Tax-Efficient Asian Investments Into Germany · Germany for all European investments can be the...

This article originally appeared in the 18 October 2010 issue of Tax Notes International Magazine on page 191.

Tax-Efficient Asian Investments Into GermanyBy Michael Pfaar, Markus Schummer and Steffen Rehling

Michael Pfaar, Markus Schummer, and Steffen Rehling review the options that investors in Asia have when trying to structure tax-efficient investments in Germany. Michael Pfaar is a partner with Ernst & Young International Tax Services in Dusseldorf, Germany, and heads the China Competence Centre in Germany, Switzerland, and Austria; Markus Schummer is a manager in Transaction Tax with Ernst & Young in Dusseldorf; and Steffen Rehling is a legal trainee with Ernst & Young in Dusseldorf. The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young GmbH.

Many Asian investors are surprised when confronted with Western tax-planning objectives: choosing legal investment vehicles adequate for business purposes and minimizing the overall tax exposure. This is not because Asian investors do not understand the concept, but based on domestic tax legislation, they would not expect those concepts to work in practice. Reducing the tax base through intercompany charges, using entities that are not subject to withholding taxes on repatriation and locations (where the trade tax is half of that in other places), and using double-dip or asset-base step-up concepts are not usually associated with Germany. Establishing an intermediary holding company in Germany for all European investments can be the structure of choice and can even be superior to better-known alternatives such as a Dutch Coaparagraphperatie (co-op) or a holding company in Belgium or Luxembourg. This article describes the tax-planning concepts in German law for Asian investors, especially those from China, Japan, Korea, Singapore, and Hong Kong.

12 November 2010

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I. Available Legal Forms in Germany

Foreign investors may establish their investments through private limited liability companies (GmbH), limited partnerships with a GmbH as general partner (GmbH & Co. KG), or a branch office in Germany. The GmbH is a commonly used separate legal entity that limits any liability arising from company activities to the amount of the registered share capital, any capital surplus, and retained earnings. It may be established by one or more (foreign) individuals or legal persons as shareholders who must make a capital contribution in kind or in cash of at least €25,000. A limited partnership like the GmbH & Co. KG has at least one general partner with unlimited liability and at least one limited partner. The characteristic detail of a GmbH & Co. KG is that the general partner is not an individual; a GmbH can be held by the limited partners. Hence, using a GmbH as the general partner economically implies that the liability of the investor is limited to the share capital of the GmbH.

The KGaA as a hybrid entity is an odd animal and is positioned between a company and a partnership. The KGaA can be stock-listed and thus is a good vehicle for U.S. investments through Europe regarding the limitation on benefits clause in U.S. treaties. In essence, the KGaA is a public LLC (Aktiengesellschaft) with one or more general partners substituting for a board of directors. Each general partner bears full liability. Accordingly, in practice

an LLC is often employed as the general partner. The share capital of a KGaA is held by shareholders while the limited partners can also contribute equity.

Without setting up a legal entity, foreign investors may establish a branch office from outside Germany by registering the branch with the local trade register and relevant tax authorities. Since the branch is legally part of the head office, the investing company must bear the liabilities arising from any activities of the German branch. Branch offices usually qualify as permanent establishments according to domestic tax law, income tax treaties, or double taxation agreements (DTAs).

II. Foreign Investments From Asia

It is often said that German tax law is somewhat complicated. This may be true, but the general principles are as straightforward as in other jurisdictions.

A. Taxation of Recurring ProfitsThe main tax imposed on a company such as a GmbH is the corporate income tax (CIT) with an applicable tax rate of 15.83 percent, including a solidarity surcharge. Further, income from trade and business related to a German PE is subject to trade tax (TT) at a tax rate of 7 to 17 percent, depending on the municipality in which the activities are performed. The large German cities have TT rates ranging from 14 to 17 percent (for example, 14.35 percent in Berlin, 15.575 percent in Dusseldorf, 16.1 percent

in Frankfurt, 16.45 percent in Hamburg, and 17.15 percent in Munich). The combined effective tax rate (CIT, solidarity charge, and TT) is around 30 percent in the major German municipalities. About 95 percent of dividend income and capital gains realized from the sale of shares in another corporation are tax-exempt for CIT and TT purposes regardless of the degree of shareholding and the holding period. An exception applies for short-term trading of shares. According to the interest limitation rule, the deductible net interest expenses are limited to 30 percent of the taxable earnings before interest, taxes, depreciation, and amortization (EBITDA) of any partnership or corporation. Net interest expenses beyond the 30 percent EBITDA barrier can be carried forward. The interest limitation rule provides three exemptions according to which no interest limitation applies:

• a business that bears not more than €3 million net interest expenses per financial year will not be subject to an interest limitation (de minimis threshold);

• a business that does not form part of a company group will not be subject to the limitation rule (stand-alone exemption); and

• the so-called escape clause allows full interest deduction if the equity ratio (equity divided by total assets) is not more than 2 percentage points below the equity ratio of the international financial reporting standards group.

