Return of Capital - a Hot Topic in German Tax Audits
Since December 2012, French companies have been liable for a 3 percent tax on distributions to their shareholders (3 Percent Tax), but practitioners have widely questioned whether this tax is compliant with the provisions of the EU treaties and the double tax treaties signed by France. French subsidiaries whose parent companies are established in an EU Member State or in a treaty-protected State should consider submitting a claim to obtain a refund of the 3 Percent Tax. To date, a number of companies have already sent a claim to the French tax authorities, and some are in the process of bringing their claim before the competent administrative lower court.
Scope of the 3 Percent Tax
The 3 Percent Tax is assessed on dividend distributions and/or deemed dividend distributions by French companies, French permanent establishments and other French entities that are liable for corporate income tax in France. For French tax purposes, the 3 Percent Tax is defined as a corporate tax due by the French distributing entity, not as a withholding tax.
However, the 3 Percent Tax does not apply to distributions made by small and medium-sized companies (as defined by EU Regulation n° 800/2008), or between companies that are included in the same French tax consolidated group. Pursuant to the French tax code, French companies, as well as non-French companies with a French permanent establishment, can form a tax consolidated group with the subsidiaries in which they hold, directly or indirectly, at least 95 percent of the shares).
Compliance with the Parent-Subsidiary Directive
Pursuant to Article 5 of the EU Parent-Subsidiary Directive, distributions to EU parent companies that directly hold at least 10 percent of the shares of the relevant EU distributing subsidiaries for at least two years are exempt from any withholding tax.
Under European Court of Justice (ECJ) case law, the withholding tax is defined as “any tax on income received in the State in which dividends are distributed, where (i) the chargeable event for the tax is the payment of dividends or of any other income from shares, (ii) the taxable amount is the income from those shares and (iii) the taxable person is the holder of the shares.” (See in particular ECJ, n° C-286/06, June 26, 2008, Burda GmbH.)
Since the 3 Percent Tax is assessed on the French distributing entity rather than the holder of the shares, the success of a claim based on the withholding tax exemption of the EU Parent-Subsidiary Directive is uncertain. In a previous case and in similar circumstances, the ECJ recognized that a tax levied at the level of a distributing entity had the same economic effect as a withholding tax and should therefore be regarded as such. (See ECJ, n° C-294/99, October 4, 2001, Athinaïki Zythopoiia AE.)
Compliance with the Freedom of Establishment
Pursuant to Article 49 of the Treaty on the Functioning of the European Union (TFEU), restrictions on the freedom of establishment of EU companies are prohibited to the extent that they cannot be justified by an overriding reason of public interest.
The 3 Percent Tax Constitutes a Restriction on the Freedom of Establishment
Under ECJ case law, differing tax treatment of French companies in comparable positions, based on their shareholders’ place of establishment, constitutes a restriction on the freedom of establishment. (See in particular ECJ n° C-324/00, December 12, 2002, Lankhorst-Hohorst GmbH.)
The 3 Percent Tax is assessed on a French distributing company held by a non-French parent company with no permanent establishment in France, but not on a French distributing company held by a French parent company if both companies are included in the same French tax consolidated group. Under French case law, the position of both French distributing companies should be considered as comparable, to the extent that the non-French parent company in question would have been in a position to form a tax consolidated group with its French subsidiary had it been established in France. Therefore, this difference in tax treatment should constitute a restriction on the freedom of establishment. (See French Tax Supreme Court, n° 249047, December 30, 2003, SARL Coréal Gestion.)
The Restriction Is Not Justified by Any Overriding Reason of Public Interest
A restriction on the freedom of establishment may be justified by an overriding reason of public interest to the extent that the restriction is proportional to the achievement of the objective pursued. In particular, the French tax authorities could argue that the restriction brought about by the 3 Percent Tax is justified because it preserves the cohesion of the tax system.
