Executive summary

On 24 March 2021, the German Government agreed on the draft bill of the German “Law implementing the EU Anti-Tax Avoidance-Directive” (Draft Law). The European Union (EU) Anti-Tax Avoidance Directives are set forth under Council Directives 2016/1164 of 12 July 2016, and 2017/952 of 29 May 2017, and are referred to respectively as ATAD I and II.

A first working draft of the German bill was published in December 2019 (see EY Global Tax Alert, Germany publishes draft ATAD implementation law, dated 12 December 2019). With respect to the anti-hybrid rules mandated by the directives, the first working draft was only subject to minor amendments, however, certain proposals that were included in the initial working draft have since been included within other legislative initiatives.

This is also the case for the government draft of the bill. The wording of the anti-hybrid rules is to a large extent unchanged compared to the initial working draft, even though this original wording was subject to controversial debate since its publication. Most notably, the government draft still foresees the applicability of these rules for expenses accruing after 31 December 2019. The fact that the draft provides that this will be deemed to not be the case for expenses which have been generated prior to 1 January 2020 unless they are recurring and could have been prevented without suffering significant disadvantages does not take away that this would be a, potentially unconstitutional, retroactive application.

Detailed discussion

Overview of the proposed changes

The wording of the anti-hybrid rules is very broad and general and does not reflect an exact technical rendition of the ATAD definitions, even though it broadly follows the ATAD framework. Deductions are generally denied for payments on hybrid financial instruments, made by hybrid entities or to reverse hybrids. In addition, deductions are denied for payments which are deductible in Germany and any other jurisdiction (double deduction), that is, no hybrid element is required for this disallowance. Moreover, imported mismatches are covered and not subject to any safe harbor rules.

With respect to the exit tax, the bill follows the principles mandated by the ATAD and allows a deferral for asset transfers out of a German permanent establishment (PE) to the EU/European Economic Area (EEA) headquarters of a taxpayer. For transfers into Germany, the newly introduced correspondence requirement for tax valuations would deny the possibility to have mismatches in the asset valuation/taxation between the country of origin and Germany. Moreover, a transfer of an asset from a foreign (not treaty exempt) PE to the German headquarters would upon application in principle lead to a taxable gain in Germany (and potentially also in the foreign jurisdiction), but a tax credit mechanism applies.

Unfortunately, the proposed changes to the German controlled foreign corporation (CFC) rules still do not include a decrease of the current effective tax rate of 25% required for the so called “high-tax kick-out” or a tax credit mechanism for Trade Tax purposes. Moreover, the Draft Law would extend the application of the German CFC rules significantly.

Currently, these rules are only applicable if the foreign corporation is controlled by German shareholders, i.e., if German shareholders own more than 50% of the shares or voting rights in the foreign corporation. According to the Draft Law, shares directly or indirectly owned by parties related to a German shareholder would have to be considered for this determination. For multinational groups, this effectively means that any direct or indirect participation of a German group entity in another, non-German group entity would result in “deemed” control over the CFC by German shareholders and, thus, make the German CFC rules applicable. In addition, CFC taxation is now imposed on non-German controlling shareholders owning shares in CFCs which are allocable to a German PE or through a partnership which creates a German PE. Besides this, the Draft Law suggests several changes to the definitions of active income. Most importantly, dividends from portfolio investments (ownership below 10% as of the beginning of the calendar year) no longer qualify as active income and could, therefore, potentially now be subject to a CFC pick-up. On the other hand, the Draft Law defines capital gains from the sale of shares generally as active income and eliminates the additional active income testing elements. The same applies to income triggered in the course of foreign qualifying reorganizations between CFCs.

Anti-hybrid rules

Germany already has a wide range of rules that are intended to counter undesired tax outcomes due to the mismatch of rules in an international context. Most of the existing rules however deal with German-outbound situations only; there are as yet only limited rules that tie the tax treatment of intra-group expenses to the tax treatment at the recipient level (a significant exception being the royalty limitation rule, which since 2018 partially or wholly denies royalty deductions to non-Organisation for Economic Co-operation and Development (OECD)-compliant preferential tax regimes).

This would change with the introduction of a far-reaching general anti-hybrid rule. The draft rule in the government bill is still broadly based on the OECD Action 2 proposal and the ATAD I and II wording. It notably does not cover cases where the foreign non- or low taxation is not triggered by a hybrid mismatch, but due to the general rules applied in the recipient jurisdiction. Hence, the proposed rule would cover the German deductibility of expenses e.g., in the following situations:

• Financing transactions where due to a mismatch of either instrument qualification or asset attribution the income is subject to no or lower taxation at the recipient level than without the mismatch (e.g., hybrid loans/equity instruments; certain stock lending- or REPO-transactions). If the non- or low taxation at the recipient level is just temporary and the transaction is structured at arm’s length, the rule does not apply.

