Disguised distributions of profits made by a foreign company from its subsidiary may be subject to additional taxation by a domestic shareholder. This may also apply if it otherwise operates active activities. Therefore, there are some things to consider, which we explain below.

The legal consequences of additional taxation are generally triggered when an unrestricted taxpayer controls a foreign corporation and this corporation generates low-tax income from passive activity. Income from passive activity is income that does not come from the active activities listed in § 8 (1) AStG. Therefore, income from active activity does not trigger additional taxation.

The question of whether hidden profit distributions are subject to additional taxation may arise, for example, if a foreign company controlled by a tax resident receives hidden profit distributions from its subsidiaries.

This occurs when a company which is subject to unlimited taxation in Germany holds a 100% interest in a subsidiary established abroad. This is in turn 100 % in the foreign-based grandfather company. The subsidiary could now provide the subsidiary with a service that the Emkelgesellschaft pays by €100,000 too high under the arm's length principle. The payment of the fee is recorded as current operating income at the subsidiary and as operating expense at the grandfather.

In the old system, open and hidden profit distributions according to § 8 (1) number 8 AStG old version always represented income from active activity. Therefore, an uptake of these shareholding income and the taxation with the additional tax in a German tax resident was basically excluded.

Although the profit distributions are actually allocated to income from passive activities according to the requirements of the so-called Anti-Tax Avoidance Directive (ATAD), the German legislature has adhered to its principle decision to allocate profit distributions to active income when implementing the directive. Therefore, such emoluments continue to be active in principle from the assessment period 2022 onwards according to § 8 (1) number 7 AStG new version. However, some remunerations have been excluded and are now to be classified as passive. These exceptions are also contained in § 8 (1) no. 7 AStG. This includes those for which § 8b KStG does not provide for tax exemption.

A central exception is regulated in § 8 (1) number 7 (a) sentence 1 AStG. It justifies that the remuneration received (e.g. distributions of profits) insofar as they have reduced the tax income of the contributing company, belong to the passive income. In fact, the exceptional provision covers cross-border situations which, according to the standards of German tax law, are regarded as a hidden distribution of profits by the subsidiary to the foreign company and have not led to a profit-increasing income correction for the distributing subsidiary. The lack of coverage of the hidden profit distribution at the level of the distributing company may result, for example, from the fact that the distribution has not been recognized.

Through the regulation, the legislature has imported the substantive correspondence principle enshrined in § 8b (1) sentence 2 KStG into the system of additional taxation. Accordingly, the general tax exemption for shareholding income applies only to the extent that these emoluments have not reduced the income of the contributing company. The goal is to prevent so-called white income. Insofar as the payment to the contributing company results in a tax deduction of operating expenses, the payment on the recipient side may not be received as tax-free share income, but must be fully taxable in accordance with the tax-reducing treatment to the payer.

The reason for excluding certain hidden profit distributions from the asset catalogue according to § 8 (1) AStG is therefore likely to be the lack of tax burden on these shareholding income abroad. If the profit distribution has not been subjected to any income tax pre-charge at the level of the distributing company that is perceived as sufficient, this should be made up by the inclusion of the profit distribution in the additional amount to the taxpayer or corporate taxpayer.

The wording of § 8 (1) no. 7 (a) sentence 1 AStG suggests that the legal consequences occur independently of the legal consequences at the level of the foreign company receiving the distribution. However, it is conceivable that the profit distribution at the foreign company is subject to an appropriate income tax burden. However, the wording does not initially take this preload into account. This could lead to a multiple burden on the shareholding income of the foreign company and the German tax resident. Then the regulation of § 8 (1) no. 7 (a) sentence 1 AStG would have an overriding effect. That is why there are exemptions.

Consequently, the tax resident, as a potential beneficiary of additional taxation, should monitor the supply and performance relationships between the foreign companies and their subsidiaries. If, according to the domestic understanding, these are not designed in accordance with the arm's length principle, but represent a hidden distribution of profits, tax access in Germany threatens within the framework of §§ 7 to 13 AStG. This results from § 8 (1) (a) sentence 1 AStG. However, he should also endeavour to document the tax assessment abroad in order to be able to claim the exemptions.

The redemptions for passivity are to be found in § 8 (1) number 7 letter a sentence 2 double letter aa AStG and especially for hidden profit distributions in double letter bb.

Hidden distributions of profits are therefore to be classified as income from active activity of the foreign company, although they have reduced the tax income of the distributing company, as far as certain conditions are met. For now, the hidden profit distribution must have increased the income of the foreign company or a person close to it. In addition, this income should not be subject to low taxation within the meaning of § 8(5) AStG. This is intended to prevent the above-described unwanted double detection.

As a result, the remuneration from hidden distributions of profits, unless they are exempted from the redemptions of § 8 (1) number 7 (a) double letter aa) AStG in the case of the foreign company, shall be regarded as passive. Due to the inapplicability of the functional approach, this applies irrespective of any functional assignment to another active activity of the foreign company.

If, however, a reduction in income is already eliminated unilaterally by a regulation or bilaterally by transfer price correction standards, § 8 (1) no. 7 letter a does not apply, since there is no actual reduction in income for the contributing entity.

