labelling, repacking, refilling, sorting and compiling items acquired into sets of goods and the application of tax marks are not considered to be handling or processing in this context. If the preconditions referred to above are not fulfilled, this constitutes trading to the full extent (BMF letter dated 14th May 2004, sub-section 8.1.2.2).

Operation of credit institutions or insurance companies (no. 3): The operation of credit institutions and insurance companies is active – subject to the deleterious participation of the taxpayer. However, this activity needs commercially established business operations.

However, the activity is considered as being passive if the banking or insurance transactions are largely (i.e. more than 50 percent) carried out with fully taxable parties according to section 7 AStG and/or with persons affiliated with these.

Trading (no. 4): Trading is also classified as active activities in as far as the transactions were concluded by the foreign company in the framework of qualified business operations and there was no deleterious participation.

The activity of a commission agent is also considered as trading. In the case of brokers’ and trade representatives’ activities, the provisions regarding services (outlined below) have to be applied (BMF letter of 14th May 2004, sub-section 8.1.4.1.2). Licensing of commercial assets constitutes letting and leasing within the meaning of section 8 sub-section 1 no. 6 lit. a AStG.

The foreign company maintains what is considered as being commercially established business operations (“qualified business operations”) if it has the material and personnel resources ensuring that it can prepare, conclude and carry out the trading transactions to be considered participating in general business transactions. Participation in general business transactions must be based on the business operations of the foreign company generating the income. Indirect participation in business activities through dependent group companies is not sufficient to this end (BMF participation of 14th May 2004, sub-section 8.1.4.2.1).

Furthermore, the trading transactions must be carried out without any deleterious participation. Activities serving to prepare, conclude or carry out the transactions are considered deleterious participation. The BMF letter dated 14th May 2004 (in sub-section 8.1.4.3.1) gives the example of the management of the foreign sales department or the deployment of representatives from the home country, the assumption of financing tasks or of the trading risk.

Services (no. 5): As in the case of trading, deleterious participation leads to passive income.

In the case of services, the legislator differentiates between the provision of services by a (lit. a) or for a (lit. b) foreign company. The legislator only provides for a counter-exception leading to active income with regard to the provision of the service for a foreign affiliated company.

Services are defined as technical, counselling, managing or administrative activities. Income from the acquisition and inclusion of receivables (real factoring) does not fulfil the criteria for a service since the collection of acquired receivables simply forms the administration of own assets. As such, real factoring leads to passive income (BMF letter dated 14th May 2004, sub-section 8.1.5.1.1).

Letting and leasing (no. 6): The provision in section 8 sub-section 1 no. 6 AStG differentiates between letting and leasing of intangible assets (lit. a with conclusive list: rights, plans, specimens, procedures, experience and knowledge), of properties (lit. b) and moveable property (lit c).

In principle, letting and leasing of intangible assets leads to passive income. Under the law, active income is only assumed in the case of research and development by the foreign company – using its own staff and resources. So far, it has not been resolved what form deleterious participation can take. The fiscal administration has not made a statement in this respect in the BMF letter of 14th May 2004.

Leasing and letting of properties are only classified as being active if the domestic shareholder of the foreign company proves that the income has to be exempt in the case of direct attribution under the double taxation agreement. This is due to the fact that by placing the foreign joint-stock corporation (in the other country with low taxation) in the chain, German taxation legislation is excluded (avoidance of abusive structuring).

In case of deleterious participation of the fully taxable shareholder, leasing and letting of mobile property leads to passive income. The shareholder participates in leasing or letting of the mobile property of the foreign company if he/she carries out activities which, based on their function, are part of commercial leasing or letting. For example, participation applies if a person assumes inventory management and financing tasks or arranges the conclusion of the letting or leasing agreements for a foreign company (BMF letter dated 14th May 2004, sub-section 8.1.6.3).

Taking out and granting of loans (no. 7): Taking out and granting of capital in the form of loans only forms an active activity if such capital is exclusively taken out at foreign capital markets and is granted to foreign companies and/or business establishments with active income according to section 8 sub-section 1 no. 1 to 6 AStG or to domestic companies.

Profit distributions (no. 8): Profit distributions by joint-stock companies always constitute active income.

Profits from the sale of shares (no. 9): Profits from the sale of shares are considered as being active in as far as the gain on disposal is not attributable to assets which lead to income according to section 8 sub-section 1 no. 6 lit. b AStG (Letting and leasing of properties) or section 7 sub-section 6a AStG (Intermediate income of a capital investment nature).

There are numerous legal uncertainties in the application of this standard. For example, it is not clear up to which shareholding level (in the case of multi-tier group structures) the absence of deleterious assets needs to be proven, how the gain on disposal has to be divided for active and passive assets and how open reserves have to be treated.

