Summary of Changes in German International Tax Law in 2003

22.03.2008719 Mal gelesen

 by Dr. Robert Amann, Dr. Max Goettsche and Dr. Frank Stockmann

1. Introduction

With the Tax Relief Reduction Act (StVergAbG) passed on 11 April 2003  and the so-called Tax Relief Reduction Act Basket II (StVergAbG Basket II), passed on 19 December 2003  many central provisions of German international tax law affecting the tax treatment of international business relations with Germany were changed. The changes relate to the calculation of foreign income for purposes of crediting foreign taxes, to sanctioned transfer pricing documentation obligations, to the Foreign Tax Act (AStG), in particular the CFC rules, to the German thin capitalization rules, to the domestic participation exemption and to the taxation of foreign investment income under the Foreign Investment Act (AuslInvestmG). These changes will be discussed in this article.

A number of other important tax changes indirectly affecting the tax treatment of international business relations with Germany, for example, limitations to the use of corporate losses, had been passed by the end of 2003. These changes as well as the recent reform of investment fund taxation  will not be commented upon in this article.

2. Tax changes by the StVergAbG

A. Income Tax Act

In the Income Tax Act (EStG) the foreign tax credit provisions (EStG, s. 34c) have been changed by the StVergAbG. Via s. 26, para. 6, sentence 1 of Corporate Tax Act (KStG) this amendment also applies to corporate taxation and in most cases also where a German double taxation convention (DTC) requires the application of the credit method as way of eliminating double taxation, because on technical procedural implementation of the credit method German DTCs generally refer to domestic regulations.

According to s. 34c of EStG any tax assessed and paid in a foreign state and not subject to any claim to reduction is to be credited toward German income tax. Foreign tax credit presupposes that the party doing so is subject to unlimited tax liability in Germany 5 and the foreign income in the state of source is applied to a tax comparable to German income tax. The foreign income will be determined according to German tax law. Section 34c of EStG limits the foreign tax credit to the German tax amount applicable to such foreign income. This section also contains a per-country limitation. The carry-forward of foreign taxes not creditable in a tax year as tax credit to subsequent tax years is not possible.

The calculation of the maximum amount creditable (MAC) has now been changed. According to the previous wording of s. 34c of EStG, the MAC was to be calculated in such a way that the German income tax on the general taxable income, including the foreign income, is split up in a ratio of such foreign income to the general taxable income:

MAC = foreign income x German income tax
 general taxable income 

In determining foreign income  all income from the jurisdiction in question must be included, thus also such income as is not subject to any taxation in the foreign state in question. It has in this context no bearing whether non-collection of taxes is due to a lack of tax liability, to a legislative tax exemption, to a tax abatement or to an actual non-taxation. In regard to the expenditures connected with the foreign income, according to Federal Tax Court case law only such expenditures are deducted as are directly related commercially with the generation of such income.

The StVergAbG reduces the MAC by introducing two new provisions. First, income not taxed in the country of source according to its own legal system may no longer be taken into account when calculating the MAC.  The modified splitting formula for calculating the MAC is therefore as follows:

MAC = foreign income ./. not taxed foreign income x German income tax
 general taxable income 

1. Example 1

Taxpayer D, resident in Germany, earns the following income:
• domestic income: € 100,000,
• foreign income from jurisdiction A as per s. 34d of EStG: € 100,000, of which € 50,000 is not taxable abroad,
• tax assessed and paid abroad (jurisdiction A): € 30,000,
• German income tax in the assessment period: € 100,000.

According to the new regulation, under s. 34c, para. 1 of EStG the MAC will be (€ 50,000 / € 200,000) x € 100,000 = € 25,000; this thus gives rise to an excess foreign tax credit of € 30,000 ./. € 25,000 = € 5,000. According to the previous regulations, under s. 34c, para. 1 of EStG, on the other hand, there would have been a MAC equal to (€ 100,000 / € 200,000) x € 100,000 = € 50,000; and the whole foreign tax in the amount of € 30,000 may be credited against German income taxes.

