Foundations of Foreign Tax Law

Objective and Purpose of the Foreign Tax Act (AStG)

• The Foreign Tax Act (AStG) aims to prevent tax disadvantages for the German treasury resulting from tax avoidance strategies abroad. It is intended to ensure that income and assets which continue to have significant economic links to Germany remain subject to German taxation even after a relocation abroad.

Extended Limited Tax Liability (§ 2 AStG)

• Applicability: This regulation applies to natural persons who move their residence or habitual abode abroad while retaining significant economic interests in Germany.
• Requirements (§ 2 Abs. 1 AStG):
  • German citizenship.
  • Unlimited tax liability for at least 5 years within the last 10 years prior to the relocation.
  • Residency in a low-tax country (2/3 less tax at a taxable income [zvE] of 77,000 EUR) or lack of residency as well as granted preferential taxation (§ 2 Abs. 2 AStG).
  • Significant economic interests in Germany (§ 2 Abs. 3 AStG).
  • More than 16,500 EUR in income subject to limited tax liability (§ 2 Abs. 1 S. 3 AStG).
• Tax Consequences:
  • Recording of income earned in Germany (§ 2 Abs. 1 S.1 1.HS. EStG (Income Tax Act)).
  • Taxation for up to 10 years after the relocation.
  • The tax rate is based on world income (progression clause § 2 Abs. 5 S. 1 AStG).
  • No final withholding effect for withholding taxes (§ 50a EStG).
  • Hardship regulation possible (§ 2 Abs. 6 AStG).

In the case FG München (Az. 8 K 883/17), the plaintiff, a German citizen who had moved her residence to London, was taxed in Germany on the basis of extended limited tax liability pursuant to § 2 AStG. The point of contention was the application of the British "remittance basis" and its classification as preferential taxation. The court decided that the "remittance basis" should be regarded as preferential taxation, which triggered the extended tax liability in Germany. The claim was dismissed, but the appeal to the Bundesfinanzhof (BFH) was admitted.

Significant economic interests in Germany, as defined by § 2 Abs. 3 AStG, include in particular participations in domestic commercial enterprises or corporations as well as certain income and assets. Specifically, participations in domestic companies are considered significant if they exceed certain income or asset limits. These thresholds are 30% of total income or total assets, or in absolute terms 62,000 € for income and 154,000 € for assets (not including foreign income or assets within the meaning of § 34d EStG). This definition is crucial for the extended limited tax liability of individuals who move their residence abroad but maintain close economic ties to Germany.

Case Scenario:

Mario Flug (M) has lived in Frankfurt am Main since birth. In 2021, he marries Frida Ghost (F), an Australian. In 2022, the two emigrate to Monaco, a country with no income tax and no double taxation agreement (DTA) with Germany.

In 2023, M and F earn the following income:

• a) Participation in MUC KG in Munich (25,000 €): M is a partner in MUC KG in equal parts with two other partners.
• b) Self-employed activity in Frankfurt (20,000 €): M keeps a small office in Frankfurt to maintain his license as a tax advisor and earns income from it.
• c) Interest from private loans (5,000 €): M has granted a loan to an acquaintance, which is secured by a property in France.
• d) Royalties (8,500 €): M licenses a patent to a company in the USA, which is used in a German production facility.
• e) Interest from a German bank investment (7,500 €): Interest from an investment at a German bank.
• f) Profits from a fitness centre in Monaco (80,000 €): Profits from a fitness centre that M operates in Monaco.
• g) Interest from an unsecured loan by F (5,000 €): F has granted an unsecured loan to a friend who used it to open a restaurant in Frankfurt.

Solution:

Applicability of Extended Limited Tax Liability (§ 2 AStG):

Since there is no (full) Double Taxation Agreement (DTA) with Monaco, § 2 AStG is applicable without restriction. There is only a DTA regarding information exchange. See also Principles for the application of the Foreign Tax Act dated 22.12.2023, Tz. 2.0.2.1.

Impact on Income Tax Liability:

the spouses have completed a full change of residence. They have neither a residence in Germany within the meaning of § 8 AO (Fiscal Code) nor a habitual abode within the meaning of § 9 AO. As a result, unlimited income tax liability within the meaning of § 1 Abs. 1 EStG is excluded.

Consequently, limited income tax liability under § 1 Abs. 4 in conjunction with § 49 EStG and extended limited income tax liability under § 2 AStG may be considered.

Income of F:

Frida Ghost (F), the wife of Mario Flug, does not have German citizenship and earns the following income in 2023:

• Interest from an unsecured loan (5,000 €): F granted her friend an unsecured loan used to open a restaurant in Frankfurt.

