Addressing tax cuts and tax traps

The central feature of the 2008 corporate tax reform was the reduction of the corporation tax rate, from 25 percent to 15 percent. The trade tax calculations have also been revised, leading to an effective reduction of this tax, too – from some 18-20 percent in large cities for 2007 to around 15-17 percent in 2008. The composite rate for all taxes on income for 2008 has effectively fallen to a range of 30∞33 percent, 30.2 percent in Berlin, 32 percent in Frankfurt and 33 percent in Munich. The corresponding range in 2007 was 39-41 percent, i.e. the burden has fallen by eight or nine percentage points.

A rate range of 30-33 percent, while certainly not low, is not particularly high in the international comparison. From this point of view, Germany can be said to have significantly improved her tax climate, especially as she has never sought to compete with tax havens.

The aim of the tax reforms was to send a signal that Germany welcomes foreign investment and, from now on, is not going to tax the results at rates higher than those found in many other industrialised nations. However, the reforms were also not to cost more than €5 bn in terms of lost tax revenue. In a total budget of €283 bn, €5 bn is not a large sum – hardly enough to send out a very convincing signal.

Anti-abuse measures
Another feature of the reforms is the transformation of anti∞abuse measures into revenue raisers, especially those curbing the sale of tax loss companies and restricting the deductibility of interest paid to shareholders. There is also a new provision to tax a deemed gain on the transfer of a business function abroad. Through these reforms it seems that – at least for the present – the circle has been squared, although no one knows for how long the system will hold. Moving functions around the world as needed to keep a corporate structure slender is not necessarily a tax abuse. However, for Germany it is a reason to levy exit taxes.

Since the 1980s, when the loss carry∞forward limitation of five years was abolished, the sale of tax∞loss companies – that is, of companies whose only asset is a loss carry forward – has been considered an abuse. Various attempts have been made to curb it. Up to 1997, the loss carry∞forward was forfeited upon the acquisition of three∞quarters of the share capital of a dormant company by an acquirer, followed by a restart of business operations using substantially new assets. Arguably, any construction caught by this provision was abusive, at least in the sense that the business operation making the loss was unlikely to be similar to that claiming relief on recovery.

In 1997, the rules were changed to reduce the minimum share transfer to one of more than 50 percent and to extend the harmful injection of substantially new assets to businesses continuing in operation. This tightening of the rules, even then, was mostly driven by revenue∞raising considerations. Certainly, the 1997 provision has made corporate reorganisations substantially more complex, and has rendered attempts to save failing businesses – risky in any case – substantially more costly. On the other hand, the change in shareholder was restricted to the immediate shareholders, and consequently changes in ultimate group ownership on, for example, a successful takeover of a company publicly quoted on the New York stock exchange, were not impeded by a German regulation.

For 2008 the rules have been entirely recast. If more than 50 percent of the shares are acquired by a single shareholder over a five∞year period, the entire loss carry∞forward is forfeited. If the combined acquisition is more than 25 percent, but not more than 50 percent, the loss carry∞forward will be cut in proportion to the share transfer. Injections of capital and restarts, or continuations, of business are no longer relevant and a related∞party rule now ensures that a German loss will be curtailed or forfeit on any share acquisition of more than 25 percent at any level in the corporate chain of shareholdings, and regardless of whether the transfer is temporary or permanent, or of whether it is within the group or to an outside party.

Thus we no longer have an anti∞abuse provision, but a money-maker in its own right. Unfortunately, the taxable event, the share transfer, does not of itself generate the income needed to cover the tax cost, and, equally unfortunately, it is often dependent upon occurrences far beyond the control or influence – or even the knowledge – of local management.

Unsuccessful foreign takeover bids, involving the assembly of a significant holding on a foreign stock exchange, followed by its disposal shortly afterwards when the bid fails, can easily leave the German subsidiary with its loss∞recovery plan in ruins. Corporate reorganisations are now only feasible where German losses are insignificant. Transferring ownership in a family business to the next generation can be a nightmare despite plans for inheritance tax incentives to keep family businesses within the family. Outside attempts to save troubled businesses will benefit the government sooner than the new owners. On the other hand, there is a growing realisation that not all loss relief claims under new ownership are abusive, and the Bundesrat has requested an amendment to the Annual Tax Bill 2009 to preserve the loss carry∞forwards for offset against future profits earned from an existing potential.       

