Vol. 4 No. 1, January/February 1997 GERMANY THE TAX TREATMENT OF SHAREHOLDER COSTS By Dr Heinz-Klaus Kroppen and Stephan Huffmeier* . INTRODUCTION onsidered to be busi- even if they were, such German tax law does no le from the taxable d always of a com provision costs. S any such a which GENERAL TAX TREATMENT OF PARENT from a German de these dividends in its taxable urposes (and is in general e tax paid b ection with these divi- le, the situation does other related an exception n subsidiary and outward charge tions. Even if costs are classified as b icipal necessarily mean that they are tax d
ol. 4 No. 1, January/February 1997 TPJ from a foreign subsidiary, which are tax exempt in Germany mean that both direct and indirect costs relating to it are not under a tax treaty. Where the German subsidiary passes on tax deductible. By contrast, if one assumes that the treaty hese tax-free dividends to the parent company, the latter exemption applies to the gross amount of the dividends no does not have to include them in taxable income either. With costs are excluded from tax deductibility under the tre regard to the costs incurred in connection with the tax-free exemption. German domestic law prohibits the deduction of income, the law states that direct costs cannot be used to expenses directly related to exempt( foreign) income. How reduce the taxable basis of the parent. The treatment of these ever, the Tax Court did not identify what these directly relat costs corresponds to that of costs incurred in connection with ed costs are In this respect, the wording of the German tax other income for which the relevant tax treaty provides a tax law provision is not clear. The Court, which had to decide on exemption. This issue is dealt with in more detail in B the deductibility of interest payments in connection with a Costs incurred in connection with the acquisition of a domes- loan obtained by a geman parent company to finance the tic participation(e.g- purchase price, notary public fees)have acquisition of its foreign subsidiary, provided the following to be capitalized. Because German tax law does not allow solution: interest payments are fully deductible from the tax- ordinary depreciation on participations, these costs affect the able income of the parent company. Only in the yeshe taxable income of the parent only if the conditions for hich dividends are paid sidiary to write-down are fulfilled (e.g. a long-term decrease in the German parent, is the deductibility restricted in so far as th value of the participation)or when the participation is sold amount of dividends corresponds to the amount of the inter Capital gains realized on the sale of a' domestic participation are included in the current taxable income of the parent com- Example pany and are not taxed differently from other income. The former special tax-free amount(DEM 30,000 reduced by any ear 3 excess of the capital gain over DEM 100,000)which was dividend 0 50,000 applicable upon the sale of a 100% shareholding to one pur- interest 30.000 30000 30,000 chaser was abolished as of the beginning of 1996. Costs deductible interest 30.000 incurred in connection with the sale of the participation are 20,000 deductible from taxable income which, as mentioned earlier, As mentioned earlier, the Court,'s decision expressly applies includes capital gains. ayments. Whe r the restriction also applies to other costs (e.g. monitoring costs)is unclear. B. Foreign participations Costs incurred in connection with the acquisition of a foreign participation are treated in the same manner as those incurred The tax treatment of income received by a German parent in the acquisition of a domestic participation. 2 company from foreign participations depends on whether the The sale of a foreign participation by a german parent com- tax credit method or the exemption method applies to such pany is treated in the same way as the sale of a domestic par- income. The tax credit method is laid down in German ticipation: the capital gain is included in taxable income domestic law. The exemption method is usually provided for However, there is an important exception for foreign partici- by German tax treaties. If the relevant conditions imposed pations of greater than 10% If the dividends from that parti for the exemption method takes precedence over the credit the absence of a treaty, the foreign subsidiary aty, or in under the. treaty are satisfied, the treaty clause that provides cipation would have been tax exempt under a ta method in German domestic law income from activities for which the law does not expresso rule out tax privileges, the capital gain derived from the sa Under the credit method, dividends are treated as ordinary of that participation is tax exempt. current income of the German parent company and foreign taxes can be credited under certain circumstances against the Costs incurred in connection with such a sale reduce the cap. German tax liability. Costs incurred in connection with this ital gain and not the current taxable income of the parent income are generally fully deductible from the German tax company. The