Draft bill for CbC reporting and other anti-BEPS measures published

2016 Issue 2

German Tax & Legal Quarterly 2|16

Legislation

German Ministry of Finance publishes draft bill to implement country-by-country reporting and other measures against base erosion and profit shifting On 1 June 2016, the German Ministry of Finance (BMF) published a technical draft of the Act Concerning the Implementation of Changes to the EU Administrative Cooperation Directive and of Additional Measures against Base Erosion and Profit Shifting. The core part of the draft is the implementation of the non-public Country-by-Country (CbC) reporting standards, as proposed by the Organisation for Economic Co-operation and Development (OECD) in its report on Action 13 of the Base Erosion and Profit Shifting (BEPS) project. The draft foresees mandatory CbC reporting for fiscal years beginning after 31 December 2015. The draft also includes the implementation of the

Content

01 Legislation

07 German tax authorities

09 German court decisions

16 EY publications and events

European Union (EU) Automatic Information Exchange Directive which was adopted in December 2015 and governs the exchange of information concerning advance cross-border rulings and advance pricing arrangements. These actions are flanked by additional transparency measures.

The BMF has asked interest groups to submit comments by 17 June 2016. It is expected that the draft will be introduced into Parliament on 13 July 2016, and that the Act will be finalized during the second half of 2016.

Please refer to our Global Tax Alert dated 2 June 2016 for a detailed discussion of proposed measures and consequences for taxpayers.

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Legislation

To modernize and facilitate the digitalization of Germanys tax administration system, the German Federal Parliament passed the Bill on modernization of tax assessment procedures on 12 May 2016. The coalition partners in Berlin additionally agreed to add to the bill a clarification on production costs calculation as well as an extended period of notice for certain RETT transactions of foreign tax debtors.

Tax filing obligationsAnnual tax returns prepared by taxpayers who do not engage a certified tax adviser must currently be filed by 31 May at the latest of the year following the calendar year in which the financial year ended. This filing date shall be extended by two months to 31 July. In cases where a certified tax adviser prepares the tax return, the filing date shall also be extended by two months until the end of February of the second calendar year.

Late-filing penaltiesGoing forward, the tax authorities will have no discretionary power when assessing late-filing penalties. The amended provisions leave no room for considering any personal excuses for failing to file a tax return by the due date.

Time limit for advanced rulingsFor the first time, the Fiscal Code will introduce legal provisions obligating the tax authorities to issue a requested advanced ruling within a certain period of time. The bill stipulates a deadline of six months. However, the bill contains no penalties for a possible violation of this deadline.

Production costsThe bill introduces new legal provisions for the calculation of production costs for tax accounting purposes which leave the currently applicable lower limit of production costs unchanged. This legislative clarification is important as finance authorities had tried to increase this lower limit since new income tax guidelines (Einkommensteuerrichtlinien) were released in 2012.

Extended period of notice for real estate transactions of foreign taxpayersThe two-week notice period for transactions subject to the Real Estate Transfer Tax Act (GrEStG) shall be replaced by a one-month period for foreign taxpayers. Considering that in certain cases the taxpayer and the purchaser may not be identical, it will still be necessary for compliance purposes to carefully monitor both periods of notice even in real estate transactions which exclusively involve foreign entities.

After the 2013 decision to tax portfolio dividends (below 10% ownership) derived by corporate taxpayers, which were previously tax exempt, an intense political discussion ensued as to whether capital gains from portfolio shareholdings should also be taxed. On 4 May 2016, the German Federal Government clarified that such an extension will not be implemented during the current investment tax reform that is planned to be passed in early July.

The Federal Government underlined in its statement that fostering growth of the venture capital sector in Germany is a key element of its economic strategy and that any additional burdens on financing conditions of innovative start-ups have to be avoided. This would require an effective mechanism exempting start-ups from the discussed capital gains taxation which would also have to be compliant with EU state aid provisions. The Federal Government now admitted that to date, it has not been able to develop such an exemption mechanism. Officially, the Government is still examining potential ways to tax capital gains from portfolio shareholdings, but given the fruitless efforts of the last three years and the clear opposition of conservative finance politicians, it is expected that the issue is off the table at least until the end of the current legislative period in 2017.

Bill on modernization of tax assessment procedures passed Parliament adds provisions on production costs calculation and RETT

Taxation of capital gains from portfolio shareholdings postponed (indefinitely?)

EY German Tax & Legal Quarterly 2.16 | 2

Legislation

Claims for refund of German withholding tax on portfolio dividends that have been received by certain non-German resident corporate entities should be dealt with by a central authority, the Federal Council (Bundesrat) states in its considerations for a new draft law. This should apply to corporate entities that are not yet covered by existing legislation, e.g., corporate entities resident in non-European Union (EU) jurisdictions, nonresident pension funds and nonresident investment funds. If ultimately adopted by the German legislator, this new law could provide for legal certainty for nonresident investors regarding the refund of withholding tax based on EU law. The lack of rules on responsibility for administrative processing of such claims is one of the main obstacles why EU refund claims have been kept on hold by the German tax authorities.

If ultimately adopted, this new law could not only provide for legal certainty, it could also speed up currently pending refund claims that have been filed by taxpayers with the German tax authorities in relation to portfolio dividends. Despite providing for legal certainty with respect to claims for refund of withholding tax on German portfolio dividends, the current draft law does not provide for a statute of limitations with regard to claims based on the free movement of capital.

For more information, please see the Global Tax Alert dated 18 May 2016.

Following publication of the Panama papers, Germanys Finance Minister, Mr. Schuble, published on 11 April 2016 an Action Plan against Tax Fraud, Tax Avoidance Schemes and Money Laundering 10 next steps for a fair international tax system and a more effective combat against money laundering. It is not expected that the Action Plan will be implemented in one single legislative initiative. Instead, the different issues will be introduced independently, some of them e.g. in the context of the domestic implementation of the 4th and the expected 5th EU Anti-Money Laundering Directive. The feasibility of other points depends on the success of further international negotiations (e.g. plans to create and link global registers for beneficial company ownership).

Please refer to the International Tax Alert dated 18 April 2016 for more details of the proposed measures.

German Federal Council urges new procedural rules for EU refund claims for German withholding tax in relation to portfolio dividends

German Finance Ministry issues 10 Point Action Plan against Tax Fraud, Tax Avoidance Schemes and Money Laundering

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http://www.ey.com/Publication/vwLUAssets/German_Federal_Council_urges_new_procedural_rules_for_EU_refund_claims_for_German_withholding_tax_in_relation_to_portfolio_dividends/$FILE/2016G_01061-161Gbl_DE%20FC%20urges%20new%20procedural%20rules%20EU%20refund%20claims%20for%20German%20WHT%20relation%20portfolio%20dvdends.pdfhttp://www.ey.com/Publication/vwLUAssets/German_Finance_Ministry_issues_10_Point_Action_Plan_against_Tax_Fraud_Tax_Avoidance_Schemes_and_Money_Laundering/$FILE/2016G_00616-161Gbl_DE%20FM%20issues%2010%20Point%20Action%20Plan%20against%20Tax%20Fraud%20Tax%20Avd%20Schemes%20Money%20Lnder.pdfhttp://www.ey.com/Publication/vwLUAssets/German_Finance_Ministry_issues_10_Point_Action_Plan_against_Tax_Fraud_Tax_Avoidance_Schemes_and_Money_Laundering/$FILE/2016G_00616-161Gbl_DE%20FM%20issues%2010%20Point%20Action%20Plan%20against%20Tax%20Fraud%20Tax%20Avd%20Schemes%20Money%20Lnder.pdf

Legislation

On 10 May 2016, the German government agreed on stricter rules for engaging external workforce, which are planned to come into force on 1 January 2017. The main objective of the new law is to introduce transparent rules to avoid an abusive switch from employment to service contracts.