Loan interest
Until 2007 a thin capital rule disallowed the interest paid on a shareholder loan, to the extent that the loan exceeded one∞and∞a∞half times the shareholder’s portion of the equity in the company. This rule has now been changed to disallow the entire net interest expense in excess of 30 percent of EBITDA. Small businesses are exempt by the condition that this ‘interest limitation’ rule does not apply to taxpayers with a net interest expenditure of up to €1m. Further exemptions also exist in favour of borrowings by non∞group companies or by group companies with a debt/equity ratio of no more than one percentage point higher than that of the group as a whole. However, these exceptions are generally only applicable to outside finance. Loans from shareholders of more than 25 percent of the equity only qualify, where the interest paid to the shareholder in question is not more than 10 percent of the total net interest expense. Interest in excess of the limitation can be carried forward, thus offering the prospect of ultimate relief when a company’s profitability rises to a level beyond which outside finance is no longer needed. In this day and age, that level of profitability is unattainable for most companies.
The government’s intention was to hinder attempts to convert profits to interest, thereby moving the place of taxation from Germany to the home of the foreign creditor, by financing a German venture with a loan, rather than with equity. What it has also achieved is to disrupt the smooth operation of cash∞pooling systems and centralised corporate treasury functions, to seriously impede group reorganisations, to penalise businesses with fluctuating capital requirements and to hinder attempts to match the profits from an acquisition with the costs of financing it.

Transfers of business functions
The transfer of business functions does not fall into quite the same category. Here the revenue∞raising aspect comes to the fore. The government sees a business organisation as something semi∞permanent, that is, subject to change on the basis of a conscious management decision. The idea of flexible reaction to the needs of the moment without regard to national borders is at the heart of EU thinking, but disturbing to the concept of ‘unharmonised’ local taxation by member states. In principle, the idea is that developing a business function takes time and money that is mostly written off to current expense. Once developed, the function has value as a viable business unit that cannot easily be reproduced. Is it moved abroad, a third party acquirer would be prepared to pay an arm’s length price for it – i.e. its market value. This leads to a gain, corresponding to the value of the intangible, built up with costs already deducted as expenses. Consequently, this gain should be taxed.

Whilst this taxation does not seem unreasonable at first sight, one has to consider that the value of the intangible at the time of transfer has (like most other investments in projects of uncertain outcome) little to do with the cost of establishing it. Perhaps more significant, though, is the objection that the transfer of functions within a group does not involve outside parties. Taxing a deemed gain means demanding a tax payment before the income has been earned. Leaving the function where it is will avoid the payment, but may not be efficient, and can therefore be detrimental to the long-term benefit of the company.

An illegal ‘exit tax’?
One view of the tax on the transfer of functions is that it is an ‘exit tax’, and potentially in contravention of Community Law. However, it is difficult to state with certainty that something is contrary to EC Law until the ECJ has passed judgment on the issue. There has not yet been a directly relevant case – taxing transfers of functions is not a new concept, but is new to the statute books of most countries – although it is difficult to see how taxing a transfer of a function to another EU country can be anything but a restriction on the company’s freedom of establishment.

One argument for the tax would seem to lie in the national interest in securing the right to tax on ultimate disposal of the asset. However, this argument is weak in EU Law as it is dependent upon there being no other, less onerous way of achieving the same legitimate object. Even assuming the object to be legitimate, a less onerous way would seem to be available in establishing the deemed gain upon transfer, but deferring taxation until the asset is sold to a third party or leaves the EU.

This, for example, is currently the practice in respect of significant shareholdings in German companies held by individuals who choose to move to another country within the EU, following an ECJ ruling against a French obligation to provide a bank guarantee to secure payment of the ‘exit tax’ potentially due later when the shares were sold (ECJ judgment C-9/02 de Lasteyrie du Saillant of March 11th, 2004). In many cases, there will be no real opportunity to offset the German ‘exit tax’ in the new location. Apart from the fact that the German calculation of the deemed gain – laid down in some detail in a Transfer of Functions Order – might not be accepted in the other country, one would normally expect the acquiring entity to capitalise the intangible and to write it off over its expected useful life. Tax relief would generally follow the amortisation period under the new country’s rules, and in this regard some countries are more generous than others.

