The European Court of Justice published its long-awaited ruling in the "Hornbach Baumarkt AG" case (C-382/16) on May 31, 2018, and this has considerable explosive force.
The ruling concerned letters of comfort for which the German shareholder had not charged the foreign subsidiaries any remuneration.
The foreign Group companies undoubtedly had negative equity and were dependent on bank loans for the continuation of their business operations and for the intended expansion. The financing bank had made the granting of the loans dependent on the provision of a (so-called hard) letters of comfort by the plaintiff (the domestic shareholder). The competent tax office assumed that under the same or similar circumstances independent third parties had agreed a liability remuneration (Aval) and adjusted the income of the plaintiff pursuant to § 1 (1) German Foreign Tax Act, AStG (in the version applicable from 2003) for the assumed liability remuneration.
After an unsuccessful appeal, the plaintiff brought an action before the Finance Court of Rhineland-Palatinate against the underlying decisions. This was referred to the ECJ for a preliminary ruling because of doubts as to the compatibility of § 1 AStG with the freedom of establishment. The tax court justified the submission, among other things, by the fact that a taxpayer had the possibility to demonstrate and prove within the scope of the cross-comparison audit that the conditions agreed with the foreign company corresponded to the cross-comparison. However, the standard does not provide for proof of non-taxable economic reasons for concluding a transaction on terms and conditions that are not customary for third parties and that lie in the corporate affiliation of the parties involved. The provision does not take into account that the shareholder may have an economic self-interest in the business success of "his" company because he participates in this success through profit distributions. The Finance Court saw in this a considerable economic reason in the sense of the previous ECJ jurisprudence in the case "SGI" (Judgment of 21th January, 2010 Case C-311/08).
In particular, the Advocate General expressly did not follow the latter argument in his final motions of 14 December 2017. If the economic self-interest were to be permitted as a justification for conditions that do not conform to arm's length principles, the notion of an arm's length transaction would be deprived of all meaning. This would mean that all business transactions with subsidiaries would be completely and readily exempt from the application of the principle because a parent company would always have an interest in the success of its subsidiary.
Surprisingly, the ECJ followed the opinion of the applicant and the referring tax court without having responded in a single sentence to the extensive arguments put forward by the Advocate General.
The ECJ first affirmed an encroachment on the freedom of establishment, which was only possible from the point of view of the need to preserve the division of taxation powers between the Member States and affirmed this justification in the present case.
- 1 AStG is suitable to meet this goal. However, national law must also be necessary to justify interference with the freedom of establishment. For this purpose, the taxpayer must have the possibility of providing evidence of any economic reasons for the conclusion of a transaction not customary for third parties (such as RS. SGI, C-311/08, marginals 71 and 72).
Contrary to the opinion of the German Federal Government, the term "economic reasons" also includes those arising from the sole existence of links between the parent company domiciled in the member state concerned and its subsidiaries domiciled in another member state. Since in the present case the subsidiary is dependent on the allocation of capital for the expansion of its business operations, since it does not have sufficient equity, economic reasons could justify the transfer of capital by the parent company - also - under conditions not customary for third parties.
Moreover, the defendant and the Federal Government did not claim any tax evasion, either in the form of purely artificial design or purely with the intention of reducing profits.
Thus, the plaintiff's "economic self-interest" in the success of the subsidiary could justify the voluntary comfort letter, especially since the plaintiff participates in future profit distributions. In addition, it has a "certain responsibility" in financing the subsidiary.
It is now for the present tax court to examine whether the applicant has been given the possibility of providing evidence of any economic reasons for the conclusion of the letters of comfort, without excluding the possibility of taking into account economic reasons arising from its position as a shareholder of the non-resident company.
Prospects and Possible Consequences
It is not unlikely that the Finance Court of Rhineland-Palatinate will now find in the main proceedings that the plaintiff was wrongly deprived of the opportunity to demonstrate its economic self-interest in the future success of its subsidiaries by waiving guarantees for the letters of comfort given. This would also justify the behavior not customary in other countries under § 1 AStG.
The consequences of this ECJ case law have already been described by the Advocate General to the ECJ in his Opinion of 14 December (recitals 107 et seq.), in which he correctly pointed out that the decisive factor in the matter is which types of economic reasons are permissible or will be permitted in future for the acceptance of behavior between affiliated companies that is not customary in other countries. If now the granting of favorable, unusual economic conditions can or could be justified solely by the fact that it is important to guarantee the success of the subsidiary, the concept of customary foreign business in the European context is taken away from any meaning! It is conceivable that in future all business transactions with subsidiaries would be readily and completely exempt from the application of the arm's length principle, because a shareholder in each of the subsidiaries would be excluded from the application of the arm's length principle, if a company has an interest in the success of its business, provided that these have not been agreed in an unlawful manner and purely with the intention of reducing taxes.
It remains to be seen how German lawmakers will deal with this ruling. It may be possible to formulate a catalogue of unrecognized economic reasons or a positive catalogue of solely recognized economic reasons within the framework of the long announced so-called "Third-Party Settlement Ordinance" in the case of conditions that are not customary in an arm's length settlement.
If such a legal regulation violates European Union law, according to prevailing view European law within the abstract procedure for reviewing norms in accordance with Art. 93.1 No. 2 German Constitution in conjunction with Sec. 13 no. 6, 76 Law on Constitutional Court reviewed by the Federal Constitutional Court. However, an infringement of European law would not result in the rule being ineffective, but in its inapplicability, since Union law merely takes precedence in application and does not take precedence. In the event of such an infringement, the competent Federal Constitutional Court would have to establish the inapplicability of the provision contrary to the Community. However, a so-called incident-control of standards by a finance court would also be possible. With a possible arm's length regulation, the question to be clarified in individual cases as to recognized economic reasons in the case of conditions between affiliated companies that are not customary in themselves would also not be finally clarified.
In its judgment of 25 June 2014 (I R 88/12), the Federal Fiscal Court had still denied the conformity with European law of § 1 AStG para. 1 valid until 2002 in the case of an interest-free loan granted by a shareholder to its company. The Saxon Fiscal Court has deemed § 1 AStG applicable as of 2003 to be in conformity with European law by reference to the Federal Fiscal Court ruling. The appeal is pending at the Federal Fiscal Court under Case I R 14/16.
Contact
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Stefan in the Schlaa, Attorney at Law
Email: imschlaa(at)ispglobaltax.com