Germany: 138. Recent Court Decisions On Abuse Of Law And Treaty Shopping

Last Updated: 8 July 1998
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1. Introductory
2. "Monaco" decision overruled
3. IFSC decisions by the Tax Court of Baden-Wuerttemberg
3.1 Statement of facts
3.2 Court's principal holding and grounds thereof
3.3 Other issues addressed by the court
3.3.1 Relationship of sec. 42 AO to EU law
3.3.2 Relationship to the International Taxation Act
3.3.3 Non-tax reasons rejected by the court
3.4 Possible alternative grounds of the decision
4. Treaty shopping decision of the Federal Tax Court
4.1 Statement of facts
4.2 Highlights of the court's holding
4.2.1 sec. 42 AO not inapplicable by reason of tax treaty
4.2.2 Rule shopping vs. treaty shopping
4.2.3 Application of sec. 42 AO to non-resident persons
4.2.4 No preclusion of sec. 42 AO by sec. 50d (1a) EStG for years prior to 1994
4.2.5 Relation of sec. 42 AO to sec. 50d (1a) EStG
4.2.6 Criteria of application of sec. 42 AO
5. Conclusions

For disclaimer and copyright see end of this article.

In article no. 119, we reported on a recent Federal Tax Court decision (IStR 1998, 113 - 27 August 1997) applying the general anti-abuse provision of German tax law, sec. 42 AO (Abgabenordnung or tax procedure act). The present article expands upon the same subject by commenting on two tax court decisions currently on appeal to the Federal Tax Court and on a second recent decision by the Federal Tax Court itself. The Federal Tax Court decision poses various treaty shopping issues.

1. Introductory

German tax law contains a general anti-abuse provision in sec. 42 AO, which reads as follows:

"The tax laws may not be circumvented by abuse of legal structuring possibilities. In case of [such] abuse, the tax claim [of the tax authorities] is the same as that arising under a structure appropriate to the economic transaction."

The vagueness of the statute makes it difficult for taxpayers and tax authorities alike to know when it will apply. Obviously, a structure cannot be "abusive" in the sense of the law just because it was preferred over another structure which would have resulted in greater tax liability. Over the years, the courts have tended to regard structures as abusive if they are unusual (artificial, contrived) and serve no sound business purpose.

The decisions here reported on may be indicative of new court sanction for a broader interpretation of sec. 40 AO than has hitherto been permitted. Two stem from the Tax Court of Baden-Wuerttemberg and concern Irish International Finance Service Centre (IFSC) companies, the other was rendered by the Federal Tax Court with respect to withholding tax on payments to foreign athletes.

2. "Monaco" decision overruled

The Federal Tax Court handed down a decision in 1982 which held, or was at least interpreted as holding, that sec. 42 AO applied only with regard to corporations ( such as functionless "mailbox" companies) interposed by domestic taxpayers (BFH BStBl II 1982, 150 "Monaco"). This decision has now been overruled by the Federal Tax Court (IStR 1998, 113 - 27 August 1997, reported on in article no. 119, and BFH BStBl II 1998, 235 - 29 October 1997, reported on below). Under these decisions, the anti-abuse provision is equally applicable to companies interposed by foreign taxpayers liable to tax in Germany on German source income. Nevertheless, certain differences arguably still remain between domestic and foreign taxpayers regarding the manner of application of the anti-abuse clause (see below sec. 4.2.6).

3. IFSC decisions by the Tax Court of Baden-Wuerttemberg

The two decisions by the Tax Court of Baden-Wuerttemberg, both dated 17 July 1997, have been appealed to the Federal Tax Court. They are known as the "Ireland I" and "Ireland II" decisions (IStR 1998, 629 and 758 and IWB Nr. 17 of 10 Sept. 1997 - Fach 3a Gruppe 1 p. 629 ff.). Ireland II is also published in EFG 1997, 1204 .