It is questionable what the legislators meant by income 'not taxed in the source jurisdiction according to its legal system' and left out of the equation the issue of determining foreign income. In our opinion, in view of the objectives pursued by s. 34c of EStG, the following items would be covered by that concept:
• revenues not taxable abroad according to ius loci;
• income specifically exempted from taxes;
• income for which dispensation from taxes has been granted.

In such cases there is no double taxation, for which reason there cannot be any necessity of eliminating it through tax credit.

In contrast to determination of the dividend, income not taxed abroad should be taken into account when determining the divisor (the total of all income). By ignoring income that is not taxed in the source country the MAC, until now country-related, is now additionally limited to single sources of income.

When determining foreign income of a domestic business, now all business expenses with an economic relationship with the foreign source revenues must be considered (new s. 34c, para. 1, sentence 4 of EStG). A direct connection between business expenses and revenues is no longer necessary.

2. Example 2

Taxpayer D, resident in Germany, is the owner of high yield bonds held as a business asset of its domestic business. The bonds have been issued by foreign bank X. To secure its financial investment, D avails himself of a guarantee from foreign bank Y for which he has to pay a bank guarantee commission in the amount of 80 per cent of the interest received from bank X. The interest is subject to a foreign withholding tax. Both banks are located in the same national jurisdiction.

According to the new law the guarantee commission should be deducted from the interest (s. 34c, para. 1, sentence 4 of EStG) so that the foreign income and consequently the MAC is reduced accordingly. According to the previous law such expenditures were not to be deducted since in the opinion of the Federal Tax Court any direct connection between the interest and the bank guarantee commission was missing.

The new regulations raise in particular the question of whether the tax court's case law, according to which general administrative costs and refinancing costs, for instance, are not to be included when determining imputable taxes, will continue to be valid or whether the new regulations require that pro rata general corporate, financial and administrative costs are considered as business expenses when determining the foreign income. These new regulations are applicable for the first time in the 2003 tax assessment period.

B. Corporate Tax Act

In the Corporate Tax Act (KStG) special regulations on determining income of subordinated corporations in case of a tax consolidation between group companies in s. 15 of KStG has been amended as of the 2003 assessment period to the effect that the so-called gross method now also applies with respect to foreign dividends that are tax-exempt under a DTC. This affects income and business expense deduction (e.g. refinancing expenditures) in investments in foreign corporations.

The so-called gross method has been introduced by the UntStFG of 20 December 2001  for the taxation of earnings of a subordinated corporation within the meaning of s. 8b of KStG (inter alia dividends and capital gains from shares in corporations). The gross method in the version of the UntStFG was not applicable to foreign dividends that where tax-exempt under a DTC with the consequence that contrary to the legal situation obtaining prior to the UntStFG even sole entrepreneurs and partnerships could receive foreign dividends free of tax under a DTC participation exemption via an interposed domestic subordinated corporation, even if they would not have fallen under the remit of the DTC participation exemption in case the dividends were derived directly.

1. Example 3

Since UntStFG went into effect, dividends of the Dutch BV could be passed through to partners in the KG (limited partnership) without any German tax charge. The business expense deduction for any eventual acquisition loan was not jeopardized  if that loan had been taken out at the level of the KG and had been passed on to the GmbH (subordinated corporation) as equity.
 
This 'legal loophole' has now once again been eliminated by the StVergAbG. According to the new regulations, the DTC participation exemption is no longer applied at the level of the subordinated corporation but at the level of the parent (in the example above: the KG) under the provisions applicable to the latter as if the latter itself earned the income and thus incurred the concomitant expenditures as well. In the case of a sole entrepreneur or a partnership as parent, where the attributable income accrues to individuals, the DTC participation exemption is thus not applicable, and only the half-income method may be used, i.e. half of the dividends will be included in the tax base.

