Tax sanctions from Germany – and how to escape them
Offshore taxation demystified (Part 3)
“Basically, if fewer smart thirty-something’s, educated in business and law schools and fluent in five languages, were engaged to pour over German tax legislation and amendments with a fine-tooth comb in order to find ways of avoiding tax, if this did not happen, then I could reduce tax rates.“ (Germany‘s Minister of Finance, Peer Steinbrück, in a speech at a tax conference in September 2009).
A Friendly Word
Convinced by strong economic pressure from the G8-countries and an intelligent exploitation of the recent financial, political and religious disruptions, the Caribbean offshore countries could not resist to “be committed to international standards of anti-money laundering legislation and practice, counter terrorist financing legislation and financial regulation and international efforts to combat financial crimes.”
As a result, the blacklist of uncooperative tax havens is currently empty. All 84 Caribbean and non-Caribbean jurisdictions on the radar screen of the OECD agreed to implement the standard.
However, the OECD regularly updates which tax havens and other jurisdictions implemented them and which are in delay, although they agreed to the standards. The later ones will be good candidates for a new blacklist. The OECD‘s viewpoint is obvious: A friendly word and a gun will get you a lot further than a friendly word alone.
The OECD itself has no power to implement sanctions against any blacklisted country. However, its member states have already opened and shown their toolbox of countermeasures.
Typically, they have three options: First, the tax environment for blacklisted countries can be damaged by changes in the domestic tax laws of OECD member states. Second, a review, repeal and/or refusal of bilateral tax treaties may occur. As a third measure, aggressive tax audits and non-tax measures like an embargo, the cancellation of free trade agreements or punitive tariffs and customs might frighten and discipline offshore jurisdictions.
The future of the Caribbean offshore business depends on the abilities of revaluation, adjustment, and assimilation. The coming years will see winners and losers in the Caribbean offshore arena. Therefore, it is essential to be prepared for the next moves.
Case study: The German Anti-offshore Legislation
Although the black list is empty, Germany continues to combat offshore jurisdictions by strict new legislations and new blacklist mechanisms. Tax experts and oppositional politicians pointed out that this new legislation is, therefore, untimely, redundant, and unnecessary.
In spite of massive criticism, the government made it clear that from their viewpoint, there is a need for such regulations until the promises of the gray list states are kept and the respective information exchange agreements are concluded. Otherwise, the intention to prevent tax evasion resulting from an insufficient tax information exchange cannot be fulfilled.
The new German legislation might provide an excellent lesson in how an implementation of the OECD‘s strategy will work in other G8 states as well. It is coming soon to legislation near you.
The “Act for Combating Tax Evasion“ (“Steuerhinterziehungsbekämpfungsgesetz“) modifies the basic tax laws of Germany. These are, above all, the Income Tax Law, the Corporation Income Tax Law, and the Fiscal Code.
In September 2009, the Federal Government enacted an implementing ordinance (“Steuerhinterziehungsbekämpfungsverordnung“) which aims to clarify how the taxpayer has to implement the new law in his business dealings. Generally, the new legislation will be applicable for the first time in the tax year 2010.
From a constitutional point of view, it is doubtful whether the ordinance is legally valid. It shifts accountability for the legislative enactment procedure from the parliament to the executive bodies.
Under generally accepted constitutional principles, an ordinance made by the executive is null and void, if the underlying law does not define the content, purpose, and scope of the ordinance in detail. Tax lawyers are currently in a wait-and-see mode for the outcome of the case. However, no one should expect that the ordinance will be rejected retroactively by the German constitutional court in later years.
It is the basic concept of the new legislation to impose sanctions on the taxpayer if he enters into business relationships with specific jurisdictions and does not comply with specific duties. Both conditions have to be met before any adverse tax effect occurs.
It is a trivialization and belittlement to argue that only some tax benefits are denied. These measures, including a shoot-to-kill policy, result in tough sanctions and a substantial economic downside for any offshore legislation affected.
Area of Application
The legislation applies to all German taxpayers with cross-border business relations to offshore countries. This includes individuals as well as corporations. The same rules apply for offshore entities with a permanent establishment in Germany and German taxpayers maintaining a permanent establishment in the offshore country.
The law excludes “cooperative” offshore jurisdictions from its area of application. It is decisive whether the offshore business entity is resident in a foreign country with a tax treaty in line with Article 26 of the OECD Model Convention.
Article 26 of the OECD Model Convention provides the most widely used legal basis for a bilateral exchange of information for tax purposes. It creates an obligation to exchange information that is foreseeably relevant not only to the correct application of a tax convention but also for general purposes of the administration and enforcement of domestic tax laws of the contracting states.
Article 26 was updated in July 2005, at which time additional paragraphs were added. These paragraphs make it clear that a state cannot refuse a request for information solely because it has no domestic tax interest in the information, or only because it is held by a bank or other financial institution.
If no such tax treaty exists or the tax treaty deviates from this OECD standard, it is sufficient, that the country typically provides information in a type and scope comparable with the OECD Model Convention.
Even if it is not yet the standard practice to provide information, the law sees it as sufficient, that the country is willing to do so. Reviewing the legislative history and introductory statement shows that timely measures of the offshore legislations to introduce this OECD standard are required.
From a practical point of view, there are three options. Either there has to be a qualified clause in a tax treaty or tax information exchange agreement (“TIEA”), or it has to be the common practice without having the qualified tax clause. Or as a third possibility, the country has to be ready to follow this practice by implementing article 26 soon.
