The European Court of Justice (ECJ) has recently decided that Germany's anti-treaty shopping rule is not compatible with the EU-Parent-Subsidiary Directive and infringes the EU freedom of establishment (ECJ joint decision on Deister Holding C-507/16 and Juhler Holding C-613/16 dated 20 December 2017). While the decision concerns a former version of sec. 50d (3) of the German Income Tax Act (GITA) which was applicable until 2011, significant conclusions for the current version of the law can be drawn from the ECJ's reasoning in the decision.
Because a further case is pending (C-440/17), the ECJ will soon have the opportunity to decide on the current version of GITA's sec. 50d (3) as well.
Deister Holding and Juhler Holding cases
Both cases that were jointly decided by the ECJ pertain to dividend distributions by a German resident corporate entity to an EU-resident shareholder. Deister Holding, a Dutch entity that held a 26.5 percent share in a German entity, rented office premises and employed two employees in the Netherlands. The sole shareholder in Deister Holding was an individual resident in Germany. Juhler Holding, a Danish entity with shareholdings in Germany, did not rent its own offices but used the premises, facilities and staff of other group companies. Juhler Holding was fully owned by a company registered in Cyprus, which was held by an individual resident in Singapore.
Article 5 (1) of the EU-Parent-Subsidiary Directive (PSD) establishes the principle that – other than for the purpose of preventing tax fraud or abuse – an EU member state shall not levy withholding tax on profits distributed by a subsidiary established in its territory to a shareholder resident in another EU member state. While Deister Holding and Juhler Holding should thus generally have been eligible for an exemption from German withholding tax on dividends, the German tax authorities nevertheless levied withholding tax in these cases due to the German domestic anti-treaty shopping rule.
A benefit granted to a taxpayer under an EU Directive or a tax treaty (ie, the reduction or exemption from German withholding tax) is subject to the German anti-treaty shopping rule in sec. 50d para. 3 of GITA. Technically, the German anti-treaty shopping rule first examines whether a shareholder in the foreign entity would itself not be eligible for the benefit under the EU Directive or tax treaty, reflecting the fact that a Directive or treaty shopping arrangement could generally occur in cases where an entity in a Directive or treaty jurisdiction is interposed. If the shareholder is not eligible for benefits, then sec. 50d para. 3 GITA establishes further conditions which may exclude the otherwise available relief from withholding tax. In particular, a relief is rejected in cases where:
- there are no economic or other substantial reasons for the interposition of the foreign entity or
- the foreign entity did not earn more than 10 percent of its entire gross income for the financial year in questions from its own economic activity or
- the foreign entity does not partake in common economic trading with its trade or business suitably equipped for its business purpose.
Once any of these conditions is fulfilled, there is an irrefutable presumption for a Directive or treaty shopping situation and, thus, an abusive arrangement.The taxpayer does not have further legal means to demonstrate any individual facts to the contrary.
Significantly, the law precludes any reasons to be brought forward that stem from its shareholder or the group, even though in practice strategic or economic reasons of the group often determine the use of a particular legal entity to separate out a specific business. Also, the management of assets alone is statutorily defined as not constituting economic activity.
Decision and reasoning of the ECJ
The ECJ decided that sec. 50d GITA in its former version infringes both Art. 5 (1), Art. 1 (2) of the PSD and the EU freedom of establishment in Art. 49 of the Treaty on the Functioning of the European Union (TFEU). While the PSD clearly prohibits the levying of withholding taxes on dividend distributions in its Art. 5 (1), according to Art. 1 (2) a member state may introduce such tax for the purpose of preventing tax fraud or abuse. According to the ECJ's established case law, such measure must have, however, the specific objective to prevent wholly artificial arrangements which do not reflect economic reality and seek to unduly obtain a tax advantage.
It is on this point that the ECJ found the anti-treaty shopping rule to violate the PSD. The ECJ in particular argued the following:
- The German rule does not specifically seek to prevent wholly artificial arrangements but in a general fashion covers all situations where a shareholder is invested in a foreign entity and would itself not be eligible for a Directive or treaty benefit. However, this fact in itself would not indicate an abuse according to the ECJ.
- Second, the ECJ argued that the rule would lead to an irrefutable presumption that tax fraud or abuse were proven once its generic conditions are fulfilled, and would neither require the tax authorities to provide any initial evidence that an abusive arrangement is present nor give the taxpayer the opportunity to provide individual evidence of economic reasons for the chosen structure. Also, the conditions in the law separately or taken together would not necessarily indicate an abuse or tax fraud.
It is noteworthy that the ECJ held that neither the economic activities of the taxpayer merely consisting in the management of assets of a subsidiary nor its income being solely derived therefrom would per se indicate an abuse. It also held that, to test an abusive arrangement, all facts of a case would need to be verified, including organizational, economic or other grounds in the group, as well as structure and strategies of the group.
In relation to the freedom of establishment, the ECJ held the same considerations to be applicable and thus found an unjustified infringement caused by the former version of sec. 50d (3) GITA.
While the case on the current version of the anti-treaty shopping rule has not yet been decided by the ECJ, the decision in Deister Holding and Juhler Holding may ultimately lead to a change of a legal regime which often left foreign investors puzzled by the considerable, if not futile, administrative efforts required to prove eligibility for a withholding tax exemption in Germany.
In practice, it has often been quite difficult to defend a treaty position because the German tax authorities in many cases qualified dividend income as passive income resulting from mere asset management activities unless rather specific circumstances could be presented. Also, based on the wording of the law, the tax authorities dismissed altogether any reasons that resulted from the applicant's group strategy or business organization. This situation is further aggravated by the fact that the taxpayer could not provide any individual counter-evidence.
In light of this decision of the ECJ, the German tax authorities may no longer disregard mere asset management activities by the applicant or business reasons originating from the applicant's group when assessing eligibility for Directive or treaty benefits.
The ECJ has now indicated that EU laws set limitations to such an approach when a member state is seeking to curb potential treaty abuse.Importantly, these considerations made by the ECJ should equally apply to the current version of the law. Thus, it can be expected that the ECJ should come to similar conclusions in relation to the applicable law in the pending case.
It is advisable to consider an administrative appeal against any rejection of a withholding tax exemption by the Federal Tax Office, even under the current anti-treaty shopping rule, to retain any potential upside from further developments.