Transformation (no. 10): A tax-neutral conversion can only be carried out within the country or within the EU/EEA; the German transformation tax act [UmwStG] does not apply to conversions in third countries. Since accounting values can often be continued abroad, most third-country transformations can lead to income with low taxation and can, hence, be, subject to taxation under controlled foreign corporation rules in Germany.

According to section 8 sub-section 1 no. 10 AStG, all preconditions for the book valuation must be fulfilled for a waiver of taxation under controlled foreign corporation rules for a foreign conversion, with the exception of the preconditions of residence and the company structure at the transferring legal entity and at the legal entity taking over. UmwStG is notionally confirmed as being applicable without fulfilment of the personal preconditions under section 1 sub-sections 2 and 4 UmwStG. There is no commitment to the foreign amount stated according to foreign law (federal government printed document 542/06, p. 59 and 65).

The transformation income only has to be subsumed as active income if the hidden reserves included in the shares are not based on assets which serve to generate intermediate income of a capital investment nature at the downstream affiliated company. Also, in the case of affiliated companies which are not directly downstream, the disjunction profit is part of the disjunction income of a capital investment nature (section 8 sub-section 1 no. 10 in conjunction with 8 sub-section 1 no 9 middle part of the sentence AStG).

 

Taxation under controlled foreign corporation rules according AStG – Exception for mixed income according to section 9 AStG

If the intermediate company generates both active and passive income, the law provides for relative and absolute exemption limits to avoid taxation under controlled foreign corporation rules. A three-level examination has to be carried out to apply section 7 sub-section 1 AStG with the requirement of cumulative fulfilment of the criteria.

According to section 9 AStG, taxation under controlled foreign corporation rules does not apply if

  • the passive gross income does not amount to more than 10 percent of the company’s total gross income (relative company-specific exemption) AND
  • the company’s passive gross income does not exceed an amount of EUR 80,000 overall (absolute company-specific exemption) AND
  • finally, the passive gross income must not exceed an amount of EUR 80,000 also for a single fully taxable taxpayer under consideration of all his shareholdings (shareholder-specific exemption).

The provision in section 9 AStG ties in to the requirements in section 7 sub-section 1 AStG. This passive income does not have a taxation effect only if this income does not exceed the relative and absolute exemption.

 

Criteria for taxation under controlled foreign corporation rules: Low taxation

The foreign company’s passive income is subject to taxation under controlled foreign corporation rules if the income tax burden is less than 25 percent (section 8 sub-section 3 s. 1 AStG). Low taxation also applies if income taxes of, at least, 25 percent are legally owed but not actually charged (section 8 sub-section 3 s. 3 AStG).

A foreign company with intermediate income is not subject to low taxation because its income is subject to taxation at another company in the framework of group taxation (e.g. tax group, consolidation) (BMF letter of 14th May 2004, sub-section 8.3.1.2).

The income tax expense has to be determined by comparing the intermediate income established under German tax legislation and the taxes to be paid by the foreign company. Voluntary tax payments do not have to be considered. As a rule, the income tax burden corresponds to the income tax rate of the country of residence. In determining the income tax expense, we do not only have to consider the general tax rate but also preferential rates and exemptions for income from passive acquisition or for companies without active operations as well as the tax assessment basis, which might be applicable (BMF letter of 14th May 2004, sub-section 8.3.2.1).

 

Taxation under controlled foreign corporation rules according to AStG – Counterproof within the EU/EEA (motive test)

In the legal case of Cadbury Schweppes (of 12th September 2006 - C-196/04), ECJ ruled in the reference for a preliminary ruling that the British counterpart of German taxation under controlled foreign corporation rules violates the freedom of establishment. In the opinion of ECJ, taxation under controlled foreign corporation rules is only in line with community law if it is limited to purely artificial and non-functional structuring aiming to avoid taxation.

Apart from a subjective element which comprises the pursuit of a tax advantage, there must be objective indications […] (sub-section 64) [that] the establishment of a controlled foreign company is connected with a commercial reality regardless of the presence of reasons of a tax type [sub-section 65] in order to ascertain the presence of such tax evasion. The foundation of this must be connected with an actual establishment with the purpose of engaging in real business activities in the host member state (sub-section 66).

The German legislator responded to the ECJ Cadbury Schweppes ruling by revising section 8 sub-section 2 AStG. In the case of intermediate companies with registered offices or a management body within the EU or EEA (Norway, Iceland, Lichtenstein), there is the option of counterproof that the intermediate company engages in real commercial activity. However, the counterproof is excluded for income attributed to a foreign company by a company or permanent establishment based in a third country via section 14 AStG (Avoidance of structuring).

 

Controlled foreign corporation rules under AStG – Legal consequences for the shareholders

In the case of individual domestic parties involved, the amount attributed belongs to the income from capital assets provided the shareholding in the foreign company is part of the private assets. According to section 10 sub-section 2 s. 3 AStG, the separate tax rate under section 32d EStG (flat-rate withholding tax) does not have to be applied.

