According to the Draft Guidance with reference to the case law of the Federal Tax Court (BFH), profits that were

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1 German Tax Monthly May 2014 May 2014 German Tax Monthly Content Limitation of Corporate Tax Loss Deduction (Draft BMF Guidance) Limitation of Corporate Tax Loss Deduction (Draft BMF Guidance) According to the loss limitation rules (specified in section 8c of the German corporate income tax law), loss carryforwards and losses not utilized by a corporation are forfeited partially, if within a period of five years more than 25 % of, inter alia, the share capital in a corporation is transferred to an acquirer or a so-called group of acquirers (detrimental change in ownership). Where more than 50 % of the shares are transferred, loss deduction will be completely denied. On 15 April 2014, the Federal Ministry of Finance (BMF) issued a Draft Guidance on the corporate tax loss limitation rules. The new guidance shall replace the existing BMF guidance of 4 July In contrast to the existing BMF guidance of 4 July 2008, the Draft Guidance deals in particular with the mid-year change in ownership as well as the group exemption provision and the hidden reserves provision, which were newly included in 2009 and partly amended in Mid-year change in ownership If the detrimental change in ownership occurs during the current business year, any loss incurred up to this point in time is subject to the limitation of loss deduction. According to the Draft Guidance with reference to the case law of the Federal Tax Court (BFH), profits that were generated in the period up to the change in ownership may be offset against losses not yet used provided that the minimum taxation of profits is observed. Offsetting, however, shall only be considered if the overall result of the business year in which the detrimental change in ownership occurs is positive. If profits are generated before the detrimental change in ownership and losses incurred after the detrimental change in ownership, the profits or losses must first be netted. Pursuant to the Draft Guidance, the earnings of the entire business year shall be allocated according to economic criteria to the period of time before and after the change in ownership. This can be carried out by way of an interim financial statement. Insofar as no interim financial statement is prepared, the allocation of earnings shall be estimated. In case of a tax group ( Organschaft ), there shall be a separate application of the loss limitation rules on the level of the controlling entity and on the level of the controlled entity, i.e. before the attribution of income from the controlled to the controlling entity. 2. New Double Tax Treaty with the People s Republic of China 3. Tax Group: BFH (I R 45/12) Ruling on the Early Termination and Minimum Term of Profit and Loss Absorption Agreements 4. BFH (I B 85/13): Serious Doubts about the Constitutionality of the Earnings Stripping Rules 5. Treatment of Interest on Back Taxes and Tax Refunds for Income Tax Purposes 6. Lower Tax Court of Nuremberg (5 K 1552/11): Repayment of Equity from Corporations in Non-EU Countries 7. Corporate and Indirect Tax Rate Survey 2014 Responsible Dr. Martin Lenz mlenz@kpmg.com Published by KPMG AG Wirtschaftsprüfungsgesellschaft The Squaire, Am Flughafen Frankfurt/Main, Germany Editorial Team Prof. Dr. Gerrit Adrian Alexander Hahn Andreas Martin Christian Selzer Dr. Dennis Weiler

2 2 / German Tax Monthly / May 2014 Group exemption provision Pursuant to the group exemption provision, a detrimental change in ownership does not exist if the same person directly or indirectly holds 100 % of the shares in the transferring and the acquiring entity. As a result, unused losses are entirely preserved. According to the draft guidance, the transferring entity is the entity holding the shares in the loss making company before the transfer of shares. The acquiring entity is the entity holding the shares after the transfer of shares. There must be a shareholding relationship between the same person and the transferring and the acquiring entity. Pursuant to the BMF Guidance, this requirement is not met if e.g. an individual, a foundation or a local authority is either the transferring or the acquiring entity. In addition, the group exemption provision shall not be applicable if there is more than one shareholder in the transferring or the acquiring entity (e.g. in the case of a listed company or a