3.1 Statement of facts

The facts of Ireland I and Ireland II are similar and may be stated (in simplified form) as follows: Together with others, a German parent corporation formed an Irish subsidiary located in the International Finance Service Centre (IFSC) in Dublin. The Irish subsidiary was licensed by the Irish authorities as a registered IFSC company. In the years at issue, 1990 and 1991, the Irish subsidiary qualified for a reduced rate of Irish corporation tax (10 % instead of 40 % or 43 %) under the Irish IFSC subsidy scheme, the purpose of which is to create jobs in Dublin in the international financial services sector. The business purpose of the subsidiary was the investment of funds in international finance markets. The subsidiary had a board of directors, but no premises of its own and only a couple of part-time employees. The subsidiary entered into management contracts with other financial service companies (also IFSC companies), and the management service provider managed its assets, as it did those of various other similar companies. In the case of Ireland II, the court emphasised that the German parent corporation was a large German insurance company which independently managed DM 15 billion of investments in addition to the sums invested through its IFSC subsidiary.

3.2 Court's principal holding and grounds thereof

The court held that interposition of an IFSC subsidiary was in both cases (Ireland I and II) abusive within the meaning of sec. 42 AO and that German tax was therefore to be imposed as if the German parent had invested its capital directly through the Dublin financial services market, in effect, as if the German parent had contracted directly with the Dublin management service provider. The income from the investments was therefore to be attributed to the parent as interest income taxable in Germany under Germany's tax treaty with Ireland. The court did, however, allow deduction of the expenses associated with the abusive structure, stating that they were equivalent to the expenses which would have arisen if the German parent had contracted directly with a Dublin asset management service provider. The court also allowed deduction of the 10 % Irish corporation tax paid by the IFSC subsidiary, although this was obviously not an expense which would have arisen under a direct investment.

The decisions rest on the court's finding that the interposition of the IFSC subsidiary was motivated solely by tax considerations and not supported by any non-tax purpose. In view of the slight degree of substance in and the minimal activities conducted by the Irish subsidiaries, the cases did not sharply pose the important issue of whether significant substance (employees and premises) and independent economic activity will shield a corporation from attack as abusive if non-tax motivation ("economic or other relevant reasons") is lacking.

The decisions are also not entirely clear as to the significance of the management service contracts. While one of the casenotes for Ireland II suggests that such "outsourcing" is positively damaging at least with regards to securities investment activities, the grounds of the decision itself seem to state no more than that activities conducted by an asset management company on behalf of an interposed subsidiary are not sufficient to prevent application of sec. 42 AO when no non-tax purpose for interposition of the subsidiary can be demonstrated.

In his interesting comments on Ireland I (IWB Fach 3a Gruppe I pp. 632 ff. at p. 634), Dr. Horst-Dieter Hoeppner, a senior official in the Federal Office of Finance (Bundesamt fuer Finanzen) argues that the trend of Federal Tax Court case law is towards requiring both "economic or other relevant [non-tax] reasons" for interposition of a subsidiary and substance in the interposed company (significant economic activity of its own). In his view, no amount of substance or independent economic activity can save a structure from being abusive if a legitimate non-tax purpose (which need not be the sole purpose) is lacking.

It is, however, by no means clear that the Federal Tax Court will endorse this position (see comments on Federal Tax Court decision in sec. 4 below).

3.3 Other issues addressed by the court

Other major issues addressed by the court in Ireland I and II are summarised briefly below:

3.3.1 Relationship of sec. 42 AO to EU law

The taxpayer raised various defences under EU law which the Federal Tax Court will certainly confront again on appeal. The lower court's holdings were as follows:

  • The German anti-abuse provision of sec. 42 AO is not pre-empted by a general unwritten EU anti-abuse clause.
  • The approval given by the EU Commission under Article 93 of the EC Treaty to the Irish IFSC tax subsidy scheme does not immunise the interposition of an IFSC company from review under sec. 42 AO. The court did accord some weight to this issue, however, and was at pains to show both that the type of investment here involved did not further the governmental objectives of the IFSC scheme and that application of sec. 42 AO on a case-by-case basis would not completely negate the legitimate effect of the subsidy scheme, because other corporations, e.g. with more substance, could still be interposed without posing abuse issues under sec. 42 AO.
  • Application of sec. 42 AO does not violate the taxpayer's freedom-of-establishment rights under Articles 52, 58 of the EC Treaty.