parent company is required to recapture liability. Nevertheless, the allocation of costs to the foreign amounts written down in previous tax years. Thus, it has to income is necessary in order to determine the maximum reduce the amount of tax-free capital gains by the amount of amount of creditable foreign tax. the recapture. However, if the German parent company real in connection with this income are not tax deductible. The from its taxable income. This regime is aimed at encouraging German Supreme Tax Court recently affirmed its earlier foreign investors to set up holding companies in Germany opinions by stating that the exemption for dividends under most tax treaties refers to the gross amount of the dividend rather than the dividend net of charges incurred in connection with it, as some german state tax authorities had assumed The difference between the two opinions may be significant if one assumes that the exemption under a tax treaty applies to the net income derived from the participation, that would 2. See IL.Aabove @1997 International Bureau of Fiscal Documentation
ITPJ Vol. 4 No. 1, Jar /February 1997 lll. CHARGES FOR SHAREHOLDER/ 3. Issuance of shares in the parent company STEWARDSHIP ACTIVITIES The financing of the parent company is not the concern of the As mentioned in the introduction, shareholder costs have to former and therefore these costs have to be bome by the be viewed as separate from business costs(the latter being defined as the costs incurred in connection with the busI- 4. Costs of listing on a stock exchange ness). By contrast, shareholder costs may be defined as those incurred in connection with the company-shareholder rela- (including advertising costs) tionship. The German Supreme Tax Court has handed down If the listing involves shares of the subsidiary, the costs several decisions which distinguish between these two types should be allocated to the subsidiary because the financing is of costs. In addition, the German tax administration issued in necessary for the business operations of a company. If, hoy 1983 a circular entitled"Principles for the examination of ever, it is the stock of the parent company which is listed. the income allocation in the case of internationally affiliated costs have to be bome by the parent company enterprises"(hereinafter"Administrative Principles"). The circular expresses the views of the tax authorities on income. 5. Banking costs of dividend payments allocation between internationally affiliated companies. In our opinion, some of these principles are not consistent with At the subsidiary level, the banking costs of dividend pay. the legal definition of business costs This definition does not ments are, in our opinion, related to the distribution of aguish between intemal relationships and cross-bor ncome rather than the generation of income. Strictly speak relationships ing, they should be classified as shareholder expenses(see however, B. ). A. Classification of shareholder/stewardship activities 6. Costs of annual financial reports In current German tax practice, the terms"shareholder costs" German commercial law imposes on companies the obliga- and"stewardship costs"are used interchangeably, unlike in tion to draw up year-end financial statenwver, a company may paragraph 79 of the 1995 OECD Transfer Pricing Guidelines, of a certain size, to publish them. Howe nents and, if they are where a distinction is made between the two. German tax voluntarily publish its financial statements for public rela- practice, however, does distinguish between stewardship tions purposes. In both cases, the costs are directly connected costs and those costs which benefit the subsidiary. Therefore, with the business operations of the company. The costs of the costs listed below are classified. as either those resulting generating financial reports of the parent company may not from business operations (business expenses)or those be allocated to the subsidiary incurred in connection with the company-shareholder rela- tionship. The classification of an expense as a business 7. Yearly contributions to the Chamber of Commerce expense by itself does not necessarily mean that the amount as a payment resulting from the company-shareholder rela- join the local Chamber of Commerce. The costs incurred in tionship usually means that it is not deductible by the sub- connection with such membership are a requirement for sidiary. The tax treatment of these costs is discussed in B. doing business and therefore, both the company and the par- below ent have to bear their respective shares 1. Activities relating to the juridical structure of the 8. Costs of the supervisory board The supervisory board serves the interests of both the compa- In our opinion, the juridical structure is a matter for the ny(e.g. the staff)and the shareholders. Under certain condi ent company. Thus, any costs incurred in connection tions, German company law requires a company to hav ve a activities relating to this structure should be classified as, supervisory board. The costs of complying with this legal shareholder costs (paragraph 6.3.2. of