How can service contracts be abusive?Instead of hiring employees, companies often conclude service contracts with freelancers. In the IT sector, for example, it is common practice to conclude service contracts for particular services, such as programming of specific software components. The companies do not have to pay social security contributions for the freelancers and do not have to observe workers rights (e.g. protection against dismissal, working time limits, sickness pay) or participation rights of the works council. However, if freelancers are treated like employees, service contracts are considered abusive and the service contracts are requalified with retroactive effect as employment contracts. In addition, the companies must pay social security contributions (employers and employees contribution) for the past four years and observe all workers rights as well as works council participation rights.

What are the criteria for abusive service contracts?In practice, the main problem is to differentiate in which cases companies are allowed to conclude service contracts with freelancers and in which cases someone has to be employed. A new section 611a will be inserted into the German Civil Code (BGB) to this end. The following main criteria indicate that a service contract has to be seen as abusive: The feelancer receives technical directions, The feelancer receives directions about the working time, duration of work (e.g. daily working time) or place of work, The freelancer has no possibility to organize the work without the company

If an overall assessment based on these criteria leads to the result that someone has to be regarded as an employee, an employment relationship will automatically be concluded retroactively.

What are the consequences of abusive service contracts?The requalification of service contracts into employment contracts leads to the obligation to observe all workers rights, the payment of social security contributions as well as the involvement of the works council. In addition, it can have serious administrative and criminal consequences even for the managing directors and involved executives: Up to 5 years in prison for the managing director of the company and employees who assisted in deploying the freelancer

(e.g. branch manager, HR department) as no social security contributions were paid for the freelancer; A fine of up to 1 million for the company; Payment of all social security contributions including interest; Reputational damage.

Thus, it is important for companies to review and monitor their workforce management. This includes transparency on the use of service contracts as well as the contractual terms. Also, clear internal responsibilities and processes need to be in place prior to the engagement of freelancers. Going forward, companies are obliged to perform checks on the working conditions of the engaged freelancers as the assessment of requalification is made primarily on the basis of the actual circumstances, not only on the basis of the contractual framework.

New regulations to counter abuses of service contracts

EY German Tax & Legal Quarterly 2.16 | 4

Legislation

New German/Philippine double tax treatyThe new double tax treaty between Germany and the Philippines entered into force on 18 December 2015. It is applicable as of 1 January 2016.

The new treaty does not follow the OECD recommendations published in the final BEPS reports (action item 7) in October 2015 regarding the artificial avoidance of permanent establishment (PE) status. In particular, the treaty does not consider the proposed changes to Art. 5 of the OECD Model Tax Convention which follows a substance-over-form approach regarding commissionaire arrangements. The treaty contains the standard language of Art. 5 of the OECD Model Tax Convention 2014 regarding the fixed place of business, the auxiliary activities, and the agency PE.

The maximum withholding tax rate on dividends is limited to 15%. This rate can be reduced to 10% if the dividend is paid to a corporation that directly owns at least 25% of the capital of the subsidiary. A further reduction to 5% can be achieved if the dividend is paid to a corporation that directly owns at least 70% of the capital of the subsidiary.

The maximum withholding tax rate on interest is limited to 10% (Germany does not levy interest withholding tax on plain vanilla intercompany loans, i.e. loans with a fixed interest rate). The interest withholding tax rate is reduced to 0% if the interest recipient is the beneficial owner of the interest payments, and if the interest is paid in connection with a sale of commercial or scientific equipment on credit or in connection with the sale of goods between two companies.

The withholding tax rate on royalties is limited to 10%.

New German/Finnish double tax treatyOn 19 February 2016, the new German/Finnish double tax treaty was signed. It still requires ratification by the countries and will not be applicable before 1 January of the calendar year following the ratification.

The new treaty does not follow the OECD recommendations published in the final BEPS reports (action item 7) in October 2015 regarding the artificial avoidance of permanent establishment (PE) status. In particular, the treaty does not consider the proposed changes to Art. 5 of the OECD Model Tax Convention which follows a substance-over-form approach regarding commissionaire arrangements. The treaty contains the standard language of Art. 5 of the OECD Model Tax Convention 2014 regarding the fixed place of business, the auxiliary activities, and the agency PE.

The maximum withholding tax rate on dividends is limited to 15%. This rate can be reduced to 5% if the dividend is paid to a corporation that directly owns at least 10% of the capital in the subsidiary (however, subject to further conditions, a 0% withholding tax rate can often be claimed under the EU Parent Subsidiary Directive).

On interest and royalties, only the recipient state should have the taxing right.

The new Germany/Israel double tax treaty is expected to become applicable as of 1 January 2017The new double tax treaty was signed on 21 August 2014 in Berlin. On 20 November 2015, it was ratified by Germany and on 10 May 2016 by Israel. The exchange of the instruments of ratification is expected to be finished by the end of 2016. In such a case effectively from 1 January 2017, the double tax treaty (2014) will replace the double tax treaty (1962) as amended by the 1977 protocol. For further details of the double tax treaty (2014), please refer to the German Tax Quarterly issue 3/2014.

The new Germany/Japan double tax treaty is expected to become applicable soonThe new double tax treaty was signed on 17 December 2015 in Tokyo. On 13 May 2016, it was ratified by Germany. The double tax treaty (2015) will enter into force on the thirtieth day after the exchange of notifications confirming that both contracting states have completed their internal ratification procedures and will replace the double tax treaty (1966) as amended by the 1979 and 1983 protocols. For further details of the double tax treaty (2015).

Please refer to the German Tax & Legal Quarterly issue 3/2015.

Negotiations for Germany/Panama double tax treaty are in final stageThe Germany/Panama double tax treaty is almost finalized, according to the German Federal Government. The draft was initialed in 2013. Remaining questions relating to constitutional and international law are currently being reviewed. The treaty is based on the OECD Model. Furthermore, the German Federal Chancellor and the President of Panama agreed to start negotiations for a treaty covering the exchange of information in a timely manner.

Update on tax treaties

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Legislation

With the amendment to the Combined Heat & Power Generation Act (KWKG 2016) taking effect on 1 January 2016, the Federal Ministry for Economic Affairs and Energy was able to complete an important topic on its 10-point energy agenda. The most important changes for commerce and industry for those who already operate combined heat and power (CHP) plants or those who are planning on operating CHP plants in the future are summarized below. Similar changes apply to operators of warming and cooling storage, respectively of heating and cooling networks, as well.

Support scheme for CHP plantsThe effects on plant operators vary. The previous version of the KWKG (KWKG 2012) continues to apply to CHP plants which started continuous operation before 1 January 2016 (existing plants). In these cases, the support scheme does not change.

The KWKG 2016 fully applies to new plant operators, i.e. in principle to those plants starting continuous operation on or after 1 January 2016. This is important because the criteria as to whether CHP plants will receive financial support have changed and, in addition, the criteria for the supplementary payment amounts have changed as well.

In some cases, the operators of CHP plants have the right to choose between old and new law regarding the CHP support scheme. As a rule, the choice between old and new law should depend on the amount and duration of the level of supplementary payments in the respective applicable version of KWKG.

Newly built coal-fired CHP plants will no longer be eligible within the KWK support scheme. However, the legislator financially encourages the switch from coal-fired CHP plants to gas CHP plants. Furthermore, the legislator grants a supplementary payment for gas-powered CHP plants, even if the duration of the initial supplementary payments under the KWKG 2012 has already expired.

State aid approval reservation for CHP supporting schemeThe whole support scheme according to KWKG 2016 is at present still subject to state aid approval by the European Commission and it is uncertain whether the KWKG 2016s support scheme will become applicable as it is described above.

