Annual Tax Act 2019 tightens withholding obligation for economic employers in Germany

On November 29 the German Bundesrat approved Germany’s Annual Tax Act 2019 (Gesetz zur weiteren steuerlichen Förderung der Elektromobilität und zur Änderung weiterer steuerlicher Vorschriften “Jahressteuergesetz 2019” – “JStG 2019”). The JStG 2019 tightens the obligation of economic employers to withhold wage tax pursuant to Sec. 38(1) sentence 2 of the German Income Tax Act (ITA) from 2020 on. The sentence will in the future contain the added phrase “or should have borne under the arm’s length principle”. In particular, this will affect German companies to which employees are seconded from affiliates abroad.

Economic employers’ obligation to withhold wage tax

Under the current version of Sec. 38(1) ITA, the obligation to withhold and transfer wage tax applies to both the ‘legal’ employer (sentence 1) and the domestic ‘economic’ employer (sentence 2). The withholding obligation for economic employers was introduced in 2004 against the following background:

The double taxation treaties concluded between Germany and other countries predominantly feature the same wording as Art. 15 OECD-MC for the allocation of the right to tax income from employment. Pursuant to Art. 15(2)(b) OECD-MC, Germany has the right to tax income from employment performed in Germany if the remuneration is paid by a domestic economic employer. This applies from the first day of any cross-border secondment. Before the introduction of Sec. 38(1) sentence 2 ITA, an assessment procedure was potentially the only way for Germany to assert its right, under national and treaty law, to tax the income from employment generated by an employee seconded to Germany. This led to a risk of tax shortfalls because the domestic receiving entity (in the absence of an employment contract concluded with the seconded employee) did not qualify as a domestic employer obligated to withhold wage tax within the meaning of Sec. 38(1) sentence 1 ITA.

In dispute: Wage tax withholding obligation when costs are not charged

In connection with the concept of an ‘economic employer’ within the meaning of Sec. 38(1) sentence 2 ITA, it has been disputed whether an obligation to withhold wage tax also applies in cases where an employee on secondment performs work for the domestic entity, but the foreign-resident employer (under civil law) of the seconded employee decides not to pass on the salary expenses, even though the arm’s length principle, properly applied, would require it to do so. The tax authorities have so far taken the view that the principles developed for the interpretation of the concept of ‘economic employer’ in treaty law (Art. 15(2)(b) OECD-MC) affect the scope of the obligation to withhold wage tax pursuant to Sec. 38(1) sentence 2 ITA (see guidance issued by the Federal Ministry of Finance on May 3, 2018, Federal Tax Gazette Part I 2018, p. 643, para. 129). They reason that, according to the interpretation of the economic employer within the meaning of Art. 15(2)(b) OECD-MC, the state in which the work is performed has the right to tax if the company resident in the state in which the employee is working should have borne the remuneration costs. Whether that company actually does so has no bearing on the allocation of the right to tax income from employment.

In a legally binding decision of April 22, 2016 (8 K 3290/14, DStRE 2018 p. 468), the Tax Court of Munich opposed the tax authorities’ view of the correlation between the economic employer within the meaning of treaty law and the employer obligated to withhold wage tax within the meaning of Sec. 38(1) sentence 2 ITA. Based on the wording of that sentence, the Tax Court of Munich concluded that the domestic (receiving) entity economically bears the costs of the secondment only if the foreign (sending) entity receives financial compensation. The tax authorities’ interpretation of the provision that a wage tax withholding obligation is already in place if the domestic company “should (regularly) have borne” the remuneration has to date lacked a legal basis.

Legal amendment of the withholding obligation for economic employers

The legal amendment triggered by the JStG 2019 comes in response to the tax authorities’ interpretation, rejected by the tax court, of Sec. 38(1) sentence 2 ITA. It is intended to close what the tax authorities view as a regulatory gap. The Tax Court of Munich’s decision in effect created an option to decide on the wage tax withholding obligation of the domestic receiving company based on the allocation of the secondment expenses; in cases where those expenses are not passed on, the only way for Germany to exercise its right to tax under national and treaty law is through an assessment procedure. Following the change to the law, a domestic receiving company will be required to withhold wage tax for a seconded employee if it were in theory required under the arm’s length principle to pay the wage for the work performed. Whether financial compensation is actually paid is not relevant.

Practical consequences

• German companies to which employees are seconded from affiliates abroad will need to check in the future even more carefully if the requirements of an economic employer are fulfilled;
• Examining the underlying interests of the employee’s activities in Germany will become increasingly important. In doing so, it will be crucial to establish whether the domestic company would be obligated – irrespective of its actual practice – to bear all or part of the costs of the secondment or business trip;
• Deciding not to pass on salary (or secondment) expenses will no longer protect a foreign sending company against domestic liability claims for wage tax not transferred.