On January 20, 2021, the German federal government issued the draft for a law on the modernization of relief from withholding taxes (WHT). Changes have been proposed, in particular, for the following tax rules:
- new procedural rules to obtain relief from German WHT;
- new specific anti-abuse rule against treaty shopping and EU directive shopping;
- new transfer pricing rules.
New Procedural Rules to Obtain Relief from German Withholding Taxes
Under the draft law, the provisions regarding the tax withholding relief procedure would be governed by a new Section 50c of the German Income Tax Act. However, the currently applicable procedural rules on relief from German withholding taxation would in general be maintained. As a principle, the payer of cross-border dividends and royalties will still be required to withhold income taxes on behalf of the payee even in cases where such payment is exempt according to an applicable income tax treaty or under a EU directive.
The payer may not refrain from WHT if an exemption certificate has been issued prior to payment. Upon request, the Federal Central Tax Office will issue such a certificate if the legal requirements are met. The draft law allows for an exemption certificate to be issued for royalty payments even if it is unclear whether a tax liability exists. This would be a great relief for foreign licensors, resulting in more legal certainty.
However, exemption certificates will still only be issued with prospective effect for a maximum term of three years. Furthermore, the draft law, for the first time, explicitly requires the payer to file a “zero” WHT return in cases where no tax must be remitted due to the exemption certificate.
From 2024, the WHT relief procedure will become fully digitized. Any application for a WHT refund or an exemption certificate must be transmitted electronically via the electronic interface of the Federal Central Tax Office. The notification is also issued electronically.
New Specific Anti-Abuse Rule Against Treaty Shopping and EU Directive Shopping
The German WHT regime remains two-fold: dividends and royalties paid to a foreign payee are first subject to German WHT of 15%/25%, plus solidarity surcharge, which must be remitted unless an exemption certificate has been granted. The foreign payee may seek a refund under EU directive or under an income tax treaty. However, the payee may be denied any relief from German WHT under a domestic anti-treaty/directive shopping rule.
The Court of Justice of the European Union has found in two separate cases that the current wording of the anti-abuse rule conflicts with EU law. Therefore, the anti-abuse rule has been amended to allow—among other things—for a full rebuttal of the abusive nature of a transaction. Apart from this, the draft law still assumes treaty shopping and tax avoidance in certain multi-tier shareholding relationships.
Accordingly, a foreign payee of dividends or royalties may only be entitled to any relief from German WHT if:
- its shareholders would also be entitled to the same treaty or directive relief if they directly received the tax-inducing payment; or
- the source of income has a significant connection with the genuine economic activity of the foreign company; or
- the foreign company provides proof that the principal purpose for the interposition of the foreign payee is not to obtain a tax advantage; or
- the main class of shares in the foreign company is traded substantially and regularly on a recognized stock exchange.
A genuine economic activity is denied where the payee only generates income from royalties or dividends, where it takes an intermediary position of passing on such payments to another person, or where the payee does not provide for an adequately equipped business.
The proposed anti-treaty/directive shopping rule should make it more difficult to obtain WHT relief. For instance, based on the wording of the law, the case can be made that a foreign shareholder is no longer entitled to treaty relief if its own shareholder would be subject to a different legal provision (e.g., another income tax treaty), even if both legal provisions provide for the same kind of treaty relief.
Moreover, the proposed rule will also apply in cases where the relevant income tax treaty already contains an anti-treaty shopping rule, like the limitation of benefits test. This would be the case under Article 28 of the income tax treaty between Germany and the U.S., for example.
New Transfer Pricing Rules
The most significant changes concern Section 1(3) of the German External Relations Act, which is the fundamental German tax rule in transfer pricing. In particular, the functional and risk analysis is given significantly more weight by the draft law. Based on the new law, transfer pricing audits in future will focus more on the actual circumstances of the case and to a lesser extent on the contractual arrangements (substance over form).
