Germany

Author: | Published: 9 Jul 2001
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The year 2000 and the first half of the year 2001 have been notable for the considerable changes they have brought to the tax environment for banks and financial services providers in Germany. In addition to the big German Tax Reform Act, which includes various sections of specific importance for this business sector, there have also been interesting court decisions and developments in the areas of tax audits and the interpretation of legal provisions by the authorities. In the following article, the authors have selected the most important issues to be taken into account by all banks and financial services providers, either doing business in Germany or considering entry into the German market.

Prohibition of compensation and deduction of losses resulting from derivative transactions

For banks and financial services providers, it is normal business practice to cover risks from transactions in shares with share derivatives (either quoted or OTC) reflecting an opposite risk position. Usually, such or similar risk management is at least partially required by the supervisory authorities.

The first step in Germany's big tax reform project – the so-called "Steuerentlastungsgesetz" 1999/2000/2001 – introduced a restriction on the deduction of losses from derivatives transactions for businesses (section 15, para 4, sentence 3, German Income Tax Law). This limitation was mainly introduced because the government had become aware of certain investors assigning non-profitable private derivatives transactions to their businesses to gain tax deductions for the losses. However, a special exception rule meant that this new restriction did not apply to transactions undertaken in the course of the usual business of banks, financial services providers and financial businesses in the sense of the KWG (German Bank Supervisory Law).

Under the subsequent tax reform law – the Steuersenkungsgesetz of mid-2000 – the bank exception from the abovementioned restriction was no longer intended to apply to derivatives whose underlying basis was shares. As a result, the compensation of losses resulting from hedges would only have been possible with profits resulting from such deals. Such a consequence would have been very drastic for banks, as loss compensation between deals with shares and corresponding hedge deals would no longer have been possible.

The prospect of such a bleak future led some banks to threaten to transfer such activities abroad. As a reaction, even before the new regulations of the Steuersenkungsgesetz had become legally effective, the federal government decided to further reform the law – the "Eigenhandelsteuerfolgengesetz" (EigenhandelSteufoG) regulating the taxation of the dealing of banks for their own accounts in shares. It is part of the law "Gesetz zur Änderung des InvZulG 1999" and became legally effective as of January 1 2001.

Following this amendment, the compensation of losses against profits resulting from deals with shares and corresponding hedge deals is still possible as follows:

  • the restriction on loss compensation and loss deduction for derivatives (section 15, para 4, sentence 3, German Income Tax Law) does not apply to deals belonging to the usual business of banks, financial services providers and financial businesses, or deals serving the hedging of deals belonging to their usual business (section 15, para 4, sentence 4, German Income Tax Law); however
  • as an exception to this exception, a restriction on loss compensation and loss deduction applies to transactions whose purpose is the hedging of share transactions, if the capital gain on the sale of these shares is not subject to corporate tax according to section 8 b, para 2, German Corporate Tax Law or – in the case of a bank organized as a partnership – partly tax-exempt according to section 3, no 40, sentence 1, letter a and b, in connection with section 3 c, para 2, German Income Tax Law (section 15, para 4, sentence 5, German Income Tax Law).

In fact, although the new rule is far from being an ideal solution, it is at least in line with the general principles of the German tax system, ie expenses or losses in connection with tax-free income are not meant to be tax deductible. On the other hand, expenses or losses in connection with taxable income are tax deductible.

Tax exemption on capital gains

One of the major innovations resulting from the German tax reform is the introduction of a general tax exemption for all dividends and capital gains received by corporations (section 8 b, German Corporate Tax Law). This covers foreign source dividends and shares in foreign corporations, as well as domestic source dividends and shares in domestic corporations. There is no minimum holding period or minimum participation required. However, there are some special rules applicable for banks, financial services providers and financial businesses.

Regulation under the Steuersenkungsgesetz

According to the Steuersenkungsgesetz, the tax exemption on capital gains was intended to be granted only on condition that the shares being sold had been held as business assets for at least one year. Depreciations on the going concern value made during this period were not deductible for tax purposes.

Regulation according to the Gesetz zur Änderung des Investitionszulagengesetzes 1999

The aforementioned Gesetz zur Änderung des Investitionszulagengesetzes 1999 abolished the requirement for a minimum holding period of one year for shares. Otherwise, there would have been a kind of speculative period for every shareholder in the form of a corporation, comparable to the rules for individuals before the Tax Reform Act.

However, to ensure a corporate tax obligation remained on short-term deals made by banks and financial service providers with shares (corresponding to the modifications to the loss utilization restrictions on derivatives, see above), the German government introduced a new regulation (section 8 b, para 7, German Corporate Law) as follows:

  • the tax exemption for dividends and capital gains received by corporations is not applicable to banks and financial service providers (in the sense of section 1, para 12, KWG), if respective shares are recorded in their trading book; and
  • furthermore, the tax exemption for dividends and capital gains is not applicable to financial businesses ("Finanzunternehmen" in the sense of the KWG), if they purchased respective shares for short-term profits by dealing for their own accounts.