As currently known in the market, the European Commission takes the position that (i) the support scheme has to be linked to a bidding process (comparable to bidding processes for renewable energy support schemes), (ii) transnational support of CHP has to be strengthened and (iii) the reduction of the CHP surcharge for energy cost intensive companies has to be limited (comparable to the reduction of the EEG surcharge for energy intensive companies).

As the state aid approval by the European Commission is still pending, the support scheme under KWKG 2016 is currently not applicable, which means significant economic insecurity for CHP plant operators who planned the construction and operation of their CHP plants on the basis of the support scheme within KWKG 2016. It is expected that there will be further developments which may lead to amendments to KWKG 2016.

Introducing direct marketingAccording to the KWKG 2016, operators of CHP plants with more than 100 kW electrical CHP power can no longer simply supply electricity to network operators. They have to do direct marketing, i.e. supply to third parties, or consume themselves.

Increased electricity rate due to CHP surchargeFor all end consumers who receive electricity from the grid, the CHP surcharge (KWK-Umlage) under the KWKG is included in their electricity rate. Large electricity consumers can reduce the surcharge. However, going forward, higher thresholds will apply and the actual reduction will be less than in the past.

In the past, according to the Federal Supreme Court (BGH), all electricity quantities consumed within the closed distribution system (geschlossenes Verteilernetz) or the customer facilities system (Kundenanlage) counted towards reaching the privilege threshold for both closed distribution systems and customer facilities systems. Based on the new legislation, the electricity consumption of each individual consumer within closed distribution systems will have to exceed the threshold on a stand-alone basis. For customer facilities systems, the legislator has not provided guidance on how the threshold is to be calculated.

New German Combined Heat & Power Generation Act (KWKG)

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German tax authorities

On 30 March 2016, the Federal Ministry of Finance (BMF) issued a decree ordering the non-application of two recent Federal Tax Court (BFH) decisions (case references: I R 23/13 dated 17 December 2014 and I R 29/14 dated 24 June 2015) to other cases. Both decisions dealt with the application of the arms length principle to intra-group loans in a treaty context. For a more detailed summary of these decisions, please refer to section German court decisions in this issue.

The tax authorities do not agree with the BFHs view that Art. 9 of the OECD model treaty or corresponding provisions in Germanys tax treaties bar Germany from making adjustments beyond the pricing of the intercompany transaction in question (in the decided cases, a tax-effective impairment write-down of the loan was at issue). As mentioned above already, the German government has now also proposed an amendment to the German Foreign Tax Act with an enhanced, treaty-overriding statutory definition of the arms length principle, which must be applied in a uniform way to all relevant Art. 9 OECD-type tax treaty situations. As a consequence, the German arms length interpretation, which has still to be formulated within the scope of a separate ordinance, would take precedence over a treaty based interpretation in cross-border situations.

No application of recent Federal Tax Courts decisions on precedence of Art. 9 OECD model treaty over domestic income adjustment rules

On 18 March 2016, the German Ministry of Finance (BMF) issued the draft version of the Administrative Principles on the Profit Attribution to Permanent Establishments for public discussion. The draft serves as an application guide for the tax authorities. It contains examples and further explanations on the BMFs interpretation of the Authorized OECD Approach. Industrial and municipal associations as well as expert groups were invited to comment on the draft by 13 May 2016. It is expected that the final Administrative Principles will be published in the second half of 2016.

For a more detailed analysis of the draft, please refer to our tax alert issued on 8 April 2016

as well as

our tax alert issued in May 2016

Draft administrative principles for the profit attribution to permanent establishments

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German tax authorities

The legal regulations with regard to a voluntary disclosure exempting from punishment were severely tightened in 2011 and again in 2015. As a result, there has been uncertainty whether a mere notification and correction of incorrect tax returns is sufficient to avoid tax criminal risks or whether the correction should comply with the formal requirements of a voluntary disclosure. The German tax authorities increasingly tend to take a very strict view on taxpayers corrections and a classification as voluntary disclosure can trigger the assessment of additional payments.

With the administrative directive dated 23 May 2016, the relevance of an internal tax control framework in the context of corrective filings is addressed for the first time. The Federal Ministry of Finance states: If internal tax control frameworks are in place, this may be regarded as evidence that the taxpayer acted neither intentionally nor with (gross) negligence.

Companies are legally obliged to file correct tax returns in due time. However, even despite reasonable diligence in the tax department of the company, mistakes in the tax returns filed and notifications might occur. Companies need to organize and document the tax relevant circumstances properly in order to be considered tax compliant. In this regard, an effective tax control framework leads to more efficient tax processes and can provide greater legal certainty.

A working group at the Institute of Public Auditors in Germany (IDW) is developing the requirements of a tax control framework based on the existing IDW auditing standard 980 (IDW PS 980) in close cooperation with the Federal Ministry of Finance.

Taxpayers who are able to prove that an adequate tax control framework has been implemented will be able to substantially mitigate legal risks resulting from tax audits. Furthermore, the risk of tax criminal measures and administrative penalties after filing corrected tax returns will be significantly reduced. Accordingly, the implementation of a tax control framework based on IDW PS 980 is a means to effectively protect individuals from tax criminal risks.

The main components of such a tax control framework con-sist of a documented group tax policy, specific tax guidelines, a risk and control matrix as well as process docu mentation. Based on the above mentioned developments, many groups have started to analyze their existing tax processes in order to improve the internal tax control framework giving them a robust basis to prevent uncomfortable dis-cussions with the tax authorities.

The German Federal Ministry of Finance (BMF) issues an administrative directive in which a tax control framework is recognized as an element of tax compliance to protect against tax criminal risks

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German court decisions

Two decisions of the Federal Tax Court (BFH) (cases I R 23/13 and I R 29/14) address the conflict between the arms length principle of the Art. 9 para. 1 of the OECD Model Convention and the domestic income adjustment provisions of sec. 1 AStG (2003) (German Foreign Tax Act). In both cases it was questionable whether a German parent company was eligible to tax-effectively write down a shareholder loan granted without collateral to its foreign subsidiary. The tax authorities were in both legal cases supported by the Federal Ministry of Finance (BMF).

Case I R 23/13 denial of tax-effective write-down of shareholder loans to a US subsidiary due to missing collateralization barred by treaty provisionsIn the case I R 23/13 decided on 17 December 2014, the shareholder loans were granted to a US subsidiary and were impaired in value in the same assessment periods. The German tax authorities completely denied tax-effective write-downs of these shareholder loans. The tax authorities considered missing collateralization of these shareholder loans as terms which would not have been agreed in an arms length situation and argued that these arrangements hence resulted in a non-arms length reduction of income at the level of the domestic shareholder.

The BFH rejected the tax authorities considerations. According to the BFH, missing collateralization should not result in adjustments to profits because a requirement to seek collateral could not be reconciled with the arms length provisions of the applicable double tax treaty (DTT). Art. 9 para. 1 of the Germany-USA DTT (1989) basically corresponds to Art. 9 para. 1 of the OECD Model.

With its decision dated 11 October 2012 (case reference: I R 75/11), the BFH had for the first time demonstrated its understanding of the interaction between a DTT and domestic arms length rules, according to which treaty provisions executed a blocker effect towards special income adjustment provisions, such as a deemed dividend distribution. On the one hand, treaty provisions on dealing at arms length had no self-executing impact. They became applicable only after implementation into domestic tax law, which, in turn, provided for adjustments to profits. On the other hand, these treaty provisions had a blocker effect: They prevented any further-reaching adjustments which might otherwise be required under the applicable domestic law. According to the BFH, strict adherence to this blocker effect was the only way to implement a uniform benchmark for both contracting states, securing that the re-writing of transactions did not give rise to economic double taxation.

