158 TTPJ ULY/AUGUST 2003 Recent Developments GERMANY Section I of the Foreign Tax Code and the Applicability of cFc rules: Federal Tax Court Decision of 19 march 2002 Dr Stephan Rasch' and Dr Achim Roeder2 INTRODUCTION income adjustment based on sec. 1 KG 100% lows of shares (1)If a taxpayers income from business relationships with related party is reduced because the taxpayer has agreed loan at an interest rate on conditions for such cross border business relationships addition to taxable that differ from the conditions that would have been GMbh income based ( arms length interest between unrelated parties under the same or similar stances then, notwithstanding other provisions his shall be determined as it would have accrued under of shares ditions agreed between unrelated parties For the time being, Sec. I is the only stipulation in german tax law that explicitly mentions the internationally accepted arms length standard. In this respect, however, of the Federal Tax Court in the past. umber of decisions In the years in question, the KG had debt claims against B Another issue associated with Sec. 1 is whether the con- AG in Deutschmark and Swiss Franc at an interest rate of trolled foreign company(hereinafter: CFC)rules(Secs. 7- 4% per year. This interest rate did not conform to the have made an income adjustment based on Sec. 1. The of lower instance held that this justified an increase in the application of both the CFC rules and arms length stan- taxable income by DEM 155, 170(for 1986), DEM dard might lead to double taxation. The Federal Tax Court 258, 355(for 1987), DEM 40, 163(for 1988), and DEM addressed this issue in its decision of 19 march 2002 5 670, 554(for 1989). These amounts were added to Kgs income under Sec. 1. In addition based on Sec. 7. which is part of the CFC legislation, the German tax authorities 2. FACTS The case concerned a German limited partnership that 1. Manager, European Transfer Pricing Group, Deloitte Touche Dussel ranted a loan to a foreign related entity. The dispute dorf. under Sec. 1. The plaintiff was a German limited partner-,. Unless otherwise noted, statutory references are to the Foreign Taveldor. etween the parties related to an estimation of income 2. Director, European Transter Pricing Group, Deloitte Touche Duss ship (Kommanditgesellschaft, hereinafter: KG)that held 4. see eg federal Tax Court decision of 21 June 2001, ref. I B 141/00.See all the shares in F GmbH during the years in question also Eigelshoven, Internationale Wirtschafitsbriefe F3 Deutschland Gr.I,at (1986 to 1989). F Gmbh itself held 100% of shares of the 17 )i aseseener fhtermthon es stemsrerhechl, ec. AStG nste 8161 nanagement in Switzerland Dautzenberg and Goksch Incrundschau(2001), The structure of the relevant related parties can be ht(2000), at 305; cf also Federal Tax Court, decision of 29 November 2000 trated as follows: ref. 85/99, Deutsches Steuerrecht(2001), at 737; for an analysis see Kroppen ational Wirtschafisbriefe(2001), at 484 ederal Tax Court, decision of 19 March 2002, ref. I R 4/01, Bundes- steuerblatt(2002)Il, at 644 6. Tax Court of Manster. decision of 26 October 2000. ref. 15 K 5406/98 F Entscheidungen der Finangerichte(2001), at 6 @2003 International Bureau of fiscal documentation
158 ITPJ JULY/AUGUST 2003 © 2003 International Bureau of Fiscal Documentation 1. INTRODUCTION Sec. 1 of the Foreign Tax Code3 deals with the adjustments of income for transfer pricing purposes and reads as follows: (1) If a taxpayer’s income from business relationships with a related party is reduced because the taxpayer has agreed on conditions for such cross border business relationships that differ from the conditions that would have been agreed between unrelated parties under the same or similar circumstances then, notwithstanding other provisions, his income shall be determined as it would have accrued under the conditions agreed between unrelated parties. For the time being, Sec. 1 is the only stipulation in German tax law that explicitly mentions the internationally accepted arm’s length standard. In this respect, however, Sec. 1 has also been the subject of a number of decisions of the Federal Tax Court in the past.4 Another issue associated with Sec. 1 is whether the