The preservation of the cohesion of the tax system would be regarded as a valid justification if there was a direct link between the grant of a tax advantage and the compensation for that advantage through a tax levied within the framework of the same tax regime. In the scenario at hand, the French tax authorities would claim that the exemption from the 3 Percent Tax granted to distributions within French tax consolidated groups is compensated by the taxation of distributions made to shareholders of the French parent companies, and that this objective would not be achieved if exemption from the 3 Percent Tax were also granted for distributions to non-French parent companies.
It is unlikely, however, that this justification would be upheld in the courts, since the exemption from the 3 Percent Tax granted to distributions within French tax consolidated groups is not subject to the condition that the distributions received by the French parent company be distributed onward to its shareholders and thus be subject to the 3 Percent Tax. (See ECJ n° C-300/07, June 18, 2009,Aberdeen Property Fininvest Alpha Oy.)
Furthermore, non-French parent companies that have a permanent establishment in France are entitled to form a French tax consolidated group, such that distributions by their French subsidiaries are definitely exempt from the 3 Percent Tax. Therefore, French subsidiaries that are at least 95 percent held by EU parent companies should be entitled to claim a refund of the 3 Percent Tax based on article 49 of the TFEU.
This position is also shared by the European Commission, which launched an infringement procedure against France on February 26, 2015, on the ground that the 3 Percent Tax constitutes an infringement to the freedom of establishment. The European Commission also argued in its notification letter that the 3 Percent Tax constitutes an infringement to the Parent-Subsidiary Directive, as discussed above.
Compliance with the Double Tax Treaties Signed by France
Most of the double tax treaties signed by France include a non-discrimination provision, pursuant to which French companies that are wholly or partly held by residents of the other contracting State shall not be subjected to taxation that is more burdensome than the taxation to which other similar French companies are or may be subject.
Under French case law, the French subsidiary of a non-French parent company should be considered as similar to a French subsidiary that is included in a French tax consolidated group to the extent that the non-French parent company would have been in a position to form a tax consolidated group with its French subsidiary had it been established in France. (See French Tax Supreme Court, n° 233894, December 30, 2003, Andritz.)
Therefore, French subsidiaries that are at least 95 percent held by parent companies established in a treaty-protected state should also be entitled to claim a refund of the 3 Percent Tax based on the non-discrimination provisions of the relevant double tax treaty.
Introducing a Claim to Obtain a Refund of the 3 Percent Tax
Claims to obtain a refund of the 3 Percent Tax (based on the grounds discussed herein) must be sent to the French tax authorities no later than December 31 of the second year following the year in which the 3 Percent Tax was paid.
If the French tax authorities reject the claim (or do not reply within a six-month period), the taxpayer will be entitled to bring the claim before the competent administrative lower court during a two-month period following the notification of the refusal (or, in case of a deemed refusal, following the end of the six-month period). The lower courts typically render decisions within two years following commencement of the action.
If the court decision is not satisfactory to the taxpayer, an appeal can be brought before the competent administrative court of appeal, and ultimately before the Supreme Tax Court, in case of a breach by the court of appeal of a rule of law.
Critical Factors in Handling Italian Transfer Pricing Controversies
Dr. Gero Burwitz
One of the most heavily disputed topics between taxpayers and the German fiscal authorities is whether a return of capital by a non-German-resident subsidiary of a Germany-based parent is tax neutral, or whether it must be deemed a taxable dividend. In a 2013 judgment, the regional Fiscal Court of Nuremberg approved the tax neutrality of returned capital in a case involving the spin-off of a U.S. subsidiary. The case is now pending before the Federal Fiscal Court, and a decision is expected later in 2015 or in early 2016.
The principle that a return of capital is tax neutral at the parent level is applicable to parent companies resident in Germany. In contrast, a distributed profit (dividends) is taxable at the level of the shareholder that receives such dividends. If the shareholder is a German corporation, 95 percent of the dividends are tax exempt; 5 percent of the dividends are taxable as a fictive non-deductible business expense. Therefore, the dispute between taxpayers and the authorities centers on whether the repayment is fully tax neutral, or whether 5 percent of the payment is subject to German tax. If a portfolio company distributed the dividends, the dividends are fully taxable.