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However, the second and third exemptions are subject to counterexemptions regarding some harmful shareholder debt finance structures.

The German-source income of a branch office or partnership is subject to German CIT and TT at the above mentioned rates if it qualifies as a PE in Germany. In general, the German domestic tax law, income tax treaties, and DTAs follow the OECD approach regarding the criteria of a PE. The income allocation between the foreign head office and the German PE must adhere to the arm’s-length principle. This is also true regarding the capitalization of the German PE. German tax authorities require an arm’s-length equity ratio (principle of endowed capital), which is based on the arm’s-length principle in article 7 of the OECD model treaty. The interpretation is quite unique in the international tax environment.

Under German legislation, tax law does not follow the civil law regarding the taxation of partnerships. From a civil law perspective, partnerships are regarded as separate legal entities that may enter into contracts with both their respective partners and third parties. From a tax law perspective, partnerships are generally considered to be transparent. Thus, the income of a partnership is taxable for CIT purposes at the partners’ level. Unlike in many other countries, the German concept of coentrepreneurship (Mitunternehmerschaft) stipulates that the partnership’s income

includes the income sourced from assets and liabilities at the partners’ level related to the partnership’s business. For technical reasons, the partnership’s income from both levels is determined at the level of the partnership in total before the profits are finally allocated to the partners. Partners may enter into contractual relationships with the partnership and receive payments as consideration for a loan, intellectual property, or services. In German tax law, such payments are generally considered business income from the PE and thus subject to CIT and TT.

Taking into account that the related expenses are deductible for German tax purposes, this gives rise to planning opportunities. When a partner provides equity or debt to the partnership that he refinances with a loan from a related or third party, interest expenses arising from the loan will be considered deductible at the partnership’s level. This can result in double-dip situations when the partner’s country of residence also considers the interest expenses to be deductible. The partnerships’ general taxation principles also apply to the general partners of a KGaA. Thus, the corporate veil of the KGaA is transparent regarding the income that is to be allocated to the general partners.

B. Repatriation of ProfitsThe principle of the free flow of passive income such as dividends, interest, and royalties within the EU common market in many circumstances limits domestic

passive income treatment. If an appropriate entry vehicle is used, non-European investors may also benefit from the European common market.

1. Dividend PaymentsIn the absence of any favorable treatment, dividends paid out from a resident GmbH or KGaA to their nonresident corporate shareholder are eventually subject to dividend withholding tax at a rate of 15.83 percent, including solidarity surcharge. For instance, direct investments from Hong Kong would have to bear such a withholding tax on dividends and thus an indirect holding structure could be beneficial. Regarding direct investments from Japan, China, Korea, or Singapore, the respective income tax treaties or DTAs with Germany reduce the German withholding tax to lower levels (15 percent, 10 percent, or 5 percent). Investments structured through an intermediate company within the EU can lead to a further reduction compared to the treaty rates, with a zero rate available under domestic German rules thanks to the EU parent-subsidiary directive. However, any reduction of dividend withholding tax is subject to the strict German anti-treaty-shopping rules. In this respect, the German tax authorities challenge investment structures involving intermediate companies solely for the purpose of utilizing the beneficial withholding tax rates under a treaty, a DTA, or harmonized domestic tax law. The anti-treaty-shopping

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rules apply when a nonresident corporate shareholder of a German company does not satisfy the strict business substance test. The business substance test requires cumulatively that:

• the nonresident indirect parent company that is not entitled to the aspired withholding tax reduction has neither economic nor nontax reasons for having the intermediate holding company in the shareholding chain;

• the intermediate holding company generates more than 10 percent of its gross income from own active business operations; and

• the intermediate holding company has a qualified business undertaking.

The repatriation of profits generated by a German partnership and the repatriation of profits to the general partners of a KGaA are not subject to any withholding or base remittance tax.