the Administrative obligation should therefore be considered necessary to the Principles). Conversely, these costs are not caused by the business operations of the company. business operations of a subsidiary and therefore do not qual- On the other hand, companies that are not required to estab- ify as business expenses of the subsidiary. lish a board sometimes do so voluntarily. In this case, the 2. Meetings of the parent's shareholders (including expenses may not entirely qualify as business expenses since the board may perform certain functions in the interest of the shareholders. In practice, however, the costs of the supervi- These costs do not arise out of the business operations of a sory board are treated as business expenses. Paragraph 6.3.2 subsidiary either. They have to be borne by the shareholder (paragraph 6.3. 2 of the Administrative Principles) Minister of Finance of 23 February 1983(V C5-S 13414/83). For the unofficial English translation of this circular. see the chapter on Germany in The Tax Treatment of Transfer Pri- c 1997 International Bureau of Fiscal Documentation
Vol 4 No. 1, January/February 1997 ITPJ f the Administrative Principles states that the costs of the B. Tax treatment of charges for shareholder pervisory board of the parent company cannot be bome by stewardship activities e subsidiary. Supervisory boards have both control and advisory functions. If a function relates to the business of a In general, under German tax law, the taxpayer may use bus subsidiary, then arguably some of the costs could be business ness expenses, but not shareholder costs, to reduce taxabi expenses(see B) income. There are, however, exceptions. Certain costs 9. Parent's audit of the subsidiary although classified as business expenses, are not deductibl (e.g. costs incurred in connection with tax-free income a Costs incurred in connection with the parent's audit of the 50% of payments made to members of the supervisory board subsidiary seem, at first glance, to be in the interest of the see A above). As mentioned earlier, whether costs are con parent. However, such an audit may uncover information sidered to be expenses incurred in connection with the busi ness operations or with the company-shareholder relation pany-shareholder relationship ). Moreover, the parent's audit ship does not depend on whether the company and the share of its subsidiary could, in part, replace the subsidiary's own holder are both German residents or whether one of them is a intemal audit. One could argue that some of the costs are resident of a foreign country. Nevertheless, in practice, it may iness operations of the subsidiar be difficult to deduct expenses if a foreign ity is involvec qualify as business expenses(see also B below). because the company may have trouble proving that inward charges from abroad are actually caused by the busines 10. Consolidation of the results of the group company Under German commercial law, a German parent company is 1. Domestic situation required to draw up a consolidated report of the results of the In a domestic situation, it is important to determine under group of companies. The costs incurred by the parent in com- plying with the law are directly related to its exercise of con- German tax law the taxable base of each, taxpayer. The cost trol over the subsidiaries. Thus, these costs qualify as share- items mentioned in A above should be treated for tax pur- holder costs. Conversely, one could argue that these costs are poses as follows that they would not have to bear the expenses if they were a. Activities relating to the juridical structure of the parent dependent of the parent However, under certain circumstances, the law provides an Since these costs have to be allocated to the shareholder and exemption for parent companies which are themselves sub- the law allows them to be deducted, these costs may be used sidiaries of the foreign parent company. One condition for the to reduce the taxable income of the shareholder. They may exemption is that the foreign parent company must include in. not be charged out to a subsidiary. subsidiary would have had to include in the latter's consoli- b. Meetings of the parent's shareholders(including dated report had it not been exempt from this obligation. In our opinion, the exempt German company should bear part of See a above the costs incurred by the foreign parent company. C. Issuance of shares in the parent company 11. Raising funds for acquisitions of the group The expansion of the group is, in principle, a shareholder concern. These costs are not related to the business opera- d. Costs of listing on a stock exchange(including tions of the subsidiaries. However, if the parent company advertising costs) made by the latter, the costs associated therewith should be. The costs of listing on a stock exchange. may be used to considered the business expenses of the subsidiary. reduce the taxable income of the histing party. 