If the shareholding in the foreign company is part of business assets, the amount to be attributed leads to income from commercial operations, from agriculture and forestry or from self-employed work. The application of the partial income procedure (section 3 no. 40d EstG [German Income Tax Act]) or the tax exemption pursuant to section 8b KStG are also excluded by section 10 sub-section 2 sentence 3 AStG. Moreover, the attributed amount is also subject to trade tax; according to section 7 sentence 8 GewStG, a connection with the domestic permanent establishment is also assumed for the permanent establishment’s income within the meaning of section 20 sub-section 2 AStG (more details provided below).

In order to avoid double taxation, profit distributions of the foreign intermediate company are exempt from taxes according to section 3 no. 41 lit. a EstG in as far as such were subject to taxation under controlled foreign corporation rules in the past 7 years.

 

Controlled foreign corporation rules under AStG – Declaration requirements

Every fully taxable taxpayer and every taxpayer with an extended restricted tax liability holding an interest in the foreign company has to submit a declaration regarding the separate assessment; this also applies if, according to section 8 sub-section 2 AStG (Counter-proof/Motive test), it is asserted that attribution is waived. This obligation can be fulfilled by submitting a joint assessment. This assessment has to be signed by the taxpayer and by the persons specified in section 34 AO (legal representative or asset manager) in their own hand (section 18 sub-section 3 AStG).

If the financial year of the foreign intermediate company corresponds to the calendar year (1st January to 31st December), passive income for the following calendar year has to be reported and assessed (example: the 2018 financial year is decisive for the 2019 assessment year). In the event that the financial year deviates from the calendar year, the passive income has to be reported and assessed for the calendar year during which the financial year concerned ends (Example: The 2017/2018 financial year is material for the 2018 assessment year).

 

Controlled foreign corporation rules under AStG – also for permanent establishments

In the event that the preconditions for taxation under controlled foreign corporation rules are fulfilled, the switch-over clause of section 20 sub-section 2 AStG for income from permanent establishments having the character of intermediate income leads to equal status for permanent establishments and companies within the meaning of section 7 AStG. If income is generated by a foreign permanent establishment of a fully liable taxpayer and if such were taxable as intermediate income irrespective of section 8 sub-section 2 AStG (Counter-proof/motive test) in the event of this permanent establishment being a foreign company, double taxation would be avoided by consideration of the foreign taxes charged on this income (section 20 sub-section 1 AStG) rather than by an exemption.

According to the legislator’s intention, section 20 sub-section 2 AStG is designed to avoid the circumvention of taxation under controlled foreign corporation rules using a foreign permanent establishment. 

 

LHP Attorneys and Tax Advisers on controlled foreign corporation rules

Even though the German provisions on taxation under controlled foreign corporation rules have repeatedly been rejected by BFH and ECJ or declared incompatible with the basic freedoms under European legislation, they continue to play an important role in international tax law in auditors’ and tax investigators’ day-to-day work. Unfortunately, the provisions on taxation under controlled foreign corporation rules are characterised by complexity (exception – counter-exception – counter-counter-exception) which renders them particularly prone to errors for both taxpayers and their advisers. Based on our long-standing experience in international tax law, we regularly advise companies and entrepreneurs regarding questions of tax and company law. For this reason, we are very familiar with the pitfalls in this field. We offer tailor-made counselling and are pleased to discuss the practical and legal particularities in connection with taxation under controlled foreign corporation rules with you. In this process, the focus is on practical handling. We are, of course, pleased to discuss a possible mandate during a non-binding initial consultation.

Criteria for taxation under controlled foreign corporation rules: Foreign joint-stock company

Criteria for taxation under controlled foreign corporation rules: Control by a resident (control criterion)

Criteria for taxation under controlled foreign corporation rules: Income of a capital investment nature

Criteria for taxation under controlled foreign corporation rules: Passive income

Criteria for taxation under controlled foreign corporation rules: Low taxation

Taxation under controlled foreign corporation rules according to AStG – Counterproof within the EU/EEA (motive test)

In the legal case of Cadbury Schweppes (of 12th September 2006 - C-196/04), ECJ ruled in the reference for a preliminary ruling that the British counterpart of German taxation under controlled foreign corporation rules violates the freedom of establishment. In the opinion of ECJ, taxation under controlled foreign corporation rules is only in line with community law if it is limited to purely artificial and non-functional structuring aiming to avoid taxation.

Apart from a subjective element which comprises the pursuit of a tax advantage, there must be objective indications […] (sub-section 64) [that] the establishment of a controlled foreign company is connected with a commercial reality regardless of the presence of reasons of a tax type [sub-section 65] in order to ascertain the presence of such tax evasion. The foundation of this must be connected with an actual establishment with the purpose of engaging in real business activities in the host member state (sub-section 66).