3.3.2 Relationship to the International Taxation Act

The taxpayer argued that the International Taxation Act (AStG) took precedence over sec. 42 AO with respect to the taxation of the income of interposed corporations and that the AStG in force for the years in question (prior to 1992) in conjunction with the Irish tax treaty did not provide for taxation of the passive investment income here involved. The court held that sec. 42 AO has logical priority over the International Taxation Act. If sec. 42 AO is applicable to a particular tax structure, then this structure is disregarded pursuant to sec. 42 AO without reaching the secondary question of applicability of the International Taxation Act. This approach is supported by the decisions of the Federal Tax Court (BStBl II 1992, 1026 and 1029 - decisions of 23 October 1991 and 10 June 1992).

3.3.3 Non-tax reasons rejected by the court

The taxpayer advanced the following non-tax reasons for interposition of the IFSC company, all of which were rejected by the court:

  • Improvement of balance sheet of parent company by avoiding mark-to-market accounting for securities purchased directly or through investment companies.
  • Access to the special know-how of the Dublin financial markets in general and that of the interposed subsidiary's board of directors in particular.
  • There was some argument on the yield expected from investment through the interposed subsidiary as opposed to the yield on a direct investment or the yield on investment from Germany. While the facts are not completely clear on this point, the taxpayer was apparently not able to make a convincing showing of any economic advantage of the chosen structure.
  • The court was not convinced by argument that the chosen structure avoided certain organisational and bookkeeping problems.

3.4 Possible alternative grounds of the decision

Particularly with regard to Ireland II, the court stated that the facts were such that its decision might have rested on sec. 39 (2) AO, which reads in pertinent part, "property held in fiduciary capacity is to be attributed to the principal". Under this legal theory, the interposed IFSC corporation would be regarded as the fiduciary (straw man) of the German parent and attribution of the assets of the IFSC subsidiary to the parent would follow under sec. 39 (2) AO. The court expressly declined to rule on this issue since it reached a similar result under sec. 42 AO.

4. Treaty shopping decision of the Federal Tax Court

4.1 Statement of facts

In its decision of 29 October 1997 (BStBl II 1998, 235), the 1st Panel (I. Senat) of the Federal Tax Court was called upon to decide the appeal taken by a Dutch limited liability company (BV) against denial of an exemption from withholding tax on certain payments connected with athletic events held in Germany. The Dutch BV was under contract to the German athletic event organiser to provide foreign resident tennis players for tennis tournaments and render certain other services, in particular to arrange television broadcasting. Under Dutch law, the income of the BV from the German sporting events would have been subject to less than 3 % tax. Its postal address was identical with that of a large number of other companies. The BV had no permanent employees of its own in the years at issue (1988 and 1989). It apparently did have some limited term employees and freelance employees. The BV was closely related to two other similar Dutch companies, all of which were ultimately owned by the same individual.

4.2 Highlights of the court's holding

The Federal Tax Court remanded to the lower court (tax court) for further findings. It indicated that it would uphold denial of the withholding exemption certificate on the grounds that interposition of the Dutch BV was abusive under sec. 42 AO if the BV was in effect a vehicle for avoidance of German withholding tax by the foreign athletes engaged by the BV, who would not have been entitled to a withholding exemption if they had contracted directly with the German event organiser. To make this determination, more information was needed on the relationship of the athletes to the BV. If interposition of the BV were abusive, the income in question would be attributable directly to the foreign athletes involved. The highlights of the decision are as follows:

4.2.1 Sec. 42 AO not inapplicable by reason of tax treaty

The court held that the tax treaty with the Netherlands did not preclude application of German domestic law to determine to whom the income in question was to be attributed. Attribution of income, the court stated, is an issue not addressed by tax treaties as a basic matter and hence remains fully subject to domestic law unless the tax treaty contains specific anti-abuse provisions. The decision does not discuss the relationship of sec. 42 AO to such specific treaty provisions, however. In a lengthy article on the instant decision, Fueger/Rieger (IstR 1998, 353, 355 ff. and footnote 26) argue, however, that specific treaty provisions pre-empt sec. 42 AO unless the context indicates a contrary intent. They note, however, that the point is moot with respect to most German tax treaties as only a few (such as those with the United States and Switzerland) contain anti-abuse provisions.