2. Interest PaymentsIn essence, no withholding tax accrues on arm’s-length interest payments on intercompany loans. Only in very specific lending scenarios are interest payments subject to withholding tax or limited tax liability of the creditor. This may be the case when security interests on real property inside Germany are created for the lender or when the lender qualifies as a silent partner in the borrowing subsidiary or has granted a profit participating loan. In these scenarios, a general

withholding tax at a rate of 26.38 percent is levied. Again, this tax burden can be reduced to 10 percent in the DTA with China and the treaties with Japan and Korea, 8 percent in the treaty with Singapore, or a zero rate for a lender in the EU. Interest paid from a partnership to nonresident partners qualifies as part of the partnership’s income and is as such subject to German limited tax liability of the partners. The broad definition of partnership’s income under German tax law leads to conflicting qualifications under various treaties and DTAs. German tax authorities consider income at the partners’ level related to the partnership’s business as business profits according to article 7 of the OECD model treaty. This results in a conflicting qualification of the interest income because most other countries consider interest payments from partnerships to their partner as interest income according to article 11 of the OECD model treaty. The recently concluded treaty between Germany and Singapore, however, provides a provision tailored to the German concept of coentrepreneurship in order to avoid a qualification conflict.

3. Royalty PaymentsRoyalty payments from a German corporation or partnership to a nonresident company are subject to German withholding tax of 15 percent. Treaties or DTAs offer rates at 10 percent (China, Japan, and Korea) or 8 percent

(Singapore). When royalties are paid to an EU parent company, the tax can be completely eliminated on application. The reductions are subject to the German antiavoidance rules as described above. Royalty payments to nonresident partners are regarded as part of the profit of the partnership and are therefore taxed as business income. At the treaty level, most contracting states will not follow the German qualification of royalty payments as business income. Double taxation issues arise, as is the case for interest payments.

C. Exit Taxation1. Capital Gains TaxationIf a nonresident shareholder disposes of its shareholding in a GmbH, in the absence of a treaty 5 percent of the capital gain will be taxable for German CIT and TT purposes at the level of the shareholder. In most cases, Germany does not tax capital gains of a nonresident parent company that enjoys treaty protection. However, no tax exemption applies when a Chinese resident shareholder sells his shares in a German company. In most other cases, Germany may revive its taxation right only when the capital gains derive from transferring the shareholding in some land-rich companies. When a nonresident company sells its interest in a partnership, the capital gain realized from that transaction is subject to ordinary taxation with German CIT and TT. (See Table 1.)


2. LiquidationInstead of a realization of a capital gain through a share deal, a liquidation of the GmbH should be considered -- although such liquidations are only rarely applied in German practice. In the liquidation process assets are usually sold by the liquidated corporation triggering capital gains subject to CIT and TT. The remaining assets are transferred to the shareholders in the course of the liquidation process, also triggering CIT and TT on the difference between the fair market value and book value. Second, the difference between the liquidation proceeds and the historically paid-in capital (share capital and additional paid-in capital) is deemed to be distributed to the shareholder triggering the same withholding tax consequences as an ordinary dividend distribution. The dissolution of a partnership is basically treated like an asset deal

resulting in capital gain taxation with CIT and TT. There are planning opportunities available to reach a rollover relief in which only assets are transferred to the shareholder (without any liabilities) and those would remain with a German PE.

III. Tax Planning Toolkit

A. Holding StructuresAs noted above, the treaty or DTA rates regarding withholding taxes are trumped by EU harmonized domestic zero rates when it comes to investment within the EU. Thus, EU resident vehicles may be interposed when investing from Asia. Prominent locations for establishing intermediary companies inside the EU include Belgium, Luxembourg, and the Netherlands. All of them have concluded treaties or DTAs with China, Japan, Korea, Singapore, and Germany. Unlike Germany, countries such as Belgium, Luxembourg, and the Netherlands

also have a DTA with Hong Kong. However, instead of picking an EU resident intermediary outside Germany, withholding taxes can be eliminated under an (indirect) German holding structure that takes advantage of the German concept of coentrepreneurship. Thus, the pros and cons of holding structures in Belgium, Luxembourg, and the Netherlands on the one hand and in Germany on the other need to be analyzed in greater detail.

1. Dutch Co-opA Dutch co-op is an incorporated legal person with at least two members and limited liability of the shareholders. The co-op is subject to ordinary CIT in the Netherlands. However, dividend income and capital gains are excluded from the tax base if the shareholder holds at least 5 percent of the shares. Accordingly, capital losses from the disposal of such shares are nondeductible. A dividend

Type of income Domestic rate (e.g. direct HK investment)

EC harmonized rate

DTA - China

DTA - Japan

DTA - Korea

DTA - Singapore

DTA – Belgium

DTA – Luxembourg

DTA - Netherlands

Dividend 15.83% 0% 10% 15% 5%/10% 5%/15% EC EC EC

Interest 0%/25% 0% 10% 10% 10% 8% EC EC EC

Royalty 15% 0% 10% 10% 10% 8% EC EC EC

CGT right - - both Parent residence (Japan)

Parent residence (Korea)

Parent residence (Singapore)

Parent residence (Belgium)

Parent residence (Luxembourg)

Parent residence (Netherlands)

Table 1. Withholding Tax Treatment Regarding Investment in a German GmbH

Chart: Withholding tax treatment regarding investment in a German GmbH. 5% dividend WHT only for corporate shareholders holding at least 25% under the DTA – Korea and 10% under the DTA Singapore. EC harmonized rates for interest and royalties applicable for certain related parties only.


paid by a co-op to the Asian parent company is not subject to dividend withholding tax under domestic Dutch law. The co-op is generally entitled to a zero dividend withholding tax in EU member states. Subject to the application of anti-treaty-shopping rules in the operative countries, the Dutch co-op structure will eliminate European withholding tax on dividends.