partnership held by natural persons only). This could lead to the conclusion that there is no application of the group exemption provision in the case of transfers of shares to and from the top entity of a tax group. Hidden reserves provision The hidden reserves provision provides for a non-forfeiture of tax losses in the case of a detrimental change of ownership insofar as the losses do not exceed the taxable hidden reserves of the domestic business assets of the corporation. Only the hidden reserves, that are taxable in Germany, are relevant for the hidden reserves provision. Hidden reserves from shares in corporations shall generally be excluded. According to the Draft Guidance, hidden reserves from the participation of the loss-making company in a partnership are not to be considered on the part of the loss-making company for trade tax purposes. However, there is a consideration for corporate tax purposes in proportion to the company s ownership interest. The BMF Draft Guidance explains that direct detrimental changes in ownership may trigger indirect detrimental changes in ownership at the same time. The determination of the amount of the hidden reserves contained in the lossmaking subsidiary shall generally be based on the purchase price paid for the acquired company. In deviation from this, the taxpayer may provide evidence for the hidden reserves contained in the loss-making company e.g. by submission of a valuation of the company, according to the Draft Guidance. According to the BMF Guidance, hidden reserves in the business assets of the controlled company of a tax group are not to be considered on the part of the controlling entity of a tax group. As a result, the hidden reserves in the business assets of the controlled company may only be used for the current losses and the losses that were incurred before the formation of the tax group. Outlook The BMF Draft Guidance has now been sent to the trade associations, who may submit their comments by 27 May New Double Tax Treaty with the People s Republic of China On 28 March 2014, a new Double Tax Treaty between the Federal Republic of Germany and the People s Republic of China was signed in Berlin (DTT China 2014). The new DTT China is partly at variance with the OECD Model Tax Convention 2010 (OECD MTC 2010) and the German basis for negotiation for DTT (please find detailed information in June 2013 edition of German Tax Monthly). The Authorised OECD Approach (AOA) for profit attribution to permanent establishments was not included. The arm s length principle shall continue to apply to the apportionment of profits between head office and permanent establishment in accordance with the old OECD MTC However, at least the protocol with reference to Art. 7 of the DTT China 2014 includes the willingness to refer to the OECD Model Commentary on the OECD MTC 2008 in interpreting and applying the provisions of the Permanent Establishment Article. The withholding tax on dividends shall generally not exceed 10 %. The withholding tax rate is reduced to 5 % if a company directly holds at least 25 %. Partnerships as recipients of the dividends, however, are excluded from this participation exemption. For dividends derived from certain investment vehicles, the withholding tax rate must not exceed 15 %. In the case of Germany, an investment vehicle is a company according to Sec. 1 (1) REIT Act. Moreover, interest and royalties may be taxed in the State of residence of the recipient or beneficial owner (creditor). However, the right to levy withholding tax must not exceed 10 %. Generally speaking, the assessment basis for royalties is the gross amount. In the case of payments received as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment, however, the assessment basis shall amount to 60 % of the gross amount of the royalties. In these cases, the withholding tax amounts effectively to 6 %. Gains from the alienation of immovable property as well as gains from the alienation of shares in property companies may be taxed in the State where the property is situated. Gains from the alienation of other corporate shares may be taxed in the State of residence of the company if at any time during the 12 months period preceding the alienation at least 25 % of the shares of that company were directly or indirectly owned. This does not apply to the alienation of shares that are traded on a stock exchange provided that the total of quoted shares alienated during a fiscal year does not exceed 3 %.

