Germany: German Tax & Legal News - October 2004

The ministry of finance has released the final version of its new decree referred to as "Administrative Principles for the Attribution of Capital to Branches of International Banks". The Administrative Principles are designed to implement Part II of the OECD Discussion Draft on the Attribution of Profits to Permanent Establishments ("PEs") of Banks issued in March 2003 and replace the relevant section in the Administrative Principles for the Determination of Profits to be Allocated to a PE published in 1999. Whilst decrees of this nature bind the tax authorities rather than the taxpayer, they give a considerable degree of certainty, at least on matters of calculation. The new Administrative Principles apply to both German branches of foreign banks and foreign branches of German banks and contain the following provisions:

As a first step it has to be determined which of the bank's risk-weighted assets and market risk positions have to be allocated to the branch based on the functions actually performed by the branch (Allocation of Assets & Positions).

As a second step the risk-weighted assets and market risk positions allocated to the branch have to be valued under the German regulatory rules or equivalent rules as applicable in the country of the head office (Valuation of Assets & Positions). Positions hedged intrabank and intrabank current accounts are to be eliminated.

As a third step, the decree suggests two basic methods to determine the capital to be attributed to a branch for tax purposes:

1. The first and primary method is similar to the BIS ratio approach suggested by the OECD. It allocates the total bank's equity between the head office and its branches based on the proportion of the risk-weighted assets and market risk positions of the individual branch to the total risk-weighted assets and market risk positions of the bank as a whole (equity pro-rating method).
2. The second method, which is generally only to be applied, if the first method leads to an economically unreasonable result, is similar to the quasi-thin capitalization approach suggested by the OECD. It requires the branch to have the same amount of capital as would be required, for regulatory purposes of an independent bank operating in the host country taking into account the risk-weighted assets and market risk positions allocated to the branch (arm's length approach).

In applying either of the methods, at least a minimum capital, calculated as follows, has to be attributed to the branch for tax purposes: The minimum capital equals 8.5% of the total of the risk-weighted assets and market risk positions allocated to the branch. The minimum capital can be reduced to 4.5% depending on the mixture of the core capital (tier 1) and additional capital (tier 2) of the bank as a whole.

The Administrative Principles provide for simpler rules for small banking branches and new branches.

The new rules for the Attribution of Capital to Branch Banks are to be applied from 1 January 2005. The old provisions for the determination of bank branch capital (as included in the Administrative Principles for the Determination of Profits to be Allocated to a PE) expired on 31 December 2000. There are transitional provisions to be applied during the period after the expiry of the old provisions and 1 January 2005. These transitional provisions generally require the branch to have the minimum capital calculated using the second method.

Early in 2005, banks will be required for the first time to issue their private customers with statements showing their taxable incomes and capital gains as known to the bank. The ministry of finance has just issued its decree of August 31 on the formalities to be followed;

• the official form must be used or (if the statement is automatically generated) faithfully reproduced
• changes of data processing centre or system during the year justify splitting the annual statement over two periods
• statements are only required where the account-holder is a resident natural person
• statements on joint accounts are to be issued to the account-holders jointly
• the date and cost of acquisition of securities sold during the year need not be given on the statement, if not known to the bank, but the sale must be
• statements need not be issued for total investment incomes of € 10 or less if the account holder sold no securities during the year
• each statement is to be issued for the immediately preceding calendar year.

Following the Gerritse case in which the ECJ held that a resident from another EU country could not be charged to German income tax (by withholding) at more than scale rate on the German net income plus the personal allowance, the ministry of finance has issued a decree suspending a provision of the Income Tax Act setting a minimum tax rate of 25% on the non-employment income of non-residents. This follows an earlier decree applying the Gerritse ruling to tax deducted at source from the incomes of foreign athletes, artists, licensors and similar. The new decree applies to EU or EEA (EU plus Iceland, Liechtenstein and Norway) nationals resident within the EEA. The non-discrimination clauses of tax treaties may give it wider application.

The ministry of finance has decreed that all trade tax assessments (notices of chargeable trading income) should be issued subject to the outcome of cases currently pending before the Supreme Tax Court and the Constitutional Court on the conformity of the Trade Tax Act with the constitution.