• Any deduction/no inclusion scenarios, where the absence of an inclusion as taxable income is due to a mismatch in the qualification of the paying entity (e.g., disregarded transaction under United States (US) entity classification principles). This rule is not limited to financing transactions, but also covers any other payments which are in principle deductible (immediately or over time, e.g., by way of amortization); it also covers “dealings” between a PE and the relevant headquarters. An exception is granted where there also is dual inclusion income at the level of the foreign recipient, and thus the income is effectively taxed despite the mismatch (although a credit of underlying tax would in this case be harmful). The inclusion of the income due to an “equivalent” CFC income imputation would count as effective taxation and thus would turn off the anti-hybrid rule, although it is unclear whether the US Global Intangible Low-Taxed Income (GILTI) inclusion and other CFC regimes, which only impute a portion of the amount paid by the German taxpayer would count as “equivalent” CFC income imputation.

• Any deduction/no inclusion scenario, where the absence of an inclusion as taxable income is due to a mismatch in the qualification of the recipient entity (reverse hybrid; transparent under local law, but non-transparent from owner’s perspective) or a branch income inclusion mismatch.

• Any double deduction scenario, e.g., due to a reverse hybrid entity (non-transparent locally, transparent at owner level), unless coupled with the double inclusion of (positive) income; an exception applies if the taxpayer demonstrates that due to the application of a foreign anti-hybrid rule at the parent or grandparent (though not at subsidiary) level, there is no effective double deduction.

• Imported mismatch scenarios, i.e., scenarios, where there is no mismatch at the level of the direct recipient of the expense, but where there is a mismatch in income taxation at any level other than the direct expense recipient, which is directly or indirectly resulting from the expense (e.g., due to a back-to-back structure). This rule would not apply if the taxpayer demonstrates that due to the application of a foreign anti-hybrid rule at any direct or indirect recipient level, there is no effective mismatch.

In all of these cases, the German deduction is wholly denied (in the case of financing transactions, potentially only partly, if the mismatch only results in “lower” taxation, but not in a non-taxation). The rule applies to all related-party transactions (including persons acting in concert) as well as “dealings” between headquarters and PEs and also to structured arrangements involving third parties, where it is apparent from the contractual documentation or otherwise that a tax advantage resulting from a mismatch was intended. Only where it is reasonable to assume that a taxpayer which is party to an arrangement with a third party was not aware of any tax mismatch advantages and the taxpayer can demonstrate that he/she actually did not benefit from the tax mismatch, no structured arrangement would be assumed.

Even though the legislative process was initiated with the government draft only and the law is expected to be finalized by summer 2021, the draft bill still foresees that these rules are to be applied on expenses accruing after 31 December 2019. As the only exception to this rule, the Draft Law specifies expenses which were (legally) caused before 1 January 2020 unless these expenses are recurring (e.g., lease agreements, loans) and could have been avoided without significant disadvantages. A disadvantage is deemed significant if the costs to avoid the expenses in question would have exceeded the tax benefit from the hybrid arrangement, even though it is unclear why the tax benefit should be an appropriate measure for the significance of a disadvantage. Essentially, this mechanism would “punish” taxpayers for not being willing to at least spend an amount equal to the tax benefit on avoiding the tax benefit. Moreover, it is to be expected that the question of retroactivity will be discussed controversially in general. Since the legislative process was initiated in 2021 and the law will be enacted in 2021 (at the earliest), it is obvious that an application for the tax period 2020 is a retroactive change for an already completed tax assessment period. It will have to be seen whether the fact that anti-hybrid rules were mandated by EU Directives will be sufficient to convince courts that this retroactivity is acceptable in this case. At least where the effect of the German implementation of these rules would exceed the effects of the ATAD minimum standards this is at least doubtful. This includes that rules concerning reverse hybrids, which are only mandated from 1 January 2021 by the ATAD 2 Directive, would not be supported by this position.

Taxation of cross-border asset transfers/exit taxation

The ATAD Directive requires EU Member States to allow a deferred payment of any tax relating to a deemed gain from an exit event (e.g., the transfer of assets from a German PE to a foreign (EU) headquarters or the transfer of an asset from a German headquarters to an EU PE).

The deferral would be granted through a payment of the tax in five equal, annual installments, subject to certain security and holding conditions. In addition, the ATAD Directive stipulates that Member States should introduce corresponding valuation rules for assets which are transferred cross-border, so that the receiving country would be bound to step up the tax basis of the transferred asset to the value which had been underlying an exit taxation at the level of the transferor country.

The proposal follows the principles mandated by the ATAD. This leads to several significant changes compared to the current legal situation:

• While an exit tax deferral was already granted for asset transfers to EU/EEA PEs of German taxpayers, the deferral will now also have to be granted for transfers from German PEs to EU/EEA headquarters.