2. Belgian Holding CompanyAnother way to avoid withholding taxes on dividends when planning dividends from Europe to Asia is to make a shift into Belgium before entering the German or other EU markets. Belgium is a prominent location for European inbound investments from Asia and was the first country -- after China -- to sign a comprehensive DTA with Hong Kong in December 2003. What makes Belgium attractive as a European holding location is that the Belgian legislature opened the benefits designed for the common market to all non-EU countries with which Belgium has concluded a treaty or DTA. Thus, most Asian corporate investors are entitled to an exemption from dividend withholding tax paid by Belgian companies. Further, Belgian companies may enjoy a notional interest deduction for equity (3.8 percent in the years 2011 and 2012). About 95 percent of incoming dividend income is exempt from taxation if the following conditions are met:

• the shares must be held for at least one year andaccounted for as financial fixed assets; and

• the Belgian holding company must own at least 10 percent of the shares in the distributing company or the investment value must be 2.5 million (recently increased from 1.2 million) or above.

Capital gains are tax exempt without any minimum holding period or minimum shareholding.

3. Luxembourg Holding CompanyBelgium was not the only EU member state that made the benefits under the EU directives available for non-EU residents. Likewise, Luxembourg extended the scope of the zero withholding tax rate regarding outflowing dividends to countries outside the EU with which it has concluded a treaty or DTA (plus some further conditions attached). Further, Luxembourg is advantageous compared to Belgium regarding Luxembourg’s 100 percent tax exemption for dividends. In Luxembourg dividend income is tax-exempt if the shares are held for at least one year and the receiving company owns at least 10 percent of the shares in the distributing company or the acquisition costs must be at least €1.2 million. Capital gains are tax exempt under the same requirements (except for minimum acquisition costs, which must be at least €6 million for a capital gain exemption when less than 10 percent of the shares are held).

4. German KG StructureInvestors are usually stuck to the idea that the holding vehicle should be a corporation. Internationally, partnerships are rarely found

in multinational groups, mainly because of the complex tax issues related to them in an international environment. However, partnerships are commonly used in Germany and represent 20 to 30 percent of the business vehicles used in Germany and thereby more frequently employed than the GmbH (around 20 percent). The German tax law allows for a holding structure headed by a GmbH & Co. KG, which achieves zero withholding taxes on any repatriation of profits to its partners. This is especially true for non-EU resident investors because they cannot by themselves benefit from the harmonized national laws of the EU member states without interposing one or more levels of intermediate holding companies. Moreover, the German GmbH & Co. KG holding structure will not be put at risk and scrutinized under the domestic antiavoidance rules because no third company will be moved into the holding structure. There is also a low probability that it is featured on other EU countries’ blacklist. Therefore, the German GmbH & Co. KG structure is not likely to trigger other EU countries’ anti-treaty-shopping rules.

Other than the exemption from dividend withholding tax, there are advantages of such holding structure regarding financing. Assume the following scenario: The Asian investor borrows money from a bank and founds a GmbH. With that GmbH, the investor establishes a GmbH & Co. KG in which the Asian investor takes the role of a limited partner. The GmbH


takes up the role as the general partner. Capital is transferred down to the GmbH & Co. KG and GmbH by equity contribution. The GmbH & Co. KG or the general partner GmbH establishes and/or acquires companies. In such a scenario, the refinancing costs at the level of the Asian parent company are generally tax deductible in Germany because of the concept of coentrepreneurship, and the costs can be offset against the operating profits of the partnership. As most Asian countries will grant an interest deduction at the level of the partner, the interest also reduces the income at the Asian partner level (double dip).

5. German KGaA StructureWhen using a German KGaA as holding company an investor can combine the merits of a partnership and those of a corporate structure because of the hybrid and flexible character of a KGaA. The Asian investor could take the role as general partner in the KGaA, contributing the major part of equity and having a major share in the profit rights. The corporate shareholders (Kommanditaktiona?re) holding the shares in the KGaA are then only of minor importance from an economic perspective. For general partners, the taxation principles applying to partners in a German partnership are used. This means that the KGaA is treated more or less as transparent regarding the profit share of the general partner. Interest expenses at the level of the general partner are thus deductible

for German tax purposes, as is the case for partners in a partnership structure.