Referring to the case I R 75/11, the BFH interpreted the scope of Art. 9 para. 1 of the OECD Model in a way that only circumstances which had a direct impact on the arms length pricing of the cross-border transaction, i.e. in this cases the interest rate, were to be considered. Any other circumstances (relating, e.g., to the genuine nature of the arrangement or to the customary nature of the terms agreed) were to be disregarded. Subsequently, the BFH applied this interpretation to the domestic arms length provisions and concluded that a denial of a tax-effective write-down of a non-collateralized shareholder loan and accrued interest receivable was barred by the treaty provisions.

The BFH admitted that missing collateralization could generally require an upward adjustment of the arms length interest rate. However, in certain cases, an implicit intra-group credit support might prevent such interest rate adjustment. Implicit credit support describes all group synergy benefits that give rise to the ability of a groups subsidiary to borrow from unrelated third parties at an interest rate lower than if it was not a member of the group. With regard to a shareholder loan, the implicit credit support precludes any interest rate adjustments as long as the shareholder ensures the solvency of the borrower. This credit support interpretation corresponds with a view held by the German tax authorities (public letter of the BMF dated 29 March 2011), according to which implicit credit support may be considered as a substitute for collateral while examining the arms length interest rate. The tax court of first instance did not establish how the interest rate arrangement had been set. Since further fact-finding measures were necessary, the BFH set the contested judgment aside and returned it to the tax court of first instance.

Case I R 29/14 denial of tax-effective write-down of non-collateralized shareholder loan to a UK subsidiary barred by treaty provisionsIn the case I R 29/14 ruled on 24 June 2015, an unsecured shareholder loan was granted to a UK subsidiary in fiscal year 1999/2000, and impairment deductions were taken two years later. The German tax authorities argued that the loan was equity-replacing, and that because of missing collateral and the non-genuine nature of the arrangement the tax-effective write-down should be denied.

Two recent BFH decisions addressing the conflict between the dealing at arms length concept of Art 9 OECD model treaty and domestic income adjustment provisions

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German court decisions

The BFH held that an implicit credit support as such did not rule out the possibility to write down a shareholder loan to its lower market value. Credit support should only mean that the controlling shareholder aiming to secure the loan repayment claim could obtain access to the assets of the borrower. However, credit support did not preclude impairment in value of the shareholder loan in situations where such assets were not available.

The BFH rejected the tax authorities denial of the impairment referring to case I R 23/13 and the blocker effect of Art. 4 of the Germany-UK DTT (1964). An arms length adjustment was again only possible regarding the interest rate which could be revised upwards due to the lack of collateral in situations where the (lack of) implicit credit support would justify an adequate risk premium. Even if in certain situations a loan-related risk profile might not be fully reflected by revising the interest rate, these situations could not justify any farther-reaching adjustments. Consequently, a tax-effective write-down of an unsecured shareholder loan to its lower market value could not be denied with reference to the domestic arms length provisions.

It should be noted that a law change in 2008 has since that year rendered tax-effective impairment deductions on loans within controlled corporate groups practically very difficult. In addition, the tax authorities will not apply the above-mentioned case law to other open cases, and in the meantime a draft law change has been published to counter the effect of the BFH case law and secure the tax authority view (see above).

The German 30% EBITDA interest limitation rule does not apply if an enterprise belonging to a group demonstrates that its equity ratio is higher than, equal to or at least does not deviate more than 2% from the equity ratio of the group (so-called equity ratio escape). A corporation may benefit from the equity ratio escape only if it demonstrates that none of the legal entities belonging to the group has received harmful shareholder financing. Such financing is considered harmful if more than 10% of the net interest expense of a legal entity is owed to a non-group shareholder with a direct or indirect participation of more than 25%. Only interest expense arising from the liabilities recognized in the consolidated accounts of the group shall be taken into consideration. According to the circular of the Federal Ministry of Finance (BMF) dated 4 July 2008, interest expense owed to different shareholders shall be added up (overall assessment).

The Federal Tax Court (BFH) (case reference: I R 57/13) ruled on 11 October 2015 that interest expense owed to different non- group shareholders with participations of more than 25% was not to be added up while assessing the harmful shareholder financing. Instead, each non-group shareholder with an direct or indirect participation of more than 25%, where appropriate, together with its related parties or third parties with recourse to the shareholder or its related parties, shall be considered separately. The BFH admitted that the declared intention of the interest limitation rule to prevent harmful shareholder financing which occurs in case of fragmentation of a loan among several shareholders could be better achieved by an overall assessment. However, the clear wording of the rule prohibits an interpretation based on a potentially different intention.

Although the BFH ruled only with regard to the equity ratio escape, its decision also impacts another exemption, the so-called stand-alone clause, which would apply if an enterprise were not a member of a consolidated group. A corporation may benefit from the stand-alone escape only if it demonstrates that it is not subject to harmful shareholder financing. Since the legal definition of harmful shareholder financing in both exemptions is identical, taxpayers should be able to successfully appeal against deviating tax assessments issued in accordance with the BMF circular.

Definition of harmful shareholder financing under the German thin capitalization rule

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German court decisions

In its decision dated 25 November 2015 (I R 50/14), the BFH had to decide whether income earned through a US law firm partnership and allocated to German resident partners should be (partially) tax exempt in Germany under Art. 14 of the 1989 German/US Double Tax Treaty (DTT - applicable until 2007/ 2008).

The plaintiff was an international law firm established as a US Limited Liability Partnership (LLP) which rendered independent personal services (legal advice) as per Art. 14 para. 2 of the DTT. Several German resident lawyers were partners of the LLP and established the firms German office. At issue was whether the partnership earnings of the German resident partners were subject to German taxation. More specifically, the court had to deal with the question whether a taxation right for the source country (USA) according to Art. 14 of the DTT requires that the individual German partner performs independent personal services from a fixed base in the US, or whether it is sufficient if the LLP generally performs independent personal services there.

The lawyers in their tax returns applied the so-called permanent establishment model to interpret Art. 14 of the DTT. According to the permanent establishment model, income of all fixed bases of a globally operating partnership is allocated to each of the partners according to their respective share regardless of the actual place of activity of an individual partner. On appeal, the BFH dismissed this model in favor of the so-called performance model. According to the BFH, the taxation right under Art. 14 of the DTT can only be allocated to the country of source to the extent the individual partner is rendering independent professional services in person in a fixed base of the source country. Hence, if no such services are rendered by the German partner in a US fixed base, Art. 14 of the DTT should not bar German taxation of the partners partnership income, even if the LLP itself generally renders independent professional services there. The BFH reversed the case to the Munich tax court to determine the exact scope of any income allocable to the US.

In the current case, portions of the German partners income were not taxed in the US (as so-called foreign source guaranteed payment). The litigated question was whether such income must be exempted under Art. 23 of the DTT (relief from double taxation), or whether it can be taxed in Germany. Art. 14 was deleted from the OECD Model on 29 April 2000 after the OECD concluded that differences between Art. 7 (business profits) and Art. 14 (independent professional services) could not be reasonably justified. Art. 14 was also deleted in the new 2006 German/US DTT. The permanent establishment model seems thus now on solid grounds in the US/German context, and the decision should impact only those firms or individual partners where the years 2008 and earlier were held open.

Articles covering independent professional services similar to that of the former Art. 14 of the OECD Model Tax Treaty are still included in a number of German tax treaties. The performance model - as now confirmed by the BFH should thus still be applicable to such cases where individuals hold partnership interests in personal services firms with offices in those specific treaty jurisdictions.