3 3 / German Tax Monthly / May 2014 In addition, a comprehensive exchange of information according to the latest OECD standard was included in the new treaty. Due to the newly added so-called extended exchange of information clause, Germany and China exchange information to apply and enforce domestic law. Germany generally applies the exemption method to any income arising in China that may be taxed in China according to the DTT China Income from dividends shall only be exempted if such dividends are paid to a company (not including partnerships) resident in Germany that directly owns at least 25 % of the shares in the distributing (Chinese) company provided that the dividends were not deducted when determining the profits of the distributing company. The credit method, however, is applied in particular to dividends that are not covered by the exemption method, interest and royalties. A deemed Chinese withholding tax credit in the amount of 10 % for dividends or 15 % for interest and royalties is no longer provided for. A switch-over from the exemption method to the credit method shall be affected in particular with regard to the dividends of a Chinese company and the profits of a permanent establishment if derived exclusively or almost exclusively from passive activities. The same applies to conflicts of qualification if items of income are placed under differing provisions of the Agreement or attributed to different persons and if as a result of this difference in placement or attribution the relevant income would remain untaxed or be taxed lower than without this conflict. The DTT China 2014 is not applicable to Hong Kong and Macau as the Chinese tax law is not applicable in these two special administrative regions. The German Institute Taipei and the Taipei Representative Office in Germany concluded a separate tax treaty with Taiwan, which entered into force on 7 November 2012 (please find detailed information in February 2012 edition of German Tax Monthly). The DTT China 2014 has not yet entered into force. It requires transposition into the national law of both Contracting States as well as subsequent mutual notification thereof. The DTT China 2014 shall enter into force on the thirtieth day following the day on which the last notification is received and shall have effect as of 1 January of the following calendar year. With the entry into force of the new DTT, the old DTT China of 10 June 1985 shall expire. 3. Tax Group: BFH (I R 45/12) Ruling on the Early Termination and Minimum Term of Profit and Loss Absorption Agreements Where a corporation with its place of management in Germany (controlled company) agrees to transfer all its profits to a single other commercial business (controlling entity) by a profit and loss absorption agreement (PLAA), the controlled company s income is attributed to the controlling entity for income and trade tax purposes. One requirement in this context is that the profit and loss absorption agreement is concluded for a term of at least five years and that it is effectively implemented throughout its entire duration. An early termination is to be recognized for tax purposes to the extent that the termination is justified by good cause. In a ruling of 13 November 2013, the BFH voiced its opinion as to whether a contractually agreed early termination of the PLAA may be deemed good cause for termination within the meaning of the relevant tax law provisions (see 1.). In the case at hand, the reason for the early termination was that from the perspective of the parties to the agreement, the purpose of the agreement of offsetting losses has been fulfilled. In addition, the BFH gives its view as to whether shortening the required total term of five years because the controlled company applied an abbreviated financial year prevents the recognition of the tax group for tax purposes (see 2.). In the case under dispute a limited partnership (Kommanditgesellschaft, W-KG) was the sole shareholder of a GmbH. The two companies concluded a PLAA on 12 May 2005 for a term of five years. The agreement was to be applied for the first time to the fiscal year of the GmbH (controlled company) deviating from the calendar year and beginning on 1 July The agreement provided for the possibility of early termination in case the shares in the controlled company are sold. With the consent of the local tax office, on 25 November 2005 the GmbH shifted its fiscal year to the period 1 April - 31 March (previously 1 July - 30 June). With an agreement dated 6 March 2007 the PLAA was terminated in mutual agreement with effect as of 31 March 2007, following the sale of W-KG s shares in the controlled company to the parent company of the German subgroup. The local tax office retroactively denied the recognition of the tax group. According to the tax office s view, the required minimum term of five years was not observed as the agreement has been terminated without good cause. The tax office is of the opinion that a contractually agreed cause for early termination of the PLAA cannot constitute good cause for the purposes of tax law in order to avoid arbitrary terminations of tax groups. 1. The BFH confirmed the view of the tax authorities. The principles applied to the extraordinary termination of a contract for good cause under civil law do not necessarily apply to the interpretation of the concept of good cause under tax law. According to the BFH the (tax-law specific) requirement of a minimum term is alien to the civil-law requirements for an effective PLAA. A contractually agreed good cause for termination with the sole intention of limiting the legal consequences of the tax group by means of a cancellation of the agreement cannot be compatible with the purpose and meaning of a minimum contract duration which is meant to avoid arbitrary influences on taxation. The BFH is convinced that, in order to avoid an undermining of the required fiveyear period by means of contractual arrangements, an early