For banks, financial services providers and financial businesses, this means that dividends and capital gains from shares belonging to short-term deals are subject to corporate tax. On the other hand, it is possible for them to deduct the corresponding depreciations on going concern values and capital losses for tax purposes.

The main disadvantage under the new system is that dividends received on trading book shares are now subject to double taxation, because of the abolition of the former imputation tax credit system. They are subject to 25% corporation tax at the level of the distributing company and to 25% corporation tax for the receiving company.

Furthermore, there are definition problems for the so-called financial businesses concerning the applicability of the exception rule. Whereas banks and financial services providers that are subject to bank supervisory legislation have a defined trading book, this is not the case for financial businesses. Actually, the German government created a new term for short-term transactions without defining what period is considered to be short term. Businesses should therefore watch future developments carefully, as a clarifying letter ruling from the authorities is very probable.

The "half-income-regulation"

A regulation similar to the exemption rule for corporations was created for banks, financial services providers and financial businesses in the form of a partnership (section 3, no 40, sentences 5-6, German Income Tax Law).

Generally, one-half of the income of an individual resulting from the sale of shares (section 3, no 40 a, German Income Tax Law) or from a dividend (section 3, no 40 d, German Income Tax Law) is tax-exempt under this new rule. This so-called half-income regulation was also introduced as part of the Steuersenkungsgesetz.

However, this regulation is not valid for capital gains from shares owned by banks and financial services providers if the shares belong to their trading book, similar to the exception rule for corporations, already described. The tax exemption also does not apply to capital gains from shares purchased by financial businesses for the purpose of gaining short-term profits by trading for their own accounts (section 3, no 40, sentence 5, German Income Tax Law). In this respect, the same definition uncertainties arise as for corporations.

Recent developments concerning the dotation capital of German branches of foreign banks

Current handling according to the tax authorities' directive treating permanent establishments in Germany

Normally, the granting of a loan with interest between headquarters and a branch is not possible for tax purposes, as both are part of the same legal entity.

However, the German tax authorities used to acknowledge the deductibility of such interest for banks, subject to the restriction that there had to be a minimum dotation capital and that only the interest for loans exceeding this capital amount was considered as tax-deductible expenses. Actually, the deductibility of interest is based on the assumption that money is the trading good of banks, and as for sales branches, it would be acceptable to sell goods from the headquarter with a profit mark-up, and banks should not be put in a worse position.

The dotation capital and interest deduction were regulated in a directive of the German Ministry of Finance, the so-called "Betriebstättenerlaß" (end of 1999 – before this date it was part of various smaller directives) that divided the German branches of foreign banks into three categories:

  • German branches of banks with their headquarters' seat in an EU member state;
  • German branches of banks that are treated as equal to those of EU banks (ie US and Japanese headquarters); and
  • other German branches of foreign banks (eg Chinese, Korean or Turkish headquarters).

For the third category, the dotation capital is identical to the minimum statutory dotation capital defined in the national banking supervisory law (KWG). For the first and the second categories, for which no minimum dotation capital is required by the banking supervisory law, the German tax authorities created a schedule for the determination of the dotation capital. According to this schedule, the minimum amount of dotation capital for tax purposes depends on the balance sheet total at the end of the preceding financial year with a minimum amount of dotation capital of Dm2 million ($868,000) (or euro5 million [$4.2 million] for US and Japanese banks). If a branch starts business during the year, the dotation capital for tax purposes amounts to at least Dm2 million, independent of the balance sheet total of the branch's opening balance.

A higher amount for the dotation capital has to be applied if the average balance sheet total of the latest 12 so-called BISTA reports (statistical balance sheet total reports in Germany) is higher by at least 20% in comparison with the closing balance of the preceding year.

The result was a rather simple rule that made it possible to calculate the deductible interest amounts based on the prior year balance sheet, and that did not require any separate accounting or documentation.

Planned modifications

As the applicability of the regulations in the Betriebstättenerlaß concerning the dotation capital was limited in time until December 31 2000, important changes in the treatment of German branches of foreign banks have to be expected in the near future. The German Ministry of Finance already announced vis-à-vis the German associations of banks that the current regulation concerning dotation capital will not be extended, and that there will be a new system in the future. Informed opinion on the regulation mainly goes as follows at present:

  • the application of the minimum capital rules of national bank supervisory authorities for tax purposes does not seem to be a satisfying solution, as for most of the German branches of foreign banks, ie those of EU banks, Japanese and US banks, German bank supervision does not require a minimum dotation capital. An analogous application of the existing rules of bank supervision to those banks only for tax purposes appears not be a practical solution for them, as compliance with the respective procedures is quite complicated, ie it would be necessary for tax purposes to establish accounting procedures that have just now been avoided by means of the introduction of the exemption from national German banking supervision for certain foreign banks;
  • according to a second opinion, the existing schedule for the determination of dotation capital should be changed, ie the percentages might be increased and/or the steps of the balance sheet totals will be changed. The advantage for the banks lies in the fact that they could continue to use the old procedure that is quite simple. On the other hand, their taxable income would always be increased; and
  • furthermore, the OECD has issued a so-called "Working Hypothesis" for the allocation of profits between the headquarters and a permanent establishment with a focus on the treatment of permanent establishments of banks. According to this proposal, the allocation of capital to a branch has to fulfill the arms-length-principle, for which purpose the OECD proposes certain methods that are based on risk allocation principles similar to the Basel standards. The first step when applying such a method would be an assessment of risks for each asset or transaction of a bank. In a second step, the share capital will be allocated between the headquarters and the branch accordingly based on risk.

The OECD then considers different methods to achieve this goal. One method proposed is seen in the analogous application of national supervisory regulations for banks organized as corporations. As a second method, the possibility is discussed of determining the capital by a comparison with independent banks in the country of the branch. Finally, as a third method, the dotation capital of the branch could be determined by a proportional calculation – this seems to be the method preferred by the OECD.

It cannot yet be judged how the German tax authorities will decide in the end, as they have not made any detailed proposals – they have only started discussions with the associations of banks and with tax experts. Nevertheless, all banks operating in Germany via a branch or planning to do so should be aware of the fact that the tax rules are going to change in the near future.

Developments concerning the taxation of option transactions

The treatment of option transactions for tax purposes on the part of the option seller is a widely discussed topic in Germany at present, and was last touched on in a judgment of the Tax Court of Munich of November 28 2000.

According to this judgment, which confirms an opinion of the tax authorities that was published in 1994/1995, the option premium has to be treated as taxable income at once by businesses dealing in options. The option seller (short position) is not allowed to record the option premium received as accruals for liabilities or to treat it as deferred income in the tax balance sheet.

By distinguishing between the purchase of the option and the contract of sale in case of the exercise of the option by the buyer, the court follows the so-called "two-contracts-theory" of the tax authorities' approach that is based on a Supreme Tax Court decision of the early 1990s. However, this earlier court decision concerned the taxation of individuals who in general are using a cash basis for income and not an accruals basis. Therefore, the opinion of the tax authorities is rather doubtful.

Furthermore, with respect to possible losses resulting from the option position (upon exercise by the buyer), this risk is reflected according to German accounting literature via so-called accruals for unrealized losses from pending transactions. However, since 1997, such accruals have not been acceptable for tax purposes.

In a worst-case scenario, since the decision of the tax court of Munich, it is no longer possible from a tax perspective to reflect the risk from a short option position, while the received option premiums must be treated as income at once.

As the result is a very high tax burden for banks as option sellers, the pending appeal against the tax court decision that has been filed with the Supreme Tax Court will hopefully bring a decision that is more friendly towards banks. However, until the decision has been made (it cannot be expected earlier than 2002 or 2003), all businesses involved in short option transactions in Germany should be aware of a substantial tax risk.

Developments concerning avoir fiscal

The "avoir fiscal" is a French tax credit that is granted to German taxpayers by the government under the France-Germany tax treaty, and that includes a possibility for a tax refund if the credit exceeds the German tax liability in the relevant year. The German government gets 50% of the avoir fiscal back from the French government.

Recently, several tax audits of German banks and financial services resulted in the finding that the use of this tax credit in connection with transactions that incur a pre-tax loss or low profits is treated as abusive by the tax authorities. This is comparable to the former dividend stripping issues with German shares that were finally decided by the Supreme Tax Court in 1999.

In one typical case, a foreign bank sold French shares to an affiliated German bank, to make use of the avoir fiscal. At the same time, the German bank bought put options on the French shares as a hedge deal. The fixed day for the sale of these shares according to the put option was after the day of the distribution of the dividend. In case the market price for the shares was higher than the price of the put on this fixed day, the bank would have sold the shares on the market for that higher price.

The possible loss from this deal was limited to the amount of the difference between the original purchase price for the shares plus the option premium, and the price for the shares according to the put. However, the chance of profit was not limited.

The German tax auditors considered such a transaction structure to be a case of abuse of the law (German general anti-abuse rule) and refused to grant the avoir fiscal.

However, there are as yet no court cases or official directives from the tax authorities concerning this type of transaction, apart from a very general letter stating only that "all avoir fiscal transactions of a certain volume must be reviewed and reported by the tax auditors to the supreme tax authority". It is also not clear whether German anti-abuse rules apply to the avoir fiscal, as it is regulated in the France-Germany tax treaty and not in German domestic tax law.

Further developments in this area should be watched carefully by all companies dealing with French shares in Germany.

Final remarks

The authors hope they have demonstrated that the tax environment for banks and financial services providers in Germany has undergone substantial changes recently, and is still continuing to develop. Consequently, future developments should be watched carefully to avoid unpleasant results, especially during tax audits.


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