Anti-treaty shopping rule: German tax court lowers substance requirements

The German anti-treaty shopping rule under Sec. 50d(3) of the German Income Tax Act (ITA) is designed to prevent abusive relief from withholding tax on dividends and interest. It is highly controversial, and the European Court of Justice has found that it conflicts with European law, particularly with regard to EU dividends.

On January 23, 2019, the tax court of Cologne decided that the former version of Sec. 50d(3) ITA applies only to a limited extent to interest payments in a treaty context, as is the case for dividends paid within the EU. The case law principles established by the European Court of Justice therefore apply to interest payments. Consequently, the substance requirements have been lowered. In particular, the substance requirements do not necessarily have to be met at the level of the nonresident interest-receiving company itself. It may be sufficient for them to be met at the level of an affiliate residing in the same country, such as a management company providing services to the interest-receiving company.

Background

Dividends and interest paid by a German company to a nonresident payee are initially subject to German withholding tax of up to 25% plus solidarity surcharge. However, the nonresident entity can be entitled to withholding tax benefits on the basis of EU law (and the EU Interest and Royalties Directive for interest payments) and/or a tax treaty (and Art. 11 of an applicable tax treaty for interest payments).

Nevertheless, a nonresident dividend-/interest-receiving company may not be entitled to any relief from German withholding tax, unless

• it has shareholders who would also be entitled to treaty relief if they directly received the tax-inducing payment, or
• the gross income earned by the nonresident payee derives from its own genuine economic activity, or
• with regard to income from non-genuine economic activity (i) there are economic or other substantial reasons for the nonresident payee to be involved and (ii) the nonresident payee participates in general economic transactions with a business operation suitably set up for its business purpose.

The European Court of Justice (ECJ) ruled that Sec. 50d(3) ITA breaches EU law in connection with EU dividends (see Christian Kahlenberg’s blog in German).

In response, the Federal Ministry of Finance published an administrative guideline dated April 4, 2018, stating that the old version of Sec. 50d(3) ITA no longer applies to dividends paid to EU/EEA shareholders before January 1, 2012. The substance requirements have been lowered for the new version of Sec. 50d(3) ITA concerning dividends paid to EU/EEA shareholders after December 31, 2011.

Domestic case law on cross-border interest payments

In the case under consideration, the plaintiff is a Cypriot corporation that subscribed to a convertible bond issued by a German-resident corporation. The bond has an interest rate of 5.5% p.a. In addition, the plaintiff held a total stake of 15% in German corporation. The plaintiff’s business model is to acquire and hold interests in companies in the shipping industry as a strategic and financial investor. During the period in dispute, the plaintiff held only the stake in the German corporation.

Management of the plaintiff was conducted by an affiliate based in Cyprus that employed its own personnel and used office space containing the necessary work equipment and communication devices. The plaintiff used the office of the affiliate management company and had no physical presence of its own in Cyprus.

The plaintiff applied for a withholding tax refund of 15% on the interest paid in 2010 and 2011 on the legal basis of Sec. 50d(1) sentence 2 ITA and Art. 11 of the Cypriot-German tax treaty. The German tax authorities rejected the refund request on the legal basis of the German anti-treaty shopping rule under the former version of Sec. 50d(3) ITA.

Limited income tax liability for interest from convertible bonds

In its judgment of January 23, 2019, the tax court of Cologne affirmed the limited income tax liability of the Cypriot plaintiff in Germany with the interest from the convertible bonds. The limited income tax liability stems from Sec. 49(1) no. 5a ITA. This is justified by the literal reading of the norm, the statutory system and the history of that norm. However, the questions arising are precisely why the case is now pending at the Federal Tax Court.

Relief from withholding tax on interest payments

The tax court of Cologne also affirmed that the Cypriot plaintiff had a claim for relief from withholding tax on interest. This claim is based on Art. 11 of the tax treaty between Cyprus and Germany (in conjunction with Sec. 50d(1) sentence 2 ITA).

In the Cologne tax court’s view, the anti-treaty shopping rule stipulated in Sec. 50d(3) ITA does not prevent this, although the payment-receiving plaintiff had no personnel and no office premises of its own.

Limitations of the anti-treaty shopping rule

The German tax authorities’ denial of the relief from withholding tax on interest was rightly rejected by the tax court of Cologne. Against the background of the ECJ decision, the tax court of Cologne does not apply the former version of Sec. 50d(3) ITA without restriction. Instead, it limits the scope of the anti-treaty shopping rule, which preserves its validity.

According to the ECJ’s judgment of October 20, 2017 (ref. no. C-504/16, C-613/16, Deister Holding/Juhler Holding), the anti-treaty shopping rule stipulated in Sec. 50d(3) ITA does not exclusively serve the prevention of purely artificial arrangements that have no economic grounds and are established solely for the purpose of using unjustified tax advantages. The German anti-treaty shopping rule merely contains an irrebuttable presumption of abuse based on given general criteria, i.e. it does not give the foreign payee the opportunity to prove the existence of economic grounds. This violates European law.

In line with the principles developed by the European Court of Justice, a refund of withholding tax cannot be denied simply because the foreign payee does not have its own, duly set up, business. The rationale is that the group of companies to which the plaintiff belongs also had a Cypriot management company whose role was not abusive. The management company is of a permanent nature and had its own adequately equipped business operations in the form of its own offices and employed staff. It therefore carried out a true economic activity. In the tax court’s view, this is sufficient for a claim for relief from withholding tax in favor of the plaintiff.

No stand-alone approach for the anti-treaty shopping rule

The tax court of Cologne also refers to established case law on the earlier anti-treaty shopping provision (see Federal Tax Court of May 31, 2005, I R 74/04, known as the Hilversum II decision). In connection with asset-managing intermediate companies, an abusive, tax-driven structure cannot be assumed in the case of an active group company that is domiciled in the same country and of a permanent nature. Since the plaintiff and the affiliated management company, which provided management services for the plaintiff, are of a permanent nature, there is no abuse of laws in the case under dispute.

The stand-alone approach, as stipulated in Sec. 50d(3) sentence 2 ITA, does not stand in the way of this. In the light of the European free movement of capital and the case law principles of the European Court of Justice, the German anti-treaty shopping provision must be interpreted in such a way as to preserve its validity. In the case at hand, this means the stand-alone approach must be restricted. Hence, the facts and circumstances of the affiliated management company with substance can be attributed to the plaintiff.

Implications for nonresident taxpayers

The tax court of Cologne dealt with the application of European case law on the former version of Sec. 50d(3) ITA and with regard to interest (from convertible bonds). The court’s conclusions are good news for taxpayers. They should also apply in relation to the currently applicable version of Sec. 50d(3) ITA, which the ECJ also considers to be contrary to European law.

The anti-treaty shopping rule under Sec. 50d(3) ITA requires a certain level of substance in the residence country of the nonresident interest-receiving company. The tax court of Cologne assumes a substance to be sufficient if

• office or business premises,
• personnel, and
• means of communication

are available in the residence country of the interest-receiving company. Whether the interest-receiving company itself has the required level of substance is not decisive. Rather, it is sufficient if (any) affiliated company has such a level of substance, as long as it is based in the same country. In addition, the substance requirements for purely asset-managing companies should not be subject to excessive requirements. In the case at hand, services were also provided by the affiliated company with substance to the interest-receiving company without any substance. However, the assumption of a sufficient level of substance should not depend on the provision of certain services between the associated companies, i.e. this issue was not decisive in the case under dispute.