The interest from the unsecured loan could theoretically be subject to German taxation as it is connected to a restaurant located in Germany. However, due to the specific circumstances (the loan is unsecured and F has no significant economic interests in Germany), this interest is not subject to German income tax.

§ 49 Limited taxable income

(1) Domestic income within the meaning of limited income tax liability (§ 1 paragraph 4) are (…)

 5. Income from capital assets within the meaning of (…) c) § 20 paragraph 1 numbers 5 and 7 if (…)

aa) the capital assets are directly or indirectly secured by domestic real estate, by domestic rights subject to the provisions of civil law concerning real estate (…) (..)

Since the loan granted to the friend is unsecured, there is no security provided by domestic real estate, meaning the requirements for limited tax liability within the meaning of § 49 Abs. 1 Nr. 5 lit. c, aa EStG are not met.

Because F does not hold German citizenship and has moved her residence to Monaco, her income generally does not fall under extended limited tax liability within the meaning of § 2 AStG in Germany, unless she had income from a German source.

Furthermore, F was not subject to unlimited tax liability in Germany for long enough (not 5 years in the last 10 years).

Interest from the unsecured loan of F (5,000 €): Since this loan is unsecured and F does not have German citizenship, the interest is not taxable in Germany.

Not taxable: 5,000 €.

Income of M:

Requirements for M:

M meets the requirements of § 2 AStG because he

• is a natural person with German citizenship (§ 2 Abs. 1 S. 1 AStG),
• was subject to unlimited tax liability within the meaning of § 1 Abs. 1 EStG in conjunction with § 2 Abs. 1 S. 1 AStG for at least 5 years in the last 10 years, and
• is now resident in a low-tax country (Monaco), a territory with low taxation within the meaning of § 2 Abs. 1 S. 1 Nr. 1, Abs. 2 Nr. 1 AStG. Monaco does not levy income taxes on natural persons; thus, the requirement is met as the income tax is lower by 1/3 (at a minimum zvE of 77,000 EUR) than German income tax.
• In addition, he has significant economic interests in Germany within the meaning of § 2 Abs. 1 S. 1 Nr. 2 AStG. The participation in MUC KG is sufficient (§ 2 Abs. 3 Nr. 1 AStG). By comparison, if M were a limited partner, more than 25% of the KG's income would have to be attributable to him to meet the requirements.

Result: The requirements for extended limited tax liability are met for M. M is taxable for the year 2022 and the following 10 years on all income within the meaning of § 2 Abs. 1 S. 1, 1st HS that would not be foreign income within the meaning of § 34d EStG in the case of unlimited tax liability. The catalogue of income within the meaning of § 49 EStG is thus expanded (so-called extended domestic income).

• Income in detail:
  • a) Share of profit from MUC KG (25,000 €): This income from business operations § 15 Abs. 1 S. 1 Nr. 2 EStG is taxable in Germany, as the participation constitutes a domestic permanent establishment (§ 49 Abs. 1 Nr. 2 lit. a EStG).
    • Taxable: 25,000 €
  • b) Income from self-employed activity in Frankfurt (20,000 €): This income from self-employment § 18 Abs. 1 Nr. 1 EStG is taxable, as it is earned or exercised/utilised in Germany (§ 49 Abs. 1 Nr. 3 EStG).
    • Taxable: 20,000 €
  • c) Interest from the private loan (5,000 €): This interest is income from capital assets § 20 Abs. 1 Nr. 7 EStG and is not taxable in Germany, as the loan is secured by foreign real estate (France) ( § 49 Abs. 1 Nr. 5 lit. c, aa EStG is ruled out) and does not represent a German income source. Foreign income within the meaning of § 34d Nr. 6 EStG is present. Therefore, § 2 AStG is ruled out.
    • Not taxable: 5,000 €.
  • d) Royalties (8,500 €): This income from rental and leasing within the meaning of § 21 Abs. 1 S. 1 Nr. 3, Abs. 2 Nr. 1 EStG is taxable in Germany, as the patent is used/utilised in a domestic permanent establishment of a mechanical engineering company from the USA. No further domestic target point is required. The withheld German withholding tax of 15% according to § 50a EStG is not a final taxation (§ 2 Abs. 5 S. 2 AStG).
    • Taxable: 10,000 €.
  • e) Interest from the (German) bank investment (7,500 €): This interest is income from capital assets within the meaning of § 20 Abs. 1 Nr. 7 EStG and is subject to capital gains tax of 25% (§ 43a Abs. 1 S. 1 Nr. 1 EStG). Since there is no security provided by domestic real estate, § 49 Abs. 1 Nr. 5 lit. c, aa EStG is ruled out. Since there is also no security provided by foreign real estate, § 34d Nr. 6 EStG is ruled out. Thus, § 2 AStG is fulfilled.
    • Taxable: 10,000 €.
  • f) Profits from the fitness centre in Monaco (80,000 €): This income from business operations within the meaning of § 15 Abs. 1 S. 1 Nr. 1 EStG is earned in Monaco and is not taxed in Germany, as it counts as foreign income (§ 34d Nr. 2 lit. a EStG).
    • Not taxable: 80,000 €

