New subject areas in Tax DD under ATAD: Foreign Tax Act

On 24 March 2020, the second draft of the Act on the Implementation of the EU Anti-Tax Avoidance Directive (ATAD-UmsG) was published. On 28 September 2020, the Finance Committee of the German Bundesrat surprisingly included its own ATAD implementation proposals in its recommendations for an opinion concerning the government draft of the Annual Tax Act 2020. It is therefore still quite possible that, in addition to the Controlled Foreign Company (CFC) rules, there will be central changes in intra-group financing under Article 1a of the Foreign Tax Act (AStG).

Controlled foreign company rules

German CFC rules constitute a deviation from the so-called separation principle, so income arising in foreign subsidiaries and permanent establishments becomes taxable in Germany. Although the regime under the Act remains unchanged, changes are expected to be introduced to the so-called list of activities which exhaustively defines income exempt from the CFC rules. In future, for example, charging interest will be considered harmful without exception and dividends will have to be treated differently depending on the tax already paid and the size of the shareholding.

As a trend towards lower tax rates can be observed worldwide, CFC rules are increasingly focusing on foreign subsidiaries and permanent establishments. If it turns out that the foreign income is taxed at a rate of less than 25 percent (as determined according to German regulations), the rate is considered by the legislator as a low tax rate.

Interest and investment income of foreign holding companies in low-tax countries may then become subject to CFC rules in Germany. According to the recommendation of the Finance Committee of the German Bundesrat, the low tax rate threshold should be lowered to 15 percent. However, countries such as the Netherlands or the USA are currently considered low-tax countries under the Foreign Tax Act.

The same may apply to foreign subsidiaries and permanent establishments in whose local business German group companies are quite considerably involved. If, for example, a German head office posts employees abroad to help in sales activities or in the provision of services, this may constitute a harmful practice within the meaning of the Foreign Tax Act.

Failure to identify that CFC rules apply to a given matter can lead to high liquidity outflows on the part of the German parent as tax claims are subject to high interest rates, and these liquidity outflows should be identified during tax due diligence.

Intra-Group Financing

The planned Article 1a (1) AStG-E (draft) would introduce a cap on the deduction of expenses for tax purposes arising from cross-border financing relationships within an international corporate group under certain conditions.

If the provision is implemented in the version of ATAD-UmsG as drafted, it will be necessary in future to examine whether a third party would have granted the loan to the corporate company under the same conditions. Such examination would focus on the solvency of the borrower and on determining whether taking out the loan was economically necessary judging by the object of the company. If yes, it should then be clarified whether the parties have agreed an interest rate at arm's length.

The determination whether the agreed interest rate is at arm's length is made based on the refinancing costs of the multinational group and thus, de facto, creditworthiness of the group is assessed based on a group rating. Interest payments of a German group company based on higher interest rates than the group financing would be adjusted to increase profits.

The fact that the proposed Act is a hot topic is becoming visible against the background of the most recent rulings on outbound cases, with which the BFH (Federal Tax Court) is challenging its previous case law. Accordingly, implicit support does not substitute intra-group collateral required in loans. If no sufficient and recoverable collateral is provided, this lack should be compensated for by charging higher interest rates. This might diametrically run counter to Article 1a AStG-E.

The draft of ATAD-UmsG is in conflict not only with earlier rulings of the BFH, but also with international standards concerning recognising financial transactions. Double taxation in cross-border group structures would probably be inevitable. Therefore, it is a welcome development  that the legal regulations and tightened provisions pursued by the BMF (Federal Ministry of Finance) have been excluded  from the recommendations of the Finance Committee of the Bundesrat.

Conclusion

The changes to the Foreign Tax Act arising from the Act on the Implementation of the EU Anti-Tax Avoidance Directive (ATAD-UmsG) would lead to double taxation. These higher tax costs should be estimated as part of tax due diligence – irrespective of the unclear legal situation in the international context. Ideally, first tax optimisation areas could be identified already at that stage.