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published on 8 June 2020 | reading time approx. 3 minutes
by Dr. Dagmar Möller-Gosoge and Susanne Hierl
Income tax and social security do not generally form the focus of a tax due diligence. In most cases, all that is done is an analysis of the report from the most recent external income tax audit, and the audit reports from the pension insurance providers and/or health insurance companies. In individual cases, however, significant income tax and social security liability risks may exist within a target company. For this reason, this area should never be entirely dropped from a tax due diligence but, depending on the sector, it may even be its main focus.
An employer is liable for the income tax retained and paid for employees under the regulations. If a social security insurance obligation exists, the employer must also deduct social security contributions. Due to the lengthy time limits, which well exceed the limitations applicable for tax, retrospective social security contributions payments in particular constitute a significant potential risk.
An asset deal cannot provide a complete waiver for the extensive liability for income tax and social security contributions owed by the target company under a share deal. However, the liability of the entity taking over the company for corporate taxes in the case of an asset deal is limited to two years and to the purchase price amount of the full or partial business. Beyond that, only a guarantee or indemnity clause in the SPA (share purchase agreement) can protect against any liability for income tax and social security contributions.
Independent freelancers or others operating in similar ways, e.g. sub-contractors, may turn out to be subject to income tax and social security insurance due to the statutory regulations on self-employment. If this is only recognized retroactively, the employer has to pay the total contributions (including the employee’s share) for at least the last four years of the duration of the employment relationship. If intent to defraud is assumed, this period can be increased to 30 years.
Only in a case where the employment or contractual relationship still exists, can the employer assert claims against the bogus self-employed party. In practice, this is usually only possible to a very limited extent. There is no possibility of reimbursement of the contributions to be paid by the employer. Cases of doubt can be clarified using a request procedure for status clarification with the German pension insurance federation. In a tax due diligence process, such procedures are frequently requested.
(Senior) employees are often granted options that give them the right to acquire shares in their employer’s company or partnership at a price that is defined in advance. With regard to the tax treatment of the non-cash benefit for the employee represented by a grant of share options, in particular the question of the income tax timing frequently gives rise to legal disputes. The question of the period of receipt arises for the employer, since they have to withhold and pay income tax at the time of receipt of the non-cash benefit. If the employer fails to comply correctly with this obligation, there is a risk of him being liable for the income tax.
As part of the Tax Due Diligence, it is normal to ask whether a request for a ruling from the Tax Office was submitted in such cases.
Even without a fixed business facility, companies can create a permanent establishment for tax pur-poses just because of their activities abroad. This can be the case for construction and assembly projects that exceed a certain duration. On the other hand, so-called representatives dependent on the company who are abroad can constitute a permanent establishment for tax purposes of the German company.
Internationally, there is a general consensus that the permanent establishment concept does not always correctly reflect current business models. In many cases, taxation can be avoided through lack of a physical presence in the source state, even though a significant part of the value creation takes place there. Given this, the OECD proposed an expansion of the permanent establishment concept in 2015, among other things. In future, for the establishment of a permanent establishment for tax purposes, it should be sufficient if representatives can act with de facto power of negotiation, or that these persons play a significant role in the conclusion of contracts.
Germany is still cautious with regard to the implementation of this new definition of the concept both in German law and in German double taxation agreements. Internationally, however, there is a clear and growing tendency to assign a tax liability to local representation, which may consist simply of individual employees, based on their local business activities, for example in the context of service facilities.
This means for employees employed in cross-border situations that their activities may in some circumstances constitute a permanent establishment for tax purposes for the employer. This will then automatically lead to local taxes and, where applicable, social security contributions for the employee. The social security obligation abroad needs to be checked for each individual case and can only be avoided by submitting the necessary applications in advance for starting up the cross-border activity. A retrospective certificate can only be obtained in rare cases.
As part of the Tax Due Diligence, we therefore analyse whether cross-border employee deployment could potentially lead to foreign permanent establishments for tax purposes, which in turn would mean not only foreign corporate taxes, but also taxes and charges for employees.
If the obligation for tax and other deductions is identified for the overseas employees as part of the tax due diligence or foreign business audit, then there will normally be a risk of double taxation if the salary also continues to be subject to income tax and social security withholding in Germany.
The “183-day rule” is now often no longer applied when looking at cross-border employee deployment within a company structure with permanent establishments. Usually, employees are only subject to taxation in the country in which their work is performed if
As, under international principles, a permanent tax establishment can generally not be an employer, “Employees of the permanent establishment” will be subject to tax and, if relevant, to social security charges from their first day of work in the country of the head office. In this case too, a review is needed, and the relevant applications should be submitted. The same applies to the reverse case when “Employees of the parent company” are working in the country of a permanent establishment; they are also subject to tax in the country of the company’s permanent tax establishment from the first day of working there, regardless of the “183-day rule”. As the employer is liable for the correct deduction of income tax, in these cases there are significant risks relating to tax and other charges for both employees and companies.
The employer is liable for making income tax and social security payments on behalf of their employees. In practice, it may often not be possible to reclaim any additional charges from bogus self-employed people or subcontractors. Additional charges for employees are usually borne by the employer through loss compensation by the employer.
Retrospectively identified income tax and social security obligations therefore always lead to increased wage costs and compliance expenses. Ideally some initial starting points for tax improvements can be identified as part of the Tax Due Diligence.
Thorsten Beduhn
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