When starting a company abroad, you should always avoid these five common mistakes. On the one hand, it is about the location of the management, which must be abroad. Furthermore, the transfer of assets from a domestic company to a foreign company involves the discovery of hidden reserves. Thirdly, there must be proof of active income from the foreign subsidiary in order to avoid additional taxation. Fourthly, it should be noted that in this country a withholding tax is levied on license fees. And fifth, the licensing barrier introduced last year poses a risk. Under certain circumstances, royalties to the foreign subsidiary in Germany are excluded from the deduction of operating expenses. This article goes into all five problem areas and shows new design possibilities.

Before we explain the 5 risks that exist when you set up a company abroad, we describe the starting point for our considerations. We are interested in a subsidiary of a company based in Germany that is to be founded abroad. This can be, for example, a Spanish S.L., a Dutch B.V. or a Swedish AB. Furthermore, it is initially irrelevant what purpose this subsidiary serves. In some cases, however, we will clarify their role in order to examine the link with the risks involved. Therefore, the structure of our contribution follows a transitional approach from the general issue to the special case.

Setting up a company abroad – Risk number 1: Place of management

Unlike the statutory headquarters of the company, which is located abroad at the subsidiary we are considering, the headquarters of the management may be located in Germany. Because the headquarters of the management is exactly the place from which all business decisions are made. However, this is also the decisive criterion in determining whether a limited company in Germany bears the characteristic of unlimited tax liability, as it is provided for in § 1 (1) KStG. So it is absolutely necessary to avoid that the management takes place from Germany. Otherwise there is a risk of double taxation. You can avoid this error with one of the following three solutions:

2.1 Solution number 1: Commuting to the place of management abroad

If you set up a company abroad, then one solution is that the managing directors document their travel routes from Germany. In addition, all business decisions should be logged accordingly. This proves to the tax office that the management actually takes place abroad. It is irrelevant whether the business management of the subsidiary actually takes place in the country in which it was established or in another country. So if there is a possibility of commuting close to the border, this is absolutely recommended. The main thing is that there is no management in Germany.

However, if there is an intention to locate the management of the subsidiary and the subsidiary is located in a country far away from Germany, this may in some cases entail considerable travel costs. Sometimes, however, a business decision has to be made only every few months or even only once a year – such as in the case of a holding company. In such a case, however, it is obvious to combine this obligation with a subsequent holiday. Perhaps it is even worthwhile if you start a company abroad?

2.2. Solution number 2: Relocation of the Managing Director abroad

Another approach is the departure of the managing director abroad. However, it must then be noted that the managing director is not a shareholder of the German parent company or holds a maximum of 1% in it, otherwise an exit taxation is to be expected.

2.3 Solution Number 3: Hiring a Managing Director Abroad

As a third alternative, you can consider the obligation of a managing director abroad. This also secures the place of management abroad. However, this also causes costs that you actually want to avoid. And the question of whether you are willing to entrust your business to someone else must of course also be answered positively.

It is often the case that you want to set up a company abroad, for example to transfer rights and licenses from a German company there and then rent them. Because the associated fees can then help the German parent company to reduce profits – and thus help to reduce taxes.

3.1. The discovery of hidden reserves

However, the transfer of such and other assets abroad is linked to the fact that this leads to a discovery of the hidden reserves. The higher the difference between the book value and the market value, the greater the amount to be taxed as a hidden reserve. If, for example, the book value of an asset is EUR 1.00, because it has already been written off, but the asset actually has a market value of EUR 1,000,000, then a tax on the EUR 999,999 of the hidden reserve must be paid when the asset is transferred, without having received a corresponding equivalent value.

3.2 Solution: Creation of assets to be rented abroad

Founding a company abroad – Risk number 3: Additional taxation

The next cliff to be circumvented is the income of the subsidiary, which is to be founded abroad. Here, the restriction applies that the profits of this subsidiary are exempt from taxation in Germany only if they are based on active income. What income is meant here is specified in § 8 (1) AStG. This includes, for example, income from agriculture and forestry, trade or services, to list only three of the total of 10 species. It is therefore important that the foreign subsidiary is more than just a pure license company, because otherwise it comes in addition to the taxation abroad also the additional taxation in Germany. Of course, you should definitely avoid this mistake when setting up a company abroad. We will be happy to advise you in more detail on this too.

Founding a company abroad – Risk number 4: Withholding tax

If, as described in the previous section, fees for the use of licenses, patents and other rights are actually paid to the foreign-based subsidiary, then this is also the subject of the so-called withholding tax according to § 50a EStG. This tax is 15 % of the amount paid as a licence fee.

For example, if a patent fee of EUR 100,000 is paid to the foreign subsidiary, EUR 15,000 goes to the German Treasury as withholding tax and only EUR 85,000 goes to the subsidiary. Thus, the withholding tax on the income of the subsidiary is to be withheld in advance and paid separately to the tax administration.

Now the question is whether this withholding tax may be eligible for the foreign-based subsidiary. There is no single answer to this. After all, this depends, among other things, on bilateral agreements to avoid double taxation between Germany and the respective foreign country. So if you want to start a company abroad, you should get the appropriate information. As a tax consultancy firm with a focus on international tax law, we are your competent point of contact.

Speaking of withholding tax deductions, it is possible to take into account all expenses incurred by the subsidiary in direct economic connection with the leased assets when calculating the withholding tax. However, the curiosity is that this regulation has no legal basis. However, if withholding tax on, for example, artistic or sporting performances is not applicable, then this crediting is legitimized by § 50a (3) EStG. This led to a legal dispute in which the Federal Finance Court decided at last instance that fees for patents, licenses and other rights should also benefit from this deduction. In the meantime, the Federal Ministry of Finance has taken this into account and issued this regulation by circular.

Founding a company abroad – Risk number 5: Licensing Barrier

In addition, when licensing companies are founded abroad, the licensing barrier must be observed, as it applies since 01.01.2018 by § 4j EStG. In this case, there may be a prohibition on deducting expenses associated with the payment of licence fees. If the subsidiary has to pay income taxes of less than 25 % on the licence income, then the deduction of the licence expenses at the German parent company is lower by a factor corresponding to the ratio of the lower foreign tax rate and the 25 % required by law in this country. If you want to set up a company abroad in order to be subject to a tax rate of less than 25%, then the difference between the amount saved there and the tax rate set at 25% in Germany is due to the German Treasury.

An example of calculation: The income tax in the country where the subsidiary is established is only 15%. Then in Germany only a share of 75% of the license fees is deductible in the determination of income. The calculation (25 % – 15 %)/25 % = 1/2.5 shows that a quarter of the expenses are excluded from the deduction.