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.

Background

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.