4 4 / German Tax Monthly / May 2014 termination must be derived from objective reasons according to the inherent standards of tax law instead of being based on an arbitrary decision of the contracting parties. 2. However the BFH emphasizes that, opposed to the contractually agreed cause for early termination in the case at hand, the shift and abbreviation of the first fiscal year of the controlled company does not affect the recognition of the tax group under tax law, because the agreement was subject to the reservation of an extraordinary termination for good cause expressly concluded for a term of five years. The BFH denied a general statutory requirement that this minimum term of five years must be met in the form of five fiscal years comprising twelve months each. The fact that, as a consequence of the shift of the fiscal year, the agreed five years will possibly end in the middle of a fiscal year of the controlled company does not question the minimum term agreed at the point in time of the conclusion of the agreement. In this case, however, it has to be noted that the agreement shall not be terminated in the middle of the fiscal year since a mid-year termination would be deemed retroactively tax effective on the beginning of the fiscal year. Thus, the tax group would not be effectively performed over five years for tax purposes. 4. BFH (I B 85/13): Serious Doubts about the Constitutionality of the Earnings Stripping Rules According to German tax law expenses caused by the operating activities of a taxpayer are tax-deductible and generally reduce the tax assessment base (so-called objective net principle). In the case of interest expenses, however, the earnings stripping rules must be observed pursuant to which the deduction of interest as business expenses is limited under certain circumstances. In this context the question arises whether the limitation of the deduction of interest as business expenses constitutes an unjustified breach of the objective net principle and thus a violation of the general principle of equality laid down in the constitution. In the case at issue the plaintiff incurred large amounts of interest expenses in the year under dispute 2008 which were only partly tax-deductible due to the application of the earnings stripping rules. The plaintiff filed an administrative appeal against the corporate income tax assessment for constitutional concerns and, in parallel, applied for a suspension of execution. When a taxpayer applies for a suspension of execution he can achieve that the payment of the taxes assessed in the assessment notice is suspended until further notice. The precondition is that there are serious doubts about the lawfulness of the disputed assessment notice. In addition, the taxpayer must have a legitimate interest in the suspension of execution that deserves priority over the public interest in the enforcement of the law. In the case at hand both the local tax office and the Lower Tax Court of Münster refused to grant the suspension. They agreed that serious concerns existed with regard to the constitutionality of the earnings stripping rules. However, they did not find that the applicant s interest in the suspension deserved priority over the public interest in the enforcement of the law. It was now up to the BFH to decide whether the plaintiff is granted the suspension or not. According to the view of the BFH there are serious doubts as to whether the limitation of the deduction of interest expenses under the earnings stripping rules is compatible with the general principle of equality laid down in the constitution. The BFH regards the limitation of the deduction of interest expenses as business expenses as a breach of the objective net principle and has serious concerns as to whether this breach is justified. The BFH explains that the earnings stripping rules - at least as set out today - cannot be justified as a means to fund tax rate reductions such as the reduction of the corporate income tax rate from 25 % to 15 % or the change of the basic trade tax rate from a maximum of 5 % to a uniform rate of 3.5 % under the 2008 Business Tax Reform Act. The BFH does not see, either, that the earnings stripping rules are required as a means to stabilize tax revenues or prevent unpredictable tax losses. Furthermore, the earnings stripping rules cannot be justified as a measure to prevent abuse, or to counteract an erosion of the domestic tax base or abusive arrangements. The BFH decided that, apart from that, the plaintiff must be granted the suspension in the case at hand. In the view of the BFH the plaintiff has a particular interest in the suspension which deserves priority over the public interest because the danger of lower tax revenues for the public purse is comparatively low. 5. Treatment of Interest on Back Taxes and Tax Refunds for Income Tax Purposes According to German tax law, a general interest rate of 0.5 % per month applies to back taxes and tax refunds arising after a waiting period of 15 months (beginning at the