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The German government on March 24 passed a draft bill (Draft) aimed at implementing the Anti-Tax Avoidance Directive (ATAD). The Draft is expected to become law before the September elections.
Taxpayers should particularly analyze the Draft’s hybrid rules impacting deductibility of expenses, since these would be implemented retroactively, and monitor the Draft as it proceeds through the legislative process.
On December 10, 2019, the German Ministry of Finance published an initial draft bill for implementing ATAD. It published a second draft bill in September 2020 (though it was dated March 24, 2020). Recommendations to include the ATAD rules in the 2020 Annual Tax Bill were not adopted. However, the government draft bill passed the cabinet on March 24, 2021.
The Draft includes the ATAD rules on hybrid mismatch arrangements. Furthermore, the existing German CFC and exit taxation rules would be adjusted in light of ATAD.
The Draft’s most significant provisions are described below.
Under Article 9 and 9b of the ATAD, EU Member States must disallow tax deductions for expenses arising from hybrid mismatch arrangements. The tax deductibility of expenses shall be denied, if (1) the corresponding income is not effectively taxed (a deduction / no inclusion, or ‘D/NI’ outcome) or (2) the expenses are tax deductible in another jurisdiction (a double deduction, or ‘DD’ outcome). An exception may apply to the extent the taxpayer has ‘dual-inclusion income’ - i.e., income that is included in ordinary income in two jurisdictions.
Furthermore, the tax deductibility of expenses shall be disallowed in case of an imported hybrid mismatch. An imported hybrid mismatch can arise if a hybrid mismatch between two foreign jurisdictions is shifted (‘imported’) into another jurisdiction via the use of a non-hybrid instrument (such as a normal loan).
German law will implement the hybrid mismatch provisions through the introduction of a new draft Section 4k of the Income Tax Act (ITA). Amendments to other sections of the German ITA and Corporate Income Tax Act (CITA) accompany the Section 4k ITA draft, in seeking to ensure an inclusion as ordinary income in case of hybrid mismatch arrangements (such as by disallowing application of the German domestic participation exemption).
Paragraphs 1 - 3 of the Section 4k ITA draft relate to D/NI outcomes. Paragraph 4 covers DD outcomes. Paragraph 5 deals with imported hybrid mismatches, and paragraph 6 defines the scope of the rules to transactions between affiliates and structuring arrangements. Paragraph 7 establishes a general ‘treaty override.’
Unlike the March 2020 draft, the Draft’s legislative materials clarify that the inclusion of expenses for foreign CFC taxation purposes generally would not give rise to a DD outcome under Section 4k (4) ITA draft in the event that the German entity is treated as being non-transparent.
In general, the Section 4k ITA draft has a retroactive effective date of January 1, 2020. However, a grandfathering rule exempts certain expenses that had been legally incurred before that date.
As part of implementing ATAD Articles 7 and 8, the Draft would adjust the existing German CFC rules, including with respect to the following:
One key element of the proposed draft German CFC rules is the adjusted definition of the control criterion. Currently, a foreign corporation typically is considered ‘controlled’ if German tax residents directly or indirectly hold at least 50% of the foreign corporation’s shares, regardless of whether they are related or unrelated.
The proposed new German CFC rules provide that a foreign corporation is controlled if the German (indirect) shareholder or its affiliates directly or indirectly hold more than 50% of the shares in the foreign corporation, regardless of whether the affiliates are German or non-German tax residents.
The active income catalog, which defines all active income that is not subject to the German CFC rules, would remain in place. However, the Draft adjusts and restricts the definition of certain active income items, such as for income subject to the German domestic participation exemption and income from reorganizations.
The currently applicable law, contrary to the preceding draft, remains unchanged with respect to income from trading and providing services.
The Draft maintains a 25% effective tax rate threshold; as a result, several jurisdictions continue to fall within the scope of the German CFC rules. Based on the Draft’s explanatory notes, the threshold is justified by ongoing OECD discussions related to implementing a global minimum tax.
Calculation of CFC income
German tax law needs to be applied when calculating CFC income (such as the German anti-hybrid rules, interest and royalty barrier rule, and the domestic participation exemption).
ATAD Article 5 provides that EU Member States must tax built-in gains if an asset or a business is transferred to another jurisdiction (i.e., exit taxation) or if a corporation migrates to another jurisdiction.
Furthermore, the jurisdiction to which the asset or business is transferred or to which the corporation migrates shall recognize the assets at the same value used for purposes of the other jurisdiction’s exit taxation, provided such value equals the asset’s fair market value. As a result of this rule, the tax basis of the assets is stepped up.
The adjustments to the existing German exit taxation rules include (1) unifying tax payment deferral methods and (2) adjusting rules resulting in a step-up of the German tax base in the event the German taxation right is extended or established for the first time.
In addition, the Draft would adjust the exit taxation rules for individuals, which shall become more restrictive in EU cases. Also, the indefinite deferral of tax payments until a sale of shares no longer would be possible.
In order to implement ATAD, the Draft includes several changes to existing German tax law. Taxpayers should assess the impact these rules could have. They should especially focus on the hybrid rules, as these would be implemented with retroactive effect and may impact deductibility of expenses. The Draft is expected to pass before the September elections, so taxpayers should monitor the steps in the legislative process.