The ministry of finance issued three decrees on September 23:

• on the expense deduction for home office costs (only permissible at all if the taxpayer either spends 50% of his working time in the office, or has no other office of his own), saying that the upper limit of € 1,250 is to be applied from next year per office rather than per person. Thus, if two people share a home office, they share, rather than double, the € 1,250. The decree also excludes odd job people (those with multiple minor employments) from claiming the office to be the "focal point" of their business activity overall, and so avoiding the € 1,250 limitation.
• on the extension of builders' exemption certificates (freeing the customer from the obligation to deduct withholding tax) if applied for during the last six months of validity. If applied for earlier, a new certificate will be issued, valid from the date of issue.
• on the transfer of business (or private) assets in exchange for "recurring payments". This detailed, explanatory decree covers all tax aspects of transferring businesses within families in exchange for a pension or other retirement provision and is a "must" for anyone concerned with business succession, particularly in favour of the younger generation.

A GmbH provided a loan to its shareholder without security and subsequently wrote down the loan in its accounts. In its tax return, however, the GmbH treated the write-down as a non-deductible expense. The Tax Office concluded that the write-down gave rise to a "hidden distribution" of profits to its shareholder. Germany still operated a Corporation Tax Imputation (or Credit) System during the year of the write-down. As a result of the "hidden distribution" the Tax Office therefore adjusted the tax burden in respect of the profits deemed to be distributed to bring the actual corporation tax "distribution burden" to 30%.

The Supreme Tax Court held that the mere write-down of a loan to a shareholder does not constitute a "hidden distribution" as the loan might still be repaid and the anticipated loss of the loan asset has therefore not yet been realised. The Court explained in its reasoning that a "hidden distribution" is defined as a reduction or prevented increase of the company's assets. While the GmbH posted an adjustment to the value of the loan in its balance sheet, the loan is still shown as an asset. The company's assets have therefore not yet been withdrawn by the shareholder and no "hidden distribution" has taken place. As a result, the corporation tax payable by the company for the year in which the profits were deemed to be distributed does not have to be increased to the "distribution burden" of 30%.

The Court's decision continues to be relevant to foreign shareholders after the abolition of the German Corporation Tax Imputation System, as the Withholding Tax would have to be paid on "hidden distributions".

The senior partner held a birthday party for the employees and business friends of a subsidiary of the partnership. There were 2,650 guests of which 70 were business contacts and some few personal friends of the partner and the remainder employees. However, the invitations were written on the partner's personal notepaper and in the first person singular, "... I would like to celebrate my birthday with you ....". This was held by the Court to be sufficient evidence that the occasion of the party was at least partly personal, and that its entire costs should therefore have been borne personally. The Court did not see the restriction of the guest list to almost entirely employees and business contacts, or the fact that the partner had held other parties for family and friends, as being sufficient clarification of the solely business nature of the event. The Court also declined to accept an attempt to redefine the function as a staff party; even though it was similar to other staff parties held by the subsidiary, it could not be seen as "customary" as the subsidiary held another staff party only a month later.

The final paragraph of the judgement mentions an interesting point. The acceptance by the "wages" tax auditors of the party as being "very largely in the business interests of the employer", when reviewing the correct deduction of withholding taxes, was not binding for a subsequent assessment on the company.

The case arose from an insurance company's failure to take adequate documentation and other steps in respect of its benefits granted to its free-lance agents. The back-duty office opened criminal proceedings against members of the company's management for aiding and abetting the tax evasion of others on the premise that most of the agents would not have fully declared their benefits to their own tax offices. These proceedings were eventually closed with an agreement between tax office and company on an estimate of the amount of income tax evaded. The company paid over the agreed amount on the understanding that the payment would be in settlement of the liabilities of the agents and also accepted its own penalties. The agreement specifically stated that there would be no investigations in this regard against the agents, but also that an agent who had taxed his benefits already would not be able to claim a refund. The company notified its agents accordingly.