In principle, the financial result shown in the previous example can still be achieved if the foreign subsidiary is transformed into a partnership or a permanent establishment since via a tax consolidation a DTC tax exemption of foreign permanent establishment profits (including partners' shares in profits of foreign commercial partnerships) can be passed through to a sole entrepreneur or a partnership as parent, where the attributable income accrues to individuals, without German taxation, because the individuals would also benefit in case of a direct receipt of the profits from the tax exemption. The business expense deduction at the level of the parent is not jeopardized by this.

2. Example 4

Profits from the Dutch permanent establishment (PE) can be passed through to the partners of the KG without any German tax charge. The business expense deduction for any eventual acquisition loan is not jeopardized if the latter has been taken out at the level of the KG and has been passed on to the GmbH (subordinated corporation) as equity.
 
The objective might also be better served by transferring the shares in the foreign subsidiary to a foreign commercial partnership or a foreign permanent establishment of the domestic subordinated corporation.
 

C. General Tax Code

In the General Tax Code (AO) obligations to keep records of business relations with related parties in foreign jurisdictions have been tightened up. Until now, taxpayers had no special obligations to keep records and provide documentation going beyond the general obligations to cooperate with the tax authorities under s. 90, para. 2 of AO. For the future, s. 90, para. 3 of AO creates the substantive legislative basis for special record-keeping and documentation requirements on transfer prices between the German taxpayer and its non-German related party. The provision therefore provides a legal yardstick for auditing transfer prices between affiliated companies.  The legal consequences of any violation of these obligations are regulated in s. 162, paras. 3 and 4 of AO. For detailed clarification of the exact content and scope of the record-keeping obligations, the Federal Ministry of Finance (BMP) recently published an ordinance.

1. Statutory definition of the obligation to keep records

The taxpayer is required to keep records concerning cross-border transactions with related parties within the meaning of s. 1, para. 2 of AStG. This also applies to the relationship between a company's head office and its permanent establishments.

In these situations the nature and contents of the business relation and the legal and commercial basis for agreement on prices and other terms of business must be documented. The records need only be submitted upon request in the context of a tax audit. There is a submission deadline for this of 60 days which can, nonetheless, be extended in certain cases.

The record-keeping obligations only relate to cross-border transactions. Where business relations with individuals and legal entities in another EU Member State are concerned, the regulation could be incompatible with the EU Treaty.

The BMF's ordinance contains several explanatory notices of how the obligations to keep records will be interpreted by the German tax authorities. The following points are worthy of emphasis.

• A series of general information (investment shares, business operations, organizational structure), data on business relations with affiliated companies, analyses of functions exercised by those involved and risks assumed must be submitted. This also applies to business relations exercised via intermediaries. However, the ordinance does not provide any further clarification on how to define an intermediary (i.e. intra-group or third party companies). Nonetheless, information must also be submitted on value chains resulting from the taxpayer's connection with the related party. Thus worldwide corporate group relations must be disclosed.
• Included in the obligation to keep records is also information possessed by related parties. By non-consolidated companies or minority shareholding this can be difficult since the other owners regularly have no interest in submission of the data.
• The taxpayer must in the future apply 'an appropriate method' for determining transfer prices. Considered appropriate according to this are the price comparison method, the resale price method and the cost plus method. To what extent profit-oriented methods are recognized has been left unanswered. Nonetheless the ordinance requires submission of comparative data such as prices, profit markups, gross and net figures as well as distribution of profits. This could be an indication that the tax authorities no longer reject a profit-related transfer price method in principle.
• The obligation to keep records extends to each individual business transaction. Comparative data available upon closing the deal and such data as can be obtained from freely accessible sources with a reasonable amount of effort must be submitted. The taxpayer may therefore be required to search for data from external databases.
• The obligation to provide information does not end with the closure of the transaction if the matter involves a 'persisting circumstance'. In that case, the obligation to keep records and documentation continues. If, for instance, losses should result from the business relation with related parties in three consecutive years, then the reasons for such losses and the measures taken to remedy them must also be recorded.
• The documentation of the records to be submitted must be close in time in case of so-called extraordinary business transactions, like asset transfers in the course of corporate group restructuring, essential modifications of functions and risks, business transactions subsequent to a change in business strategy or the conclusion of long-term debt agreements with a significant impact on the level of income. It suffices to meet this demand if the documents are available within six months of the end of the business year in which the transaction took place.
• The records may be generated in written or electronic form and must be kept for ten years. The documents may on request by the taxpayer also be kept in the original language.
• For small companies there are exemptions and measures of relief from the obligation to keep records and document.