German taxation of partners of a US law firm under Art. 14 of the 1989 German/US Tax Treaty

EY German Tax & Legal Quarterly 2.16 | 11

German court decisions

On 21 January 2016, the Federal Tax Court (BFH) ruled in case I R 22/14 that granting a related party the permission to use a brand name free of charge does not trigger an adjustment under the arms length dealing provisions of Sec. 1 para. 1 AStG (German Foreign Tax Act). The mere right to use the brand name is not a business activity which would require an arms length royalty.

In the case at hand, the plaintiff, a German entrepreneur, developed a graphic symbol (logo). In 1985, he registered it as a protected trademark with the German Patent and Trade Mark Office; at the same time, he registered it also for the Benelux countries, Switzerland and France. In 1994, he expanded the trademark protection to Spain, Italy, Poland and Portugal. The plaintiff held shares in several domestic and foreign corporations including a Polish subsidiary. The articles of association of this Polish subsidiary stipulated that it was allowed to use the graphic symbol. In the years 2004 through 2006, the Polish subsidiary used this graphic symbol on its web presence, commercial documents and company cars. There was no contractual obligation for a license fee payment. The German tax authorities assumed an upward arms length adjustment of the plaintiffs profit due to the gratuitous transfer of the right to use a registered trademark.

The BFH upheld the taxpayers appeal. It found that there was no general rule that a royalty always had to be agreed upon the granting of the right to use a brand name or trademark. Only where a trademark license agreement granted the right to use the group/brand name and a group/brand logo as trademark in the sale of products in a given jurisdiction, and where a value of such group name/brand/logo could be established, the arms length principle would require charging of a brand royalty. In the given case, the right to use the brand and logo was only given in the context of the company name, and according to the BFH, it had not been sufficiently established that there actually was a brand value used in the sale of products in Poland.

A permission to use a brand name does not always trigger the need to charge a royalty

In a recently published decision (case reference: I R 13/14) dated 2 December 2015, the BFH ruled on the deductibility of foreign exchange losses in a two-tier partnership structure. The plaintiff, a German trading partnership, acquired in 1999 a partnership interest in a US LP for $ 10 million. The US LP was dissolved in 2005. In the same year, the LP repaid contributed capital to its partners. When determining the LPs tax base for 2005, part of the tax-exempt loss was attributed to the German partnership. This tax assessment became time-barred. Due to the fluctuations of the exchange rate, the German partnership incurred foreign exchange losses from the LP investment and wanted this loss to be deducted from its trade tax base.

The BFH dismissed the claim. Specifically, it found that tax assessments made at the level of a lower-tier partnership were binding against the partners, that is, these assessments were to be used for determination of the tax base at the level of a higher-tier partnership without any amendments. Taking into consideration that neither profits nor losses incurred by a domestic or a foreign trading partnership were to be considered in determining the partners trade tax base, the BFH did not allow a foreign exchange loss to be included into the trade tax base at the level of the higher-tier partnership. According to the BFH, these findings did not contradict the freedom of establishment of the Treaty on the Functioning of the European Union. In the Deutsche Shell decision (case reference: C-293/06), the European Court of Justice (ECJ) found that it violated the freedom of establishment for a Member State not to allow a foreign exchange loss resulting from the repatriation of the start-up capital of its permanent establishment situated in another Member State to be deducted at the level of a head office, as such loss could never, by its nature, be taken into account in the Member State of the permanent establishment. However, with the subsequent case C-686/13 dated 10 June 2015, the ECJ specified that the freedom of establishment did not preclude the tax legislation of a Member State which, in principle, exempted capital gains on certain shareholdings from corporate income tax and similarly disallowed the deduction of capital losses on such shareholdings, even where these capital losses were due to exchange rate movements.

Foreign exchange losses arising from dissolution of a foreign lower-tier partnership are not deductible at the level of the domestic higher-tier partnership

EY German Tax & Legal Quarterly 2.16 | 12

German court decisions

The plaintiff was a Liechtenstein corporation. It did not maintain a permanent establishment (PE) in Germany and is thus subject to German corporate income tax only on earnings derived from the letting of German real estate. The profit for 2010, determined as a surplus of revenue over expenditure, exceeded the bookkeeping threshold of the German General Fiscal Code. In the following year, the German tax authorities issued a notice obliging the corporation to keep accounts and prepare annual financial statements for its deemed trade leasing and administration of real estate.

In its decision dated 15 October 2015 (court reference: I B 93/15), the Federal Tax Court (BFH) granted a suspension from the obligation to prepare annual financial statements until the completion of the main proceedings before the tax court of Saxony-Anhalt (case reference: 3 K 1521/11). Although non-trading income derived by nonresident corporations from letting of German real estate shall be determined in accordance with general provisions as deemed trading income, the BFH considers it seriously questionable whether the provisions of Sec. 141 AO also comprise taxpayers who do not engage in an actual trade.

In its decision of 25 June 2015 (case reference: 1 K 68/12 (6)), the lower tax court of Bremen outlined its understanding of a permanent establishment (PE) under the provisions of domestic law. In the case at hand, the plaintiffs were a German deemed trading partnership together with its foreign limited partners, two Chilean corporations. The German partnership held 50% of the shares in a German corporation. The Chilean corporations derived dividend income through the partnership. In the years under review, no double tax treaty (DTT) was in force between Germany and Chile. The plaintiffs argued that the dividend income derived by the Chilean limited partners should be included in the partnerships trading income, which would have led to a refund of German dividend WHT, which otherwise would have become a final tax burden.

The tax court of Bremen decided in favor of the taxpayers and found that a German deemed trading partnership could create a German PE for its Chilean limited partners even where no actual trading business existed in the partnership. The Federal Tax Court (BFH) ruling according to which a PE in the meaning of the Art. 5 OECD Model always requires original trading business was not applicable for the interpretation of a definition of a PE under domestic tax law, i.e. in the absence of a DTT. Dividend income derived through a deemed trading partnership could thus be considered deemed trading income under domestic provisions.

The court also found that the shareholding should be attributed to the necessary business assets of the partnership. It was sufficient for such attribution that the shareholding served the purpose of the partnership, represented a significant item in the partnerships balance sheet, that dividend distributions of the shareholding accounted for a large part of the partnerships gross earnings and that a certain economic relationship existed between the partnership and the shareholding. Unlike in cases involving the application of a DTT, it was not decisive in the case at hand whether the shareholding additionally had a functional relationship to the business activities of the domestic PE of the partnership.

The importance of the case goes far beyond situations where foreign taxpayers are resident in countries without double tax treaties with Germany. Similar structures could be used by nonresidents deriving dividend, royalty or interest income from German sources where these nonresidents cannot ensure that they would qualify for treaty protection, e.g. due to anti-avoidance provisions. Given this potentially large impact, the German tax authorities have appealed to the BFH (case reference: I R 58/15).

Nonresident corporation subject to tax on earnings from letting of German real estate not automatically required to prepare annual financial statements

Lower tax court rules that a German deemed trading partnership can create a German permanent establishment for its foreign limited partners

EY German Tax & Legal Quarterly 2.16 | 13

German court decisions

In the early 1970ies, the Federal Tax Court (BFH) developed a so-called final withdrawal theory (finale Entnahmelehre), according to which an asset transfer from a domestic head office to a foreign permanent establishment (PE) had to be considered as a deemed transfer from the business to the private sphere of a taxpayer resulting in immediate taxation of the transferred built-in gain, if under the applicable double tax treaty (DTT) the profit of this foreign PE was tax exempt in Germany. The final withdrawal theory was based on the assumption that the Contracting State of the PE had the exclusive right to tax the whole profit derived from an assets disposal including built-in gains accumulated in other tax jurisdictions. The German tax authorities followed the legal understanding of the BFH although it was not backed by statutory law. Considering that tax liabilities in these cases were not supported by revenues from market transactions, the tax authorities mitigated the tax burden by giving taxpayers the option to defer tax payments over the remaining useful life of the transferred asset, but not longer than 10 years, and to settle them through installments. The European Court of Justice upheld this practice (case reference: C-657/13.