12. Managerial and control activities related to the Banking costs of dividend payments anagement and protection of the investment in participations At the level of the company, these costs are, strictly speaking not deductible from taxable income because they are not allocated to the shareholder since they are not incurred in income. However, in practice, the banking costs of dividend connection with the business operations of the subsidiaries. payments are of minor importance and the German tax Managerial costs associated with the management and pro- authorities are unlikely to deny their deductibilit tection of the investment can also benefit the subsidiary, e. g. At the level of the shareholder, these costs can be seen as hav make it profitable. Therefore, whether or not an item is a een incurred in connection with tax-free income business expense should be decided on a case-by-case basis. .A. above). As such. they may not be deductible even though they are generally classified as business expenses @ 1997 International b
Vol. 4 No. 1 ( since the shareholding belongs to the business activity of the I. Managerial and control activities related to the hareholder). In our experience, the German tax authorities management and protection of the investment in have never denied their deductibility participations f. Costs of annual financial reports(e.g. editorial, printing The cost of control activities should not be bome by the and distribution costs) anage bus expense if it can be shown that they were incurred in the far as these costs are intrinsically related to business interest of the subsidiary and the subsidiary benefited from operations of the company, they constitute a deductible busi- the managerial activities. ness expense. The costs of generating the annual financial reports of the parent company may be used to reduce the tax-:2. Cross-border situation ble income of the parent g. Yearly contributions to the Chamber of Commerce a.Outward charges in relation to shareholder/stewardship See f above. Where the shareholder is a german resident the cost items h. Costs of the supervisory board listed above should be deductible from the shareholder's tax able income, unless the law states otherwise(e. g. restrictions ne, supervisory board may pertorm acts in the on the deductibility of banking co interest of the shareholders(and not only in the interest of the free dividends and the 50% limitation on the deduction of company), the costs associated with the board are considered costs associated with a supervisory board In so far as the board belongs. However, under German corporate income domestic subsidiary (e. g. parent's cost of auditing a sub- tax law, only 50% of the consideration paid to the members sidiary and of preparing a consolidated report of the group company. This clause was introduced to discourage the pay- costs to the subsidiaries. ment of exorbitant sums to board members. It is not aimed at creating a distinction between shareholder costs and business In the past, the practice of charging costs from a German par- ent company to its foreign subsidiary was not a major issue in tax audits. However, this is changing rapidly. Tax i. Parent's audit of the subsidiary have begun to question the validity of business Since such an audit may also be undertaken in the interest of deducted in Germany if the activities for which the expenses the company (and not only in the interest of the shareholder), were incurred clearly benefit the subsidiary the relevant portion of the costs may, in our opinion, be usee to reduce the taxable income of the company. However, a fe b. Inward charges in relation to shareholder/stewardship court decisions do not share this view activities Where business expenses have to be distinguished from the Except for managerial and control costs, and the costs of con- held that the costs are not deductible in their entirety, unless al the ca the group results and auditing foreign subsidiaries, Whether such a decision also applies to the allocation of sidiane e not deductible in Germany by the German su one can easily allocate a portion of the costs to the business. ent and ar income between a company and its shareholder, is unclear. In With regard to the costs incurred by a foreign parent in con- our experience. the German tax authorities are willing to nection with the audit of a subsidiary, these costs should be al context al principles discussed above. However, paragraph 6.2.2.of j. Consolidation of the results of the group of companies the Administrative Principles requires that the interest of each party be clearly distinguishable and measurable Since these costs are generally classified as shareholder Although one could, in practice, distinguish the interest of the expenses, they eamon be used to r duce the tax iab lite ref the ify this interest haf the in erest f te yubsidiair it tngt be ultimate parent company makes a consolidated report, which quantified, the deductibility of the costs associated with that draw up such a report(see A above) The costs that a foreign company bears for consolidating the k. Raising funds for acquisitions of the group group's results are bome by the foreign parent company because they relate to its activities. These costs are not caused Since this is a shareholder activity, the costs incurred in con- by the business operations of the German subsidiaries. More nection therewith may not be used to reduce the taxable over, as independent companies, the subsidiaries should not income of the subsidiaries, unless they are associated with an have to bear these costs acquisition which is- made by a subsidiary 1997 International Bureau of Fiscal documentation