2. Legal consequences in case of violation

The violation of the new cooperation obligations cumulatively triggers two legal consequences: income correction under s. 162, para. 3 of AO and the assessment of a surcharge under s. 162, para. 4 of AO. The business relation with a related party leads to an adjustment of income for the domestic taxpayer according to s. 162, para. 3 of AO, if:

• the taxpayer does not submit records within the meaning of s. 90, para. 3 of AO, or
• the records submitted are essentially unusable, or
• it is established in the case of extraordinary business transactions that the records were not generated on time.

The legislator assumes, that in the three cases cited above the prices and business terms agreed with related parties were inappropriate and did not meet arm's length standards. The taxpayer can circumvent the legal consequences of the statutory presumption and thus avoid adjustment of income if it succeeds in showing that the underlying prices and business terms were appropriate. To that extent, the objective burden of proof falls on the taxpayer. If, on the other hand, the presumption cannot be refuted and if the general prerequisites of the estimate obtain pursuant to s. 162, paras. 1 and 2 of AO then the tax authorities are obliged to make an estimate. In doing so it may make upward (i.e. incremental) use of the admissible price range to the full extent at the taxpayer's expense.

The new regulations require the tax authorities to assess a surcharge:

• in case records within the meaning of s. 90, para. 3 of AO are not produced,
• where essentially unusable records are produced, and
• in case of late submission of usable records.

In the first two cases the surcharge comes to between 5 per cent and 10 per cent of the excess amount of the adjusted income but at least € 5,000. This applies also to taxpayers in a loss situation.

Where usable records are produced late, then a surcharge of up to a maximum amount of € 1,000,000 is charged with a minimum of € 100 for every day that the deadline is exceeded. The delay may be due to the fact that the documentation for extraordinary transactions was not generated on time or that the submission deadline were exceeded. The maximum amount of the surcharge is therefore decisively dependent upon whether the records were usable or not.

The tax authorities are obligated to set the surcharge. There is no discretion in regard to the basic elements of the rule but only in regard to the amount. In the latter case, the purpose of the surcharge (encouraging generation and timely submission of records), the advantages derived and the duration by which the deadline was exceeded are to be taken into consideration. The surcharge can be dispensed with if non-fulfillment of the record-keeping obligations is excusable or if culpability is minor. The surcharges are not deductible as business expenses for tax purposes.

3. First-time application

The new record-keeping obligations apply for the first time already to business years commencing after 31 December 2002. In business years that coincide with calendar years the obligations must therefore already be fulfilled in 2003. Corrections and surcharges pursuant to s. 162, paras. 3 and 4 of AO can be set for business years commencing after 31 December 2003.

D. AStG

1. Income adjustment

If a domestic taxpayer agrees with a foreign subsidiary (or a related party) upon prices not corresponding to arm's length then the German tax authorities may adjust the taxpayers income, inter alia, pursuant to s. 1 of AStG.  Precondition for an income adjustment pursuant to s. 1 of AStG is a business relationship between the domestic taxpayer and the foreign company. According to a decision of the BFH, in the past the mere shareholding relationship did not constitute a business relationship in the terms of s. 1 of AStG. Guarantee statements by a parent company in favour of a subsidiary for example were therefore not covered by s. 1 of AStG.