Any repatriation of profits to the general partner is not subject to dividend withholding or base remittance tax. A KGaA is subject to unlimited tax liability in Germany and should thus generally be entitled to treaty benefits (for example, regarding withholding tax reduction at the level of subsidiaries). Due to its ability to be listed on the stock exchange, a (listed) KGaA should qualify to pass the LOB tests under the Germany-U.S. treaty. A through-bound structure via a German KGaA as shown in the figure might thus facilitate a zero withholding tax leakage regarding dividends paid by a U.S. subsidiary to Asia. The treatment of a KGaA in the international tax environment is not clear yet because of its complex and hybrid character. There is not much tax jurisprudence or practical experience available regarding the treatment of a KGaA in other jurisdictions and for treaty purposes. Therefore, the feasibility of such a KGaA structure must be analyzed on a case-by-case basis. (See figure on the next page.)

B. Financing and Debt PushdownAs shareholder or partner of an operating German corporation or partnership, the investor can provide not only equity, but also debt (for example, by granting loans). Debt financing is still the most comfortable way to erode the tax base in high-tax countries. Loans to PEs can be provided

only by other group entities, but not within the same legal entity from the head office to the PE. Interest expenses paid by a German corporation on a shareholder loan are generally tax deductible while the interest income at the level of the (foreign) shareholder is usually not taxable in Germany. The most convenient planning opportunity to push down debt to an operating (German) corporation is the resolution of a dividend distribution by the German corporation and the switch of the dividend claim of the shareholder into a loan (novation). An alternative for a debt pushdown is the acquisition (or intercompany transfer) of the shares in the operating corporation by a German acquisition vehicle.

A consolidation of interest expenses at the level of the acquisition vehicle and the operating profits of the target entity can be reached by the mechanism of the German group taxation or a merger of the two entities. According to section 50d paragraph 10 of Germany’s Income Tax Act (Einkommensteuergesetz), interest income from loans granted by a partner to its partnership qualifies as business income at the level of the partner, which is taxable in Germany. However, from an international tax perspective, article 11 (interest income) of the OECD model treaty would apply and allocate the jurisdiction to tax to the creditor’s country of residence. This is one of many treaty overrides in German domestic tax law. The treaty override was introduced


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after the German Federal Tax Court decided that article 11 of the OECD model treaty should apply. However, if a nonresident related party of the partner provides the loan, the interest income is not taxable in Germany while the interest expenses at the partnership’s level are still deductible. The same is true for a (non-German) related party providing a loan to the German PE of an affiliate. As indicated above, interest expenses at the level of the partner for the refinancing of the equity in the partnership are also deductible for German tax purposes. For all financial tax planning, the limitations from the interest deduction limit (30 percent EBITDA; see Section II.A above) apply.

C. Step-UpIn an acquisition of German business activities, investors usually strive for an asset-base step-up. Such step-up is granted in an asset deal scenario (resulting in a PE in Germany) as well as for an acquisition of a partnership interest. Such acquisition of a participation in a partnership is treated like an asset deal because of the transparency of the partnership. The downside of all step-up scenarios is a taxable capital gain at the level of the seller. Previous tax-planning opportunities in this regard (for example, Umwandlungsmodell) in which shares in a corporation have been sold tax exempt and in which a step-up could be reached by a tax-exempt legal conversion of the target into a partnership are no longer available. In case of a disposal of the shares in a German

corporation, only 5 percent of the gain is taxable at the level of the seller. Accordingly, no step-up is granted for the underlying assets within the acquired corporation for the investor.

IV. Investor’s Tax Environment

A. ChinaAt the level of the Chinese corporate parent, both dividends and capital gains from a foreign subsidiary are taxable at the standard corporate tax rate of 25 percent (since 2008). The China-Germany DTA (which is now being renegotiated, so far without success) does not restrict this Chinese taxation. Article 13(4) of the DTA allows both the resident and the source country to tax capital gains as it deviates from the exclusive allocation of taxation rights as in article 13(5) of the OECD model treaty. Article 24(1) of the DTA stipulates the credit method including the per-country limitation and the indirect tax credit for dividends from participations exceeding 10 percent in a German company.

For dividends, the domestic Chinese rules apply an indirect tax credit, which credits foreign taxes paid on the underlying profits of the subsidiary and also including foreign withholding taxes. The Chinese foreign tax credit rules in the CIT law have been detailed by Circular 125 of December 25, 2009, which is applicable from January 1, 2008. For our structuring purposes, the most important issues are:

• How many tiers are included in the indirect tax credit?