Later, a different tax office noticed a missed benefit (rebate on a health insurance premium) when reviewing the return of an agent. It assessed income tax accordingly, and refused to take any account of the settlement made by the company. The appeal to the lower tax court was unsuccessful, although that court did refer to "a breach of tax justice" and to the "disloyal conduct of the tax administration". However, neither accusation was, in the view of that court, powerful enough to stand in the way of Supreme Tax Court cases restricting the binding effects of settlement agreements to the immediate parties. The Supreme Tax Court has now rejected the appeal, essentially confirming its previous case law. Its reasoning, though, was illuminating:

• This type of agreement can only bind the immediate parties. There is no notion of a tax inspector acting as the representative of the German tax administration in general, as opposed to his own tax office or unit.
• There is no possibility of extending the mechanism for lump sum agreements on employee wages withholding tax to mass amounts due from independent agents. To do so would mix tax types and levying points and thus confuse the financial interests of the state, provinces and local communities. It would also be problematic in terms of the division of power between the executive and the legislative and offend against the "principle of individual taxation". In any event, a step of such magnitude would require an explicit statutory basis.
• Insufficient facts were available to the Court to enable it to form an opinion as to whether the settlement was really necessary.
• There can be no reliance on the principles of "good faith" as the taxpayer, the insurance company, had made no dispositions of its own in reliance thereon.
• The time span between the two events, settlement by the company and assessment on the individual, was insufficient for either party to be able to claim tacit acceptance of the situation by the authorities.
• There is no concept in law prohibiting double taxation.

These points are summarised from the case as published. We offer no comment on their validity in terms of legal logic, or on their freedom from contradiction with other features of the tax acts. However, this case emphasises yet again, how little reliance can be placed on the formal or informal statements of the authorities, once an official sees it in his or her material or formal interest to take a different approach.

The Supreme Tax Court has held the costs of a solar energy collector to be immediately deductible as repairs and maintenance. In particular, the Court held that the (new) solar collector was neither a fixture in its own right, nor an additional cost of the building. What, though, was important was that the electricity generated by the collector was to be used to power an existing installation, in this case, a heating plant for hot water needed by the business.

The case was brought by an air hostess based in Frankfurt, but living far outside the town. Since her flights began and ended in Frankfurt, the flightplan sometimes forced her to spend the night in a hotel near the airport. The tax office rejected her claim to be allowed to deduct the hotel costs as business expenses by referring to a Supreme Tax Court case rejecting a similar claim for 1994 on the grounds that the business and private reasons for the expense were mixed. (If there are both business and private reasons for an expense, it is not deductible unless there are specific rules to the contrary). The tax office also rejected her alternative claim for double household relief, saying that occasionally taking a hotel room was not permanent enough to constitute a second household. The lower tax court sided with the tax office.

The Supreme Tax Court sided with the taxpayer. It agreed with the tax office that there was no case for double household relief, but held bluntly that the hotel costs were business expenses and, as such, deductible. They were incurred solely because of the occupation of the taxpayer and were in addition to her private costs of maintaining her own household. This case was at variance with the previous, 1994 case of a different senate and the normal procedure of a senate that wishes to depart from the law of another senate is to lay the matter before the Grand Senate - a larger body consisting of one judge from each of the eleven senates. However, the senate dealing with the present case chose to avoid that rather lengthy procedure by holding - with a clear preference for pragmatism over logical argument - that there had been in the meantime "such a basic change in the law that the senate was not departing from the decision of the XI. Senate".

Notwithstanding this success, the air hostess lost the other part of her case, a claim for the subsistence allowances of those on business trips whilst spending a day or more in Frankfurt on training courses. Here, the Court took the traditional - and otherwise generally undisputed - view, that a course held at an employee's place of work was not a business trip.

The Corporation Tax Act exempts properly registered German charities from corporation tax provided they conform to their charters. Exempted charities are also able to give donors a receipt qualifying them for corporation or income tax relief for their donations. Both privileges are interlinked and depend on the charity having its seat or place of management in Germany, in other words on its being tax resident here. An Italian charity with rental income from a German property has challenged this national exclusivity before the Supreme Tax Court on the grounds that it offends against the freedom of establishment principle of Art. 43 of the EC Treaty of Amsterdam. The Supreme TaxCourt has previously upheld the German national rule, although the last case was decided in 1976 and may well have been overtaken by changes in European law since then. Accordingly, the Court has turned to the European Court of Justice for a preliminary ruling.