German tax law has established a strict regime for proving that a distributed amount is a return of capital and not a distribution of profits. A German subsidiary must calculate its capital solely for tax purposes. It may only be assumed that a distributed amount is a repayment of capital if there is no profit that could be distributed first. This is one reason why the calculation of capital for tax purposes is not identical to the calculation of capital for German GAAP purposes. For tax purposes, capital is assessed annually by means of a separate tax bill for a subsidiary. This bill is the basis for the calculation of capital the following year, plus or minus inflows and outflows over the course of the year.
This capital assessment is also binding for taxation of shareholders: a shareholder may claim a tax-neutral return of capital only to the extent that the subsidiary’s capital decreased.
Return of Capital by a Non-German Subsidiary
The principle described above does not work if the subsidiary is not resident in Germany and therefore is not subject to capital assessment for tax purposes. In the early 1990s, the Federal Tax Court provided some relief by deciding that the tax neutrality of a capital return may not be denied simply because a subsidiary is not in a position to show its capital for tax purposes under German legal requirements. According to the court, any formal reduction of nominal capital leads to a tax-neutral capital return at the shareholder level. Furthermore, if the return of capital is not induced by a reduction of nominal capital, the capital return is still tax neutral if there is a repayment of capital reserves under the applicable local (i.e., non-German) commercial and corporate law. According to a later Federal Fiscal Court decision involving a U.S. subsidiary, these principles also apply when a subsidiary distributes shares in its own subsidiary to its shareholders (i.e., a spin-off).
Change of Law for EU Subsidiaries
Although these Federal Fiscal Court judgments offered some relief, the law still provided for different legal consequences depending on whether a subsidiary of a German parent was resident in Germany. This distinction resulted in discrimination and therefore constituted a violation of the EU right to freedom of movement of capital. In 2006, the legislature made a change to the relevant law, allowing non-German companies to apply to the Federal Central Fiscal Authority for an assessment of their capital as if they were resident in Germany. So far this right has been granted only to companies resident in the European Union, however.
This 2006 law change has raised enormous practical and legal issues. In accordance with German tax law, an EU company must show all capital elements that were repaid since the capital was contributed, dating as far back as January 1, 1977. A newly founded company might be able to meet this requirement, but a long-established company can find it extremely difficult to collect the annual reports and records of all decisions affecting the capital in order to submit the required information. It can be argued that these formal requirements constitute a new breach of the freedom of movement of capital. Smaller companies, or those with only German minority shareholders, are often reluctant to undertake the process.
The application for capital review must be filed within one year after the end of the fiscal year when the return of capital was made. Many companies miss that deadline, usually because they are unaware of the option to file an application or of the deadline, and the authorities generally will not extend the application deadline. The deadline for assessment of German subsidiaries is later, and this discrepancy might be a further breach of EU law and the Double Taxation Conventions anti-discrimination clauses.
Treatment of Non-EU Subsidiaries
The fiscal authorities argue that the 2006 change in law applies exclusively to EU entities. They claim that the legislature created the procedures for German and EU companies only, meaning that all other companies are excluded without exception. There is no room to apply the prior court rulings that allowed tax neutrality under consideration of local laws.
In its June 12, 2013, decision in the U.S. spin-off case, the Fiscal Court of Nuremberg ruled against the authorities’ opinion, holding that neither the provision’s wording nor the legislature’s intention requires exclusion of a return of capital by a third-country company. According to the Fiscal Court of Nuremberg, the court applies the prior judgments and verifies whether a payment may be qualified as return of capital under local law. As a consequence, the Germany-resident recipient of the returned capital must prove that the payment may be qualified thus by directing the subsidiary to assist by providing the necessary information.
This ruling by the Fiscal Court of Nuremberg also has the benefit of avoiding infringement of the freedom of movement of capital. That principle is the only basic EU freedom that is applicable to investments of German residents in non-EU countries and vice versa. In other words, U.S. companies may claim protection under the principle of the freedom of movement of capital.
The Federal Fiscal Court is expected to rule in 2015 or early 2016 on the fiscal authorities’ appeal against the Fiscal Court of Nuremberg’s ruling.
