German withholding tax as an investment and tax planning trap?

25/04/2022

Modernisation of the relief procedure for withholding taxes on capital gains

When international companies establish a local subsidiary in Germany, they should always consider the specifics of the withholding tax refund procedure in addition to the Double Taxation Treaty (DTT). Poor planning or errors in the application can quickly lead to double taxation and significant compliance efforts and costs. The already complicated and lengthy procedure has become even more complex as a result of the modernisation enacted in 2021.

Germany has been regarded as an attractive location for investment and holding companies from a tax perspective until now. For example, the German basis for negotiations concerning double taxation treaties provides for an exemption of 95% for recipients of intercompany dividends and an exemption of 85% for free float dividends. The EU Parent-Subsidiary Directive goes even further with a 100 percent exemption.

However, withholding tax on investment income must be deducted regardless of any overriding regulations. The foreign parent company can only recover the excess withholding taxes paid under the relief procedure from the Federal Central Tax Office (BZSt). Only those who successfully follow this procedure through to the end can avoid an effective tax charge of approximately 26% on retained earnings.

The procedure was partially revised in 2021 through the Act on the Modernisation of Relief from Withholding Taxes (Abzugsteuerentlastungsmodernisierungsgesetz, AbzStEntModG). The legislator had different objectives in mind when redrafting the regulation: on the one hand, the CJEU ruling regarding the violation of the freedom of establishment and, on the other, the implementation of the Anti-Tax Avoidance Directive (ATAD) to combat abuse.

As a result, the risk has increased that the procedure will become a protracted and also costly long drawn-out affair. Since there is currently also no updated circular from the Federal Ministry of Finance (BMF), the uncertainty is further increased.  But there are bright spots as well.

Proof of personal entitlement to relief and entitlement to relief under the substance test

Pursuant to Section 50d (3) of the German Income Tax Act (Einkommensteuergesetz, EStG), only the actual beneficiary of the inflows behind the payment creditor is entitled to relief in this respect. The person must therefore also be entitled to relief himself. As a result, the personal entitlement to relief must be reviewed individually for each indirect beneficiary of the distribution and the positive shareholding ratios added together. The practical side of this requirement is already posing considerable (documentation) challenges for tax advisers and tax managers of multinational companies.

In addition to the personal entitlement to relief, the entitlement to relief under the substance test must also now be proven. Accordingly, the receiving company must be able to demonstrate a significant connection with the economic activity of the payment debtor and also an appropriate business operation for this purpose.

Since the requirements are cumulative according to the wording of the law, it is theoretically no longer possible to assume relief in the case of an applicant that performs little activity or is economically active elsewhere. As in the past, shareholders who are not entitled to relief may be denied relief on a pro rata basis somewhere in the shareholding chain. More often than not, when it rains, it pours.

In addition, there are ambiguities regarding the substance requirement for the applicant or the scope of the “to the extent” reference in the substance entitlement test. There is a clear need for this to be clarified in a BMF circular.

Practical scope of the escape clauses

As before, a payment creditor listed on a stock exchange is exempt from the obligation to furnish proof (at least with regard to its shareholding). However, following the tightening of the law, an indirect shareholder with a stock exchange listing is no longer sufficient. This means that intermediate holding structures of listed groups must also be regarded as fundamentally at risk.

One can infer from the newly introduced provision with a cautious degree of confidence that relief will ultimately be granted even if the requirements are not met if “none of the main purposes (…of the dividend recipient…) is to obtain a tax advantage”, Section 50d (3) sentence 2 EStG. The applicant needs to therefore prove his innocence here. The practical scope of this “principal purpose test” rule, which became known in the context of the base erosion and profit shifting (BEPS) initiative, is currently also made difficult as there are many grey areas due to the lack of an up-to-date BMF circular. A search of the literature suggests that so-called meander structures as well as actively managed investment holding companies are to receive the sought-after relief. There is hardly any practical experience of this.

Even more promising seems to be the proof of the properly established business operations of the applicant. It is interesting to note here that the BZSt questionnaire considers this proof in the EU intercompany dividend case to be sufficient as an alternative rather than in addition to the personal relief entitlement in order to benefit from the exemption. There is reason to suspect that this proof of economic activity is interpreted in a quasi-redundant manner with respect to the proof that there are no abusive arrangements pursuant to Section 50d (3) sentence 2 EStG. This would indeed be a significant simplification for all structures that are not purely tax motivated. However, it is important not to celebrate too soon, as the BZSt wants to know exactly what is going on and would even like to see the applicant’s telephone connections, rental agreements and payroll journals, for example. So here, too, a cross-border coordinated copying or scanning operation is needed to deliver the documents on time. As an aside, regulations regarding data protection and trade secrets must be complied with, so, for example, the documents would have to be redacted accordingly before being sent. This can be a tedious job in the case of payroll records.

Other important aspects

In addition to the extensive documentation requirements, practical aspects must also be taken into account to ensure that the process does not fail in the end. For example:

  • An exemption is valid at the earliest from the date of the application submitted to the BZSt. This should definitely be taken into account when making dividend decisions. Otherwise, the withholding tax must be reimbursed or a notice of liability may even be issued. In the worst case, a refund application must then be submitted immediately after the application for exemption (if the application was submitted too late for the dividend).
  • The requirement to provide the applicant’s tax residency certificate has almost become a classic in the catalogue of problems.  There have already been numerous cases in the EU where the issuing of such a certificate by the local tax authorities has proved to be very difficult.  Where third countries are involved, this can ultimately mean the end of the road if the relevant certificate cannot be provided. At least with regard to the form, the BZSt is now prepared to accept forms from other authorities as well, provided they are written in English.
  • Since it can take even years for a final decision to be made regarding the applications, it is important that an application be filed in good time.
  • An arm’s length test is not carried out in the context of withholding tax. Transfer pricing should therefore also be borne in mind in order to avoid paying withholding tax on the distribution of excessive retained earnings in Germany. This applies all the more if a subsequent adjustment cannot be ruled out for procedural reasons.

In conclusion, it should be noted that in the case of economically justified structures, a refund procedure can be successful. However, the process must be carefully prepared in order to successfully obtain the requested refund or exemption and to avoid double taxation.

Alexander Schabowski ([email protected]), Tax consultant and MBA. Member of Auren’s Global Taxperts team – our experts for cross-border tax issues