controlled foreign company (hereinafter: CFC) rules (Secs. 7- 14) are applicable in situations where the tax authorities have made an income adjustment based on Sec. 1. The application of both the CFC rules and arm’s length standard might lead to double taxation. The Federal Tax Court addressed this issue in its decision of 19 March 2002.5 2. FACTS The case concerned a German limited partnership that granted a loan to a foreign related entity. The dispute between the parties related to an estimation of income under Sec. 1. The plaintiff was a German limited partnership (Kommanditgesellschaft, hereinafter: KG) that held all the shares in F GmbH during the years in question (1986 to 1989). F GmbH itself held 100% of shares of the B AG, a public company with its place of residence and management in Switzerland. The structure of the relevant related parties can be illustrated as follows: In the years in question, the KG had debt claims against B AG in Deutschmark and Swiss Franc at an interest rate of 4% per year. This interest rate did not conform to the applicable market interest rate at the time. The Tax Court of lower instance6 held that this justified an increase in the taxable income by DEM 155,170 (for 1986), DEM 258,355 (for 1987), DEM 40,163 (for 1988), and DEM 670,554 (for 1989). These amounts were added to KG’s income under Sec. 1. In addition, based on Sec. 7, which is part of the CFC legislation, the German tax authorities 1. Manager, European Transfer Pricing Group, Deloitte & Touche Düsseldorf. 2. Director, European Transfer Pricing Group, Deloitte & Touche Düsseldorf. 3. Unless otherwise noted, statutory references are to the Foreign Tax Code (Außensteuergesetz). 4. See e.g. Federal Tax Court decision of 21 June 2001, ref. I B 141/00. See also Eigelshoven, Internationale Wirtschaftsbriefe F. 3 Deutschland Gr. 1, at 1761; Wassermeyer, Internationales Steuerrecht (2001), at 113; Wassermeyer, in Flick/Wassermeyer/Baumhoff, Außensteuerrecht, Sec. 1 AStG note 816.1; Dautzenberg and Goksch, Betriebs-Berater (2000), at 904; Herlinghaus, Finzanzrundschau (2001), at 241; Köplin and Sedemund, Internationales Steuerrecht (2000), at 305; cf. also Federal Tax Court, decision of 29 November 2000, ref. 85/99, Deutsches Steuerrecht (2001), at 737; for an analysis see Kroppen and Rasch, Internationale Wirtschaftsbriefe (2001), at 484. 5. Federal Tax Court, decision of 19 March 2002, ref. I R 4/01, Bundessteuerblatt (2002) II, at 644. 6. Tax Court of Münster, decision of 26 October 2000, ref. 15 K 5406/98 F, Entscheidungen der Finanzgerichte (2001), at 62. Recent Developments GERMANY Section 1 of the Foreign Tax Code and the Applicability of CFC Rules: Federal Tax Court Decision of 19 March 2002 Dr Stephan Rasch1 and Dr Achim Roeder2 KG F-GmbH B-AG loan at an interest rate of 4% (=/ arm’s length interest rate) 100% of shares 100% of shares income adjustment based on Sec. 1 addition to taxable income based on Sec. 7 D CH
JULY/AUGUST 2003 ITPJ 159 djusted the income of F gmbh by deducting the above albesteuerung), which requires the tax authorities to con mentioned amounts sider any facts for the income determination only for the individual taxpayer that is subjected to these facts 3. DECISION OF THE FEDERAL TAX COURT Accordingly, in the case at hand, the question of whether or not Sec. I is applicable be answered in reference to the facts and circumstar If a German company grants a loan to a foreign subsidiary not subject to the addition G KG itself. however is the arm's length principle, the taxable income of the ger- ive double taxation could only be avoided by appealing for man company must be adjusted under Sec. 1. even if the equitable relief. taxable income of the foreign subsidiary is added to the taxable income of the German parent company of the sub- 4. ADDITIONAL REMARKS sidiary(based on Sec. 7). Any double taxation that may arise in these cases must be eliminated by a corresponding adjustment at the level of the German parent company's First and foremost, it is important to avoid double taxation income calculated for CFC purposes. This was the that stems from an income adjustment under Sec. I and an approach applied by the German tax authorities and the income attribution due to CFC rules. It