Please refer to the German Tax & Legal Quarterly issue 2/2015 for further details).

A first attempt to introduce exit taxation into the German Income Tax Act (EStG) was made in 2006 when lawmakers included Sec. 4 para. 1 sentence 3 EStG (2006) stipulating that transactions precluding or restricting the right to tax profits from a disposal or use of an asset were to be treated as deemed withdrawals. However, with decisions I R 77/06 of 17 July 2008 as well as I R 99/08 and I R 28/08 of 28 October 2009, the BFH gave up the final withdrawal theory. Moreover, it concluded that prior to 2006, no legal basis for exit taxation existed in German tax law. This change in case law was inspired by the fresh interpretation of DTT provisions. On the one side, the exemption method of Art. 23 A OECD Model did not impinge on the right

Does the German Income Tax Act (EStG) contain legally effective provisions for exit taxation?

The participation exemption at the level of a German corporation is effectively limited to 95% of the gross dividends as 5% of the tax-exempt dividend income is added back to the corporate tax base as a deemed non-deductible business expense.

The German tax authorities also expand the scope of this add-back to controlled foreign company (CFC) law and treat 5% of the tax-exempt gross dividends paid by a CFC out of the passive low-taxed income which has already been imputed into the domestic corporate tax base in the year of actual dividend distribution or in the previous seven years as a deemed non-deductible business expense. In these cases, 105% of the passive low-taxed income derived through a CFC become effectively taxable at the level of a German corporate shareholder.

The tax court of Bremen (case reference: 1 K 4/15 5) denied the application of sec. 8b para 5 KStG on tax-exempt dividends paid by a CFC out of income already imputed into the domestic shareholders corporate tax base. The court argued that the intent of CFC law is to deny the tax rate arbitrage benefits of interposing a CFC, but that the CFC rules should not be an instrument of punitive taxation.

The court also rejected the interpretation of the tax authorities, according to which a non-application of the lump-sum add-back in the case at hand would result in non-deductibility of actually incurred expenses. According to the court, the general principle denying the deductibility of expenses directly connected with tax-exempt income may not apply since the income of the CFC has been imputed into the domestic tax base.

The findings of the case should also be applicable to a tax-exempt capital gain derived by a domestic corporation from a disposal of shares in the CFC entity.

The decision of the tax court has been appealed by the tax authorities and is currently pending before the Federal Tax Court (case reference: I R 84/15).

Should 5% of the tax-exempt dividend distributed by a controlled foreign company be subject to tax as a deemed non-deductible business expense?

EY German Tax & Legal Quarterly 2.16 | 14

http://www.ey.com/Publication/vwLUAssets/2015_EY_GTLQ_Q2/$File/German_Tax_Legal_Quarterly_2-2015.pdf

German court decisions

Under the German Reorganization Tax Act, a merger of two corporate entities may upon application be carried out at tax book value provided that inter alia the right of Germany to tax any gain on the disposal of the transferred assets at the level of the absorbing corporate entity is not precluded or restricted. Since the publication of the Reorganization Tax Act Decree by the German Ministry of Finance, it was controversially discussed whether this precondition can be met for the shares in the surviving corporate entity in case of a down-stream merger, where the disappearing entity was owned by nonresidents.

In the case 6 K 1947/14 K, G ruled by the tax court of Dsseldorf on 22 April 2016, a German corporation was merged cross-border downstream into its subsidiary in Luxembourg in 2009. When the merger became effective, the assets and liabilities of the transferring corporation became property of the absorbing corporation; the shareholding of the transferring corporation in the absorbing corporation was transferred to the shareholder of the transferring corporation, a company resident in the USA. The German corporation applied for a tax-neutral merger and recorded in its closing balance sheet all assets, including the shares in its Luxembourg subsidiary at tax book value. The German tax authorities took the view that the shares in the Luxembourg subsidiary should have been recognized in the closing balance sheet of the German corporation at fair market value because Germany lost the right to tax any gain on the disposal of these shares by the US resident company. Such transfer gain would have been 95% tax exempt.

The tax court rejected the tax authorities interpretation and concluded that there was no legal basis to tax any gain on the disposal of the shares in the absorbing corporate entity. Although the transferred assets as such comprised both the assets that were transferred to the absorbing corporate entity as well as the shares that were deemed transferred to the shareholders in a downstream merger, the clear wording of the law indicated that the lawmakers had secured the German right to tax built-in gains only with regard to the first category of assets. Considering that the courts decision contradicts the Decree, and creates a potential for untaxed income, the tax authorities are expected to appeal the case to the Federal Tax Court.

Lower court allows tax neutrality of downstream merger, even where Germany loses taxing rights for shares

to tax built-in gains which had been accumulated at the level of domestic head office prior to transfer at the time when the foreign PE disposed the asset in question. On the other side, with the arms length principle of Art. 7 para. 2 OECD Model, a clear separation of the built-in gains accumulated before and after the transfer existed.

Since the lawmakers were apparently guided by the final withdrawal theory, its abandonment gave rise to interpretation of the exit taxation provisions as void. Transfer of assets to foreign PEs should not trigger exit taxation because Germany had the unrestricted right to tax transferred built-in gains. After the transfer, the assets were used by the same enterprise so that there was no room to assume a withdrawal. A possibility of such interpretation induced the lawmakers in 2010 to add a clarifying sentence 4 to the exit taxation provisions of Sec. 4 para. 1 EStG, according to which preclusion or restriction of the right to tax profits from disposal or use was to be assumed especially in cases of an asset transfer from a domestic to a foreign PE. The application provisions stipulated that the final withdrawal theory should apply with retroactive effect in all cases which had not yet become time-barred. Some prominent voices including the former presiding judge of the BFHs First Senate responsible for abandonment of the final withdrawal theory keep considering German exit taxation provisions void even after incorporation of Sec. 4 para. 1 sentence 4 EStG (2010).

The tax court of Dsseldorf (case reference: 8 K 3664/11 of 19 November 2015) now ruled on the applicability of exit taxation provisions to patents, trademarks and utility models transferred in 2005 to a Dutch PE. Later, the tax court of Cologne (case reference: 10 K 2335/11 of 16 February 2016) decided on the applicability of exit taxation to a shareholding transferred in 2005 to a Belgian PE. In both cases, these courts of first instance concluded that Sec. 4 para. 1 sentences 3 and 4 EStG (2010) provided a valid legal basis for exit taxation in 2005. Both courts found that the retroactive application of the exit taxation provisions did not violate the German Constitution because these legal provisions only codified the case law which had existed for decades. Both courts of first instance allowed appeals. The decision of the tax court of Dsseldorf has already been appealed and is currently pending before the BFH under reference I R 95/15.

EY German Tax & Legal Quarterly 2.16 | 15

German court decisions

If an agency agreement is terminated, the agent may demand adequate and equitable compensation for lost commission payments caused by the termination pursuant to Art. 89b German Commercial Code (HGB). Since this provision is based on the EC Directive on Commercial Agents, this compensation is very similar throughout European countries.

Compensation obligations tend to be expensive for manufacturers, in particular since they can be neither excluded nor limited. Therefore, some manufacturers prefer authorized dealers over commercial agents to avoid such payments. But manufacturers should be aware that authorized dealers may be entitled to compensation as well. Recent case law of the German Supreme Court (BGH) confirms this view.

An authorized dealer might claim compensation by analogy with the provisions of Art. 89b HGB like a commercial agent if the dealer is (i) integrated into the distribution system of the principal and has similar obligations and tasks as an agent would have (especially regarding reporting, customer relationship management, exclusivity, non-competition, minimum purchase obligations, sales targets; audit, supervision and instruction rights of principal etc.) and (ii) obliged to transfer its customer base (by providing customer names and address) to the principal, so that the principal can continue to supply its products to these customers after termination of the distribution agreement.