In practice, it cannot be expected that the area of application of the anti-offshore legislation will be determined on a case-by-case basis. Instead, the German government, respectively the Federal Ministry of Finance, will publish a list and request each local tax office to follow this guideline. The list will contain three categories.
- First, the countries which entered into a tax treaty in conformity with the OECD Model Convention.
- Second, a list of countries which follow the wishes of the OECD without having formally a clause similar to article 26.
- Third, the list will contain the countries which are at least willing to cooperate.
The list will be reviewed and updated on an irregular basis. Germany‘s tax lawyers are already familiar with such countries’ lists, for example, with respect to the cross-border VAT refund procedure.
It should be noted that the regular tax rate of the offshore country will have no impact on the applicability of the new legislation. The willingness to exchange tax information is the only criterion.
What are the Documentation Obligations?
The anti-offshore legislation provides for the following eight transfer pricing documentation requirements:
- Nature, content and scope of business relationships.
- Contracts and agreed contractual arrangements including any later modifications.
- The usage of intangible assets, disposed of by the taxpayer or his business partner in connection with the business concerned.
- The functions exercised and the risks assumed by the parties, including following modifications.
- The assets involved.
- The business strategy used.
- The significant market situation and competitive relationship.
- The ultimate shareholders and beneficiaries of the parties.
These documentation requirements are not applicable if the total amount of sales and services to a person does not exceed Euro 10,000 in each business year.
All these documentations have to be prepared and delivered promptly. Promptly means made within six months of the end of the relevant business year, and to be submitted within 30 days of the date on which the authority demands it be done.
Additional Obligations to be Considered
Business relations with a financial institution in offshore jurisdictions are a further point of attack by the new legislation. The ordinance expects that the tax authorities lodge a claim for information directly against the offshore bank. On request, the taxpayer is obliged to grant a power of attorney to the tax authorities for all such judicial and extrajudicial measures.
Also, the new legislation would request that the taxpayer signs a sworn declaration that the declared financial income earned through or from offshore banking institutions is complete and correct. It will give the taxpayer cold comfort to know that he cannot be punished with penalty payments or prison if he rejects to give such affirmation in lieu of an oath.
In principle, the law requires hard evidence on an existing business relation with an offshore banking institution, or at least a clear indication of the existence of a specified relationship with an offshore bank. However, in practice, this will be a toothless limitation of the tax authority’s proceedings as soon as the assumed name of a bank is disclosed.
Another question is whether any non-cooperation of the financial institution vis-a-vis German tax authorities would result in sanctions for the taxpayer. A bank in a blacklisted country might not be very carefully concerning the know-your-customer-requirements. Therefore, the requested information might be not available for the bank. At least it would be an uphill battle for the German tax authorities to convince a non-cooperative court that the required background information is available.
What are the Sanctions and Downsides?
As a general rule, any expenditure to offshore countries shall be non-deductible for tax purposes. The wording in the ordinance “in connection with activities” is broad and vague. It would be nothing but fair to allow a deduction at least in cases where it is proven or obvious that the expenditure has been subject to offshore taxation. However, the German government implemented the new legislation with a shoot-to-kill intention and will not listen to such arguments.
Transfer pricing documentation requirements typically result in the possible downside that the fair market price is in the worst case estimated by the tax authorities. However, under the new legislation, the taxpayer faces the risk that the offshore payments will be entirely non-deductible. This means the tax authorities have the power to deny the deduction of corresponding expenses completely. This is the most alarming nature of the beast.
Another part of the sanction package deals with withholding tax obligations. As a general rule, any relief from withholding taxes is denied under the new legislation in the case of investments from or through offshore countries.
As the last part, the de facto 95% exemption of dividend revenues in a German limited liability company will not be applicable for offshore dividends. This will make offshore subsidiaries less attractive from the tax planning point of view.
How to Deal with Anti-Offshore Legislation
In a nutshell, what is the overall conclusion after reviewing the new legislation for combating tax evasion? The mouse that roared – or the empire strikes back? The stopping power against effective tax planning seems to be not very impressive.
The new law, enhanced by the new ordinance, has three weak and three strong points: The weaknesses merely come from a diplomatic dance more than from an ignorance of law and practice.
- The tax authorities will have to go a long way to fight against constitutional and practical hurdles. Is it really possible to overrule the individual bilateral tax treaties? Is it constitutional to authorize the government – and not the legislator – to specify the blacklist of offshore countries?
- The black list is empty and the whole legislation obsolete. The government has the power and authority to name and shame certain offshore jurisdictions independently from the OECD and other G8 countries. However, in a common European market, this seems to be non-cooperative concerning the EU member states.
- The new legislation does not allow any dragnet operations and, luckily for the taxpayer, resigns from the only powerful and effective weapon.
Seeing these deficits, it is easy to say that the German legislator brought a knife to a gunfight. However, the other side of the coin is primarily the shoot-to-kill policy of the new legislation. The deductibility of expenses, the relief from withholding obligations, and the preservation of tax exemptions will either survive the battle or not. It is a black-or-white approach with no gray areas accepted.
The second aspect is the substantially increased cooperation and retention obligation of the taxpayer. It can be expected that any offshore bank account number disclosed and any other sensitive information leaked, will result in a comprehensive tax audit.
The third aspect, and may be most alarming one, is the fact that the new legislation has not to be qualified as the high-water mark of the anti-offshore initiative. It is merely the starting point for more.
Anyway, tax planning is a precise business. The restrictions and requirements of the OECD model convention, the European and U.S. tax legislation, and the increasing experience of the international tax authorities have to be integrated and implemented in the future cross-border tax structuring and the business relations with Caribbean offshore jurisdictions.