The “most appropriate transfer pricing method” is to be determined based on the actual functional risk profile. The hierarchy of transfer pricing methods under the current version of the law will be dropped. All transfer pricing rules are deemed equally applicable without any preference for standard over profit methods.
The new paragraph 3a contains statements on narrowing the price range. A range of (potentially) comparable values must regularly be narrowed down by means of the interquartile range method.
In addition, the mean value approach is retained for the hypothetical arm’s-length test alone.
According to the new Section 1(3c) of the German External Relations Act, the DEMPE (development, enhancement, maintenance, protection and exploitation) concept, introduced by the BEPS project into the Organization for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines 2017, will be introduced into German domestic tax law. Going forward, the concept of functional ownership of an intangible asset will replace the significance of legal and economic ownership.
Accordingly, group companies performing or contributing to the performance of the DEMPE functions will be deemed to participate from the (residual) profit generated with the intangible. The financing (for example, of the development or creation of an intangible asset) on the other hand, no longer entitles to profit share derived from the use of the intangible.
The concept of economic ownership as previously proposed by the OECD is thereby abandoned. As a result, the economic or even the legal owner of the intangible may be limited to a mere routine compensation. It is expected that many multinationals will be required to reorganize their royalty arrangements accordingly.
Specifically, for any transaction in connection with intangible assets, the draft law requires further examination of whether the actual profit generated with the intangible deviates significantly (by more than 20%) from the profit expectations on which any original valuation was based. If this is the case, and no price adjustment clause has been agreed, the German tax authorities may adjust the taxpayer’s income accordingly within a seven-year period, starting at the conclusion of the transaction. Under certain circumstances, no adjustment is to be made.
Section 1(3b) of the German External Relations Act contains the familiar provisions on the transfer of function. Going forward, for the assumption of a transfer of a function, tax authorities only need to show that either an asset or other benefits (previously and) are transferred. This should extend the applicability of this exit tax rule significantly. However, there will be no transfer of function if the transferee exercises the transferred function exclusively for the transferor and is in return appropriately remunerated with a routine service fee based on the cost-plus method.
According to a revision of the upper house of parliament (Bundesrat), the OECD report on Transfer Pricing Guidance on Financial Transactions will also be incorporated to a large extent into German domestic tax law. This should be expected to have a significant impact on inter-company loan and guarantee arrangements as well as on the allocation of benefits in a cash pool arrangement. It is particularly worrying that the taxpayer should henceforth bear the burden of proof that the funds are to be characterized as debt capital. Stand-alone credit ratings will no longer be recognized.
It is also to be expected that group financing entities will be subject to more scrutiny in future German tax audits. Most of these companies should constitute mere intermediaries according to the draft law and should therefore only be entitled to a routine service fee. Multinationals which have set up group finance as an “internal bank” should look at the inter-company relations and the respective functional risk profile in more detail.
In addition, the definition of a “related party” is intended to extend to unrelated parties which are part of the same network organization as the taxpayer. This should be the case where the network is distinguished by close strategic and operational cooperation.
Further Proposed Changes
The draft law also proposes changes for the following tax rules:
- obtaining of WHT relief in case of a foreign hybrid entity is to be tightened;
- claiming tax losses in case of legal reorganizations is to be further tightened;
- additional provisions concerning certain tax certificates in case of WHT on capital income to be withheld by financial institutions in particular and the exchange of information on tax arrangements using the capital markets.
In particular the proposed changes of WHT relief in case of a foreign hybrid entity could have unjustified consequences, for instance in cases where the payee is a U.S. LLC whose shares are owned by U.S. corporations.
The tax policy measures of the federal government are still to be approved by the German parliament. At this point in time, it is still open whether all the proposed changes will be adopted, and within what timeline.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Sven-Eric Bärsch is a Tax Adviser and Partner at Flick Gocke Schaumburg, Frankfurt; Lars H. Haverkamp is a Tax Lawyer and Associated Partner at Flick Gocke Schaumburg, Düsseldorf.