A GmbH was incorporated in one community and had a branch in another. Where that is the case, trade taxable income is generally allocated between the communities on the basis of wages paid. The branch employed the majority of the GmbH's employees and was located in a community that effectively levied no trade tax. Following the Tax Concessions Pruning Act, communities with a very low trade tax rate, including the one where the GmbH's branch is located, are to be treated as trade tax havens and ignored for trade tax purposes from 2003 onwards. As a result, the Tax Office issued an assessment allocating all of the GmbH's trade taxable income to the community where it was incorporated. The GmbH appealed against the assessment and submitted a claim for the postponement of the trade tax until a final decision is taken regarding the pending appeal. Assessments allocating a business' trade taxable income are generally subject to audit and can therefore be open for years.

The Court now ruled that the trade tax is due despite the pending appeal against the assessment ignoring the tax payer's branch in a trade tax haven.

While for German domestic companies there is no (trade tax) advantage any more in allocating employees to a trade tax haven, foreign companies might still consider locating their only German PE in a trade tax haven.

The European Company Statute (in theory) came into force on 8 October 2004, over thirty years after it was first proposed by the Commission. The European Company Statute is a legal instrument based on European Community law that gives companies the option of forming a European Company - formally known by its Latin name of "Societas Europeae" (SE). A European Company can operate on a European-wide basis and be governed by Community law directly applicable in all Member States. As a European Company a business can restructure fast and easily to take advantage of the trading opportunities offered by the Internal Market.

A related Directive concerning worker involvement in European Companies entered into force at the same time. However, only six of the 28 EU and EEA Member States have implemented the regulations at national level necessary to allow European Companies to be set up on their territory. Until the rest do so, many companies operating in more than one Member State will be denied the option of being established as a single company under Community law and thus of being able to operate throughout the EU with one set of rules and a unified management and reporting system.

Only Belgium, Austria, Denmark, Sweden, Finland and Iceland have so far taken the necessary measures to allow European Companies to be founded on their territory, despite the fact that the European Company Statute was adopted at EU level in 2001.

Under the European Company Statute, a European Company can be set up by the creation of a holding company or a joint subsidiary or by the merger of companies located in at least two Member States or by the conversion of an existing company set up under national law. The minimum capital requirement has been set at €120,000 so as to enable medium sized companies from different Member States to create an SE.

Under the accompanying Directive on employee involvement, the creation of a European Company requires negotiations on the involvement of employees with a body representing all employees of the companies concerned. If it proves impossible to negotiate a mutually-satisfactory arrangement then a set of standard principles applies, the exact nature of which depends on the format for worker participation in the companies concerned before the European Company was set up.

For the full texts of the Regulation on the European Company Statute and of the accompanying Directive on employee involvement, see: http://www.europa.eu.int/comm/internal_market/en/company/company/official/index.htm

The Bundestag recently passed a draft bill enacting two EU Directives and one EU Regulation into German law. The draft is now awaiting approval by the Bundesrat.

The Directive is designed to abolish withholding taxes on interest and royalty payments between associated companies and thus eliminate the double taxation on these payments. Under the new rules, no tax is withheld on royalties and interest payments made by companies and branches in Germany, if certain conditions are met:

• The recipient is an associated company or branch/head office of the payer; and
• The recipient of the payments is subject to corporate income tax in their country of residence; and
• A claim for exemption from or repayment of withholding tax is submitted to the German tax authorities.

The new rules do not apply to payments, which

• are deemed to be "hidden distributions" under German law;
• are based on profits; or
• exceed the arm's length amount.

The EU Directive's transitional arrangements allow some of the new member states, that joined the EU on 1 May 2004, to levy withholding taxes. The draft bill therefore provides for tax credits for withholding tax suffered during the transitional period.

The Directive is designed to combat international tax evasion, strengthen collaboration between the member states tax administrations and to facilitate the exchange of information relevant for the correct assessment of taxes on income and capital.

The Regulation is designed to facilitate the co-operation and exchange of information between the tax authorities of the member states, to ensure proper application of VAT and combat fraud. The Regulation came into force from 1 January 2004 without having to be formally enacted into German law. The draft bill, therefore, merely incorporates references to the Regulation into the relevant German legislation.