In the future it will no longer depend on the distinction whether a relationship relies on contractual agreements or on corporate law but all civil law relations except incorporation law agreements are defined as business relations in the terms of s. 1 of AStG. Therefore and in particular, guarantee commitments like binding letters of comfort (harte Patronatserklärung) or binding credit guarantees  and loans (including those to replace equity) are affected by this. Non-binding letters of comfort (weiche Patronatserklärung), on the other hand, do not entail any income adjustment under s. 1 of AStG for lack of any civil law payment obligation.

2. CFC legislation

(a) Extension of scope of passive income in case of trading activity

Income from trade could previously only result in passive income and trigger a CFC income inclusion at the level of the domestic shareholder if the merchandise or goods were delivered by the marketing or purchasing company from a foreign country to its domestic shareholder or a person related thereto or vice versa. Any delivery within Germany or between foreign countries did not lead to passive income.  In the future, it will suffice for the presumption of passive activity that the resident taxpayer or the latter's related party provides the foreign (marketing or purchasing) company with control over the goods or merchandise traded. In that way, even the purely domestic transaction establishes a passive activity. Physical delivery is no longer required. This broadens the scope of application of the CFC income inclusion.

(b) Extension of treaty override

If the basic elements of the CFC rules are met, the inclusion of the foreign company's passive income occurs pro-rata in the general taxable income of each German shareholder. Previously, as an exception to this rule, no income inclusion occurred, if the requirements of the applicable DTC participation exemption were fulfilled, s. 10, para. 5 of AStG, thus sheltering foreign passive income from German CFC taxation.

According to the StVergAbG, this treaty protection was repealed entirely, which has drastic consequences for international group structures. The suspension of the DTC's prevailing applicability over the AStG also embraces group financing structures which, previously, were subject to a 60 per cent income inclusion only.

With this Germany has come to contradict international law agreements in force. In its motivation, Germany argues that this is the majority view among OECD Member States allowing the enforcement of domestic anti-avoidance provisions (e.g. CFC legislation). Unfortunately, however, there is not even any debate with the opposite view expounded by the French Conseil d'Etat.

(c) Passive permanent establishment or partnership income

Previously, passive income derived by a foreign permanent establishment or a foreign commercial partnership was not covered by German CFC taxation pursuant to s. 20, para. 2 of AStG, except passive income with a capital investment character.

In the future all income of the foreign permanent establishment or partnership will trigger an income inclusion at the level of the German 'shareholder' (i.e. headquarter or partner) if they qualify as passive income, provided the permanent establishment is located in a low-tax jurisdiction.

3. First-time application

Section 1, para. 4 of AStG as amended by the StVergAbG is to be applied for the first time in the assessment period of 2003. The amended CFC rules must likewise be taken into consideration in case of business year coinciding with calendar years of the foreign company or permanent establishment in the tax assessment period of 2003. Where the foreign company or permanent establishment's business years diverge from calendar years the amended regulations apply with corresponding temporal delay, in other ways from 2004 onward at the latest.

3. Tax changes by the StVergAbG Basket II

A. Thin capitalization

With its decision dated 12 December 2003 in the case C-324/00 (Lankhorst-Hohorst GmbH) the ECJ has found that Art. 43 of the EC Treaty (right of establishment) is obstructed by s. 8a, para. 1, no. 2 of KStG because, in principle, German thin capitalization rules  discriminate debt-financing of German corporations by foreign shareholders compared to debt-financing by domestic shareholders.

Section 8a of KStG has now allegedly been fashioned in conformity with Community law.  Essentially this has been accomplished by equal treatment of debt financing by domestic and foreign shareholders. Generally, any remuneration for debt (except for short-term debt) paid by a corporation directly or via an interposed partnership to a shareholder with a holding of at least 25 per cent or to a person related thereto or to a person with the possibility to take recourse thereto (e.g. a bank on the basis of a guarantee) will in the future be qualified as constructive dividend in case of hybrid debt or if a debt-to-equity ratio of 1.5:1 (safe-haven) is exceeded. The extended safe-haven for holding companies (3:1) lapsed on the grounds that it in practice has been widely used to suction off profits.