Result:

Sum of taxable income: 65,000 € (Not taxable 85,000 €)

• of which income subject to capital gains tax: 10,000 €,
• of which to be taxed at the standard rate 55,000 € = Tax base
• plus personal allowance (Grundfreibetrag) 2023 for calculating the tax rate 10,908 €

According to § 32a Abs. 1 EStG, the basic tax table is to be applied.

• Tax base 55,000 € + Foreign income 85,000 € + Personal allowance 10,908 € = zvE 150,908 €
  • Tax 0.42 × 150,908 − 9,972.98 = 53,408.36 € Tax amount rounded down to the next full Euro amount, Tax according to § 32a Abs. 1 EStG: 53,408 €
    • Average tax rate: ((53,408 € / 150,908 €) * 100) 35.39 %
• Tax on Tax base (55,000 € * 35.39%) 19,465 €
  • minus withholding tax § 50a EStG (15% of 10,000 €) -1,500 €
  • Remaining 17,965 €

Since § 2 Abs. 5 S. 1 AStG provides for its own progression clause, income to be taxed at the standard rate is taxed at the rate resulting from all income (i.e., including foreign income of 85,000 €). The withholding tax within the meaning of § 50a EStG exceptionally has no final effect (§ 2 Abs. 5 S. 2 AStG), so that income subject to it must also be taxed at the personal tax rate.

• Income subject to capital gains tax 10,000 €
• minus saver's allowance § 20 Abs. 9 EStG 1,000 €
• = Tax base 9,000 €,
  • of which 25% (§ 43a Abs. 1 S. 1 Nr. 1 EStG) 2,250 €
  • minus creditable capital gains tax -2,500 €
  • = – 250 €

Result:

• Total tax burden: 21,750 € (19,465 € - 1,500 € + 2,250 € – 2,500 €)
• Amount still payable: 17,715 € (17,965 € + (-250 €))

Exit Taxation (§ 6 AStG)

• Objective: To ensure that hidden reserves formed in a participation in a corporation do not escape the German treasury when a tax resident moves their residence abroad.
• Standard Case (§ 6 Abs. 1 AStG):
  • Applies to natural persons who were unrestrictedly tax liable for at least 7 years (within the last 12 years before the end of unrestricted tax liability) and move their residence under § 8 EStG or habitual abode under § 9 EStG abroad, not just temporarily.
  • Shares in corporations under § 17 Abs. 1 S. 1 EStG are fictionally treated as sold.
• Sale Fiction: The fair market value (gemeiner Wert) of the shares is used as the fictional sale price; losses are not realised in this process.
• Deferral (§ 6 Abs. 4 AStG): Upon application and subject to providing security, the tax on the fictional capital gain can be paid in instalments over 7 years.
• Acquisition Fiction (§ 6 Abs. 1 S. 3 AStG): In the event of a later actual sale, the gain is reduced by the taxed increase in value, provided that tax was paid for it.

Case Scenario: Taxation of asset appreciation upon change of residence abroad

Spanish citizen José Palermo (JP) has been in Berlin since 1990 and moves to Uruguay in May 2023, after successfully building up two participations in Germany (100% in Rotwein GmbH and 2% in Weinverkaufs GmbH) and one participation in Spain (10% in Vino Bueno S.A.). The start-up costs of the GmbH were 100,000 EUR, and the fair market value in May 2023 was 1.1 million EUR. The question is what the tax consequences of this move to Uruguay are.

Solution:

Elements of exit taxation for JP according to § 6 Abs. 1 S. 1 AStG

• JP is a natural person and was unrestrictedly tax liable under § 1 Abs. 1 EStG for at least 7 years in the 12 years prior to the end of his unlimited tax liability. Spanish citizenship is irrelevant.
• His unrestricted income tax liability in Germany ends with the move in May 2023.
• He holds shares according to § 17 Abs. 1 S. 1 EStG, as he participates with at least 1% and all shares are held in private assets.