Germany, for example would, in most cases, insist on an amortisation period of 15 years, and some countries do not give relief for the amortisation of intangibles at all. At best, a company is faced with an immediate payment with the corresponding relief spread over a period stretching into the distant future, which is not an appealing prospect!

Deemed gain
Since the German calculation of the deemed gain seems to follow normal commercial logic, one might be forgiven for assuming that it should, at least in principle, be acceptable abroad. However, the calculation does not in fact follow normal commercial logic, but rather the interests of the tax authorities in ensuring that all the uncertainty falls on the taxpayer. The calculation is based on the average between the value to the buyer and that to the seller, both values to be subject to a review clause in the light of actual developments following the transfer. Calculated this way, the transfer price includes the benefits of synergies and location of the buyer – something which a third party buyer would not normally accept. After all, the buyer’s motives are nothing to do with the seller.

The review and adjustment clause is understandable in the interests of fiscal control, but problematic in practice. The statement in the Order to the effect that third parties would agree on such a provision simply is not true. Applied to the presumption in the Order of a ten∞year adjustment period unless the taxpayer can show a shorter period to be appropriate in the circumstances, it becomes extreme. The commercial reality is that the buyer investigates the nature of the asset before he buys it and then assumes the risk of being unable to deploy it in the manner he intends.

Price adjustment clauses are sometimes found in contracts for the acquisition of entire businesses but even then are restricted to defined factors warranted by the buyer that the seller cannot immediately influence. These can include minimum sales levels for the next eighteen months, or that named major customers remain loyal to the company. The period is, naturally, limited to the time needed by the acquirer to get to know the company well enough to make his influence on business strategies felt. Ten years to achieve this is unrealistic. Given that the nature of an intangible changes with use – technological development is constant, and customers or their buying patterns change – one might expect the calculation to make assumptions in respect to the period before the intangible can be regarded as an acquirer’s own development. However, this is not the case. Instead, the calculation assumes an infinite period of future usefulness to the acquirer of the unchanged intangible, unless the German taxpayer can produce evidence showing otherwise.

OECD involvement
On September 19th 2008 the OECD released a discussion draft of a paper on “The Transfer Pricing Aspects of Business Restructurings” for public debate.  The paper aims to provide guidance to governments and business alike on the transfer pricing implications of international business restructurings involving the transfer of assets, risks, functions and opportunities around a group, i.e. between related parties. It is devoted to four aspects in particular, risk allocation between related parties, arm’s length compensation for the restructuring itself, application of the arm’s length principle to the post∞restructuring arrangements, and the “exceptional circumstance” of the refusal by a tax administration to accept a transaction or structure adopted by the taxpayer. Much of the OECD report covers the same subjects as the German Transfer of Functions Order, so one might be justified in hoping for a lively response from Germany to the OECD’s call for comments from the public by February 19th 2009.

A disincentive to inward investment?
If these deficiencies can be seen as a disincentive to inward investment, then largely it is for fear of not being able to withdraw afterwards if business circumstances warrant. As Mark Twain said, “It is easier not to get on the train, than to jump off.” Taxation is, of course, not the primary factor influencing an investment decision, but it is certainly one of the more important secondary considerations, particularly if geographical aspects are not predominant.

On the other hand, mobility is not everything. Stability has value, too. Not every company has long∞term losses, is under∞financed, or has its next location in mind when planning a move now. The reduction of the tax rates to an average level for Europe is certainly a clear message to business that the tax bill will not be exorbitant and that this attitude is an accurate reflection of the general tax climate  would seem clear from the other recent or planned tax changes. Investment income of private individuals is to be taxed at a flat rate of 25 percent in 2009, the double tax treaty with the USA has recently been amended – particularly noteworthy is the abolition of dividend withholding tax on dividends on 80 percent shareholdings – inheritance tax is to be reformed, especially with concessions to ease the succession of family businesses within the family. The tax scene is, though, as complicated as ever and there are still plenty of traps to be avoided. As ever, the only answer is careful planning.