The originally planned extension of the scope of s. 8a of KStG to payments for the use of immovables or other business assets has not been implemented. However, s. 8a of KStG has been amended to include also shareholder-debt-financing of non-resident corporations.

The escape clause for payments at arm's length is in principle to remain (unless the shareholder-debt is used to acquire shares from a shareholder, see also below s. 8a, para. 7 of KStG). For administrative simplicity's sake, a maximum allowance of € 250,000.00 has been introduced, meaning that reclassification of remuneration for debt into a constructive dividend is not to occur if remuneration for debt does not exceed a total of € 250,000.00 per annum.

Taking out credit to finance business within the meaning of s. 1 of the Banking Regulation Act, in particular by banks is expressly exempted from the scope of s. 8a of KStG's applicability (re-exception when passing the funds on to related companies that are not banking institutions themselves).

Previously, it was widespread practice to circumvent s. 8a of KStG by the interposition of partnerships.  These options are now limited under the new version of s. 8a of KStG according to which s. 8a of KStG also applies if the debt is assigned to a partnership in which the corporation by itself or jointly with a related party within the meaning of s. 1, para. 2 of AStG has a direct or indirect holding of one-fourth.

Finally, s. 8a, para. 7 of KStG includes a new anti-abuse provision for debt-financed share transactions within the corporate group. According to this, s. 8a of KStG applies also to remuneration for debt if the debt has been subscribed for the purpose of acquiring shares and the seller as well as the provider of the debt is a shareholder with a holding of at least 25 per cent in the relevant corporation or a related party or a third party (such as a bank) with rights of recourse on it (e.g. on the basis of a letter of comfort). No safe haven is granted. This regulation is supposed to prevent models commonly seen in recent practice where in a holding structure the equity relevant in s. 8a of KStG shall be increased by a tax-free sale of shares under s. 8, para. 2 of KStG (step-up of book values).

In the future, s. 8a of KStG also applies with respect to the municipal business tax. However, this is not regulated in the StVergAbG Basket II, but in the Municipal Business Tax Reform Act  through the cancellation of the previous exemption in s. 9, no. 10 of the Municipal Business Tax Act (GewStG).

B. National participation exemption

1. Partial harmonization of disallowances for business expenses related to dividends

Currently, the deduction of business expenses relating to shareholdings in domestic and foreign corporations is subject to a variety of different disallowances applicable in different circumstances.

The tax treatment of business expenses economically related to domestic or foreign dividends received by corporations shall now be harmonized. Previously, s. 8b, para. 5 of KStG provided that a lump sum of 5 per cent of foreign dividends is deemed to be non-deductible business expenses. A different disallowance existed with respect to domestic dividends. In the future, the lump sum rule in s. 8b, para. 5 of KStG shall apply also to domestic dividends.

As previously may the application of s. 8b, para. 5 of KStG be prevented through the establishment of a tax consolidation. In case of shareholdings in foreign corporations, structures similar to those explained above in point 2 can be used to the same effect.

2. Amendment of capital gains taxation

In the future, s. 8b, para. 3 of KStG shall provide that a lump sum of 5 per cent of capital gains with shares shall be deemed to be non-deductible business expenses. This shall apply also in case of a tax consolidation. The new regulation is supposed to prevent the possibility of circumventing the above-mentioned disallowance in s. 8b, para. 5 of KStG by retaining a corporation's profits and subsequently selling the investment tax free.

In addition, the determination of capital gains shall be expressly regulated in s. 8b, para. 2 of KStG. Business expenses related to a share transaction shall be deducted from the revenues and shall thereby reduce the amount of the tax-exempt capital gain. This has the effect, that only 5 per cent (cf. s. 8b, para. 3 of KStG above) of the business expenses related to a share transaction will reduce a corporate shareholder's taxable profit.

