In 2021, Germany implemented the Act Combating Tax Avoidance and Unfair Tax Competition (Gesetz zur Abwehr von Steuervermeidung und unfairem Steuerwettbewerb, the “Act”) which introduced specific tax measures affecting individuals, corporates, partnerships or asset pools maintaining business relationships or shareholdings in or with reference to non-cooperative jurisdictions. The non-cooperative jurisdictions covered by the Act are generally linked to the so-called EU blacklist. The tax measures implemented with the Act are far-reaching and encompass i.a. special withholding taxes on payments to recipients in such jurisdictions, denial of participation exemption for dividends and capital gains derived from such jurisdictions or even non-deductibility of business expenses linked to such jurisdictions. The Act is generally applicable from 1 January 2022. The above tax measures are staggered in application (in principle depending on the date of the inclusion of the respective jurisdiction in the list), apply to both related and unrelated parties and are additionally accompanied by extensive documentation and compliance requirements.
While as of its implementation in 2021, the EU-blacklist included mainly exotic jurisdictions, given the far-reaching tax character of the measures, combined with the anonymity of global financial markets, the Act was in the focus of the German financial industry from the outset. Further, classification of the Russian Federation as an EU-blacklisted jurisdiction in 2023 additionally elevated the importance of the Act. Currently, the following jurisdictions are considered non-cooperative: American Samoa, Anguilla, Antiqua and Barbuda, Bahamas, Belize, Fiji, Guam, Palau, Panama, Russian Federation, Samoa, Seychelles, Trinidad and Tobago, Turks and Caicos Islands, U.S. Virgin Islands and Vanuatu.
On 14 June 2024, the Federal Ministry of Finance published the final circular (the “Circular”) on the application of the Act. The Circular is largely in line with the draft version published for expert feedback in November 2023, however, there are few practically significant (and also surprising) changes. The following insights focus mainly on the impact of the Circular on German inbound financing transactions as well as the Circular’s explanations regarding the German limited tax liability and the withholding tax obligations of German residents making payments to recipients in non-cooperative jurisdictions.
Focus points for financing transactions
For inbound financing transactions, the key pressure points in connection with the Act and the Circular relate to practical aspects of (i) withholding tax on interest payments to non-resident finance parties, (ii) non-deductibility of interest expenses at the level of the obligor, and (iii) general treatment of partnerships.
Withholding tax on interest payments to non-resident finance parties
German tax law generally does not stipulate non-resident taxation or withholding tax obligations on interest payments on straight-forward not profit participating loans or bonds (unless performance contingent or secured by German-situs real estate). However, pursuant to the Act, in case the non-resident lender/noteholder is considered to be tax resident in a non-cooperative jurisdiction, the interest payments would generally become subject to a withholding tax of 15.825% (or 18.8% in a gross-up case) with the obligor being obliged to withhold. However, on the global financial market, the issuer of an instrument has virtually no information or control as regards the tax residency of the noteholder. Given the statutory withholding obligation of the obligor, such factual information deficit would lead to non-compliance of the obligor. Against this background and upon criticism from the financial industry, an exemption from withholding tax was included in the Act for (i) bearer notes (Inhaberschuldverschreibungen), if these are certificated by a global note, deposited in a central depository and tradeable on a recognized stock exchange as well as (ii) comparable foreign instruments fulfilling these criteria. The Circular includes further details and explanations regarding the exemption of such bearer notes and comparable debt instruments from the withholding obligation of the German payor.
The Act, however, does not include an exemption for registered notes (Namensschuldverschreibungen) as such. This issue is only addressed in the Circular, pursuant to which registered notes could also benefit from the exemption, but only if the notes are issued in the name of a credit institution (Kreditinstitut) as a nominee. This requirement will, however, rarely be fulfilled in practice, as registered notes are technically issued in the name of a nominee of a clearing system (and not a credit institution). This key technical difference is, however, not explicitly covered by the Circular and thus, it remains unclear whether the exemption would apply in cases where the noteholders are anonymous, but the notes are registered in the name of a nominee that does not qualify as a credit institution. From the perspective of the obligor, it should be ensured that against the background of potential practical impossibility of withholding at least dedicated wording is included in the financing documents to demonstrate compliance best efforts.
Non-deductibility of interest expenses of the obligor
The ultimate tax measure under the Act is the non-deductibility of business expenses from business relations with non-cooperative jurisdictions. From a timing perspective, this measure in principle applies only from the fourth year following the inclusion of the respective jurisdiction on the list (i.e. first application in 2025 for jurisdictions that were included on the initial list in 2021). In the finance context, this measure makes especially interest deductibility at the level of the obligor conditional on the tax residency of the lender/noteholder (in a somewhat similar manner to the anti-hybrid provision of the ATAD directive). Similar to the withholding tax, also this measure casts doubts as regards information and enforcement deficits.
