Outbound investments: Tax-neutral capital repayment from foreign corporations - BMF provides clarity

If a shareholder invests taxed funds in a corporation, the mere re-distribution of the investment amounts must not be subject to taxation again at the shareholder's level. Otherwise, there would be double taxation of the mere return of capital at the shareholder level, even without any new profits being generated by the corporation.

The current Corporate Income Tax Act takes account of this fundamental requirement for appropriate income taxation by providing for a tax-neutral capital repayment from domestic corporations (GmbH, AG), insofar as payments are made from the nominal capital or from the so-called tax contribution account in accordance with Section 27 KStG. For this purpose, the balance of the tax contribution account is also determined separately each year.

Likewise foreign corporations domiciled in a member state of the EUcan provide a tax-neutral return of capital contribution upon request (Section 27 (8) KStG). Although no tax contribution account is established for these companies, the return of contributions can be determined by applying the principles applicable to domestic companies accordingly, although this is quite time-consuming in practice.

Problem third country companies

However, the treatment of the return of contributions from foreign corporations that are not domiciled in the EEA (so-called third countries, such as Switzerland or the USA) has been controversial for years and has now been the subject of several supreme court decisions (see e.g. BFH of 13 July 2016, VIII R 47/13). For these companies, no tax deposit account is established as a basic requirement for a tax-neutral return of capital contributions. In contrast to EEA companies, the law also does not provide for the possibility of a tax-neutral return of capital contributions upon application.

In practice, the associated risk of double taxation in the case of capital returns taxed as dividends without favourable treatment has led to a high degree of legal uncertainty and nonsensical adjustment measures. For example, in the case of investments in foreign funds, fund managers have been obliged under so-called side letter agreements not to pay the capitalisation of downstream foreign corporations into the capital reserves, but only to invest in the nominal capital or alternatively to grant shareholder loans (cf. Elser, Ausländische Private Equity Fonds - Steuerliche Aspekte aus Sicht des deutschen Anlegers, in: Wassermeyer/Richter/Schnittker (eds.): Personengesellschaften im Internationalen Steuerrecht, Chapter 9, 2nd edition 2015).

BMF creates clarity

Fortunately, the Federal Ministry of Finance (BMF) by letter dated 21 April 2022 has now taken a position on the above-mentioned topic, taking into account the case law that has been issued in this regard, which now ensures generally applicable legal certainty. The main points in Contribution repayment payments from third-party corporations can be summarised as follows:

• Nominal capital repayments are generally tax-neutral at the level of the shareholder. They do not lead to taxable dividend income, but merely to a reduction in the shareholder's acquisition costs for his investment in the foreign company. However, in the case of previous capital increases from company funds (e.g. conversion of capital reserves into nominal capital), Section 7 (2) KapErhStG must be observed, according to which the capital reduction leads to taxable dividend income within five years of the capital increase. The actual existence of a nominal capital reduction and repayment must be proven by means of suitable documents (foreign balance sheet, shareholder resolutions, register entries, etc.).

• The Repayment of contributions not made to the nominal capital (e.g. in capital reserves, share premium, etc.) can also be tax-neutral. This is from the foreign trade balance, preceding the year of distribution to the shareholder. Fortunately, the tax authorities do not require either a commercial balance sheet prepared in accordance with German law or a reconciliation to German tax law in accordance with Section 60 (2) EStDV.

However, it should be noted that, in line with the treatment of distributions from domestic companies, direct access to the contributions is not possible, but rather the retained profits must first be distributed subject to tax in accordance with the order of utilisation of Section 27 (1) KStG.

Fortunately, these regulations are also applicable at shareholder level for distributions from EEA companies if the company itself has not submitted an effective application in accordance with Section 27 (8) KStG.

Yours TAXGATE Team will be pleased to assist you in obtaining tax-free income from foreign shareholders in Germany in accordance with these new principles.