I. Background to add-back taxation
German income tax law treats corporations as independent taxable entities. Accordingly, their earnings are initially only subject to taxation at this entity (separation principle). The shielding effect could give tax residents the idea of shifting income to foreign corporations in order to gain a tax advantage there through a low tax level. For this reason, the German legislator introduced the add-back taxation in the 1970s in order to prevent such clumsy arrangements.
Under certain conditions, add-back taxation cancels the separation principle and attracts the foreign income of a foreign corporation to Germany, where it is subject to taxation for the domestic participant. It is thus simulated as if the domestic participant had earned this income directly.
Under the current legal situation, add-back taxation applies if a domestic shareholder or shareholder (domestic control) holds a stake of more than 50% in the foreign corporation and the corporation does not generate any active income in accordance with Section 8 AStG (asset catalogue) and the foreign corporation with the passive income is also subject to low taxation in accordance with Section 8 (3) AStG (tax rate < 25%). If the conditions are met, the foreign corporation is designated as an intermediate company (in contrast to pure letterbox companies, which are fully taxed even without the AStG).
For foreign corporations with their registered office or management within the EU, it is possible to avoid the legal consequences of add-back taxation despite the fulfilment of the conditions, provided that it can be proven that this foreign corporation participates in general economic transactions (Section 8 (2) AStG).
II. Tightening of add-back taxation through the ATAD Implementation Act and the resulting future fields of action
EU regulations require all member states to transpose a minimum standard for add-back taxation into national tax law (Anti-Tax Avoidance Directive, ATAD). In the meantime, the Federal Government's draft legislation to implement this Anti-Tax Avoidance Directive (ATAD Implementation Act) has been published. This draft results in significant changes to the taxation of add-backs in accordance with sections 7 et seq. AStG, which are analysed below. The conditions for the application of add-back taxation remain essentially the same (receipt of passive income originating from a low-tax country; tax rate < 25%); for additional planned changes in the case of tax havens, see TAXGATE Blog of 2 March 2021. However, the draft also contains new regulations that go far beyond the target and may result in considerable compliance and advisory costs if the draft is implemented. We would like to outline the main changes below.
A. Introduction of the control concept
a) Control concept through shareholding structure
The previously applicable national control concept will be abandoned and replaced by the control concept. In future, the control requirements are to be considered on a shareholder-related basis. Pursuant to Section 7 (1) and (2) AStG-E, a foreign corporation is controlled if an unlimited taxpayer (also applies to limited taxpayers) alone or together with related parties (e.g. in a group structure) directly and indirectly holds more than half of the voting rights or more than half of the nominal capital. The following two simplified examples (from the government draft) are intended to illustrate the control concept in a comprehensible manner: 
A-GmbH, which is domiciled in Germany, holds an interest of 49% in the foreign, low-taxed (tax rate < 25%) and passive income-generating intermediate company (ZG). B-S.à.r.l., which is domiciled in France, holds an interest of more than 25% (here: 100%) in A-GmbH and 2% in ZG. Under the previously applicable rules, there was no domestic control, as A-GmbH only holds a stake of 49% in ZG. According to the new control concept, however, such shares will in future constitute an add-back, as in addition to the 49% held directly by A-GmbH in the ZG, the related party B-S.à.r.l. will also attribute a shareholding of 2% to it (as B S.à.r.l. holds at least 25% (here: 100%) in A-GmbH). This means that A-GmbH "controls" ZG with a 51% shareholding. However, an additional amount of 49% is then attributed to A-GmbH. The same result would be achieved with regard to the control ratio if, for example, the shareholding structure described above continues to apply and A-GmbH only holds an interest of 1% in the ZG instead of 49% and B-S.à.r.l. holds an interest of 50% in the ZG instead of 2%. In this case, too, A-GmbH "controls" the ZG for 51%. An additional amount of 1% is then attributed to A-GmbH. 
The second diagram is more complex and shows how the audit is to be carried out for a group structure. The control concept with the corresponding control ratios must be determined for A-GmbH, B-GmbH and C-GmbH respectively. A-GmbH directly holds 40% in ZG. Furthermore, it is a related party of B-GmbH (as it holds at least 25%), so that the direct shareholding of 40% of B-GmbH is also attributable to A-GmbH. With regard to the indirect shareholding in C, the shareholding ratios are calculated (25% * 20%). In total, A-GmbH has a controlling interest of 85%. B-GmbH has a direct shareholding of 40% in ZG. In addition, A-GmbH and C-GmbH are related parties, meaning that their shareholdings in ZG are fully included in the control quota of B-GmbH (totalling 100%). C-GmbH holds a direct interest of 20%. Furthermore, B-GmbH qualifies as a related party, meaning that the shareholding of 40% is also attributable to C-GmbH. The controlling interest of C GmbH is therefore 60%. This means that all three companies have fulfilled the control quota and must comply with the rules on add-back taxation. Conclusion: The simplified examples make it clear that the new control concept means that a large number of companies that have not yet had any contact with add-back taxation should have compliance issues such as the preparation of AStG declarations on their radar in future. In particular, the requirements for control (and the determination of the control ratio) with regard to related parties will in future result in an annual and detailed review of the group structure (based on a current group organisational chart) in order to ensure the extent to which shareholder-related control exists.
b) Control by aligned interests pursuant to section 7 (4) AStG-E
In addition to the shareholding structures explained under a), related parties also exist if the parties involved have similar interests in order to achieve coordinated behaviour with regard to the intermediate company. According to the explanations in the Federal Government's draft bill, such concerted behaviour can occur in the case of family members, for example.