It has been long established in German jurisdiction that compensation claims of authorized dealers active in Germany can be neither excluded nor limited. But it has been disputed in German legal literature if compensation claims of authorized dealers not active in Germany but abroad within an EC/EEC foreign country might be excluded. This controversy has now been ended with the BGH decision of 25 February 2016 (VII ZR 102/15). According to this decision, compensation claims of authorized dealers active in EC/EEC foreign countries cannot be excluded or limited. Therefore, commercial agents and authorized dealers are treated equally in this regard.

For the German export industry, this will constitute a competitive disadvantage within EC/EEC as most EC/EEC countries do not provide for equal or similar compensation obligations of their manufacturers towards authorized dealers. Manufacturers may prevent such compensation claims by avoiding the integration of authorized dealers into their distribution systems or by agreeing on the application of foreign (non-German) law for the distribution relationship which does not provide for compensation claims of authorized dealers. It is only in regard to distribution territories outside EC/EEC countries that manufacturers can still exclude compensation claims of authorized dealers under German law without facing any difficulties and disadvantages.

Compensation for authorized dealers German Supreme Court (BGH) decides in favor of EC distributors

EY publications and events

Please find pdf-versions of the EY publications listed below by clicking on the related picture. The free EY Global Tax Guides app provides access to our series of global tax guides. www.ey.com/GL/en/Services/Tax/Global-tax-guide-app

Upcoming EY events

Worldwide corporate tax guide (2016 edition) The worldwide corporate tax guide summarizes the corporate tax systems in 162 jurisdictions.

Worldwide personal tax guide (2015-16 edition)The worldwide personal tax guide summarizes the personal tax systems and immigration rules for individuals in more than 160 jurisdictions.

Worldwide VAT, GST and sales tax guide (2016 edition) Inside this guide you will find extensive details of value-added tax, goods and service tax and sales tax systems of 115 jurisdictions.

Munich International Tax Seminar (MITS)

Plenaries and workshop presentations by international EY partners on current international tax and TP topics of interest to tax directors/international tax managers

Optional visit of the Oktoberfest for the 2016 opening ceremony, as well as lunch/afternoon entertainment

Language: EnglishDate and location: 16-17 September 2016 in MunichEvent contact: Aleksandra Blachowska, aleksandra.blachowska@de.ey.com

Worldwide Personal Tax GuideIncome tax, social security and immigration 201516

EY German Tax & Legal Quarterly 2.16 | 16

http://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2015/$FILE/Worldwide%20VAT,%20GST%20and%20Sales%20Tax%20Guide%202015.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Personal_Tax_Guide_2015-16/$FILE/Worldwide%20Personal%20Tax%20Guide%202015-16.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide_Corporate_Tax_Guide_2016/$FILE/2016%20Worldwide%20Corporate%20Tax%20Guide.pdfhttp://www.ey.com/Publication/vwLUAssets/Worldwide-VAT-GST-and-sales-tax-guide-2016/$FILE/Worldwide%20VAT,%20GST%20&%20Sales%20Tax%20Guide%202016.pdf

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EY German Tax & Legal Quarterly 2.16 | 17

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EY Tax AlertPermanentestablishments of banks:Draft of the German AdministrativePrinciples relating to the Applicationof the Arms Length Principle toPermanent Establishments SpecialRegulations for Banks

The German tax authorities have substantiated their interpretation of theAuthorized OECD Approach (AOA) provided in the BsGaV[Betriebsstttengewinnaufteilungsverordnung: German Ordinance onthe Application of the Arms Length Principle to PermanentEstablishments] through the publication of a new draft, the VWG BsGa-E[Entwurf der Verwaltungsgrundstze frBetriebsstttengewinnaufteilung: Draft of the German AdministrativePrinciples relating to the Application of the Arms Length Principle toPermanent Establishments]. This interpretative letter of the FederalMinistry of Finance is of considerable importance for the banking sector,since credit institutions due in part to regulatory considerations oftenconduct their international business through permanent establishmentstructures. The bank-specific content of the VWG BsGa-E thereforedeserves particular attention and is presented below.A separate alert has been published on 8 April 2016 with regard to thegeneral regulations, which apply, as appropriate, to permanentestablishments of banks. The insurance-specific aspects of the VWGBsGa-EA are also dealt with in a separate alert. The VWG BsGa-E containsno specific regulations relating to the area of asset management.

EY Tax Alert May 2016

EY Tax AlertPermanentestablishmentsof banksDraft of the GermanAdministrative Principlesrelating to the Application ofthe Arms Length Principle toPermanent Establishments Special Regulations forBanks

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1. Allocation of loan receivables

The VWG BsGa-E states that the sales/trading function should generally be consideredas the function of assuming corporate risk (which corresponds to the KERT function asdefined by the OECD report on permanent establishments) because it makes the creditdecision and thus determines the assumption of the credit risk by the bank. Theinterpretative letter defines the sales/trading function with reference to the OECDreport on permanent establishments, according to which the sales/trading function isresponsible for the quantitative and qualitative credit rating of a potential client, thecredit decision, the pricing of the loan and the negotiation of the contractualconditions with the customer.

Functions downstream from lending have no influence on the initial loan allocation.However, they can authorize the transfer of the loan receivable to another permanentestablishment under certain narrow conditions (marginal no. 204208).

EY comments:It is inconsistent with the Authorized OECD Approach (AOA) that downstreamprocesses have no influence on the decision about allocation and could lead to disputesover allocation. The VWG BsGa-E bases its approach on the hold-to-maturity strategy.Yet in reality business models also exist whereby the bank sells (securitizes) or hedgesloan receivables using financial instruments immediately upon lending or at asubsequent point of time. In these cases, a discrepancy can arise between allocationsmade according to the BsGaV and those made according to the AOA since thedownstream risk management function contributes a significant share of added valueand is indispensable to lending.

If a bank makes standardized loan offers with an automated loan commitment and usescentrally developed automated verification systems to this end (loan factories), theoffer shall represent the function of assuming corporate risk as the only identifiablepeople function. In such cases, neither the decision to develop the credit factorysoftware nor its ongoing maintenance shall constitute the function of assuming thecredit risk. However, the use of the systems by another permanent establishmentresults in a dealing (marginal no. 209212).

EY comments:In our opinion, targeting the acquisition function in the automated retail lendingbusiness can lead to misallocations because the risk assessment and the credit decisionare effectively made automatically through software based on the risk model developedby the bank. The value added from the software can be partly recouped charging anappropriate dealing fee. However, a loan default would arise in the permanentestablishment of the sales employee who accepted the offer. Yet all that this employeehas contributed to the risk assessment is entering the client parameter into thesoftware and implement a decision on the basis of the risk assessment made by thesoftware.

In complex financing transactions such as project or property financing, it can be thecase that the function of assuming credit risk is exercised by various permanentestablishments of the bank. The determination of which element of the function hasthe greatest importance should be made based on qualitative criteria (marginalno. 213).As in the example given for insurance permanent establishments (marginal no. 295),scorecard models should also be applicable in the banking sector. In this regard, it isimportant that the weighting is made according to qualitative criteria. It would beinappropriate to use quantitative criteria such as the number of employees or the time

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taken for work steps. In contrast, it can be appropriate to take into account the salarycosts of employees who carry out processes within the function of assuming corporaterisk but the weighting should not be made solely on this basis.Rather, the activities actually carried out by the employees should be documented andqualitatively weighted. In this context, it should be noted that the negotiation of thecontractual terms is very important and an analysis should be made of the extent towhich the customer applications which have already been reviewed by a permanentestablishment and submitted to the head office are subject to a rigorous review by thehead office. A purely formal sign off is not relevant to the allocation (marginalno. 215). In cases of doubt, the customer relationship constitutes a decisive factor(marginal no. 218).