The problem of hidden distribution of profits in the additional taxation arises not only in supply and service relationships. Hidden distributions of profits can also regularly be seen in foreign conversion processes.

For example, a GmbH that is subject to unlimited taxation in Germany may hold a 100% stake in the foreign-based subsidiary T-Co. T-Co may hold a 100% stake in the foreign subsidiary E-Co. The assets of E-Co are transferred to T-Co under foreign law. However, the E-Co continues to exist. The transfer takes place under foreign law at book values. Therefore, neither E-Co nor T-Co generate income under foreign law.

Then it is initially questionable how additional taxable income can arise at all. On the one hand, E-Co is exclusively active; Secondly, T-Co does not seem to receive any income at all from the tax-neutral reorganisation measure. Furthermore, both E-Co and T-Co are located in a high-tax country, so that low taxation also does not appear obvious.

For this reason, in practice it regularly emerges that in the case of foreign reorganisation measures a case of application of § 8 (1) no. 7 AStG can arise only as a result of an examination process at the level of the transferred legal entity. Such cases therefore require special attention. We are happy to advise you on this.

Income from conversions generally leads to active income according to § 8 (1) no. 9 AStG. Conversion within the meaning of § 8 (1) no. 9 AStG includes conversions under the UmwG (merger, division, separation, separation, transfer of assets, change of legal form) and conversion-like operations. The latter include, for example, the exchange of shares or the transfer of business assets through individual succession.

The § 8 (1) no. 9 half sentence 2 AStG contains an exception. Insofar as the income is derived from the transfer of assets which were not used to generate active income, passive income is present. The decisive factor is therefore the intended use of the assets.

Half sentence 3 has an exemption. Accordingly, there is active income if the conversion could have taken place in Germany at book values notwithstanding § 1(4) of the UmwStG and actually took place abroad at book values.

Since E-Co generates only active income in the case in point, the income from the transfer of assets must in principle be classified as active. This now results explicitly from § 8 (1) sentence 1 AStG, according to which capital gains share the fate of the activity referred to in points 1 – 9 with which they are related. This applies despite the low taxation due to the tax book value approach.

It is questionable, however, how the foreign reorganisation measure at the shareholder level of the T-Co should be assessed from an external tax point of view.

It should be noted that the transaction was tax neutral under foreign law. According to German principles, however, the transaction would have to lead to the discovery of the hidden reserves in the transferred assets at the level of E-Co. Against this background, the transfer could constitute a hidden distribution of E-CO to T-Co in the form of a prevented increase in assets. Then there is a hidden profit distribution, so that the foreign T-Co would achieve shareholding income within the meaning of § 8b (1) sentence 2 KStG.

Profit distributions are generally active according to § 8 (1) no. 7 AStG. However, under the exception of §8(1)(7)(a) AStG, passive income could be assumed at T-Co level. A profit distribution in Germany always takes place by revealing the hidden reserves in the transferred assets. In this respect, the necessary income tax burden at the level of E-CO is therefore lacking, since the transfer takes place at book values. The transfer to book values thus represents a prevented increase in tax income at the level of E-Co. As a result, the tax burden is lower than it should actually be. Therefore, it cannot be ruled out that the criterion of income reduction within the meaning of § 8 (1) 7 (a) AStG is fulfilled. In accordance with this lack of pre-charge, the hidden distribution of profits could be classified as passive in the case of additional taxation. It comes

Nor does the revocation of § 8 (1) number 7 letter a sentence 2 double letter aa AStG intervene. Accordingly, there is active income insofar as the contributing entity with the income underlying the emoluments is already an intermediary company. For this purpose, the contributing body would have to generate passive income. However, since E-Co only generates active income, it is not an intermediate company.

If the income from the reorganisation measure is classified as passive at the level of the subsidiary T-Co, it is therefore an intermediary company for a domestic shareholder. Therefore, the income is subject to German additional taxation. Then there would be an effective tax burden of 30% at the level of M GmbH under the additional taxation.

If the foreign reorganisation measure were to take place directly at M GmbH, which is subject to unlimited taxation in Germany, i.e. without the involvement of T-Co, the hidden distribution of profits would be covered by the national correspondence principle for corporate tax purposes. Therefore, it would be fully subject to corporate tax at M GmbH level. For trade tax purposes, however, a reduction is made for the hidden distribution of profits in accordance with § 9 no. 7 GewStG. Thus, the hidden profit distribution would only be subject to an effective tax burden of 15.825 %. As a result, the additional taxation would lead to a higher burden.

The hidden distribution of profits according to § 8b (1) sentence 5 KStG is tax-free if it has increased the income of the related person. In the case of additional taxation, there are two alternatives under which the hidden distribution of profits can be classified as an active income type. In the first alternative, the hidden distribution of profits, which reduced the income of the contributing corporation, increased the income of the foreign company itself. In the second alternative, the hidden distribution of profits increased the income of a person close to the foreign company. In addition, the increase in income in both alternatives may not be taxed low according to the requirements of § 8(5) AStG.