end of the assessment period) where tax assessments deviate from the up to then paid tax amount. In the case of tax refunds, interest is paid benefiting the taxpayer (interest on refund amounts), in the reverse case the taxpayer has to pay the interest liability (interest on back taxes). Interest on back taxes may not reduce the profit determined for income tax purposes. This applies to individuals as well as to corporations. As opposed to this, interest on refund amounts received by individuals or corporations is subject to tax. The consequence is that the tax treatment of interest on back taxes and of interest on refund amounts differs. According to a recent administrative guideline issued by the Regional Tax Office (OFD) of Lower Saxony, the differing tax treatments of interest on back taxes and interest on tax refunds may, in individual cases, lead to substantive inequity. This may happen, where both back taxes and tax refunds

5 5 / German Tax Monthly / May 2014 are due from or to the same taxpayer based on one and the same event. An event in this sense is an individual transaction that increases and reduces taxes in different assessment periods, but is closely related in terms of time and substance. Upon application, the OFD therefore permits by means of an equitable relief for factual reasons to offset the interest on back taxes with interest on refunds. The application has to be filed with the competent tax office. Example: As a result of a tax field audit a corporation s inventory increased as of 31 December 2010, leading to a higher profit and correspondingly higher corporate income taxes for the assessment period 2010, on which interest on back taxes falls due. However, with regard to the year 2011, the profit adjustment leads to a profit reduction, lower corporate income taxes and interest on tax refunds. Both interest cases are related to the same event (profit shift between periods in the context of a tax audit). Based on the OFD's guideline it would be possible in this case to apply offsetting of interest on back taxes and interest on tax refunds for equitable reasons. 6. Lower Tax Court of Nuremberg (5 K 1552/11): Repayment of Equity from Corporations in Non-EU Countries Pursuant to German tax law, a distinction has to be made between profit distribution and repayment of a contribution (nominal capital, capital reserve). Repayments of contributions are not taxable. In order to distinguish between profit distributions on the one hand and capital repayments on the other hand, German corporations have to carry a special account called "contribution account for tax purposes. All contributions not made to the nominal capital (including constructive contributions) have to be shown in this account. Only payments reducing the nominal capital or the contribution account for tax purposes are tax exempt. The problem is that "contribution accounts for tax purposes are an unknown concept in foreign countries. In the past, the BFH ruled that if a foreign corporation lacks a contribution account for tax purposes, this does not automatically mean that all payments made by this corporation to its German shareholders are treated as profit distributions. A capital repayment is assumed, where a payment is considered to be a capital repayment under the pertinent foreign commercial law or company law (in the case at hand US law). In 2006, the German rules on contribution accounts for tax purposes were extended to EU corporations. For a domestic taxpayer to be able to receive tax exempt capital repayments from a EU corporation the EU corporation has to prove that the payment originates from the nominal capital or the contribution account for tax purposes. Without such proof, payments from a foreign EU corporation have to be regarded as profit distributions. No statutory provisions were established for corporations residing in non-eu countries. It is therefore questionable, whether payments from corporations in non- EU countries are generally deemed profit distributions or whether the above BFH principles continue to apply unchanged. In its recent ruling of 12 June 2013 the Lower Tax Court of Nuremberg (5 K 1552/11) confirmed the continuing application of the BFH s principles. The ruling applies to the case of a US corporation (A) that carried out a "spin-off." In connection with the "spin-off", shares of another (US) corporation (B), which were previously held as part of the assets of A, were distributed to the shareholders of A. In the context of the "spin-off", every shareholder of A obtained another share in B for each share in A. The local tax office had assumed that any payment from a corporation residing in a non-eu country had to be regarded as profit distribution because of the absence of statutory provisions on contribution accounts for tax purposes for corporations residing outside of the EU. The Lower Tax Court of Nuremberg, in contrast, decided that capital repayments from a corporation in a non-eu country shall not be regarded as taxable income from capital, if the pertinent foreign commercial law or company law assumes a repayment from capital reserves. Appeal has been filed with the BFH (VIII R 47/13). 7. Corporate and Indirect Tax Rate Survey 2014 Under the following Link you find KPMG s International Corporate and Indirect Tax Survey. It compares corporate and indirect tax rates from over 130 countries. * * * * The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. 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