should be taken Federal Tax Court explicitly approved this approach to account that sec. I ties to the income determination Inder Sec. 4 of the Income Tax Act. The additional The Federal Tax Court further held that the exceptionally income taxable under Sec. 7, however, technically does low interest rate led to an increase in B AG's profits If the not rely on an income adjustment. The latter is part of the parties would have agreed on an appropriate interest rate, determination of the taxpayer's income. Therefore, Sec. 7 B AG would have borne higher interest expenses that in should take precedence over Sec. 1. Sec. I should only be turn would have decreased B AGs taxable income. At the applied if the income has not been determined in accord- same time, B AG's passive income and, subsequently, the ance with the arms length principle addition at the level of F GmbH on the basis of the CFC The lower Tax Court's opinions that the requirement of axation,would have been reduced as well. Accordingly, B Sec. I (reduction in income) is not valid, seems to be prob AG's advantage derived from the lower interest rate that lematic. The Tax Court did not consider that Sec. I ties to increased the taxable income of F gmbh and simultan- the income determination under Sec. 4 of the Income Tax able income of KG. As a consequence, income generated Act, but does not tie to the income in the sense of Sec. 7 abroad was shifted to Germany and was taxed twice i.e. the Tax Court mixed two different spheres that need to be distinguished fror There is much controversy surrounding, the discussion Finally, in order to effectively avoid double taxation,it regarding how to avoid this type of double taxation. The tax authorities take the position that Sec. I also applies to seems to be appropriate to limit the scope of Sec. 1 by means of a teleological reduction. 4 A teleological reduc under Secs. 7 to 14. Thus when the amount of the add- tion leads to a limitation of the scope of a stipulation though its wording would open and allow application of itional income to be allocated to the intermediate corpor- the legal consequence of the law. Such a limitation is Jus- ation under CFC rules' is determined, it is necessary to make a compensating adjustment. ThIs argument is based tified by son of a divergence of the wording and the on Sec. 1.5.2 of the Administrative Principles for the ratio legis of the respective law. examination of income allocation in the case of interna- Sec. I intends to ensure a consistent taxation of entities tionally related enterprises considering the taxpayers economic capacity Certain authors in tax literature(as well as the Tax Court cation of Sec. 1. however, must not result in double tax ation that would cause a violation of the constitutional of Munster, as seen in one of its decisions) take the pos- based principle of taxation in line with the taxpayers ition that Sec. 7 has priority over Sec. l, i.e. Sec. I is not applicable if Sec. 7 applies. It is argued that the addition economic capacity. Therefore, in cases where Sec. I and 7 that is taxable under Sec. 7 is part of the determination of sons are affected by the income adjustment(Sec. 1),and income, while the income adjustment-based on Sec. I only takes place after the income determination, i.e. at ter stage. The Tax Court of Munster supported th interpretation and argued that Sec. I is not applicable 7. Sec. 103)ASIG because the requirements of Sec. I would not be fulfilled 8. Federal Ministry of Finance, letter of 23 February 1983, BMF IVC5-S A reduction in the taxpayer's income-as required under 9. Decision of 7 August 1997, ref. 15 K 144/96 F, Entscheidungen der Sec. 1-would not occu richte(1997), at 1289 The Federal Tax o not ultimately resolve 10. See Wassermeyer, in Flick/wassermeyer/Baumhoff, AuyBensteuerrecht, flict of opinions art held that in situation 12. See Federal Tax Court, decision of 23 August 1999, ref GrS 2/97, Bun against separate legal pel-ased on the principle of the tax- Finan-gerichte(1997), at 1289 997, ref. 15 K 144/96 F,Entscheidungen der ity over Sec. 1. This ns, Sec. 7 does not take prior- 13. Decision of 7 August I ation of the individual taxpayer(Grundsatz der Individu- 14. See Wassermeyer, in Flick/wassermeyer/Baumhoff, auBensteuerrecht 2003 International Bureau of fiscal do
