Taxation of add-backs - understanding and averting tax traps
German entrepreneurs who want to expand abroad prefer a low-tax location. Companies are often founded in tax havens for this purpose.
Why not?
Low-taxed profits abroad offer the opportunity to achieve higher profit distributions in Germany. As is well known, these profit distributions are also “tax-privileged” in Germany (keyword: flat-rate withholding tax/partial income procedure for natural persons as shareholders or tax exemption in accordance with Section 8b KStG for corporations as shareholders).
But beware: German add-back taxation can throw a spanner in the works of this idea.
Overview
WHAT YOU SHOULD KNOW ABOUT ADD-BACK TAXATION?
German tax law generally taxes corporations independently (so-called separation principle). This means that a GmbH taxes its profits and the shareholders pay tax on the GmbH’s profit distributions. In principle, this concept applies to domestic and foreign companies.
In the context of add-back taxation, the income of the foreign company is taxed at the level of the German shareholder. The aforementioned separation principle is broken in cross-border constellations under certain conditions.
With this regulation, the legislator wants to prevent income from being shifted to foreign corporations. In particular, if the company is taxed at a low rate abroad.
The regulations on add-back taxation have already existed for 50 years. However, they have been amended with effect from 2022(Section 7 AStG, Section 8 AStG).
WHAT REQUIREMENTS MUST BE MET?
In the case of add-back taxation, the income of the foreign corporation is attributed directly to the German shareholder. The attribution is based on the shareholder’s shareholding.
Taxation takes place virtually independently of a profit distribution, i.e. even if the income is retained in the foreign company.
This requires the following in brief:
- The foreign company is controlled by persons with unlimited tax liability in Germany
- The foreign company generates passive income that
- Be taxed at a low rate (<25%)
The requirements must be met cumulatively for the add-back taxation to apply.
Unlimited taxpayers can be natural persons who hold shares in a foreign company. Or also German companies with shareholdings abroad. In the following, these groups of persons are also referred to as entrepreneurs for ease of understanding.
WHEN DOES CONTROL EXIST?
Control is deemed to exist if more than half of the voting rights or the shares in the nominal capital or the profit/liquidation proceeds of the foreign company are directly or indirectly attributable to the taxpayer alone or together with related parties.
A shareholding of more than 50% therefore constitutes control.
WHEN DOES LOW TAXATION APPLY?
Low taxation is deemed to exist if the foreign company is subject to a tax burden of less than 25% (§ Section 8 (5) AStG ).
It should be noted that the foreign income must be calculated according to German principles in order to determine the tax burden. A kind of comparative calculation must therefore be carried out to check whether low taxation applies. This can be very time-consuming in practice.
A rough assessment is therefore sufficient as a first step. For example, the income tax rate for companies in Switzerland is 12% to 13%. In Hong Kong, the tax rate is around 17%. In these cases, it is obvious that a comparative calculation will also lead to the result of low taxation.
In some other cases, it is not so clear. One example is the Netherlands:
From 2021, corporation tax in the Netherlands will be 25% for taxable income above EUR 245,000. Taxable income below this amount will be taxed at 15% corporation tax. On average, the total tax burden can therefore be less than 25%. Under certain circumstances, the Netherlands may be a low-tax jurisdiction from a German perspective. A comparative calculation is therefore advisable.
WHAT IS PASSIVE INCOME?
The legislator has in § Section 8 (1) AStG The Federal Council has listed a catalog of active income that is generally not subject to add-back taxation.
If the foreign company generates the income listed in the catalog and meets the activity requirements, the income is not added. Conversely, this means that income not included in the catalog is considered passive income and is added.
The rule-exception-back-exception construct of the provision makes the regulation very complicated. A detailed examination is therefore always required.
The following is a brief overview of cases that can be regarded as passive income.
TRADE
If the foreign company is active in the trade of goods, the income is generally deemed to be active.
However, passive income may exist if the foreign company purchases the goods from the German entrepreneur (distribution company) or sells the goods to him (purchasing company).
However, if the business operations of the foreign company are set up in a commercial manner, it participates in the market and carries out its activities independently without the involvement of the German entrepreneur, there is no passive income despite the intra-group procurement.
SERVICE
If the foreign company provides services, the income from these services is generally capitalized.
Passive income always exists if the foreign company can only provide the service with the support of the German entrepreneur or provides the service to the German entrepreneur.
In the case of the provision of services to the German entrepreneur, a German add-back of income can be avoided by an active independent activity with a certain substance.
LETTING AND LEASING
This includes not only income from the letting and leasing of real estate, but also the licensing of intangible assets. The income derived from this can be passive income.
In particular, income from the licensing of rights (e.g. via foreign IP companies) must be classified as passive. An exception applies if the foreign company carries out its own R&D work without the involvement of the German entrepreneur and the income is received for this.
THE LEGAL CONSEQUENCES OF ADD-BACK TAXATION
If the above-mentioned requirements are met, the passive income is attributed to the German entrepreneur in proportion to his shareholding (so-called add-back amount).
The add-back amount is regarded as a notional dividend to the German entrepreneur.
But beware: the dividend is taxed at the (individual) tax rate of the German entrepreneur.
The “tax-privileged” provisions such as the flat-rate withholding tax, the partial income procedure and the tax exemption pursuant to Section 8b KStG do not apply in the case of add-back taxation.
This makes foreign participation very unattractive from a tax perspective.
However, the tax paid abroad can be credited in order to avoid double taxation (but: no credit against German trade tax).
In addition to the tax consequences, the add-back taxation leads to a high administrative burden when determining the add-back amount. Furthermore, a separate determination of the basis of taxation in Germany is required.
HOW TO AVOID ADD-BACK TAXATION?
In principle, add-back taxation can be avoided if the German entrepreneur only holds less than 50% of the shares in the foreign company. In this case, there is no control.
In addition, providing the foreign company with an active independent activity of a certain substance can avoid add-back taxation. The company then generates active income.
PRACTICAL TIP
Expansion abroad should be carefully considered. Many entrepreneurs are enthusiastic about the low tax rates abroad and do not consider the German tax consequences.
The formation of a foreign company without its own business activities entails a high tax risk. Income cannot simply be shifted abroad without German tax consequences.
My recommendation in a nutshell: Plan the expansion and activities of the foreign company in advance.
An “upgrade” of activities abroad can also lead to the avoidance of German add-back taxation.
Do you have a risk of German add-back taxation and need tax advice?
I am happy to support you in the following areas:
- Examination of the requirements for add-back taxation
- Design to avoid add-back taxation
- Assistance with appeals and lawsuits before the tax courts in connection with add-back taxation
- Expert opinion on individual questions of add-back taxation
- Support with the declaration of add-back taxation
Please feel free to contact me!
Disclaimer
This article does not constitute legal or tax advice, but is for general information purposes only. Every situation is individual, so I always recommend professional advice to avoid tax disadvantages.
The article uses simple language for better understanding and is also abbreviated with regard to the individual conditions required by law.
Last updated July 20, 2022
