Legal Framework
Legislation
What legislation sets out the economic substance requirements in your jurisdiction?
Provisions that require a certain amount of economic substance for tax purposes are regulated, on the one hand, at the national level using tax laws. For cases of tax relief provided for in double taxation agreements, there is a special provision (section 50d, paragraph 3, German Income Tax Act (ITA)). This provision orders, in general, that no use can be made of a relief provided for in a double taxation agreement regarding the deduction of withholding tax if the interposition of a company without substance leads to a more favourable result for the taxpayer than the direct receipt of the benefit subject to withholding tax (treaty shopping).
In addition, there are general provisions such as the general abuse prevention requirement (section 42, the General Fiscal Code (GFC)), which applies in national German tax law to all types of tax and constellations (domestic or cross-border). This is thus intended to cover, in addition to other abuse prevention provisions, cases of intermediate foreign companies without economic substance.
Nevertheless, this regulation is very general, since, as mentioned, it covers all types of tax. The extent to which it applies can therefore only be answered on a case-by-case basis.
However, recourse to these provisions would not be sufficient to answer the question from a German perspective. National German tax law is also increasingly shaped by legal principles under European law in the area of direct taxation. Legal principles such as directives oblige member states to implement their regulatory content in national law. Examples of this are the Parent–Subsidiary Directive (Directive 2011/96/EC) and the Interest and Royalties Directive (Directive 2003/49/EC). Regarding the former, article 1, paragraphs 2–4 provide that for an ‘improper arrangement’ whose essential purpose is to obtain a tax advantage that is ‘contrary to the object or purpose of this Directive’, the advantages granted by this Directive shall not be applied. In the case of the latter, the Directive refers in article 5 to national rules to prevent abuse.
Regarding Directive 2011/96/EC and European legal principles containing provisions to prevent abuse, their binding interpretation is exclusively carried out by the European Court of Justice (ECJ). The Court must deal with abuse prevention provisions when it examines whether certain national provisions are compatible with secondary law (such as the Directive) but also with primary law (the European Fundamental Freedoms).
Here, the ECJ has established the formula of the ‘purely artificial arrangement’, which should not allow a tax concession because it ‘(does) not reflect economic reality and those purpose is unduly to obtain a tax advantage’. (See ECJ Case C-6/16 Eqiom and Enka (2017) ECLI:EU:C:2017:641, paragraph 34 and ECJ Case C-504/16 Deister Holding and Juhler Holding (2017), ECLI:EU:C:2017:1009, paragraph 65ff. See also the European Union Overview chapter in this edition.) However, this remains a vague criterion and does not clear up the overall very fuzzy context of the abuse prevention rules, at the European or at the (indirectly affected) national level.
The Unshell initiative (ATAD III Directive proposal), which the European Commission has formalised with the Directive proposal of 22 December 2021, is now a first, promising attempt to clarify the rules of economic substance and make them more concrete for the legal practitioner.
With this initiative, the European Commission is pursuing the following goals:
It is necessary to lay down a common framework, in order to strengthen Member States’ resilience against practices of tax avoidance and evasion linked to the use of undertakings which do not perform an economic activity even if presumably they are engaged with economic activity and therefore do not have any or have only minimal substance for tax purposes. This is done in order to ensure that undertakings lacking minimal substance are not used as instruments of tax evasion or tax avoidance. (I)t is critical to agree on a common set of rules for determining what should be considered as insufficient substance for tax purposes in the internal market as well as for delineating specific tax consequences linked to such insufficient substance.
Accordingly, it can be summarised that the linchpin of the national, German regulations on economic substance remains section 50d, paragraph 3, ITA and section 42, GFC. However, these will have to be interpreted in light of the ATAD III Directive proposal in the future. This is due to the position that a legal act such as an EU Directive has in relation to member states. An EU Directive is not directly applicable and does not replace national law; however, member states are obliged to implement the contents of the directive in the best possible way.
This does not mean that the directive must be transposed into national law in full conformity and with the same wording. Nevertheless, the national transposition law must be consistent with the aims and purposes of the directive. Deviating regulations are possible but are subject to the control of the ECJ regarding the sufficient transposition of the directive as well as compatibility with primary law, such as the fundamental freedoms.
Section 50d, paragraph 3, ITA is a provision that is subject to constant change. Since it concerns cross-border and intra-community situations, it is also subject to evaluation based on European law standards. This results in multiple changes to the provision itself or its interpretation. European law does not permit the general or prevalent prohibition of forms of cross-border, advantageous tax structuring, because the free choice of location (and thus the choice of legal system) is one of the pillars of European unification.
Relevant entities
What types of entity are subject to the economic substance requirements in your jurisdiction?
Substance requirements set out by the ECJ generally apply to taxpayers carrying on economic activities in the EU through corporations or permanent establishments.
Furthermore, ATAD III is drafted to apply to undertakings considered as tax residents and that are eligible to receive a tax residency certificate in a member state. These are entities engaged in an economic activity, regardless of their legal form, that are tax residents in an EU member state.
Relevant activities
What activities trigger the economic substance requirements in your jurisdiction?
Structures that are considered to be purely artificial lead to a critical examination of the substance of the entities involved.
According to the special provision of section 50d, paragraph 3, ITA, there is presumption of an abusive arrangement if the following facts from the area of treaty shopping are cumulatively given:
- persons who have an interest in the company seeking the tax benefit would not be able to receive the tax benefit if they received the benefits directly from the distributing company; and
- the actual source of income has no significant relationship with the economic activity of this entity (the intermediary company).
On the one hand, the presumption of an abusive structure can be invalidated by proof to the contrary. This may still be feasible regarding the first prerequisite (comparison of the results in the case of indirect as well as direct participation). With regard to the second prerequisite – the relevant connection of the actual source of income with the economic activity of the intermediary entity – the reference to ‘proof to the contrary’ does not help. Criteria such as the exercise of a ‘reasonably established business’ do not help either.
Here, too, the ATAD III initiative will bring relief for the legal practitioner by means of more precise guidelines.
Tax residence requirements
Must entities be tax resident (or deemed tax resident) in your jurisdiction to be subject to the economic substance requirements? If yes, what are the tax residence rules and requirements? If not, do the economic substance requirements in your jurisdiction differ with respect to non-resident entities ?
Substance requirements are only referred to in German tax law when they regard cross-border constellations. These can take place within the EU; however, they are also applicable to cases in which double taxation agreements exist with non-EU member states and provide for relief from German withholding tax.
The substance test takes place at the foreign company receiving the payments. Since German income tax law is based on the territorial and worldwide income principle, only cases of non-resident taxation are thus covered.
Guidance
Has the government published guidance on the economic substance requirements?
There is no helpful published guidance. There was an information letter from the Federal Ministry of Finance in section 50d, paragraph 3, ITA, but it has become obsolete because it failed to recognise the ECJ’s requirements for abuse prevention in conformity with European law. In the course of the implementation of the ATAD Directives, it is reasonable to assume that after a certain period of time following the ITA adapting the Unshell initiative there will be published guidance.