Taxation of Low-Tax Transactions in Germany

The higher is your tax burden, the more you are tempted to go for a sophisticated tax planning techniques involving offshore entities. However, your home tax authorities keep their nose to the wind. Among others, Germany is known for its elaborated anti-avoidance legislation, developed to prevent its taxpayers from using offshore transactions aiming to reduce their German tax liability.

Tax Residency in Germany

German taxation system is based on residence, rather than on citizenship principles. Individuals, German nationals and aliens, having their domicile or place of abode in Germany, are considered residents for tax purposes. If you are a German tax resident, you have an unlimited German tax liability, including your worldwide income, even if you are resident abroad.

Non-resident aliens have a limited tax liability covering only income from German sources.

A company with the central management and control functions being executed from Germany is a resident for tax purposes. A foreign company is considered a German tax resident, if its management functions are shifted to Germany.

Change of Domicile

If you leave Germany and change your domicile, you become a non-resident national keeping a limited tax liability (with income from German sources). However, additionally you may get an extended limited tax liability, if the following conditions are met:

  • you used to live in Germany for 5 years during the 10 year period preceding the change of domicile;
  • you have retained essential economic ties with Germany;
  • you changed your domicile from Germany to a low-tax jurisdiction, or you cannot prove any tax residence at all;

In short, the extended tax liability, with certain exceptions and conditions, involves 10 more years of tax liability with all income, that would not be otherwise taxed after you left Germany, as if you would be staying its resident.

For the purposes of individual income tax estimation, a foreign jurisdiction is considered to be a low-tax one, if the overall tax burden on the individual in that jurisdiction constitutes less than two-thirds comparing to what it would be in Germany for a single person with an annual income of EUR 77,000.

If you leave Germany after you have been subject to unlimited German income tax liability for at least 10 years prior to emigration to another country, you are subject to tax on emigration. The tax is being charged on unrealized gains from the increase in the value of your share in a domestic company in which you, directly or indirectly, have owned at least 1% of the share capital at any time within the preceding 5 years.

Anti-Avoidance Regulations

German tax law provides for the following substantive instruments to prevent German taxpayers from using low-tax jurisdictions to avoid German tax liability:

  • add-back taxation, or Controlled Foreign Company (CFC) Regulations,  or intermediate companies regulations – sections 7-14 of the Foreign Tax Act;
  • case law in respect of the “foreign-base companies”;
  • general misuse provision – section 42 of the Tax Code.

Add-Back Taxation

Following the general rule, a foreign company qualifies as an intermediary company for the purposes of German tax liability, if all of the below conditions are met:

  • a German taxpayer, individual or corporate body, has a participation in a foreign company, directly or indirectly;
  • German shareholders control more than 50% share in that foreign company, directly or indirectly;
  • this foreign company is from a low-tax jurisdiction, and
  • this company has income stemmed from passive sources.

The passive income of an intermediate company in the amount attributable to the German shareholder’s share is treated as deemed dividend or imputed income. It is to be included in the personal income report as income from capital investments or business income, depending on the case, subject to full taxation in Germany. This rule applies even if that income was not yet distributed to the shareholder (add-back taxation principle).

Herewith, no regular domestic tax incentives apply. Although the income of intermediate company is generally treated as dividends, domestic German exemption rules do not apply. The add-back amount is fully taxable at the regular flat rates. Also, in case the company’s activity brings losses, they are not allowed for reduction of the German tax basis of the shareholder.

Any dividends, being paid to the shareholder from the respected income during the year of liability or the next seven years, are tax-exempt as they have already been taxed in full under the add-back principle.

Ownership and control aspects are being checked in the end of the reported year. Cross ownership doesn’t save the shareholder from tax transparency. Even the shares legally owned by the trustee are being attributed to the beneficial owner.

In case of mixed income, if passive income of the intermediate company does not constitute more than 10% of its gross receipts and it’s not more than EUR 60,000, it is disregarded for tax purposes under CFC regulations (petty provision).