Fictional sale of shares according to § 17 EStG

JP must apply a fictional sale (sale fiction) to all of his shares. The capital gain within the meaning of § 17 Abs. 2 EStG is the difference between the sale price and the acquisition costs. However, since no actual sale has taken place, the fair market value of the shares at the time unrestricted tax liability ends replaces the sale price (§ 6 Abs. 1 S. 1 AStG).

For Weinverkaufs GmbH and Vino Bueno S.A., a loss in value results. These may not be offset against increases in value.

Determination of gain according to § 17 Abs. 2 EStG:

• Fair market value of shares in Rotwein GmbH at the time of exit: 1,100,000 EUR
• minus acquisition costs: 100,000 EUR
• Gain: 1,000,000 EUR (No allowance under § 17 Abs. 3 EStG)

Partial Income Method (Teileinkünfteverfahren - TEV) within the meaning of § 3 Nr. 40 c EStG

• 40% tax-free: 400,000 EUR
• 60% taxable (tax base): 600,000 EUR
• Taxation at the personal tax rate

Since there are no indications that JP intends to return to Germany, an exception to exit taxation due to temporary absence under § 6 Abs. 3 AStG is not possible.

Upon application, a deferral according to § 6 Abs. 4 AStG is possible. In this case, the tax is to be spread over 7 years and security must be provided.

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Variant 2 of the scenario: JP also holds 100% in Weinverkaufs GmbH; Vino Buena S.A. does not exist. Before emigrating, he wants to know how a loss in value can be taken into account.

Offsetting losses in value against increases in value is not possible. To benefit at least indirectly from the loss in value that occurred, JP would have to carry out (ideally tax-neutral) restructurings before the move, e.g.:

1. Merger of Rotwein GmbH and Weinverkaufs GmbH

• Procedure: JP could merge Rotwein GmbH and Weinverkaufs GmbH before his departure.
• Advantages: The loss in value of Weinverkaufs GmbH is offset against the increase in value of Rotwein GmbH. This reduces the taxable profit from the transfer of functions and thus the exit taxation.
• Legal Basis: The merger could be tax-neutral under the Umwandlungssteuergesetz (UmwStG - Reorganisation Tax Act), provided the requirements are met.

2. Interposition of a holding company

• Procedure: JP could establish a holding company before moving that takes over 100% of the shares in Rotwein GmbH and Weinverkaufs GmbH.
• Advantages: The holding structure allows for the consolidation of profits and losses of both companies. Tax optimisation through the later sale or restructuring of the participations. Flexibility in managing assets and potentially lower tax burden in a sale within the holding structure.
• Legal Basis: The establishment and interposition of the holding company is tax-neutral pursuant to § 21 UmwStG, if the requirements are met.

3. Share swap

• Procedure: JP could contribute his shares in Rotwein GmbH and Weinverkaufs GmbH into a newly founded holding company in exchange for new shares.
• Advantages: The share swap can be tax-neutral, so that hidden reserves in the contributed shares are not immediately taxed. Tax burdens are deferred, and JP gains flexibility in future asset planning. In the event of a later move abroad, especially to an EU/EEA state, exit taxation could be deferred interest-free as long as the shares are not sold.
• Legal Basis: The share swap is tax-neutral according to § 21 UmwStG. The deferral of exit taxation is performed according to § 6 Abs. 5 AStG, if the requirements are met.

All three options offer JP ways to optimise the tax implications of his move from Germany. Choosing the right strategy depends on the specific circumstances, including planned future activities and the tax frameworks in the involved countries. Through timely planning, JP can significantly reduce his tax burden while gaining flexibility in managing his participations.

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Scenario 2: BO has lived in Frankfurt since birth and founded the German Grounds Ops GmbH in 2018, which provides various ground handling services (e.g., push-back, cleaning, check-in) at Germany's largest airports (acquisition costs of the participation were 100,000 EUR, fair market value in November 2022 (time of move) was 1,300,000 EUR. At the same time, he participated in the larger Handling Services S.A. from Spain, which provides similar services at Spanish airports (2% participation, acquisition costs 2018: 200,000 EUR, fair market value in November 80,000 EUR).

Solution:

Requirements for exit taxation § 6 Abs. 1 S. 1 AStG:

• BO is a natural person.
• Was unrestrictedly tax liable for at least 7 years within the last 12 years before the end of unrestricted tax liability.
• BO holds shares within the meaning of § 17 Abs. 1 S. 1 EStG, as he holds at least 1% of Ground Ops GmbH and Handling Services S.A. (100%).
• BO's unrestricted income tax liability ends by giving up his German residence.

