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In March this year, the Commission has initiated treaty violation proceedings against Germany directed against section 50 d paragraph 3 of the German Income Tax Act. According to the opinion of the Commission this regulation breaches the principle of freedom of capital movement within the EU. This income tax regulation aims at curtailing the international business practice of treaty shopping, i.e. choosing a jurisdiction offering favorable withholding tax conditions in regard to Germany`s domicile for a holding company. Among such countries are Austria, Cyprus, Denmark, Labuan, Luxembourg, Malta, Madeira, Mauritius, the Netherlands and Switzerland.

The aforementioned regulation provided in national income tax law stipulates that intermediate companies based in a low tax jurisdiction and receiving dividends from a German subsidiary under certain conditions are deemed insubstantial for German taxation purposes. The consequence of being considered a letter box company is a derecognition of the advantages as provided in the Double Taxation Agreement with the respective country.

German law regulates the following criteria any foreign mother company has to comply with in order to be granted the advantages of any DTA:

- there must be a reasonable business interest in maintaining it

- it must maintain an office in the foreign country

- it must employ staff and

- at least 10 per cent of the foreign company`s profits must be gained due to its own operation.

The tightening of the German tax laws was a reaction to a judgement rendered by the German Federal Fiscal Court in 2008. The case submitted to the court was about a Swiss citizen who had established a corporation in Luxembourg in 1992 serving as a shell company for a corporation located on the British Virgin Islands. Over the years a German subsidiary paid 13.600.000 Deutsche Mark in dividends to its parent company in Luxembourg. The German tax office resisted to apply the low withholding tax rate on these transferred income of the subsidiary. It argued that the only purpose of the company structure was the evasion of taxes. Long enduring court actions followed. The German Federal Fiscal Court finally ruled that it were the fiscal authorities that shared the burden of proof for their statements and not the German subsidiaries.

The act revising the German tax law was supposed to make the issue easier for the tax office. However, the EU Commission does not tolerate this national override of the more liberal international law. In particular, it objects against the schematic 10 per cent rule which is of no use for identifying a letter box company. In contrast, this rule could also place an insurmountable hurdle for regular corporate holdings which have not been established for the purpose of tax evasion.

Furthermore, the EU-Commission objects that German law does not allow holding companies who are deemed insubstantial to produce proof of the contrary.

The chances that the action of the EU Commission will succeed is high. In 2004 the European Court of Justice rendered a judgment in this case against England in re Cadbury Schweppes. The company had maintained subsidiaries in Ireland and the British internal revenue service tried to tax their profits whereas the business group wanted to achieve a (significantly lower) taxation in Ireland.

Should Germany be compelled to revise its laws and make it consistent with EU law at least offshore jurisdictions belonging to the EU and the European Economic Area will profit. In the meantime, business who have established such structures are well advised to take legal remedies and defend themselves vigorously against any attempt of the German tax authorities to circumvent international law.

Henning Haarhaus
Certified German Attorney-at-Law
Certified Tax Specialist Lawyer

Schlossstr. 29, 12163 Berlin
Tel. ++49/ (0)30/ 7720.6623
Fax ++49/ (0) 30/ 7719-0026
http://www.kanzlei-haarhaus.de/english/Overview-english.htm

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