EY comments:We welcome the consideration of qualitative factors. The approach based on thescorecard model reflects the common practice of numerous banks. Yet it must also beseen critically that according to the German tax authorities the scorecard model onlyrelies on processes until the time of lending (creating a new financial asset a loanaccording to the OECD) for the assessment of the qualitative weighting. In accordancewith the AOA, the key entrepreneurial risk taking (KERT) functions of the downstreamprocesses should also be taken into consideration.

2. Re-allocation of loan receivables

Approval of changes in loan allocation is severely restricted by the BsGaV. A re-allocation of loan receivables can be made if the risk management for this assetexercised by another permanent establishment exceeds the importance of the otherpeople functions which have already been performed. However, in the example given,the transfer is conditional on non-performance on the part of the borrower, becauseaccording to the German tax authorities the risk management function only outweighsthe other functions under this condition (marginal no. 225). In addition, there may be are-allocation to the permanent establishment to which the client relationship isallocated (marginal no. 222).

EY comments:It is inappropriate and inconsistent with the AOA to make non-performance aprecondition for changing a loan allocation. A change in allocation should be possible atleast up until the point when the original permanent establishment no longer exercisesany risk management function with respect to the loan (for example, due to thecentralization of the function at the head office) because at this point the relevantpermanent establishment is no longer able to manage the risks arising from the loanreceivable.

A change in allocation should be documented as an extraordinary business transactionand presented as such in the Auxiliary Calculation of the respective branch (marginalno. 223). This is based on the requirement that the Auxiliary Calculation has toinclude all assets, the capital, remaining liabilities and revenues and expensesattributable to the branch, including deemed revenues and expenses resulting frominternal dealings. The Auxiliary Calculation has to be prepared for each fiscal year;the first time for fiscal years beginning after 31 December 2014.

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3. Global trading of financial assets

The VWG BsGa-E contains a definition of trading transactions which is partly based onthe KWG [Kreditwesengesetz: German Banking Act]. If the bank solely tradesfinancial assets on behalf of its clients, without taking at least the short-term risksfrom trading transactions onto its own books, no trading transaction is deemed to existwithin the meaning of the VWG BsGa-E. In these cases, the general part of the VWGBsGa-E applies (marginal no. 200).

According to the VWG BsGa-E, trading and day-to-day risk management represents thefunction of assuming credit risk as a rule (marginal no. 206). The restriction of as arule (im Regelfall) is repealed in another section, however, and the trading and day-to-day risk management is determined to be the only function of assuming corporaterisk (marginal no. 216). If trading desks are domiciled in different countries, the assetsand earnings should be shared out between the bank permanent establishmentsinvolved using an appropriate key (marginal no. 274 et seq.) and the other functionsremunerated in accordance with the arms length principle.

EY comments:The approach of the tax authorities is consistent with the AOA. In reality, particularsignificance should be attached to the renumeration of the sales/marketing functionbecause this function often generates a high value added and in some cases can also bea KERT function.

4. Bank refinancing (treasury)

Generally, lending transactions between non-banking branches are not recognized asdealing but only an allocation of external interest expenses is recognized. Financingactivities shall be remunerated separately via a service fee. For banking branches,German tax authorities recognize lending transactions as dealing. These dealings haveto be priced in line with the arms length principle. The VWG BsGa-E states that theaverage refinancing rate of the credit institution plus a mark-up at arms length maynot be undercut in the settlement of loans within a bank (marginal no. 230).

Moreover, the Federal Ministry of Finance outlines that a sustained liquidity surplus(i.e., when the customer deposits taken in by the permanent establishmentconsistently exceed its financing requirements) should be allocated to the rest of thecompany and in this respect the permanent establishment is only entitled to a fee fora notional service (capital procurement). However, the VWG BsGa-E gives no furtherexplanation of when a sustained liquidity surplus exists, in particular becauseaccording to the wording of the draft the liquidity surplus arises from customerdeposits (marginal no. 232).

The VWG BsGa-E includes a regulation for banking branches that only perform adeposit gathering function. These branches shall only provide a service and not a loanto other permanent establishments and the head office (marginal no. 231).

EY comments:The exception for banks regarding the recognition of a dealing for the provision ofliquidity ought to be welcomed and is consistent with the AOA. In practice, the uncleardefinition of when a liquidity surplus exists may lead to regular discussions with the taxauditors.

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5. Endowment capital (branch equity)

The VWG BsGa-E makes clear that the equity of a foreign credit institution must beconsidered in determining the endowment capital of its permanent establishments inGermany. The risk weighting should be carried out in accordance with the provisions ofthe relevant foreign banking supervisory law (marginal no. 233).Scenarios in which a lower endowment capital is allocated to the German permanentestablishments (than the value determined by the capital allocation method) or inwhich the waiver regulation can be applied, are specified in the VWG BsGa-E withvarious examples (marginal no. 237 et seq.). For domestic branches of foreign bankinginstitutions, the endowment capital can be determined in amount of 3% of the branchsassets (at least EUR 5m) if its assets do not exceed EUR 1bn (marginal no. 242 244).

The thin capitalization/adjusted regulatory minimum approach must be complied within the allocation to foreign permanent establishments and, where applicable, this mustbe done in accordance with the provisions of the relevant foreign banking supervisorylaw (marginal no. 257).

An allocation exceeding the value reached by this method is only possible under strictconditions if this better reflects the arms length principle. The VWG BsGa-E does notspecify under which conditions this is the case (marginal no. 261).

Moreover, the VWG BsGa-E contains examples in which a foreign permanentestablishment must be allocated a higher endowment capital on the basis of theprovisions of the relevant foreign banking supervisory law and cases of thincapitalization in credit institutions in Germany and instances where the waiverregulation has been applied (marginal no. 262-269).

The VWG BsGa-E contains a safe harbor rule for cases of temporary over or underallocation if the endowment capital to be shown in the separate tax accountcorresponds to the asset and liability items actually allocated to the permanentestablishment and if the adjustment of the endowment capital is made without delay inthe following fiscal year (marginal no. 270 in conjunction with marginal no. 130).

EY comments:

The distinction between inbound and outbound issues is inappropriate and inconsistentwith the AOA. In practice, points of dispute with the tax auditors could arise regularlyespecially in outbound cases.

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6. Effective date of the VWG BsGa and implications for further administrativeprinciples of the Federal Ministry of Finance

The AOA was implemented into German tax law for fiscal years beginning after 31December 2012. However, the BsGaV applies for fiscal years beginning after 31December 2014, i.e. the preparation of an Auxiliary Calculation is required and theattribution rules for capital etc. apply from that period onwards.

In other words, the taxpayer has to prepare an Auxiliary Calculation for the first timefor its permanent establishments for financial year 2015 onwards although the armslength principle has to be considered already from financial year 2013 onwards for thepermanent establishment profit allocation.

Therefore, the parts of the VWG BsGa-E related to the profit allocation are applicableto fiscal years beginning after 31 December 2012 since the VWG BsGa-E shall act asinterpretation of the AOA as implemented in Sec. 1 (4) and (5) AStG[Auensteuergesetz: German Foreign Investment Tax Act].

With respect to the effect on other related administrative principle, the BsGa-Econtains the following statements:

The VWG Endowment Capital of 29 September 2004 shall be applicable for fiscalyears beginning before 1 January 2015 (marginal no. 464).

The VWG Permanent Establishments of 24 December 1999 shall not be applicableas far as Sec. 1 (5) AStG [Auensteuergese