Legal Consequences:

The shares in both companies are deemed to have been sold; the fact that the S.A. is a Spanish company is irrelevant. § 17 EStG is applicable to the shares even without a sale. The end of unrestricted tax liability due to the abandonment of residence is equivalent to the sale of shares within the meaning of § 17 EStG (§ 6 Abs. 1 S. 1 Nr. 1 AStG).

The sale takes place at the time of the end of unrestricted tax liability (§ 6 Abs. 1 Nr. 1 AStG). The capital gain within the meaning of § 17 Abs. 2 EStG is the difference between the sale price and the acquisition costs. Since no sale actually takes place, the fair market value of the shares at the time of the end of unrestricted tax liability replaces the sale price. Since there is no increase in value for the participation in Handling Services S.A., but rather a loss, this is not to be taken into account.

Determination of gain:

Fair market value: 1,300,000 EUR

minus acquisition costs: 100,000 EUR

Gain: 1,200,000 EUR (No allowance under § 17 Abs. 3 EStG)

TEV within the meaning of § 3 Nr. 40 c EStG, i.e., 60% of the gain is taxable: 720,000 EUR

• No exception to exit taxation within the meaning of § 6 Abs. 3 AStG, as there is no temporary absence.
• Deferral according to § 6 Abs. 4 AStG possible upon application and against security. In this case, the tax is to be spread over 7 years. The annual instalments are not subject to interest.

Controlled Foreign Company (CFC) Taxation (§§ 7-13 AStG)

• Regular CFC Taxation (§ 7 AStG):
  • Concerns domestic tax residents who are directly or indirectly involved in foreign companies.
  • Requirements:
    • Control of the foreign company by the domestic tax resident (§ 7 Abs. 3 AStG in conjunction with § 1 Abs. 2 AStG).
    • Low effective income tax abroad (< 15% from 2024) (§ 8 Abs. 5, § 21 Abs. 6 AStG).
    • The foreign company earns passive income (none of the active catalogue income listed in § 8 Abs. 1 AStG).
  • Exemption Limit (§ 9 AStG): Income must exceed a certain limit to be subject to CFC taxation.
• Extended CFC Taxation (§ 13 AStG):
  • Concerns intermediate income with an investment character, e.g., interest.
  • Exemption Limit: 10% of total intermediate income and a maximum of 80,000 €.

Practical Case: CFC Taxation of a German GmbH with participation in a Ltd. in Hong Kong

Scenario:

A German GmbH holds 51% of the shares in a low-taxed coordination centre in Hong Kong, organised as a Ltd. The tax burden in Hong Kong is below 15%. The second shareholder (49%) is a Chinese citizen. In 2024, the Ltd. earns the following income:

1. Trading income (earned in the local market with its own employees and customer base, whereby the goods were purchased from the GmbH): 700
2. Income from holding and managing securities: 100
3. Dividend income (from 100% participations, where the dividends did not reduce the income of the paying entities): 100
4. Income from group financing (the capital required for lending comes from the two shareholders as a contribution): 100

Question: Is CFC taxation to be performed for the German GmbH according to §§ 7 ff. AStG? If so, in what amount?

Solution:

EU specialities according to § 8 Abs. 2 – 4 AStG are ruled out. Hong Kong has a tax burden below 15% and is therefore a low-tax country.

Trading income:

• This trading income was earned on the local market by the Ltd. with its own employees and a self-created customer base. An established business operation is present. Since the Ltd. purchased the goods from the GmbH in Germany, this is active income.
• Legal Basis: § 8 Abs. 1 Nr. 4 AStG.
• Assessment: No CFC taxation, as it is active income.

Income from holding and managing securities:

• This income is passive income within the meaning of § 13 Abs. 2 AStG. Control is not required.
• Legal Basis: § 13 Abs. 1 AStG (extended CFC taxation).
• Assessment: The income of 100 is subject to CFC taxation as it is passive income not listed in the active catalogue of § 8 AStG.

Dividend income:

• Since the dividends did not reduce the income of the paying entities, these receipts are treated as active income.
• Legal Basis: § 8 Abs. 1 Nr. 7 AStG.
• Assessment: No CFC taxation, as the income is considered active.

Income from group financing:

• This income is considered intermediate income with investment character within the meaning of § 13 Abs. 2 AStG and does not fall under active income according to § 8 Abs. 2 AStG.
• Legal Basis: § 13 Abs. 1 AStG.
• Assessment: This income of 100 is subject to CFC taxation.