If the intermediate company has its place of management in Germany, the CFC regulations are not applicable. All income of such company would be in any way fully taxable at source under the regular German taxation rules.

Low-Tax Jurisdictions

For the purposes of corporate tax estimation, a foreign company is deemed to be low-taxed if its corporate tax burden at the place of its management (or business residence) is less than 25%, be it a consequence of a regular taxation system in the whole country or in a separate free economic zone, or due to a special regime for certain types of activities (like tax exemption of holding companies’ income or income from offshore activities) etc.

A list of low-tax jurisdictions issued by tax authorities exists for indicative purposes. It is not definitive and other jurisdictions not appearing on the list might be recognized low-tax. Even in case of the existing double tax treaty add-back amount is not treaty protected.

Passive Income

Passive income is everything apart from the active income defined by the Section 8 of the Foreign Tax Act.

Active income sources include among others the following:

  • agriculture and forestry, manufacturing and assembly, exploration of mineral resources;
  • banking and insurance (where physical presence is proved and except for transactions with the related parties);
  • trading (except for transactions with the related parties when the company cannot pass the test of carrying on independent business activities);
  • services (except for transactions with the related parties);
  • renting and leasing, except for:
    • intellectual property, unless it is a result of the company’s own research with no assistance of the related German taxpayer or persons related to the latter;
    • real-estate, unless German residents can prove that their income proceeding from such business would be exempt by a tax treaty;
    • movables, unless the company can prove carrying on its own independent business without cooperation with the related German taxpayer or persons related to the latter;
  • inter-company financing activity (as income from borrowing and granting the capital), but only in case the company can prove that the funds originate from foreign capital markets and not from the related German taxpayer or persons related to the latter;
  • dividends and dividend-like distributions from other corporations;
  • gains from sale of shares in or liquidation of or decrease of share capital in other companies, providing these gains are not being allocated to the assets serving investment activities.

Anything else is passive income. However, only a low-taxed passive income qualifies under the CFC regulations.

General Misuse Provision and Foreign-base Companies

Even if the company escapes the CFC regulations, it should take into account the general misuse provision and court law.

The general misuse provision, Section 42 of the Tax Code, applies to the structures whose first aim is to bypass the German tax. The fact of lowering foreign tax burden does not trigger application of this provision.

It restricts using of foreign-base companies in low-tax jurisdictions. Foreign-base company is generally a company that was created to avoid German tax liability. Foreign entity can be recognized a foreign-base company if it cannot provide economic justification or other reasons for its interposition, and has no own business.

The burden of proof is imposed on the tax liable shareholder.

Federal Tax Court ignores foreign-base companies for tax purposes and attributes their activities and income directly to shareholders liable to German tax.

Foreign companies trading actively should not be concerned, even if based in low-tax jurisdictions.

Foreign Personal Holding Companies

Foreign personal holding companies generally escape the add-back taxation due to the reason dividends and dividend-like distributions of profits are recognized as active income. However, they will not be useful if the company’s central management and control is located in Germany – it will be taxed in full at source. Same as it cannot be used for employment purposes, if the employee is working in Germany – any work performed in Germany results in taxation in Germany.

Additional Regulations

More instruments aimed to prevent relocation of income and property to offshore territories include:

  • transfer pricing regulations (Section 1 of the Foreign Tax Act);
  • taxation of founders, beneficiaries and other members of offshore family foundations (Section 15 of the Foreign Tax Act);
  • thin capitalization rules (Section 8 of the Corporation Income Tax Act);
  • deemed profit distributions (Section 8 of the Corporation Income Tax Act);
  • relocation of the corporation’s seat outside Germany (Section 12 of the Corporation Income Tax Act).

The above is a brief and non-technical summary of the German anti-avoidance regulations and should not be used as guidance without professional advice.