ITPJ 15 In our opinion, there is an exception to the above-mentioned (paragraph 7. 1. 2. of the Administrative Principles), includin rule where German commercial law exempts a German com- direct and indirect costs. If, under a direct charge method pany which has subsidiaries from the obligation to consoli- arms length prices are available, then costs are not relevant date the results of subordinated companies because the ulti onsolidated report(which includes the results of the sub- D. Determining the appropriate remuneration sidiaries subordinated to the Ge eman“ top subsidiary) Arguably, there is a service flow from the ultimate foreign As stated in C above, in a direct charge system, am's length parent company to the German top subsidiary which is in the prices should be used if they are available. In their absence latter's interest since it is relieved of the costs of consolidated the cost plus method should be used(by definition, it includes a profit element). Paragraph 7. 1.6. of the Adminis- trative Principles states, however, that a profit element will C Symmetrical treatment not be recognized for tax purposes in the absence of In cross-border situations, outward and inward charges are, in ever, in practice, the tax authorities sometimes allow a mark- entitled to ere is a tendency on the part of the German tax authorities up on costs to restrict inward charges and to force outward charges. This authorities in conducting audits of cross-border transactions. IV. TAX TREATY SOLUTIONS The handbook treats outward transactions differently from inward transactions. In addition, the tax authorities'attitude According to the prevailing opinion, the tax law provisions in owards the deductibility of inward charges often hinges. Germany's treaties are not self-executing(similar to Article 9 upon the amount and quality of the evidence produced by the of the OECD Model Convention). The treaties do not impose taxpayer. an obligation on the taxpayer to use a particular method for computing taxable income; rather they"allocate"taxable income, which is determined under the intemal laws of one or C. Method of allocation/apportionment the other state. The state which is entitled to impose the tax is The Administrative Principles in No. 6 and 7 distinguish The purpose of treaty provisions, such as Article 9 of the between the direct charge method and the cost allocation oECD Model Convention, is to ensure that incomeallocation method for charging out service costs to subsidiaries. The Administrative Principles clearly favour charging services tween internationally affiliated companies complies with directly to subsidiaries the arm's length principle. At least with regard to intemation- ally affiliated companies, it is generally acknowledged: that Cost allocation is permissible only if the consideration for the the German rules follow the arms length principle. The tax transfer of services can be assessed globally or where it is dif- authorities generally take the position that clauses such as ficult to ascertain the costs associated with individual ser- Article 9, do not overrule domestic restrictions on the also be determined based upon the prices charged by third OECD Repo ovisoiait. Geman tax treaties usually do not vices (paragraph 7. 1.1. of the Administrative Principles). deductibility of cos Under a direct charge regime, the arm's length price should include any provisions such as those suggested in the 1984 parties (e. g. hourly rates for consulting services). If it is not possible to establish arms length prices, the Administrative Principles require the use of the cost-plus method for direct V. TAX PLANNING CONSIDERATIONS On the other hand, under an indirect charging method, the Since the deduction of costs related to the holding of foreign recipients of administrative services in a group are charged participations has been treated rather generously by the tax the costs incurred for those services on the basis of an alloca- authorities in the past and Germany is a high-tax jurisdiction tion formula (ratio of sales, employees, capital employed, it is still common for German MNEs to hold foreign shares etc.). The formula is acceptable only if it truly reflects the directly. This is because financing costs are deductible proportion of the subsidiarys use or expected use of the unless a dividend is paid in the same year even though a administrative services (paragraphs 7. 4. of the potential dividend or sale of the foreign participation would Administrative Principles). be tax free in germany. For the cost-allocation method and the cost-plus method, the tax authorities require that they be applied on a full cost basis o 1997 International Bureau of Fiscal documentatio