adjusted the income of F GmbH by deducting the above mentioned amounts. 3. DECISION OF THE FEDERAL TAX COURT If a German company grants a loan to a foreign subsidiary at an unusually low interest rate that does not conform to the arm’s length principle, the taxable income of the German company must be adjusted under Sec. 1, even if the taxable income of the foreign subsidiary is added to the taxable income of the German parent company of the subsidiary (based on Sec. 7). Any double taxation that may arise in these cases must be eliminated by a corresponding adjustment at the level of the German parent company’s income calculated for CFC purposes. This was the approach applied by the German tax authorities and the Federal Tax Court explicitly approved this approach. The Federal Tax Court further held that the exceptionally low interest rate led to an increase in B AG’s profits. If the parties would have agreed on an appropriate interest rate, B AG would have borne higher interest expenses that in turn would have decreased B AG’s taxable income. At the same time, B AG’s passive income and, subsequently, the addition at the level of F GmbH on the basis of the CFC taxation, would have been reduced as well. Accordingly, B AG’s advantage derived from the lower interest rate that increased the taxable income of F GmbH and simultaneously – due to the income adjustment – increased the taxable income of KG. As a consequence, income generated abroad was shifted to Germany and was taxed twice. There is much controversy surrounding the discussion regarding how to avoid this type of double taxation. The tax authorities take the position that Sec. 1 also applies to business relationships with intermediate corporations under Secs. 7 to 14. Thus when the amount of the additional income to be allocated to the intermediate corporation under CFC rules7 is determined, it is necessary to make a compensating adjustment. This argument is based on Sec. 1.5.2 of the Administrative Principles for the examination of income allocation in the case of internationally related enterprises.8 Certain authors in tax literature (as well as the Tax Court of Münster, as seen in one of its decisions)9 take the position that Sec. 7 has priority over Sec. 1, i.e. Sec. 1 is not applicable if Sec. 7 applies. It is argued that the addition that is taxable under Sec. 7 is part of the determination of income, while the income adjustment – based on Sec. 1 – only takes place after the income determination, i.e. at a later stage.10 The Tax Court of Münster supported this interpretation and argued that Sec. 1 is not applicable because the requirements of Sec. 1 would not be fulfilled. A reduction in the taxpayer’s income – as required under Sec. 111 – would not occur. The Federal Tax Court did not ultimately resolve this conflict of opinions. The Court held that in situations where the application of Sec. 1 and 7 respectively are to be made against separate legal persons, Sec. 7 does not take priority over Sec. 1. This is based on the principle of the taxation of the individual taxpayer (Grundsatz der Individualbesteuerung), which requires the tax authorities to consider any facts for the income determination only for the individual taxpayer that is subjected to these facts.12 Accordingly, in the case at hand, the question of whether or not Sec. 1 is applicable must be answered in reference to the facts and circumstance of KG. KG itself, however, is not subject to the addition under Sec. 7. Finally, an effective double taxation could only be avoided by appealing for equitable relief. 