As part of its quest for good corporate governance, the European Commission has issued two recommendations to member states, on directors' remuneration, and on outside directors/supervisory boards. Both recommendations refer to quoted companies. They are to governments and call for national law and procedures to be changed as necessary to meet the desired standards. Governments are not compelled to follow them, although the Commission hopes as a minimum that they will come to be seen as the yardstick for best practice. That on directors' remuneration calls for

• detailed disclosure of the company's policy on directors' remuneration and benefits in the accounts
• a vote on the remuneration policy to be routinely held at each annual general meeting. The resolution passed could be binding or advisory in nature
• disclosure of the remuneration and benefits granted to each director. This should also include loans and guarantees in a director's favour
• shareholder approval of share purchase and share option schemes. It is the approval of the scheme itself that is intended, and not the specific grants to individuals.

The Commission emphasises that there is no intention to limit or restrict the amount of remuneration that can be awarded to directors. Rather the call is for full and prompt transparency, so that shareholders (and others) can make an informed judgement on whether the amounts and bases are appropriate in the circumstances.

The recommendation on outside directors is essentially a call to reinforce the presence and influence of outside directors, whether they sit as non-executives on a company's main board, or on their own as a supervisory board. The ultimate objective is to free managements from conflicts of interest. The main principles of the recommendation are

• there should be a suitable balance at all levels between executive and non-executive directors, so that no single individual or small group is able to act unsupervised in actual or potential conflicts of interest
• supervisory boards, or non-executive groups within main boards, should form nomination, remuneration and audit committees. These committees should adhere to set minimum standards
• a director is to be seen as independent if he is free from any business, family or other relationship that might impair his business judgement in his dealings with the company's management or shareholders
• the outside directors should - collectively - have the necessary knowledge and experience for the effective supervision of management
• no director should accept appointment if he is unable to devote the necessary time and attention to his duties
• all candidates for directorships should disclose all other major business or professional commitments.

The European Commission is considering whether a directive is needed to ensure that shareholders enjoy adequate rights of control and influence over management and that they have easy access to sufficient information for the exercise of those rights in a meaningful way. Before proceeding further, the Commission is anxious to hear the views of those potentially affected and has therefore launched a public consultation. The consultation paper with the details is available from http://europa.eu.int/comm/internal_market//company/shareholders/index_en.htm E-mail responses are requested by December 16.

The case was brought by a small Danish airline operating domestic feeder services for its two partners, Lufthansa and SAS, as well as regional, cross-border services on its own account. It maintained that its fuel, servicing and other supplies for its aircraft should be free of VAT under the international airline provision of the Sixth Directive. This provision has been inaccurately transposed into Danish law, which links the VAT exemption to the aircraft rather than to the airline.

The taxpayer fought his case with the help of the German government. The European Commission also joined in, but on the side of the Danish government, apparently in an attempt to keep VAT exemptions to a minimum. The advocate general opined against the taxpayer, saying that the Directive does not require a member state to exempt supplies for aircraft primarily flown on domestic flights by airlines chiefly operating on international routes. The Court, though, found in favour of the taxpayer, ignoring the suggestion of the advocate general, on the basis of the clear and unambiguous wording of the Directive. What was less clear was whether the airline was "chiefly" an international carrier, and how this should be measured. The Court satisfied itself by saying that airlines were international if their domestic activities were "considerably less extensive" than their international ones. It then referred the case back to the national court with the remark that it was up to that court to assess the relative extent of the international and domestic businesses, but that in doing so it must take all relevant information, in particular turnover, into account.

This case confirms German law and practice. However, it allays fears of imminent change brought about by the advocate general's opinion to the contrary.

The case was brought by a Dutch agricultural service company serving farms in Holland and in Germany. It fuelled its farm vehicles and equipment daily at its main base in Holland, taking advantage of a provision in Dutch law exempting fuel used for agricultural machinery from mineral oil tax. The machinery was taken to customers' sites the following morning and then brought back that evening after the day's work. Whether the equipment was used in Holland or in Germany was usually a spur-of-the-moment decision depending upon the weather and similar unforeseeable factors affecting the work plan at short notice. The Duisburg Customs office pressed for German mineral oil tax to be levied on the Dutch company on the import of the fuel into Germany as the import was for commercial purposes and there is no German exemption for fuel used in agriculture. The Court, though, sided with the taxpayer on the basis of the letter of the Mineral Oil Excise Duty Directive, saying that

• the fuel imported into a member state in the standard tank of a commercial vehicle could be used to power that vehicle and its machinery in that state without further taxation, provided it had been lawfully released for consumption in another member state, and
• this prohibition on taxation may be relied upon before national courts in the face of contrary national rules.