Result: The German GmbH must perform CFC taxation for income totalling 200. This is composed of 100 for holding and managing securities and 100 from group financing.

Practical Case on CFC Taxation (§ 7 Abs. 1 AStG)

Scenario:

• Resident A: A person unrestrictedly tax liable in Germany wants to invest in real estate in State B (non-DTA state). Due to possible soil contamination, he acquires the property via a corporation (KapG) in B.
• Income of the KapG: The KapG earns income of 100 from renting out the property.
• Taxation in B: The corporate tax rate in B is 10%.
• Dividend distribution: No dividend distribution to A takes place.

Question: Is CFC taxation to be performed for the German GmbH according to §§ 7 ff. AStG? If so, in what amount?

Solution:

1. Requirements for CFC Taxation:

   • Foreign Corporation (KapG): The KapG has neither its seat nor its management in Germany, so it is a foreign company.
   • Control: A, who is unrestrictedly tax liable, controls the KapG 100% as he holds all shares.
   • Passive Income: The KapG's income comes from the rental and leasing of real estate. Such income is classified as passive income according to § 8 Abs. 1 Nr. 6 lit. b AStG.
   • Low Taxation: The tax burden in State B is only 10%, which is below the threshold of 15% according to § 8 Abs. 5 AStG. Thus, it is a low-taxed company.
   • Exemption Limit: Since the KapG earns exclusively passive income, the exemption limit is exceeded.

   Result: The KapG is an intermediate company within the meaning of § 8 AStG. The KapG's income of 100 is attributed to A and is subject to CFC taxation.

2. Calculation of the CFC Amount:

   • Total Income: 100 (income of the KapG).
   • CFC Amount: Since it is passive income fully subject to CFC taxation, the CFC amount is also 100.

Conclusion: A must pay tax in Germany on the attributed income of 100 from the rental of the property by the KapG, as the income is classified as passive and the KapG is resident in a low-tax country.

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Scenario: Person A, living in Frankfurt, holds a 30% participation in a Limited in a low-tax country that earns exclusively passive income. Regardless of the participation, however, he has secured 60% of the voting rights. Does A have a participation within the meaning of § 7 AStG?

Solution: The unrestrictedly tax liable A (within the meaning of § 1 Abs. 1 S. 1 EStG, since his residence is in Germany according to § 8 AO) holds 30% of the shares in the Limited (foreign corporation within the meaning of § 7 Abs. 1 AStG, as neither the seat nor the place of management is in Germany) in a low-tax country (§ 8 Abs. 5 AStG), so in the first step the 50% limit would not be exceeded. However, § 7 Abs. 2 AStG provides for the attribution of voting rights in addition to the holding of shares. Since A has secured 60% of the voting rights, the limit is exceeded and CFC taxation applies. This design prevents the splitting of voting rights and shares to circumvent CFC taxation.

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Scenario: B, living in Berlin, holds an immediate 30% share in a Limited. In addition, he holds a 70% share in B.C.V. (a partnership) in the same low-tax country. This partnership in turn holds 30% of the shares in the Limited.

Solution: The unrestrictedly tax liable person holds an immediate 30% of the shares in the Limited (assuming voting rights correspond to shares). Since B holds 70% of B.C.V., it is a person related to B (§ 7 Abs. 3 S. 1 and S. 2 in conjunction with § 1 Abs. 2 Nr. 1 a AStG, since participation >25%). Thus, for the purpose of determining control, the shares held by B.C.V. are fully attributed to B: 30% directly + 30% held by B.C.V. = 60%, so that CFC taxation applies to B. Alternatively, B holds 30% directly and 21% indirectly (70% of 30%), thus totaling 51%.

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Scenario: C, living in Düsseldorf, also holds a 10% immediate share in the Limited. There is no connection to A and B. Is there a participation within the meaning of § 7 AStG?

Solution: The unrestrictedly tax liable C holds 10% of the shares, which is less than 50%. There are also no related persons within the meaning of § 7 Abs. 3 AStG in conjunction with § 1 Abs. 2 AStG. Thus, CFC taxation does not apply to C. Note: Persons are also considered related if they cooperate through coordinated behaviour (§ 7 Abs. 4 AStG). This is assumed rebuttably. If, for example, income with investment character is present, a participation limit of 1% is sufficient (§ 13 Abs. 1, S1, Abs. 2 AStG); in the case of exclusively such income, the limit is irrelevant (except for stock trading).