4. ADDITIONAL REMARKS First and foremost, it is important to avoid double taxation that stems from an income adjustment under Sec. 1 and an income attribution due to CFC rules. It should be taken into account that Sec. 1 ties to the income determination under Sec. 4 of the Income Tax Act. The additional income taxable under Sec. 7, however, technically does not rely on an income adjustment. The latter is part of the determination of the taxpayer’s income. Therefore, Sec. 7 should take precedence over Sec. 1. Sec. 1 should only be applied if the income has not been determined in accordance with the arm’s length principle. The lower Tax Court’s opinion13 that the requirement of Sec. 1 (reduction in income) is not valid, seems to be problematic. The Tax Court did not consider that Sec. 1 ties to the income determination under Sec. 4 of the Income Tax Act, but does not tie to the income in the sense of Sec. 7, i.e. the Tax Court mixed two different spheres that need to be distinguished from each other. Finally, in order to effectively avoid double taxation, it seems to be appropriate to limit the scope of Sec. 1 by means of a teleological reduction.14 A teleological reduction leads to a limitation of the scope of a stipulation, though its wording would open and allow application of the legal consequence of the law. Such a limitation is justified by reason of a divergence of the wording and the ratio legis of the respective law. Sec. 1 intends to ensure a consistent taxation of entities considering the taxpayer’s economic capacity. The application of Sec. 1, however, must not result in double taxation that would cause a violation of the constitutionalbased principle of taxation in line with the taxpayer’s economic capacity. Therefore, in cases where Sec. 1 and 7 are applicable because on the one hand different legal persons are affected by the income adjustment (Sec. 1), and JULY/AUGUST 2003 ITPJ 159 © 2003 International Bureau of Fiscal Documentation 7. Sec. 10(3) AStG. 8. Federal Ministry of Finance, letter of 23 February 1983, BMF IV C 5 – S 1341 – 4/83, Bundessteuerblatt (1983) I, at 218. 9. Decision of 7 August 1997, ref. 15 K 144/96 F, Entscheidungen der Finanzgerichte (1997), at 1289. 10. See Wassermeyer, in Flick/Wassermeyer/Baumhoff, Außensteuerrecht, Sec. 1 AStG note 77.1. 11. See 1. above. 12. See Federal Tax Court, decision of 23 August 1999, ref. GrS 2/97, Bundessteuerblatt (1999) II, at 782. 13. Decision of 7 August 1997, ref. 15 K 144/96 F, Entscheidungen der Finanzgerichte (1997), at 1289. 14. See Wassermeyer, in Flick/Wassermeyer/Baumhoff, Außensteuerrecht, Sec. 1 AStG, note 186
160 TTPJ ULY/AUGUST 2003 the CFC income attribution(taxable under Sec. 7)on However, tax law provides that if assets are withdrawn other hand, the teleological reduction of Sec. I is relet from one business and are transferred to another domestic business, the so-called partial values(Teihvern) must be applied. The partial value equals the acquisition costs of 5 SEC. 1 AND EUROPEAN LAW an asset; it does not include a profit element, whereas the arm's length price as required by Sec. I generally includes However, there is more to the necessary modifications a profit component. Consequently, higher taxation might than recognizing the developments in German tax law be borne in cases where Sec. I applies. The Federal Tax described above. In addition to a purely domestic perspec- Court came to the conclusion that this different taxation tive, it is also important to consider the implications of might violate the taxpayers right of free movement of ser- European law. Although there is no tendency to fully har- vices(under Art. 43 of the EU Treaty ) as well as the free- tic tax laws must not violate binding European law. In this because comparable circumstances are subject to less tax context, it is in the countries' vital interest not to breach in a purely domestic transaction as compared to cross-bo the four fundamental freedoms provided by the treaty der transactions establishing the European Union. 5 A famous example in this respect could be the treatment of Sec. I The german Federal Tax Court 6 had to decide whethe the limited application of Sec. I of the Foreign Tax Code 15 scope of application of this provision is limited to cases establishrof free movem. where"business relationships extending to a foreign coun- 16. Decision of 21 June 2001,Deutsches Steuerrecht(2001),at1290See Note try"exist, i.e. the regulation is not applicable in purely 17 see Note 2 for further i domestic cases. In the Federal Tax Court case. it was criti 18. See also Secs. 4(1)and 6(1)of the Income Tax Code cal that Sec. I requires determining an arm's length price. 