BFH rules CFC income is exempt from trade tax

The BFH has ended a long-standing controversy by ruling that passive income of a wholly-owned low-taxed foreign subsidiary that is covered by German CFC rules is not subject to trade tax because it is deemed income of a foreign PE.

In a decision issued March 11, 2015 (I R 10/14), the Federal Tax Court (BFH) held that passive income of a wholly-owned, low-taxed foreign subsidiary that is subject to the German controlled foreign company (CFC) rules is not subject to German trade tax. The BFH concluded that this CFC income constitutes deemed income of a foreign permanent establishment (PE) for German tax purposes and, thus, is deductible from the trade tax base. The BFH overturned a 2012 decision of the lower court of Düsseldorf (16 K 2513/12), putting to rest a long-standing controversy on this issue.

Under the CFC rules, passive income of a foreign subsidiary considered to be “low taxed” is taxed currently in the hands of the German shareholders. The CFC income is treated as a deemed dividend, to which exemptions and other dividend relief mechanisms do not apply. The CFC income is included in the corporate tax income base and, thus, also in the starting point for the income calculated for trade tax purposes. However, any foreign tax paid by the CFC is creditable only against corporate income tax and not against trade tax. “Low taxation” is defined as an effective tax rate below 25%. The German corporate income tax rate is 15% (plus a surcharge), so the application of the CFC rules could result in incongruous results. Accordingly, there has been some controversy around this issue.

The case involved a German corporation (GmbH) with a wholly-owned subsidiary in Singapore (A Ltd.). A Ltd. generated only passive income in the form of interest and foreign exchange gains, and was considered to be low-taxed under Germany’s CFC rules. Thus, the income of A-Ltd. was allocated to GmbH on a pro rata basis. GmbH reported the income in its corporate income tax return but did not include the income attributed from A Ltd in the trade tax base on the grounds that the income was attributable to a foreign PE for trade tax purposes. Since the trade tax is levied on a territorial basis, income of a foreign PE is not subject to German trade tax but instead must be deducted from the trade tax base. The German tax authorities did not agree with this approach, and took the position that the CFC did not constitute a foreign PE of the GmbH (but rather a PE of A Ltd), so the income was subject to trade tax, and the lower tax court agreed.

The tax authorities and the GmbH agreed that income for trade tax purposes must be calculated based on the income determined according to the provisions of the German corporate income tax act and income tax act. Therefore, GmbH must take the CFC income attributed from A Ltd. into account, as this income forms part of the GmbH’s general business income under German tax law. Accordingly, the income must be included in the starting point for determining the trade tax base, i.e. before applying deductions and addbacks (that result in the trade tax base deviating from the corporate income tax base). One of the reasons for these deductions and addbacks is that the trade tax is levied on a territorial basis, whereas the corporate income tax is levied on a worldwide basis. Following this principle, the trade tax act (section 9 no. 3 GewStG) provides for a full deduction of the income derived by a foreign PE. The BFH concluded that this provision also covered the income included from A Ltd under the CFC rules.

First, the BFH notes that the wording of section 9 no. 3 GewStG provides only that it applies to income from a foreign PE. The BFH clarified that the wording itself does not indicate that the foreign PE must qualify as a PE of GmbH, as defined elsewhere in German tax law, but rather that the income must not be attributable to a domestic PE of GmbH. The court found that the consequence of the application of the CFC rules was that the income attributable from A Ltd. constituted—for German tax purposes—deemed business income of GmbH under sections 7 and 10 of the foreign tax act (AStG). The BFH determined that this deemed reclassification allows a broader interpretation of section 9 no. 3 of the trade tax act and that GmbH should be considered to have a deemed foreign PE for trade tax purposes due to the application of the CFC rules. It follows that the application of section 9 no. 3 of the trade tax act can be extended beyond the income derived from a foreign PE of a German entity to include CFC income allocated to the German entity, as in the present case. To support that conclusion, the BFH emphasized the territorial scope of the trade tax. Further, the BFH determined that the inclusion of CFC income in the trade tax base would result in economic double taxation, as foreign taxes paid may be credited only against the corporate income tax, and not the trade tax. Finally, the BFH concluded that the application of section 9 no. 3 is necessary to prevent different treatment of nonresident subsidiaries and foreign PEs, since the income of foreign PEs would not be included in the German trade tax base.

Despite the fact that the CFC income is treated as a deemed dividend, the BFH held that the trade tax provisions dealing with foreign dividends (i.e. section 9 nos. 7 and 8 GewStG) do not apply and do not prevent the deduction under § 9 no. 3. According to the BFH, even though the CFC income is treated as a deemed dividend, its basis is the income derived by the foreign CFC and, thus, it has the character of deemed business income from a foreign PE.

The BFH decision clarifies that the income of passive foreign subsidiaries and PEs of German companies within and outside the EU is not subject to German trade tax at the level of the German parent company. Since the CFC income triggered by the application of German CFC rules is subject only to German corporate income tax, and not to trade tax, the effective tax rate on the income effectively is reduced to 15.825% (including the surcharge).

Whether there will be a legislative response to the BFH decision is unclear. While it would be easy to exclude CFC income from the foreign PE exemption under the trade tax rules, the BFH has indicated that other exemption rules also may have to be considered to reach a result in line with the German trade tax rules.

Taxpayers that previously have been assessed on trade tax income should review and potentially challenge their assessments to benefit from the BFH’s decision. It should be noted that CFC income and the trade tax exemption are included in different assessments, so taxpayers may need to monitor (and possibly challenge) different assessment notes for a single year to obtain adequate legal protection.