4.2.2 Rule shopping vs. treaty shopping

A distinction is to be drawn between a structure chosen to confer the protection of a particular tax treaty or the EU Parent-Subsidiary Directive on a taxpayer (treaty or directive shopping) and a structure selected by a taxpayer already entitled to the protection of a particular treaty in order to manipulate the applicable provisions of that treaty (e.g. to convert business profits into interest income). The latter practice is known as "rule shopping".

Fueger/Rieger argue that, while sec. 42 AO is generally applicable to treaty shopping (see preceding subsection), rule shopping is generally to be dealt with within the closed framework of the tax treaty in question. In their view, application of national anti-abuse clauses in only permissible to the extent of any overlap between the domestic anti-abuse provisions of the two countries involved and/or to the extent the terms of the treaty tacitly or expressly so permit.

4.2.3 Application of sec. 42 AO to non-resident persons

As explained under section 2 above, the court overruled its prior "Monaco" decision and held sec. 42 AO to be applicable to corporations interposed by foreign persons as well as by domestic persons. The fact that the tennis players in question were not German residents thus did not prevent sec. 42 AO from operating.

It is also noted that the tennis players in question were apparently not shareholders of the interposed BV. Fueger/Rieger argue that a relatively high level of personal involvement by the third party athletes is necessary in order for sec. 42 AO to operate with regard to them.

4.2.4 No preclusion of sec. 42 AO by sec. 50d (1a) EStG for years prior to 1994

Sec. 50d (1a) EStG was added to the income tax law with effect from 1994 onwards. It is an anti-treaty-shopping provision denying treaty benefits to foreign corporations to the extent they are owned by persons not themselves entitled to the benefit being claimed if no "economic or other relevant reasons" exist for interposition of the foreign corporation and it does not engage in independent economic activity (double requirement).

The court implied that sec. 50d (1a) EStG was merely declaratory in nature. At any rate, it refused to infer from the enactment of this amendment that a similar result could not be reached under sec. 42 AO prior to the entry into force of the anti-treaty shopping provision. Since the criteria under sec. 42 AO are very similar to those under the anti-treaty-shopping provision, the court would appear to be saying that sec. 50d (1a) EStG is superfluous.

4.2.5 Relation of sec. 42 AO to sec. 50d (1a) EStG

There is a double irony to the court's holding As Fueger/Rieger point out, the enactment of sec. 50d (1a) EStG as a specific anti-treaty-shopping statute was motivated by the Monaco decision which the Federal Tax Court has now overruled. Because of the Monaco decision, the tax authorities did not believe that sec. 42 AO could be used to prevent treaty shopping by foreign persons. However, it now develops, 15 years after the Monaco decision, that sec. 42 can be used against such structures after all.

Furthermore, in drafting sec. 50d (1a) EStG, the tax authorities relied on older holdings of the Federal Tax Court on sec. 42 AO in which disregard of foreign corporations interposed by domestic persons was made contingent on the same double requirement found in sec. 50d (1a) EStG : lack of "economic or other relevant reasons" for interposition of the foreign corporation and failure to engage in independent economic activity. However, a controversial 1992 holding by the 8th Panel (VIII. Senat) of the Federal Tax Court (BStBl II 1993, 84 - 28 January 1992) (respecting a foreign corporation interposed in a low-tax jurisdiction by domestic taxpayers) had abandoned the second requirement and thus considerably expanded the scope of application of sec. 42 AO. This decision may rest on the theory that interposition of a corporation in a low-tax jurisdiction raises a rebuttable presumption of abuse. It is currently unclear whether the 1st Panel will follow the holding of the 8th Panel or not.