19. See Kroppen and Rasch, 10 Transfer Pricing Report(2 June 2002), at835 Continued from page 153 aro de juan Ledesma Mexico reme Court Rejects Request for Preliminary Ruling Ricardo Rendon and Oscar Campero from European Court of Justice Regarding Tax Maquiladora Extension of Transfer Pricing Rules and Consolidation Regir Tax Incentive DOCUMENTATION Profit Split Agreement between the Netherlands European Union and germany on the International Allocation of Taxable The EU Joint Transfer Pricing Forum Income of Netherlands Flower Salesmen .0 Issues for Debate 23 Harm van den broek Summary Record of the First Meeting of the EU Joint Bosal Holding and the Confusion Surrounding Transfer Pricing Forum held in Brussels on the Territoriality Principle 116 3 October 2002 Netherlands antilles Victor Matchekhir Ministerial Decision on Profit Tax Ruling Policy Transfer Pricing Rules, Practice and Potential 124 @2003 International Bureau of fiscal documentation
[continued from page 153] Mexico Ricardo Rendón and Oscar Campero: Maquiladora Extension of Transfer Pricing Rules and Tax Incentives 18 Netherlands Rijkele Betten: Profit Split Agreement between the Netherlands and Germany on the International Allocation of Taxable Income of Netherlands Flower Salesmen 20 Harm van den Broek: Bosal Holding and the Confusion Surrounding the Territoriality Principle 116 Russia Victor Matchekhin: Transfer Pricing Rules, Practice and Potential Development 124 Spain Álvaro de Juan Ledesma: Supreme Court Rejects Request for Preliminary Ruling from European Court of Justice Regarding Tax Consolidation Regime 59 DOCUMENTATION European Union The EU Joint Transfer Pricing Forum Issues for Debate 23 Summary Record of the First Meeting of the EU Joint Transfer Pricing Forum held in Brussels on 3 October 2002 65 Netherlands Antilles Ministerial Decision on Profit Tax Ruling Policy 75 160 ITPJ JULY/AUGUST 2003 © 2003 International Bureau of Fiscal Documentation the CFC income attribution (taxable under Sec. 7) on the other hand, the teleological reduction of Sec. 1 is relevant. 5. SEC. 1 AND EUROPEAN LAW However, there is more to the necessary modifications than recognizing the developments in German tax law described above. In addition to a purely domestic perspective, it is also important to consider the implications of European law. Although there is no tendency to fully harmonize the tax systems of the EU Member States, domestic tax laws must not violate binding European law. In this context, it is in the countries’ vital interest not to breach the four fundamental freedoms provided by the treaty establishing the European Union.15 A famous example in this respect could be the treatment of Sec. 1. The German Federal Tax Court16 had to decide whether the limited application of Sec. 1 of the Foreign Tax Code met the requirements of prevailing European law.17 The scope of application of this provision is limited to cases where “business relationships extending to a foreign country” exist, i.e. the regulation is not applicable in purely domestic cases. In the Federal Tax Court case, it was critical that Sec. 1 requires determining an arm’s length price. However, tax law provides that if assets are withdrawn from one business and are transferred to another domestic business, the so-called partial value18 (Teilwert) must be applied. The partial value equals the acquisition costs of an asset; it does not include a profit element, whereas the arm’s length price as required by Sec. 1 generally includes a profit component. Consequently, higher taxation might be borne in cases where Sec. 1 applies. The Federal Tax Court came to the conclusion that this different taxation might violate the taxpayer’s right of free movement of services (under Art. 43 of the EU Treaty), as well as the freedom of establishment (under Art. 37 of the EU Treaty) because comparable circumstances are subject to less tax in a purely domestic transaction as compared to cross-border transactions.19 15. Under the EU treaty, there are four so-called “fundamental freedoms”, i.e. the right of free movement of persons, services, and capital, and the freedom of establishment. 16. Decision of 21 June 2001, Deutsches Steuerrecht (2001), at 1290. See Note 2. 17. See Note 2 for further references. 18. See also Secs. 4(1) and 6(1) of the Income Tax Code. 19. See Kroppen and Rasch, 10 Transfer Pricing Report (2 June 2002), at 835