• How does the FTC deal with profit “distributions” by a foreign partnership?

• How is the FTC limit calculated and what foreign taxes are accepted?

• How does it treat expenses related to the dividends -- on a net or gross basis?

The FTC credits foreign taxes in a nature similar to Chinese CIT. It credits direct taxes borne by the Chinese parent (withholding taxes) and indirectly corporate taxes on those profits borne by up to three tiers below the Chinese parent. Thus, structuring should be limited to three tiers (or only those tiers should pay taxes). Only foreign-source income derived from vehicles with a separate tax filing status is accepted, which in our opinion includes German partnerships because they have a separate tax-filing status (especially those that are head of a fiscal unity). However, this would also exclude PEs or branches, in our opinion. The FTC is calculated on an annual basis using a per-country limitation (ratio between foreign-source income from a country and total income). Any excess can be carried over to the next five years. The FTC is effectively calculated on a net basis. Expenses directly related to the shares in foreign subsidiaries (for example, interest expenses incurred by the Chinese parent for financing the acquisition/funding) are in principle deductible, but those interest expenses will


reduce the foreign-source income for purposes of FTC determination and thus ultimately the FTC. However, this would not make a difference if there is excess FTC. There are many open questions after Circular 125, which according to standard Chinese practice will be answered over time until the circular is eventually refined.

If the Chinese parent sells the shares in a foreign subsidiary, the capital gain or loss is included in the normal income tax determination. Thus, a capital gain is subject to 25 percent tax and a loss reduces the remaining income of the Chinese parent. Any excess loss is also subject to the standard tax loss carryforward expiration period of five years. While it could thus look like a good tax-planning idea for a Chinese company to realize a capital loss by selling a foreign participation to a group company, politically this might not work for all companies (especially not for a state-owned company when the loss is substantial). However, in theory this is feasible and might be put into practice for privately owned companies. For the underlying structure, the capital gains tax aspect would lead to the result that a realization of the capital gain by a foreign intermediate holding company is more tax efficient than the direct sale by the Chinese parent. Eventually, this is even true if the proceeds are repatriated as a dividend to the Chinese parent because an FTC would then become available. However, the finest result comes from the realization of capital gains by the foreign

intermediate holding company with a later reinvestment by the intermediate holding company. In other words, and for the structures noted above, if the German GmbH & Co. KG, Dutch co-op, Belgian holding company, or Luxembourg holding company realizes the capital gains, it should use the proceeds for other global investments.

B. JapanThe 2009 tax reform resulted in fundamental changes in Japanese tax law. One major change was the replacement of the credit method by a participation exemption for dividends. For fiscal years beginning on or after April 1, 2009, dividend income at the level of a Japanese parent company is tax exempt by 95 percent if the underlying participation in a corporation is at least 25 percent and has been held for at least six months at the moment when the distribution is concluded. Tax credit for any underlying dividend withholding tax or corporate tax (indirect tax credit) is no longer available. This is important for Japanese parent companies of German corporate subsidiaries because the dividend withholding tax of 15 percent according to the Germany-Japan treaty (for Japanese investments into Germany) has not been reduced yet. However, negotiations for a new Germany-Japan treaty -- which began at the end of 2009 -- seem to be on a good track.

After the introduction of the tax exemption for dividend income in Japan, the tax community expects that the new treaty will reduce dividend withholding

tax rates to either 5 percent or even zero. As noted above in the German partnership structure, there are opportunities to avoid the rather high German dividend withholding tax under the treaty. The German partnership (GmbH & Co. KG) should be structured so that it is treated as a corporation from a Japanese legal perspective and so that withdrawals from the partnership qualify as dividend income for Japanese tax purposes. Such dividend income would be tax-exempt by 95 percent at the level of the Japanese partner if the partnership interest has been held for at least six months. Interest payments of the German partnership to the Japanese parent are subject to ordinary Japanese taxation while interest expenses for the refinancing of such debt -- but also interest expenses for the refinancing of equity investments into the partnership -- should be tax deductible at the level of the Japanese parent.

Capital gains at the level of the Japanese parent should be avoided because such capital gains are -- in the absence of any capital gain exemption -- subject to ordinary Japanese taxation (with a corporate tax rate of 30 percent). However, if the GmbH & Co. KG disposes of the shares in subsidiaries, Japanese capital gains taxation can be avoided. Any capital gain proceeds realized at the level of intermediate holding companies could be repatriated as dividend to Japan or -- as suggested above for Chinese investors -- invested into other targets or subsidiaries. A disposal


at the level of the Japanese parent company might result in a double-dip scenario in case of a capital loss from the disposal of the shares or partnership interest. Japan’s strict CFC rules should be a major point of attention. They are not always straightforward and must be checked on a case-by-case basis. The CFC rules generally apply when a Japanese shareholder or partner holds the majority of shares or interest in a foreign company that is subject to a tax rate of less than 25 percent (20 percent for the fiscal year beginning on or after April 1, 2010). This must be taken into account when a capital gain is tax exempt at an intermediate holding level.