Fueger/Rieger argue, however, that sec. 50d (1a) EStG pre-empts sec. 42 AO from 1994 on. In their view, for which they adduce persuasive arguments, sec. 50d (1a) EStG codifies ("freezes") Germany's anti-treaty shopping case law in its pre-1992 state and thus prevents application of the 1992 decision by the 8th Panel to such cases.

If they are right, sec. 50d (1a) EStG would turn out to be not only superfluous (because sec. 42 AO was applicable to foreign persons all along), but also protective of treaty shopping (because, assuming it pre-empts sec. 42 AO from 1994 on, it prevents application of the 1992 decision by the 8th Panel of the Federal Tax Court to treaty shopping).

An opposing view regards sec. 42 AO and sec. 50d (1a) EStG as cumulatively applicable from 1994 on.

4.2.6 Criteria of application of sec. 42 AO

The court repeats its consistent holdings that a structure is abusive under sec. 42 AO if it is "inappropriate" to achieving the desired economic result, intended to reduce taxes, and not justified by "economic or other relevant non-tax reasons". It further states that the presence or absence of independent economic activity on the part of the interposed corporation is a "weighty indication" (gewichtiges Indiz) of the presence or absence of an "appropriate structure" and "economic or other relevant non-tax reasons". The court would thus appear to have come close to saying that a corporation with considerable substance and economic activity is seldom, if ever, to be disregarded as abusive under sec. 42 AO, at least when it is interposed by foreign persons. The court further states that the relevant level of economic activity must include assumption of entrepreneurial risk and transcend mere "administrative and legal actions".

The 1st Panel thus appears to distance itself from the 1992 decision by the 8th Panel, without, however, placing itself in open contradiction to the earlier holding.

This holding by Germany's highest tax court is not in accord with the position advocated by Hoeppner (see above sec. 3.2). Hoeppner, who is a senior official in the Federal Office of Finance which denied the withholding exemption at issue in the instant case, accordingly takes issue with this aspect of the court's decision (IWB Fach 3a Gruppe 1 p. 658).

Fueger/Rieger argue that the level of economic activity engaged in by a foreign corporation interposed by foreign persons remains a decisive criterion under sec. 42 AO. Hence, they believe that the 1992 decision by the court's 8th Panel cannot be applied in such cases irrespective of whether sec. 50d (1a) EStG pre-empts sec. 42 AO from 1994 on. They focus upon the court's comments with regard to who bears the entrepreneurial risk of an activity and contend that this is the essential test. Fueger/Rieger also contend that the 1992 decision by the 8th Panel is appropriate only to foreign corporations interposed by domestic persons because the presumption of abuse with regard to interposition of corporations in foreign low-tax jurisdictions is only valid with regard to domestic taxpayers. Thus, even though the Monaco decision (as it was popularly understood) has been overruled, an important distinction would still remain between foreign and domestic persons with regard to the application of sec. 42 AO.

5. Conclusions

As the cases discussed above indicate, Germany's courts are showing increased willingness to apply the general German anti-abuse provision (sec. 42 AO) against aggressive tax structures chosen both by resident and non-resident taxpayers. Still very much in doubt, however, is whether a corporation with significant substance and independent economic activity can be disregarded as abusive even if its interposition was solely tax-driven. The lower court decisions Ireland I and II pose interesting issues of European law and may be reversed by the Federal Tax Court on these grounds. Lying dormant in the cases discussed is also an alternative legal theory (sec. 39 (2) AO - fiduciary relationship) which may become a new prong of the tax authorities' attack against aggressive tax structures. Finally, while the holding of the Federal Tax Court under Germany's anti-treaty shopping provision in force from 1994 on may encourage the tax authorities to use sec. 42 AO against treaty shopping for years prior to 1994, there is reason to believe that sec. 42 AO is not applicable to such cases from 1994 on. In this event, sec. 50d (1a) EStG may turn out to shield treaty shopping against the more radical interpretation of sec. 42 AO espoused by the 8th Panel of the Federal Tax Court in its above-discussed 1992 decision

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This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.

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