For the time being, entities should take the following points into consideration:
- Any return of capital requires a clearly worded statement of the relevant actions, and proper documentation.
- A company’s approach to the German fiscal authorities should be twofold, as it is not clear which viewpoint might prevail:
- A third-country subsidiary should apply for an assessment of its capital for German tax purposes. This approach is consistent with the argument that third-country companies must be treated equally to EU companies under the freedom of movement of capital, and therefore the same assessment procedure should apply. Under this approach, the subsidiary bears the burden of showing the development of the capital.
- The German parent should make a tax declaration that claims tax neutrality of the returned capital. The parent should apply for a stay of procedures in light of the case pending before the Federal Fiscal Court.
UK Tribunal Rules on "Rate-Booster" Strategy
In response to the economic downturn and the growing need for tax revenues, the Italian Tax Authorities (ITA), like authorities in many other jurisdictions, have more aggressively targeted multinationals and their tax planning strategies in recent years, resulting in more domestic and international tax controversies. Transfer pricing (TP) issues account for the lion’s share of these controversies between multinationals and the ITA.
In 2010, Italy introduced TP documentation regulations that provide penalty protection for taxpayers that comply with the documentation requirements. Considering the harsh penalties applicable in cases of TP adjustments (ranging from 100 to 200 percent of the assessed tax deficiency), Italian companies (particularly Italian affiliates of multinational groups) have generally taken the opportunity to seek protection from penalties very seriously, and have made appropriate efforts to establish compliant TP documentation. In turn, the ITA have been able to rely on more complete data sets, making it easier for them to assess TP policies within multinational groups. Contrary to previous standard tax audit practice, currently no tax audit of a multinational takes place without a thorough investigation of the group’s TP policy. Not surprisingly, the number of TP controversies has dramatically increased as a result.
When facing a TP adjustment, Italian companies have an array of available remedies, including both domestic and international procedures. At a domestic level, there are various forms of settlement with the ITA, either before or after litigation has been started. Although litigation remains a viable solution, generally neither party (taxpayer or ITA) is keen to litigate TP cases, given the technicality of the issues at stake, the length of the proceedings and the unpredictability of the tax court’s decisions.
Taxpayers also can apply for a mutual agreement procedure (MAP) with the competent authorities under the applicable Double Tax Convention (DTC), in order to avoid double taxation. If the related party involved in the intercompany transaction is a resident of another EU Member State, the taxpayer may choose to initiate an MAP pursuant to the EU Arbitration Convention, which includes a mandatory arbitration clause, instead of an MAP pursuant to the applicable bilateral DTC, which usually only entails a best effort (not an obligation) for the competent authorities to reach an agreement.
The interplay between domestic remedies (settlement, litigation) and MAPs is intricate, however, and works differently depending on which kind of MAP (pursuant to the DTC or to the EU Arbitration Convention, where applicable) is initiated. In any case, the ITA’s position is that a domestic settlement forecloses the possibility of pursuing an MAP, so that in case of settlement only a correlative adjustment unilaterally granted by the other State could avoid or reduce double taxation. This position seems to contrast with the Discussion Draft on BEPS Action 14, and taxpayers eagerly await a change in the ITA’s policy.
While an MAP theoretically is the best solution from a taxpayer’s perspective, several factors put pressure on the taxpayer to settle the controversy with the ITA, resulting in loss of access to the MAP according to the ITA’s current position. Such factors include the following:
- Penalties. Tax settlement rules entail significant reductions in tax penalties, ranging from one-sixth to one-third of the applicable penalty. Such reduction may occur as a general rule when no TP documentation has been provided for the relevant fiscal year, so that the penalty protection rule is not applicable. However, reduction may also occur as a result of denial to apply the penalty protection rule—i.e., if the ITA deem that the TP documentation does not meet the statutory requirements in terms of its structure or, more likely, its accuracy and/or reliability. The ITA sometimes raise this objection, even instrumentally, in order to deny the penalty protection and put additional pressure on the taxpayer to settle the case.