C. KoreaUnder Korean tax law, domestic companies are liable to tax on both dividends and capital gains from foreign sources. Korean parent companies may claim an indirect FTC regarding dividends paid from its overseas subsidiaries when the parent company has a shareholding of at least 10 percent. However, the foreign tax relief is limited: It cannot exceed the lesser of the amount of tax paid to a foreign jurisdiction and the domestic Korean tax burden equivalent to the ratio of the foreign-source income to the total taxable income. In that case, the foreign tax paid is limited under the Korean FTC rules, and the remainder may be carried forward to the following five tax years. Under the applicable treaty concluded with Germany, the dividend withholding tax rates

for dividend income are 15 percent and 5 percent; the lower rate applies when the Korean resident parent company holds at least 25 percent of the shares in the German subsidiary.

Capital gains from the disposal of shares are taxed at the domestic corporate income tax rates of 10 percent for the first KRW 200 million (around €137,000) and 22 percent regarding the excess of that amount. A resident surtax equivalent to 10 percent of the corporate income tax is imposed, which culminates in an effective corporate tax rate of 24.2 percent regarding the taxable income exceeding KRW 200 million. However, the latter rate will be reduced from 22 percent to 20 percent from 2012 onward. Financing costs such as interest payments for loans taken up to capitalize the German outbound investment are in general deductible at the level of the Korean parent company and thus may lead to double-dip scenarios in the German KG structure. From the Korean perspective, a German partnership should qualify as a separate legal entity. Payments from the partnership to the partners are hence considered as dividend payments. Korean CFC rules must be reviewed in case of a shareholding of at least 20 percent in a foreign subsidiary. If the effective tax rate at the level of the subsidiary has not been at least 15 percent for the last three years, a deemed dividend distribution is assumed for Korean tax purposes.

D. Hong KongHong Kong has concluded a limited number of double tax agreements, notably with Luxembourg, Belgium, Thailand, China, and recently the Netherlands. While the general tax environment in Hong Kong qualifies dividend and capital gains from an outbound investment into foreign subsidiaries as being related to a foreign source and thus not subject to Hong Kong profits tax, the lack of DTAs opens a substantial exposure to foreign withholding taxes when the proceeds are being repatriated. Especially regarding investments into Europe and the U.S., this exposure will drive Hong Kong investors to use intermediate holding companies in treaty-protected countries (such as Belgium, Luxembourg, and the Netherlands) or in other countries using special legal vehicles (such as the German GmbH & Co. KG), which according to domestic rules are not liable to dividend withholding tax.

The treaty countries can be used if the anti-treaty-shopping rules in the operating countries -- where the profits are generated -- can be met. At the same time, the German GmbH & Co. KG is helpful for situations in which they cannot be met and in which the operations in Germany are meaningful. In cases when the German operations are not substantial, the use of a German KGaA can make sense as a through-bound vehicle for U.S. investments to meet the LOB provision in the Germany-U.S. treaty. As noted above, the KGaA is a hybrid, in which the interest


of the limited partner consists of shares, which can be (and in the U.S. through-bound case should be) listed on a German stock exchange. The real danger lies with the anti-treaty-shopping regulations in the big Western markets, including the U.S., Germany, Italy, France, and the U.K. Hong Kong expenses related to the foreign investment -- financing and other expenses -- are generally nondeductible for Hong Kong profits tax purposes, as they are not incurred in generating assessable income in Hong Kong.

E. SingaporeJust like Hong Kong, Singapore does not tax capital gains or capital losses unless they are a result of a trading activity, which is determined based on the sequence of events and the intention of the parent at the time of acquisition. Foreign-source dividends are also not taxed at the level of the Singaporean parent company if the underlying profits have been taxed at the source level and the highest CIT in the source country is at least 15 percent. Correspondingly, expenses related to these tax-exempt income items are not tax deductible. Singapore has no explicit CFC rules, but artificial structures will receive scrutiny by the Inland Revenue Authority of Singapore. Although Singaporean outbound investment can make use of a relatively wide treaty network of more than 65 treaties, a treaty with the U.S. still has not been concluded. Thus, one of the biggest tax-planning considerations for Singaporean

investments into the U.S. is finding an intermediate holding location for Singapore’s U.S. investments. This holding location would be one that passes the U.S.’s LOB test and substantially reduces the 30 percent withholding tax exposure in the U.S. The intermediate holding location could be found in a European country if there is sufficient substance or -- as in the case of the German KGaA -- if it can be stock-listed. For European investments, a good intermediate holding location could be Belgium, as there is a 0 percent withholding tax rate on dividends in the Belgium-Singapore treaty. However, for the Belgian holding company to claim the 0 percent intra-EU withholding tax on dividends, substance requirements of the various anti-treaty-shopping rules in the European operating countries must be observed. Otherwise, in cases involving big German operations and in cases in which there is not enough substance in Belgium, a German GmbH & Co. KG model could be more efficient because it is untested under the German anti-treaty-shopping rules.

