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 doadjusted 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 Ger￾man 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 sub￾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 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 simultan￾eously – due to the income adjustment – increased the tax￾able 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 add￾itional income to be allocated to the intermediate corpor￾ation 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 interna￾tionally 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 pos￾ition 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 con￾flict 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 prior￾ity over Sec. 1. This is based on the principle of the tax￾ation of the individual taxpayer (Grundsatz der Individu￾albesteuerung), which requires the tax authorities to con￾sider 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 effect￾ive 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 accord￾ance 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 prob￾lematic. 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 reduc￾tion 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 jus￾tified 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 appli￾cation of Sec. 1, however, must not result in double tax￾ation that would cause a violation of the constitutional￾based 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 per￾sons 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, Bun￾dessteuerblatt (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