- Interplay with MAPs under bilateral DTCs. Generally, MAPs under bilateral DTCs require that domestic remedies not be waived, obligating the taxpayer to start a domestic litigation. Under Italian rules, starting litigation does not suspend the obligation to pay the assessed taxes; one-third of the assessed taxes and relevant interest remain due. However, the taxpayer can submit a claim of suspension to the court, which has discretionary power to grant suspension of the interim payment.
- Uncertainty, timing and cost. MAPs entail uncertainty regarding the outcome for an extended period of time, and are expensive and time-consuming procedures. Moreover, as noted, most DTCs do not include an arbitration clause, so an agreement between the competent authorities is not mandatory and may not be reached.
- Profit/loss impact. Management is often more sensitive to profit/loss rather than cash impacts. If an accrual is to be made pending an MAP, it is often perceived as a final impact in a short-term management approach.
Among the factors listed above, penalties, when applicable, perhaps play the most critical role, and may constitute a trade-off that can seriously discourage a taxpayer from starting an MAP. While a reduction of the TP adjustment under a domestic settlement automatically entails an ensuing mitigation of penalties, the same reduction of the TP adjustment achieved under an MAP has no effect on the corresponding penalties.
The following example shows the minimum result required for an MAP to break even—i.e., to match the final charge (tax plus penalties) obtained under a settlement.
Tax assessment (base scenario)
Minimum result required in order to make MAP break even*
Tax due = 200
Tax due upon settlement = 120
Tax due = 160
Penalties at 100% = 200
Reduced tax penalties = 120 x 33% = 40
Tax penalties (without reduction, i.e., 100%) = 160
Total = 400
Total = 160
Total = 320
*Assuming that the higher tax due in Italy as a result of the MAP is fully offset by the tax relief on the corresponding adjustment in the other State. This analysis is negatively affected if a lower tax rate applies in the other State.
TP adjustments also can have criminal ramifications. Under Italian law, tax adjustments above certain thresholds (which are easily reached when large companies are involved) can result in tax crimes irrespective of whether any fraudulent intent or behavior by the taxpayer exists. The ITA often submit a notice of crime to the Public Prosecutor. While most of these cases are dismissed before going to trial, particularly when the tax penalty protection rule applies, in some cases criminal proceedings have actually been started (and continued) on TP matters.
The possibility of criminal prosecution clearly can be powerful factor in a taxpayer’s decision regarding defensive strategy. Under current legislation, settlement with the ITA does not automatically imply dismissal of a criminal charge, but is generally viewed favorably by the Public Prosecutor. Sometimes the choice of settlement strategy is primarily, if not solely, driven by the opportunity to facilitate the dismissal of a criminal charge. A legislative change expected to be enacted later in 2015 provides that tax settlement will automatically trigger dismissal of any criminal charge; this change will likely further increase the pressure on taxpayers to settle.
The combination of the aforementioned factors provides many practical reasons for Italian affiliates of multinational groups to settle TP adjustments with the ITA under domestic procedures, even though such settlement forecloses access to MAPs and waives the possibility for a correlative adjustment in the other State involved (unless the latter unilaterally provides relief against double taxation). This ITA policy does not seem consistent with the spirit of the DTCs entered into by Italy and appears to be in contrast with the Discussion Draft on BEPS Action 14. As long as this policy remains unchanged, however, multinationals may be forced to choose suboptimal defensive strategies when dealing with TP adjustments.
This ITA policy also often creates disappointment in the competent authorities of the other States involved, as they sometimes feel “forced” to grant unilateral relief against double taxation that they might otherwise be unwilling to concede. A practical way to mitigate this effect is to involve the competent authorities of the other State at a very early stage of the Italian administrative, and where applicable, criminal, proceedings. Such involvement can be achieved by initiating an MAP in the other State and keeping the competent authorities of that State constantly informed of any developments occurring on the Italian side, in parallel with the developments of the MAP (if any). This continuous flow of information may give the competent authorities a better awareness of the factors pushing the taxpayer to settle the controversy with the ITA, and the fact that a settlement with the ITA may ultimately represent the most effective remedy available for the taxpayer.