What legislation defines the economic substance requirements in your jurisdiction?
Provisions which require a certain economic substance for tax purposes are regulated, on the one hand, at national level by tax legislation. For cases of tax relief provided for in double taxation agreements, there is a special provision (Section 50d, paragraph 3, German Income Tax Act (ITA)). This provision generally directs that relief provided in a double tax treaty relating to the deduction of withholding tax cannot be availed of if the interposition of a company without substance leads to a more favorable for the taxpayer than direct collection of the benefit subject to withholding tax (treaty shopping).
In addition, there are general provisions such as the general duty to prevent abuse (Section 42, General Tax Code (GFC)), which applies in German national tax law to all types of taxes and constellations (national or cross-border). This is thus intended to cover, in addition to the other provisions for the prevention of abuse, the cases of intermediary foreign companies without economic substance.
However, this regulation is very general since, as mentioned, it covers all types of taxes. The extent to which it applies can therefore only be determined on a case-by-case basis.
However, recourse to these provisions would not suffice to answer the question from a German point of view. German national tax law is also increasingly shaped by the legal principles of European law in the field of direct taxation. Legal principles such as directives oblige Member States to implement their regulatory content in national law. The Parent-Subsidiary Directive (Directive 2011/96/EC) and the Interest and Royalties Directive (Directive 2003/49/EC) are examples. With regard to the first, paragraphs 2 to 4 of Article 1 provide that in the event of an “abusive arrangement” the essential purpose of which is to obtain a tax advantage which is “contrary to the object or purpose of this Directive”, the advantages granted by this Directive shall not be applied. In the latter case, the directive refers in Article 5 to national rules to prevent abuse.
With regard to Directive 2011/96/EC and European legal principles containing provisions aimed at preventing abuse, their binding interpretation is exclusively carried out by the European Court of Justice (ECJ). The Court must deal with provisions for the prevention of abuse when examining whether certain national provisions are compatible with secondary law (such as the directive) but also with primary law (European fundamental freedoms).
Here, the ECJ established the formula of “purely artificial arrangement”, which should not allow a tax advantage because it “[does] do not reflect economic reality and are intended to unduly obtain a tax advantage”. (See ECJ case C-6/16 Eqiom and Enka  ECLI:EU:C:2017:641, point 34 and ECJ case C-504/16 Deister Holding and Juhler Holding , ECLI:EU:C:2017:1009, paragraph 65ff. See also the chapter Overview of the European Union in this edition.) However, this remains a vague criterion and does not clarify the very vague overall context of the rules for the prevention of abuse, at European level or at national level (indirectly affected).
The Unshell initiative (ATAD III directive proposal), which the European Commission formalized with the directive proposal of December 22, 2021, is today a promising first attempt to clarify the rules of economic substance and make them more concrete for the legal practitioner.
With this initiative, the European Commission pursues the following objectives:
It is necessary to establish a common framework, in order to strengthen the resilience of the Member States in the face of tax avoidance and tax evasion practices linked to the use of undertakings which do not carry out an economic activity, even if they are likely to carry out a economic activity and have no or only minimal substance for tax purposes. This is done in order to ensure that companies lacking minimal substance are not used as instruments of tax evasion or tax evasion. [I]It is essential to agree on a common set of rules to determine what should be considered as insufficient substance for tax purposes in the internal market as well as to delimit the specific tax consequences linked to such insufficient substance.
Accordingly, it can be summarized that the cornerstone of the German national regulation on economic substance remains § 50d, paragraph 3, ITA and § 42, GFC. However, these will need to be interpreted in light of the proposed ATAD III Directive in the future. This is due to the position of a legal act such as an EU directive in relation to the Member States. An EU directive is not directly applicable and does not replace national law; however, Member States are required to implement the content of the directive in the best possible way.
This does not mean that the directive must be transposed into national law in full conformity and with the same wording. Nevertheless, the national transposition law must be consistent with the aims and objectives of the directive. Exceptional regulations are possible but are subject to the control of the CJEU as to the sufficient transposition of the directive as well as the compatibility with primary law, such as the fundamental freedoms.
Section 50d(3) ITA is a provision that is subject to constant change. With regard to cross-border and intra-Community situations, it is also subject to an assessment based on the standards of European law. This leads to multiple changes to the provision itself or its interpretation. European law does not allow the general or predominant prohibition of forms of cross-border advantageous tax structuring, because the free choice of location (and therefore of the choice of legal system) is one of the pillars of European unification.
What types of entities are subject to economic substance requirements in your jurisdiction?
The substance requirements established by the ECJ generally apply to taxpayers carrying out economic activities in the EU through companies or permanent establishments.
In addition, ATAD III is drafted to apply to businesses that are considered tax resident and eligible to obtain a certificate of tax residency in a Member State. These are entities carrying out an economic activity, regardless of their legal form, which are tax residents in an EU Member State.
What activities trigger the economic substance requirements in your jurisdiction?
Structures considered purely artificial lead to a critical examination of the substance of the entities involved.
According to the special provision of Article 50d, paragraph 3, ITA, there is a presumption of abusive arrangement if the following facts in the area of treaty shopping are combined:
- persons who have an interest in the company requesting the tax benefit would not be able to benefit from the tax benefit if they received the benefits directly from the distributing company; and
- the actual source of income has no significant relationship with the economic activity of this entity (the intermediary company).
On the one hand, the presumption of an abusive structure can be invalidated by evidence to the contrary. This may still be possible with regard to the first prerequisite (comparison of results in the case of indirect and direct participation). As regards the second precondition – the relevant link between the actual source of income and the economic activity of the intermediary entity – the reference to “evidence to the contrary” does not help. Criteria such as carrying on a “reasonably established business” do not help either.
Again, the ATAD III initiative will provide relief to the legal practitioner through more specific guidelines.
Tax residency requirements
Do entities have to be tax resident (or deemed tax resident) in your jurisdiction to be subject to economic substance requirements? If so, what are the tax residency rules and requirements? If not, do the economic substance requirements in your jurisdiction differ from non-resident entities?
Substantive requirements are only mentioned in German tax law when they relate to cross-border constellations. These can take place within the EU; however, they also apply to cases where double taxation agreements exist with non-EU states and provide relief from German withholding tax.
The substance test takes place in the foreign company that receives the payments. Since German income tax law is based on the principle of territorial and worldwide income, only cases of taxation of non-residents are thus covered.
Has the government issued guidance on economic substance requirements?
There are no useful published guidelines. There was an information letter from the Federal Ministry of Finance in article 50d, paragraph 3, ITA, but it has become obsolete because it did not recognize the CJEU’s requirements for the prevention of abuse in accordance with European law. During the implementation of the ATAD guidelines, it is reasonable to assume that after a certain period following the adaptation of the Unshell initiative by the ITA, guidance will be published.