V. Conclusion

In Table 2 on the next page, we provide an overview of the different holding structures and a recommendation as to the most tax-efficient planning opportunities for each Asian country.

Thanks to our colleague Joerg Gruenenberger for reviewing the section on Japan.

VI. Recommendation

Many factors should be taken into account when an Asian investor is looking for the most appropriate European holding location: the country of residence and the countries where the investment will be made; available substance in Belgium, the Netherlands, Luxembourg, or Germany; and the financing situation. The most common holding locations used in the past provide a zero dividend withholding tax for profit repatriations from EU countries if the anti-treaty-shopping rules in the countries where the operations are located (for example, Germany) can be fulfilled. A German partnership or KGaA structure provides additional value from a global tax perspective because a double dip for refinancing costs could be available, and German anti-treaty-shopping rules do not apply. For Chinese and Korean investors, it is essential not to repatriate profits to China or Korea, because there is no tax exemption for capital gains or dividends.

Interposing an intermediate holding company blocking the income and reinvesting the proceeds is recommended in these cases. The corporate shareholder chain in China should not exceed three tiers of taxpaying entities to allow full foreign (indirect) tax credit in China upon repatriation. Repatriation to Japan should be made via dividends instead of capital gains since only dividends are (95 percent) tax exempt while capital gains are


fully taxable. Japanese CFC rules must be carefully observed. The challenge to avoid the German 15 percent dividend withholding tax for Japanese and Hong Kong shareholders can be avoided with a German partnership structure. The harsh German anti-treaty-shopping rules do not apply to this

structure. The German hybrid entity form KGaA provides additional tax-planning opportunities. When a KGaA is listed on the stock exchange, it should pass the LOB test in the Germany-U.S. tax treaty and thus facilitate the repatriation in a through-bound structure when an Asian investor holds a U.S.

investment via Germany. There is much money to win or lose when choosing the most appropriate holding structure from a global tax perspective. This is why the subject should have your full attention when planning European or global investments from Asia.

China Korea Japan Singapore Hong KongDividend WHT Dutch Coop No (due to domestic tax law)LUX/BEL Hold Co. No (benefits from EC law extended to DTA countries, certain requirements)German KG No (due to domestic tax law)German KGaA No (regarding general partner)Shareholding costs deductibleAll countries Yes Yes Yes No NoDouble dipDutch Coop No No No No NoLUX/BEL Hold Co. No No No No NoGerman KG Yes Yes Yes No NoGerman KGaA Yes (general partner) Yes (general

partner)Yes No No

Capital gainsDutch Coop Capital gains at BeNeLux level tax exempt Capital gains at Asian and BeNeLux LUX/BEL Hold Co.

German KG Capital gains at the level KG/KGaA 95 % tax exempt Capital gains at Asian level tax exempt,German KGaA

DividendsAll countries FTC FTC 95% exempt exempt exemptAnti treaty shopping rulesDutch Coop German anti treaty shopping rules require substantial substance in BeNeLux, other country’s

rules to be analyzedLUX/BEL Hold Co.

German KG German anti treaty shopping rules n/a,

other country’s rules to be analyzedGerman KGaA

Table 2. Summary of Tax Implications


For additional information with respect to this ITS in the News, please contact the following:

Ernst & Young GmbH, Dusseldorf• Michael Pfaar +49 211 9352 18164 [email protected]• Markus Schummer +49 211 9352 15724 [email protected]• Steffen Rehling +49 211 9352 29593 [email protected]

Endnotes

1. German Federal Ministry of Finance, bulletin dated Apr. 16, 2010, BStBl. I 2010, 354, para. 5.1.

2. We thank our colleague Friederike Juengling for her comments regarding KGaAs.

3. German Federal Tax Court, decision dated Oct. 17, 2007, BStBl. II 2009, 356.

4. This contravened the opinion of the German tax authorities; German Federal Ministry of Finance, bulletin dated Apr. 16, 2010, BStBl. I 2010, 354, para. 5.1.

5. Thanks to our colleague Joerg Gruenenberger for reviewing the section on Japan.



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