Precedence of the German Investment Tax Act Over the German Foreign Tax Act Under the ATAD Implementation Act
On 25 June 2021, the German Federal Council (Bundesrat) approved the Act on the Implementation of the Anti-Tax Avoidance Directive, which had already been published in the Federal Law Gazette (Bundesgesetzblatt) on 30 June 2021.
The purpose of the Act on the Implementation of the Anti-Tax Avoidance Directive is, in particular, to transpose the EU ATAD Directive (Anti-Tax Avoidance Directive 2016/1164 amended by Directive 2017/952 of 29 May 2017) into German tax law and to adapt the German Foreign Tax Act (Außensteuergesetz, AStG) or the so-called controlled foreign corporation rules associated with it.
With effect from1 January 2020, the EU ATAD Directive requires member states to introduce rules to combat international tax avoidance or to align their existing national rules to the European standard created by the Directive. These rules include, for example, the introduction of an interest barrier, exit taxation, controlled foreign corporation rules (“CFC rules”) or rules to combat tax mismatches.
German tax laws already largely contain the rules to be implemented by the Directive, if only German provisions, e.g. regarding the interest barrier, served as a “blueprint” for the Directive. Except for the rule in the new Section 4k of the German Income Tax Act (“Deduction of operating expenses in the event of taxation mismatches”), the transposition of the Directive into German law thus mainly involved measures to align existing laws with the Directive, particularly with regard to the rules of the German Foreign Tax Act. In this context, the amendment of the German Foreign Tax Act posed a threat that Luxembourg investment funds would be subject to significantly stricter requirements, as explained below.
Role of the German Foreign Tax Act
Under the German Foreign Tax Act, low-taxed passive income earned by investors resident in Germany through controlled foreign (corporate) entities is attributed to the investors even without distribution and is subject to German taxation (“CFC rules”). Low taxation refers to the foreign entity’s income tax of less than 25%. Under current law, another requirement is that investors domiciled in Germany must hold an interest of more than 50% in the capital of a corporate entity domiciled abroad or have more than 50% of the voting rights. However, CFC rules also apply to an interest of only 1% if the foreign company generates income from “investments”.
According to the law, this includes income derived from holding, managing, maintaining or increasing the value of cash, receivables, securities, investments or similar assets. Luxembourg investment funds in the legal form of corporate entities that have investors resident in Germany thus frequently meet the requirements for CFC rules.
However, in Section 7(7) of the German Foreign Tax Act, the legislator has created an exemption clause for investment funds that fall under the German Investment Tax Act and exempts them from the CFC rules. Thus, Luxembourg investment funds in the legal form of corporate entities or FCPs do not fall within the scope of the German Foreign Tax Act, which means that investors resident in Germany are not subject to the CFC rules. As a result, the generally more favorable rules of the German Investment Tax Act will apply, including advance lump sums and partial exemptions.
A separate determination of the income of the investment fund and its investment companies according to German rules for the calculation of taxable profits (!) with regard to the CFC rules under the German Foreign Tax Act is not required. Luxembourg investment funds in the legal form of partnerships, such as SCSs, do not generally fall within the scope of the German Foreign Tax Act or the German Investment Tax Act; however, the rules set forth in the German Foreign Tax Act may apply to the interests held by the Luxembourg investment fund in the legal form of a partnership.
Precedence of the German Investment Tax Act Will Continue to Apply Starting in 2022
The exemption of investment funds as defined in the German Investment Tax Act from the rules specified in the German Foreign Tax Act was at risk of being eliminated as part of the measures to align the German Foreign Tax Act. In the draft bill for the Act on the Implementation of the Anti-Tax Avoidance Directive of 10 December 2019, the precedence of the German Investment Tax Act over the German Foreign Tax Act was to be removed as part of the CFC rules reform. Unlike the draft bill of 2019, the law passed on 25 June 2021, once again provides for the German Investment Tax Act to take precedence over the German Foreign Tax Act, which is similar to the wording of the law as currently in force.
Section 7(5) of the AStG, in the version applicable from 2022, stipulates that CFC rules do not apply to investors resident in Germany if the rules of the German Investment Tax Act are applicable to the foreign company or the Luxembourg investment fund. This is generally the case for investment funds in the legal form of corporate entities. It is important to note that precedence should not apply if the investment fund generates more than one-third of its income together with investors or parties associated with them.
In such a case, which occurs rather rarely in practice, the German Foreign Tax Act and the German Investment Tax Act will be applied simultaneously and, in addition to the loss of tax advantages resulting from the retention of profits, this will also result in a considerable administrative burden; ultimately a separate tax return must be prepared after all to determine the amounts under the CFC rules, based on German rules for the calculation of taxable profits. Precedence also includes Luxembourg investment funds that generate income from investments, including their portfolio companies (Section 13(5) sentence 2 of the AStG).
The first-time application of the CFC rules (Sections 7–13, 15–18 and 20 of the AStG) is intended for the assessment period for which interim income is to be added that arose in a financial year beginning after 31 December 2021 (Section 21(4) sentence 1 of the AStG).