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German Court decides in favour of a Cyprus company in a CFC case

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German Court decides in favour of a Cyprus company in a CFC case

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In a decision published on 17 October 2018, the German Federal Financial Court decided on the application of the German Controlled Foreign Company (CFC) legislation in a triangular case involving a Cyprus company.

Facts

The taxpayer was a German parent company with an indirect 100% shareholding in a Cyprus company (CY Co.) through a Dutch company (NL Co.).

CY Co. was engaged in obtaining copyright licences and sub-licensing them to companies of its group established in Russia and Ukraine. CY Co. had rented office space in Cyprus and employed several persons entrusted with tasks of an administrative nature. In 2007, CY Co. had received royalty payments from the other group companies.

The taxpayer, based on the Cadbury Schweppes case decided by the European Court of Justice (ECJ), took the view that the CFC legislation was not applicable. The ECJ decided that the CFC legislation may be applied only to wholly artificial arrangements aimed at avoiding tax. An artificial arrangement is not understood to exist where an entity carries out genuine economic activities.

However, the German Tax Authorities and the Finance Court of Münster held that the CFC legislation was applicable because no genuine economic activities were performed in Cyprus.

Legal Background

As per the German Corporate Income Tax Law (CITL) a resident company is deemed to have received a dividend if it owns more than 50% of the share capital of an intermediary company which mainly generates passive income taxed at a rate of less than 25%.

As per the CITL excessive royalty payments constitute a hidden dividend distribution for the purposes of the CFC legislation.

Issue

The issue was whether the activities of the Cyprus company constituted a genuine economic activity.

Decision

The Federal Financial Court accepted the appeal and set aside the decision of the Finance Court of Münster that the CFC legislation (which was amended after the case at hand was filed to exclude companies resident in an EEA country upon certain conditions being satisfied) should apply.

The Federal Financial Court first observed that the royalty payments to CY Co. from other group companies constitute a hidden profit distribution to the German parent company. The German parent company paid those royalties as a hidden capital contribution to CY Co. through NL Co. The Court confirmed the decision reached in previous similar cases in which it had been held that income reductions and unattained profits resulting from a business relationship do not constitute CFC income. Therefore, royalty payments could not be included in the CFC income.

The Federal Financial Court applied the ECJ's findings in Cadbury Schweppes to the case at hand for what concerns income derived from administrative activities. The Court held that such income could not be attributed to the parent entity under the CFC legislation as this would be incompatible with the freedoms under the Treaty on the Functioning of the EU. The ECJ had decided that CFC legislation may be applied only to wholly artificial arrangements aimed at avoiding the domestic tax normally due. Such a situation should not be considered to apply where, upon considering all facts, the subsidiary is resident in an EU Member State and performs genuine economic activities.

The Court also held that, for what concerns CFC legislation, the taxpayer must have the possibility to prove that an arrangement is not artificial and not mainly aimed at obtaining a fiscal advantage (subjective element). In addition, based on objective facts, it must be possible to determine that the controlled entity is actually established and that its activities are genuine (objective element). The Court held that the activities exercised in Cyprus were genuine. The fact that the activities of CY Co. could have also been carried out in Germany does not imply an artificial arrangement.


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