The German legislator responded to the ECJ Cadbury Schweppes ruling by revising section 8 sub-section 2 AStG. In the case of intermediate companies with registered offices or a management body within the EU or EEA (Norway, Iceland, Lichtenstein), there is the option of counterproof that the intermediate company engages in real commercial activity. However, the counterproof is excluded for income attributed to a foreign company by a company or permanent establishment based in a third country via section 14 AStG (Avoidance of structuring).

 

Controlled foreign corporation rules under AStG – Legal consequences for the shareholders

In the case of individual domestic parties involved, the amount attributed belongs to the income from capital assets provided the shareholding in the foreign company is part of the private assets. According to section 10 sub-section 2 s. 3 AStG, the separate tax rate under section 32d EStG (flat-rate withholding tax) does not have to be applied.

If the shareholding in the foreign company is part of business assets, the amount to be attributed leads to income from commercial operations, from agriculture and forestry or from self-employed work. The application of the partial income procedure (section 3 no. 40d EstG [German Income Tax Act]) or the tax exemption pursuant to section 8b KStG are also excluded by section 10 sub-section 2 sentence 3 AStG. Moreover, the attributed amount is also subject to trade tax; according to section 7 sentence 8 GewStG, a connection with the domestic permanent establishment is also assumed for the permanent establishment’s income within the meaning of section 20 sub-section 2 AStG (more details provided below).

In order to avoid double taxation, profit distributions of the foreign intermediate company are exempt from taxes according to section 3 no. 41 lit. a EstG in as far as such were subject to taxation under controlled foreign corporation rules in the past 7 years.

 

Controlled foreign corporation rules under AStG – Declaration requirements

Every fully taxable taxpayer and every taxpayer with an extended restricted tax liability holding an interest in the foreign company has to submit a declaration regarding the separate assessment; this also applies if, according to section 8 sub-section 2 AStG (Counter-proof/Motive test), it is asserted that attribution is waived. This obligation can be fulfilled by submitting a joint assessment. This assessment has to be signed by the taxpayer and by the persons specified in section 34 AO (legal representative or asset manager) in their own hand (section 18 sub-section 3 AStG).

If the financial year of the foreign intermediate company corresponds to the calendar year (1st January to 31st December), passive income for the following calendar year has to be reported and assessed (example: the 2018 financial year is decisive for the 2019 assessment year). In the event that the financial year deviates from the calendar year, the passive income has to be reported and assessed for the calendar year during which the financial year concerned ends (Example: The 2017/2018 financial year is material for the 2018 assessment year).

 

Controlled foreign corporation rules under AStG – also for permanent establishments

In the event that the preconditions for taxation under controlled foreign corporation rules are fulfilled, the switch-over clause of section 20 sub-section 2 AStG for income from permanent establishments having the character of intermediate income leads to equal status for permanent establishments and companies within the meaning of section 7 AStG. If income is generated by a foreign permanent establishment of a fully liable taxpayer and if such were taxable as intermediate income irrespective of section 8 sub-section 2 AStG (Counter-proof/motive test) in the event of this permanent establishment being a foreign company, double taxation would be avoided by consideration of the foreign taxes charged on this income (section 20 sub-section 1 AStG) rather than by an exemption.

According to the legislator’s intention, section 20 sub-section 2 AStG is designed to avoid the circumvention of taxation under controlled foreign corporation rules using a foreign permanent establishment. 

 

LHP Attorneys and Tax Advisers on controlled foreign corporation rules

Even though the German provisions on taxation under controlled foreign corporation rules have repeatedly been rejected by BFH and ECJ or declared incompatible with the basic freedoms under European legislation, they continue to play an important role in international tax law in auditors’ and tax investigators’ day-to-day work. Unfortunately, the provisions on taxation under controlled foreign corporation rules are characterised by complexity (exception – counter-exception – counter-counter-exception) which renders them particularly prone to errors for both taxpayers and their advisers. Based on our long-standing experience in international tax law, we regularly advise companies and entrepreneurs regarding questions of tax and company law. For this reason, we are very familiar with the pitfalls in this field. We offer tailor-made counselling and are pleased to discuss the practical and legal particularities in connection with taxation under controlled foreign corporation rules with you. In this process, the focus is on practical handling. We are, of course, pleased to discuss a possible mandate during a non-binding initial consultation.

LHP: Attorneys at Law, Tax Law Specialists, Tax Advisers PartmbB

Cologne

Theodor-Heuss-Ring 14, 50668 Cologne,
Telephone: +49 221 39 09 770

Zurich

Stockerstrasse 34, 8002 Zurich,
Telephone: +41 44 212 3535