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Scenario: The unrestrictedly tax liable D AG in Germany holds 100% of two companies abroad that earned income in 2022:

DOM Ltd. Dominica (Corp. tax rate 0%) is mainly active in the food production sector. For this purpose, it has built modern production facilities on various islands, which it operates independently. The manufactured and processed food is distributed in the region. The company leaves the resulting profits exclusively in its business account, where an interest rate of 3% is earned. The company intends to expand and build new production sites with this additional interest income.

SIN Pty. Ltd. in Singapore (15%) is a so-called shared service company that provides various services (e.g., accounting, payroll and travel expense accounting, simple purchasing activities, etc.) exclusively to D AG. For this, it has its own offices, employees and equipment necessary for the activity, which it also purchases in the local market (all contracts are concluded by it). All related decisions regarding the services received and the manner of provision (e.g., selection of employees, rooms and suppliers) are made exclusively by D AG, and the associated contracts are approved by it; SIN merely executes its will. In addition, D AG has used SIN as an investment vehicle for entry into the local real estate market. For this, SIN (financed by DAG) acquired several local properties which it rents out to third parties. Since the DTA Germany – Singapore applies, the exemption method applies to such rental income. Finally, SIN is used as a financing company in the region. It takes the money required for this exclusively from Asian capital markets and uses it to finance D AG group companies worldwide, which acquire and license external invoices.

Do both companies earn active and passive income that would be subject to CFC taxation at D AG?

Solution: The following solution steps apply to all case variants:

• D AG is subject to unlimited corporate tax within the meaning of § 1 Abs. 1 KStG (Corporate Tax Act), as it has its place of management (§ 10 AO) and seat (§ 11 AO) in Germany.
• Both DOM and SIN are foreign corporations within the meaning of § 7 Abs. 1 S. 1 AStG, as neither their seat nor place of management is in Germany.
• The foreign companies are subject to low taxation within the meaning of § 8 Abs. 5 AStG.
• Since D AG holds 100% of the shares, it has a share of more than 50%, thus control is given § 7 Abs. 1 AStG and Abs. 2 AStG.
• The exemption limit under § 9 AStG is (presumably) exceeded. The question is whether the companies earn passive income subject to CFC taxation.
• When testing, each type/source of income must be considered separately.

DOM Ltd.:

• Since the company is active in the field of food production and processing, it is an industrial activity within the meaning of § 8 Abs. 1 Nr. 2 AStG and thus active income.
• With the interest in the business account, the company earns income with investment character within the meaning of § 13 Abs. 1 and 2 AStG, which should be subject to CFC taxation. However, if such income stems from an activity that serves a separate activity of the foreign company falling under § 8 Abs. 1 Nr. 1 to 6 AStG, the income is to be considered active (functional approach § 13 Abs. 2 2nd HS AStG). Since the Ltd. earns the interest profits from the investment of its "active" profits and wants to finance further production facilities with them, this is to be assumed. Therefore, the interest is to be classified as active, as long as the economic connection to the main activity exists and no significant independent economic weight is achieved.

SIN Pty. Ltd.:

• The provision of services (Shared Services) generally constitutes an active activity (§ 8 Abs. 1 Nr. 5 AStG). However, since the services are provided exclusively to D AG (and thus to the unrestrictedly tax liable person participating in it), a requalification into passive income occurs (§ 8 Abs. 1 Nr. 5 b AStG). However, there is a back-exception according to which the income becomes active again if the company maintains a business operation set up for performing such services while participating in general commercial traffic and there is no harmful cooperation of the shareholder (§ 8 Abs. 1 Nr. 5 b 2nd HS AStG). The company undeniably has the necessary personnel and material equipment (business operation) to provide such services, which are also obtained on the local market (participation in commercial traffic). However, since all decisions in this regard are made by D AG, so that SIN merely executes the will of D AG and has no independent decision-making scope with regard to the provision of services, there is harmful cooperation on the part of D AG. Thus, passive income is present.
• With the rental, SIN generally earns active income within the meaning of § 8 Abs. 1 Nr. 6 AStG. Since real estate is rented here, however, it is passive income within the meaning of § 8 Abs. 1 Nr. 6 b AStG. The back-exception, which again leads to active income, can only be used if D AG can prove that this income would be tax-exempt in Germany if D AG were to receive it directly (§ 8 Abs. 1 Nr. 6 b 2nd HS AStG). Since the exemption method is provided for such income according to Art. 6 and 24 of the DTA, they are excluded from the German tax base and are thus tax-exempt. This is active income.
• The financing activity (borrowing and lending of capital) leads to income with investment character (§ 13 Abs. 1 and 2 AStG). The back-exception of the functional approach is not given in this case, as the income is not connected to a separate active activity of the company. Such income (interest) is also not included in the active catalogue of § 8 Abs. 1 AStG. Therefore, it is passive income.