Further, although this measure should only serve as a fallback mechanism (i.e. is only applicable if the other measures of the Act do not apply), especially the interplay with the exemption for interest withholding tax on bearer notes could lead to peculiar results. Specifically, in the cases where a bearer note falls under the exemption from interest withholding tax, the denial of interest deductibility could – based on the wording of the law – apply nonetheless (as the specific measures of the Act are technically not fully aligned). Although this issue was addressed by the financial industry with the Federal Ministry of Finance, so far, no explicit regulation was introduced. Thus, beside the customary interest deduction limitations, the interest deductibility could be also affected by the Act and the obligor should at the very least ensure that their best efforts regarding compliance are documented. It remains to be seen whether relief will be granted in a future version of the Circular or an amendment of the Act.
Treatment of partnerships
For the applicability of the tax measures, the Act does not explicitly differentiate between partnerships and corporates. Given that partnerships are generally considered transparent for German (corporate) income tax purposes, the lack of a specific statutory provision led to interpretation difficulties, which were, however, initially resolved by the Federal Ministry of Finance as the draft of the Circular considered the partnerships to be opaque for the purposes of the Act (i.e. no look-through approach). Surprisingly though, the final Circular differentiates between (i) partnerships which are resident in non-cooperative jurisdictions and (ii) partnerships resident in cooperative jurisdictions. While the latter are considered opaque, for the partnerships resident in non-cooperative jurisdictions the look-through approach is applied, i.e. the consequences for the obligor (especially withholding tax obligation or non-deductibility of interest expense) would depend on the tax residency of the business partners. The practical complexity appears to stretch even further as the Circular seems to further differentiate as regards the specific tax measures depending in turn on the residency of the business partners. Such differentiation, however, is not backed by the wording of the Act and came unannounced. Against the background of the above, transactions with finance parties in the form of partnerships seem to entail additional uncertainty and complexity and thus necessitate detailed analysis.
Other business relationships leading to withholding tax obligations
The Act establishes German limited tax liability of foreign individuals/ entities resident in a non-cooperative jurisdiction regarding selected types of income (e.g. trade in goods or rental/ leasing of rights). Other than the Act that simply lists selected types of income establishing German limited tax liability of the recipient without further details, the Circular now explains the payments in scope of the Act in detail and therefore gives valuable guidance and higher legal certainty for German business partners with regard to their filing and payment obligation.
Especially noteworthy are the Circular’s explanations regarding the trade in goods as the Circular explicitly excludes the trading of real estate as well as the trading of legal rights from the scope of the Act. The latter is particularly interesting with regard to the more and more growing importance of carbon credits and their acquisition from entities resident in a non-cooperative jurisdiction as the guidelines in the Circular provide arguments for exception from withholding tax in such cases.
Regarding income generated by individuals or entities resident in a non-cooperative jurisdiction from the letting and leasing or the sale of rights, the Circular now explains that a limited tax liability of the income recipient under the Act only exists if the only German nexus is the entry in a German public book or register. The Circular clarifies that in other cases with a German nexus, German taxable income is usually already established under the prevailing rules of the German Income Tax Act.
As a consequence of the regulations included in the Act, a German individual or entity making payments that are in scope of the Act to a recipient resident in a non-cooperative jurisdiction is obliged to withhold taxes in the amount of 15.825 % (or 18.8% in a gross-up case) of the payments and pay the taxes to the German tax authority. Further, the Act requires the German payor to submit tax filings to the German tax authorities.
Extended cooperation and documentation requirements
The Act further foresees extended cooperation obligations which require the affected taxable persons that maintain business relationships and transactions with non-cooperative jurisdictions to prepare documentation outlining and describing i.a. the business relationships with non-cooperative jurisdictions, the contracts underlying the business relationship, an analysis of functions and risks assumed by the respective parties or business strategies. The documentation ought to be provided to the tax authorities in principle within one year following the affected calendar year (special extensions apply for 2021 and 2022) as well as upon explicit request. In case of non-compliance, the tax authorities can estimate the income subject to the Act and the taxpayer would have a worse starting position (as they would need to refute the basis of the estimate).
Given that the Act also applies to business relationships between unrelated parties, the cooperation obligations were widely criticized. The Circular includes several practical simplifications, i.a. (i) the cooperation obligations shall only apply in cases where one of the tax measures actually applies (i.e. no application of cooperation obligations independent of the remaining tax sanctions, although this is not clearly based in the wording of the law), (ii) especially in the cases of unrelated parties, the fulfillment of the cooperation obligations would likely be factually limited, and (iii) for financial institutions, the data collected in the KYC process is generally considered sufficient.
Outlook
Although the Circular includes some simplifications (especially with regard to documentation requirements), the current version does not solve major practical issues for financing transactions and even causes additional uncertainty (as in the case of partnerships). Given the recent publication of the Circular, the chances for a short-term update are rather low and there is also no current initiative to amend the Act as such. Against this background, the consequences of the Act for German inbound financing transactions further remain object of necessary discussions and negotiation in a specific transaction.