German CFC rules comply with EU law thanks to standstill clause, ECJ Advocate General says

by Ninja-Antonia Reggelin

Germany’s controlled foreign company (CFC) rules violate EU restrictions on free movement of capital; however, the EU standstill clause applies to the provisions and they are thus valid, the Advocate General of the European Court of Justice (ECJ) concluded in a June 5 opinion.

The case, X-GmbH versus Finanzamt Stuttgart-Körperschaften (C-135/17), concerns the compatibility of German CFC rules, codified in the German Foreign Transaction Tax Act (Außensteuergesetz AStG), with the EU prohibition on restrictions to the free movement of capital with non-EU countries.

A German parent company held a 30% participation in a subsidiary located in Switzerland that mainly had passive income.

German CFC rules

According to article 7 AStG, if a foreign company is an intermediary for interim income of an investment nature and if an unlimited taxpayer holds a participation of at least 1 per cent, the interim income is taxable thereon to a certain extent and under further conditions. This also applies to an interest of less than 1 percent, if the foreign company exclusively or almost exclusively generates gross income, which is based on interim income with an investment character, unless the main class of shares of the foreign company is a substantial and regular trade in one recognized stock exchange takes place.

Applying these rules, the German tax authorities increased the parent company’s profits in 2005 and 2006 with the passive income derived by the Swiss entity.

The tax authorities did not allow the taxpayer to prove that the foreign corporation carries out genuine economic activites and does not constitute a wholly artificial arrangement (the “motive test”) because the CFC was resident outside of the EU/EEA.

The taxpayer challenged this assessment, arguing that the German provisions are contrary to the free movement of capital and that the standstill clause is not applicable.

EU standstill clause

The standstill clause in Article 64 TFEU allows member states to continue to apply restrictive legislation which was in force before 31 December 1993.

It covers movements of capital to or from third countries, including direct investments, establishment and provision of financial services, and the admission of securities to capital markets.

National legislation which has been amended after 31 December 1993 remains protected by the standstill clause if it is, in substance, identical to the previous legislation, or if the amendment merely reduces or eliminates an obstacle to the exercise of EU rights and freedoms contained in the earlier legislation.

Identical legislation

The German AStG has undergone several changes since 1993; thus, it is questionable whether the rules applicable to the 2006 financial year are still substantially identical to those in force on 31 December 1993.

In its order for reference to the ECJ, the German Federal Fiscal Court said that, in its view, the provision in question is still in line with the 31 December 1993 law despite the legislative amendments. Nonetheless, the German Court had doubts and sought clarification.

Free movement of capital

AG Paolo Mengozzi has concluded that, while  article 7 AStG of the German law constitutes a restriction on the free movement of capital, the law is grandfathered by the standstill clause because it satisfies the criteria both in terms of time and content equivalent.

AG Paolo Mengozzi has concluded that, while  article 7 AStG of the German law constitutes a restriction on the free movement of capital, the law is grandfathered by the standstill clause because it satisfies the criteria both in terms of time and content equivalent.

As the case at hand involved a 30% participation which would allow the German company to participate effectively in the management of its Swiss subsidiary, the AG suggests that the standstill clause should be applicable.

However, it is for the referring German court to confirm in each case whether a direct investment is concerned, the AG said.

The AG said further that if the ECJ concludes that the standstill clause is not applicable, the restriction on the free movement of capital may be justified.

The AG said there are no overriding reasons of the public interest because the German CFC rules do not target purely artificial arrangements; rather, they apply generally to prevent tax evasion.

However, the AG said that the application of CFC rules in the present case might be justified to preserve the balanced allocation of powers to tax and the effectiveness of fiscal supervision unless a bilateral framework exists between Germany and Switzerland that provides for the exchange of information in tax matters.

It is left for the referring Court to determine whether such a framework exists.