CFC Taxation and EU Law

Special features for EU/EEA companies

Special regulations apply to companies resident in the EU or the EEA. In principle, the EU fundamental freedoms, in particular the freedom of establishment according to Art. 49 TFEU, must not be inappropriately restricted by national tax regulations. Therefore, an exception to CFC taxation was introduced into German tax law, which applies if the taxpayer can prove that the foreign company carries out a substantial economic activity. This is a reaction to the ECJ ruling in the "Cadbury Schweppes" case of September 12, 2006, in which the ECJ ruled that CFC taxation is not applicable to companies that carry out a genuine economic activity.

Substance Requirements and Motive Test

To avoid CFC taxation, the taxpayer must prove that the foreign company has the necessary substance, i.e., maintains a genuine business operation and is not a mere letterbox company. These evidentiary requirements are referred to as the "motive test" and concern in particular the business organisation, the staffing levels, and the equipment of the company. The motive test, which is relevant for EU/EEA companies, is generally not applied to third-country companies unless the companies are involved in economically relevant activities. Here, the legislator sets stricter requirements to prevent taxpayers from avoiding taxes by shifting income to third countries with a low tax burden.

Trade Tax Implications

CFC amount as part of trade income: Since 2017, the CFC amount belongs to the domestic trade income, according to § 7 sentence 7 GewStG (Trade Tax Act). This means that income added back due to the AStG in Germany is fully subject to trade tax. A reduction of these amounts in the sense of § 9 Nr. 3 sentence 1 GewStG is no longer possible. This regulation aims to ensure that all income taxed in Germany due to CFC attribution is also subjected to trade tax.

Changes through the Annual Tax Act 2024: The draft of the Annual Tax Act 2024 provides that the CFC amount continues to flow unreduced into the assessment basis for trade tax. This increases the tax burden on companies that earn passive income through their foreign subsidiaries and have this added back under German law.

Omission of the non-application decree: A previous decree that overrode the BFH ruling of 11.03.2015 in certain cases has been revoked, which means that this case law now applies without restriction. The BFH ruling had decided that a reduction of the CFC amount is not possible if the income is attributable to a foreign permanent establishment.

Key Points of Tightened CFC Taxation:

1. Participations in non-cooperative tax jurisdictions:
   • Tightened CFC taxation affects participations according to § 7 AStG in foreign companies in states classified as non-cooperative tax jurisdictions.
   • These countries do not meet certain criteria, including:
     • No transparency in tax matters, for example, no automatic exchange of information on financial accounts (§ 4 StAbwG).
     • Operating unfair tax competition, e.g., through a significantly lower than usual tax level that only benefits non-residents (§ 5 StAbwG).
     • Non-compliance with BEPS minimum standards, such as the non-implementation of certain BEPS action points or no exchange of Country-by-Country Reports (CbCR) (§ 6 StAbwG).
2. Legal Consequences (valid from 2022):
   • The company is treated as an intermediate company with all low-taxed income, regardless of whether it is active or passive income (§ 8 Abs. 2, § 9 AStG).
   • This regulation also applies to permanent establishments according to § 20 Abs. 2 AStG.
3. Exception:
   • An exception to the application of tightened CFC taxation exists if the application of § 9 StAbwG results in lower taxable income than regular CFC taxation.

Current EU Blacklist (as of 20.02.2024):

Non-cooperative tax jurisdictions currently include, among others:

• American Samoa
• Anguilla
• Antigua and Barbuda
• Fiji
• Guam
• Palau
• Panama
• Russia
• Samoa
• Trinidad & Tobago
• US Virgin Islands
• Vanuatu

Tightened CFC taxation underlines the efforts to combat aggressive tax avoidance through the use of tax havens by taxing income from these territories more heavily, regardless of its type, thus protecting the tax base in Germany.

Treaty Override / Switch Over (§ 20 AStG)

• Treaty Override (§ 20 Abs. 1 AStG): National provisions that override international law agreements (Double Taxation Agreements) to prevent unjustified tax avoidance.
• Switch Over (§ 20 Abs. 2 AStG): Prevention of abuse by changing the applicable taxation rules if certain income is not or only slightly taxed.

Note This article is for general information purposes and was carefully prepared by the Lexo.Tax editorial team. Personal tax advice can only be provided within the framework of membership at Lexo.Tax – and exclusively to the extent permitted by law under § 4 Nr. 11 StBerG (Tax Consultancy Act).