According to the government draft, such interaction is assumed for partners in a partnership who are involved in an intermediate company due to the company law structure. The following example is intended to illustrate the dimension of this regulation:
If one takes the explanation of the Federal Government's draft bill at face value, then the structure shown would lead to the intermediate company being controlled by A (due to the participation via the partnership), as cooperation with the other investors is assumed due to the corporate structure. A would therefore fulfil the element of control!
Conclusion: As no further comments are made in this regard in the Federal Government's draft bill, early considerations and possible restructuring should be taken into account in 2021 in order not to fulfil the definition of concerted behaviour and thereby avoid any add-back taxation.
c) Dual resident companies
As all EU member states are required to implement the provisions on add-back taxation, the question arises as to what should apply if a taxpayer has its registered office in one member state and its place of management in the other member state. The taxpayer would initially be subject to unlimited tax liability in both states.
There are no statements on this in the Federal Government's draft bill (a tie-breaker rule cannot be derived from the draft bill). not take). This may result in double taxation or a mutual agreement procedure.
Conclusion: Efforts should be made at an early stage to avoid double residency.
B. Relationship between InvStG and AStG
Under current law, Section 7 (7) AStG blocks the add-back taxation if the provisions of the Investment Tax Act apply to the income of the foreign intermediate company. This means that, on the one hand, the income generated directly by the foreign investment fund and also the interim income generated by downstream intermediate companies and attributed to the investment fund in accordance with section 14 AStG are exempt from add-back taxation.
In the Federal Government's draft bill, Section 7 (7) AStG was replaced by Section 7 (5) AStG-E. Accordingly, the add-back taxation is not applicable if the provisions of the InvStG are applicable to the income for which the foreign company is an intermediate company. However, this does not apply if more than one third of the income from the underlying transactions is generated with the taxable person or related party.
However, due to the new concept of add-back taxation, according to which direct and indirect participations will be directly attributed to unlimited taxpayers (also applies to limited taxpayers) in future, the draft bill does not clarify that this priority also applies to participations held indirectly via an investment fund (previous provision of Section 14 AStG). The missing provision would open up the scope of application of add-back taxation in relation to intermediate companies downstream of the fund. The following example is intended to illustrate the regulatory content for downstream intermediate companies:
The downstream intermediate company does not fulfil the requirements of the Investment Fund Act (InvStG). The interest income is therefore not subject to the provisions of the InvStG and the shielding effect of the InvStG does not apply. The interest income would be directly attributed to the investors within the scope of the add-back taxation.
Conclusion: The regulation described would oblige domestic investors to submit an AStG declaration in future, which would represent a considerable compliance effort for all parties involved.
C. Adjustment of the catalogue of activities pursuant to section 8 (1) AStG-E
The current catalogue of activities will be retained in the future. Adjustments will be made to the following activities in particular:
a) Interest income is to be categorised as a passive activity in future. In future, the raising and lending of capital in accordance with the previous Section 8 (1) no. 7 AStG will be cancelled as an active activity. This categorisation as a future passive activity opens up the conditions for add-back taxation, particularly for the financing of globally active groups.
b) Profit distributions are no longer to be fully categorised as an active activity. Instead, the provisions of the KStG are implemented in the new draft bill of the ATAD. A passive activity would exist, among other things, if a free float participation (Section 8b (4) KStG) would exist if the intermediate company had not been interposed. The same would apply if Section 8b (7) KStG is relevant.
Conclusion: In addition to the considerable effort involved in assessing the control concept in the group structure as described above, the granting of loans will be "sanctioned" as a passive activity within the group in future. As a result, interest income received in future must be recognised in the AStG declaration.
D. Substance test pursuant to section 8 (2) AStG-E
If the conditions for add-back taxation are met, relief from this can be granted if proof is provided that the foreign company carries out a significant economic activity. This proof can only be provided if this company is located in the EU or in an EEA state.
The Federal Government's draft now tightens up this proof in such a way that the necessary material and personnel resources are required for the activity carried out (Section 8 para. 2 sentence 2 AStG-E).
Furthermore, the staff must be sufficiently qualified personnel who carry out the work independently and on their own responsibility. The substance requirement is therefore tightened even further in the new regulation. If the company has its main economic activity predominantly carried out by third parties, proof is excluded, meaning that the add-back taxation applies. In addition, the existing administrative assistance requirement will continue to apply.
Conclusion: In practice, attention will have to be paid in future to the extent to which outsourced activities (e.g. temporary employment, management agreements) and holding companies (requirements for sufficient substance?), among other things, may be a negative obstacle to the motive test. The conditions for the substance requirement should therefore be examined at an early stage for group structures that have group relationships in the EU/EEA on the one hand and would in principle fulfil the conditions for add-back taxation on the other.
III Outlook
The new add-back taxation contains many innovations. Companies should be aware of these at an early stage in order to cover any compliance issues and, if necessary, reorganisations in 2021.
Your TAXGATE team will be happy to answer any questions you may have about the new add-back taxation.