Finally, a new regulation introduces the possibility to retroactively deduct the large investment portfolio depreciations made by insurance companies following the downturn at the international stock markets since the year 2000 from their taxable profit.

C. Relationship between CFC rules and Foreign Investment Act

The provisions regarding the relationship between the CFC legislation in the Foreign Tax Act (AStG) and the regulations on taxation of foreign investment funds in the Foreign Investment Act (AuslInvestmG) have been supplemented. Previously it was possible under certain conditions to repatriate earnings from foreign investment funds to Germany tax free, by means of a DTC participation exemption. This 'legal loophole' was primarily used by institutional investors, for instance when setting up fund-of-funds.

1. Example 5

For German institutional investors a private equity fund-of-funds is set up, incorporated as a Luxembourg SICAF. The SICAF qualifies as investment fund in the terms of the AuslInvestmG. Its profits from investments in numerous private equity funds can be distributed tax-free to the German investors under the German-Luxembourg DTC because the AuslInvestmG does not contain treaty override provisions. The application of the German CFC rules including their treaty override provisions is prevented by s. 8, para. 7 of AStG.
 
This 'loophole' in s. 8, para. 7 of AStG has now been closed. The CFC rules including their treaty override provisions are to be applied again (in business years commencing after 31 December 2002) where the taxation of foreign investment income according to the AuslInvestmG is blocked by a DTC participation exemption.

The AuslInvestmG has been superseded by a new Investment Tax Act  with effect from 1 January 2004. Section 8, para. 7 of AStG has been amended correspondingly to regulate the relationship between the CFC legislation and the Investment Tax Act.

The application of CFC legislation continues to presuppose the existence of so-called passive income within the meaning of s. 8 of AStG. Passive income in this sense should in the previous example of a private equity fund-of-funds probably only obtain with SICAF earnings from the mezzanine funds. Otherwise, the domestic investors may continue to be protected by the DTC participation exemption.

D. Further amendments of the CFC rules

The German CFC rules do not only apply to passive income of a foreign corporation in which resident shareholders have a direct holding but also in case of passive income of lower-tier foreign corporations (foreign sub-subsidiaries). However, previously passive income of such lower-tier corporations was exempted from the application of the CFC rules if the relevant company's business activity 'served' the 'active' business activity of the upper-tier foreign company, in other words, if its activity was functionally connected with the active business activities of the upper-tier company.

This exemption has now been limited. The so-called 'serving definition' was seen as vulnerable to abuse because the regulation's wording could have been understood as saying that when the subsidiary and the parent company engage in identical activities, the subsidiary's activities always 'serve' the parent company. As a result, CFC rules could have been circumvented simply by setting up a lower-tier company, for instance for the purpose of managing capital investments without thereby having necessarily to coordinate any business between the foreign parent and the foreign subsidiary.

The 'serving definition' has now been clarified to the effect that the 'serving definition' only applies if the subsidiary's activity has some direct connection with the parent company's business activities thus providing a direct link to those activities. This will not be the case where there is no business being coordinated by the two companies. The serving definition has also been barred for income with a capital investment character within the meaning of s. 7, para. 6a of AStG because in the specific case here it is difficult to ascertain whether the concomitant activity of the parent company 'serves' or constitutes an independent activity separate from it.

E. First-time application

The revised thin capitalization rules apply for the first time in business years beginning after 31 December 2003. The amendments of s. 8b of KStG apply with effect from 1 January 2004, except the new s. 8b, para. 8 of KStG which is first applicable in the tax assessment period 2004. The changes in the AStG apply for the first time to passive income in business years commencing after 31 December 2002.

4. Summary

With the Tax Relief Reduction Act (StVergAbG) passed on 11 April 2003 and the so-called Tax Relief Reduction Act Basket II (StVergAbG Basket II), passed on 19 December 2003, the year 2003 has brought significant changes in German international tax law. Many central provisions of German international tax law were changed. It is not expected, that the pace of systematic as well as unsystematic tax changes in this area will slow down in the year 2004.

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