• Under current law, any asset transferred to a German business from a foreign PE is in principle stepped up to fair market value for tax purposes, irrespective of the foreign tax treatment and valuation. The newly required correspondence of tax valuations would deny the possibility to have mismatches in the asset valuation/taxation upon a cross-border transfer.

• For German-headquartered taxpayers with foreign PEs in jurisdictions for which the tax credit system applies (i.e., no exemption PEs), a transfer of an asset from the PE to the German headquarters would upon application in principle lead to a taxable gain in Germany (and potentially also in the foreign jurisdiction), with a credit of the foreign exit tax being granted by Germany. Again, a valuation correspondence would apply.

CFC rules

The Government took the position that the German CFC rules are generally in line with the ATAD requirements, so only a few but material changes already proposed in the first working draft are included.

The current “high tax kick out” rate for German CFC income is 25%. For quite some time now, the German Government was confronted with taxpayer demands to lower that threshold, since now in many significant foreign jurisdictions, including the US, the effective ordinary corporate tax rates are or may be below that level. The hope was thus, that Germany would, in the course of the ATAD adaption, also lower the CFC income pick up threshold to a tax rate of 15%, or at least 20%, or alternatively allow a credit of foreign taxes on CFC income against the German Trade Tax (a second German business income tax with an average rate of 14%). However, none of those expectations materialized, and the Draft Law neither includes a rate drop, nor a tax credit for Trade Tax.

First, the law introduces, in line with ATAD I, a broader control concept (control is defined as the majority of a direct or an indirect participation in the voting rights, capital or profits of the foreign company). Now, ownership interests of foreign related parties are also considered when determining whether a German taxpayer controls a foreign company. In principle, this can result in CFC taxation, even if the German taxpayer owns only a small interest in a foreign subsidiary (Example: US parent owns 100% of German company B. B owns 5% in foreign company C, A owns the remainder 95% in C – B would be deemed to have “control” over C).

CFC taxation is now in addition imposed on foreign (nonresident) taxpayers, which own CFCs through a German PE. For example, if a foreign taxpayer is a controlling partner in a German limited partnership (KG), which owns foreign subsidiaries which are allocable to the German business of the KG, that partner may now be subject to German CFC taxation on the income of the foreign subsidiaries.

All low-taxed income which does not qualify as “active” income (so called “passive” income) is subject to German CFC taxation. The catalogue of active income has, for the most part, in principle been maintained as is. The draft includes ATAD I-mandated changes which broadens the passive income definition for income earned on goods and services purchased from or sold to related enterprises. The most significant changes relate to the treatment of the CFC’s dividend income. CFC dividend income is now passive, if: (i) the dividend is a hybrid payment, unless certain narrow exceptions apply; (ii) the dividend is a portfolio dividend (<10% ownership); and (iii) certain other dividends, which would not be exempt under German law, had they been received by a resident taxpayer. On a positive note, the passive income definition for CFC capital gains realized on the disposition of shares has been eased. It is now no longer necessary for the active income qualification of that income category to prove that the sold entity did not own any assets with capital investment character. Likewise, the active income definition of gains realized in corporate reorganizations (e.g., a CFC merger) has been eased. It is now also no longer required to prove the absence of assets with capital investment character for the CFC transferee in qualifying corporate reorganizations, as the investment asset test has been abolished.

The so-called CFC “motive test” or anti-abuse test (according to the 2006 Cadbury Schweppes decision of the European Court of Justice), which bars CFC taxation of an EU/EEA Member State has been tightened. To meet the test, the language of the law requires now more precisely the presence of a substantial business activity, which the CFC needs to pursue “on its own” on the basis of appropriate operating substance and qualified personnel.

The CFC income is now deemed received by the German tax resident at the end of the fiscal year of the CFC.

Under the current regime, CFC income is deemed received by the German taxpayer a logical second after the fiscal year of the CFC. Because of this timing change, German taxpayers with CFC income from calendar year CFCs will face in 2022 a double attribution of CFC income (2021 and 2022 CFC income is taxed all in 2022).

The CFC law changes would apply effectively to all CFCs with a fiscal year beginning in 2022 (i.e., for taxpayers which are not on a calendar year, the changes apply later).

_________________________________________

For additional information with respect to this Alert, please contact the following:

Ernst & Young GmbH

• Christian Ehlermann, Munich | christian.ehlermann@de.ey.com
• Daniel Kaeshammer, Freiburg | daniel.kaeshammer@de.ey.com

Ernst & Young LLP (United States), German Tax Desk, New York

• Tobias Appl | tobias.appl2@ey.com
• Martin Schmidt | martin.s.schmidt1@ey.com