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Constructive dividends in the context of intra-group allocations

When assessing whether or not an amount should be categorised as a constructive dividend, the question that always arises relates to the arm’s length comparison. If the payment or allowance does not stand up to such a comparison then this can lead to undesirable consequences, as a recent ruling by the Hamburg tax court (Finanzgericht Hamburg, FG) shows.

Issue - Services provided to a subsidiary GmbH [a German limited liability company]

In the case in question, the holding GmbH provided various services to a subsidiary GmbH, within the framework of a service agreement, and the remuneration for this was a flat-rate 6% of the subsidiary’s sales; in the view of the court, the amount had thus been assessed at a level that was too low. There was no calculation based on the actual costs that had been incurred. In the period in question, the parent company generated mainly losses.

The FG’s view - Payments constitute constructive dividends

In its ruling of 17.3.2021 (case reference: 2 K 172/18), the Hamburg FG categorised the full amount of the flatrate payment as a constructive dividend. Payments are deemed to be constructive dividends where (among other things) there is a reduction in the assets of the subsidiary GmbH to the benefit of the holding GmbH by reason of the corporate relationship. Determining if the corporate relationship was the reason for the payment should be done on the basis of an arm’s length comparison. Such an arm’s length comparison should be evaluated from the perspective of both contractual partners. In the view of the FG, on both sides, a prudent and diligent managing director would not have approved a flat-rate sales-based rule but, instead, would always have called for a specific calculation. Therefore, all the payments by the subsidiary GmbH to the holding constituted a constructive dividend.

Critical appraisal and classification

The intention and purpose of the legal concept of a constructive dividend is generally not to recognise, for tax purposes, remuneration that is governed by the law of obligations to the extent that it exceeds an amount that is customary for this service; in addition, the excess amount is treated like a dividend. Therefore, for tax purposes, a constructive dividend creates a situation that would have arisen if customary (elsewhere) prices had been used. 

However, a constructive dividend has actually only one direction. The term ‘dividend’ already establishes that a (non-operational) transfer of assets from the subsidiary to the parent company occurs and not vice versa, as in the relevant years in the case in question. The FG cleverly upended this logic. As the agreement was sales-based this means that, formally, it was non arm’s length and therefore, from a tax perspective, effectively did not exist and, as a consequence, all the payments constitute dividends. Contrary to the usual approach, the FG did not make a distinction as to the level at which the payments were arm’s length. In this case specifically, only an excess amount would have had to be treated as a dividend. In the case in question, on the basis of the previous approach, a constructive dividend would thus not have arisen because the price had even fallen below the non-arm’s length price. The ruling was based solely on ‘formal’ criteria and took no account of economic considerations and reasons. 

If the ruling gains acceptance, then a far-reaching impact can be expected. Ultimately, this would lead to an eruption in the law on constructive dividends and constructive equity contributions. If a parent company, for example, provides services at a discount or makes available loans at a lower rate of interest to its subsidiary then, according to existing law, the amount of difference between the arm’s length price/ interest rate would not be deemed to be a constructive equity contribution due to the lack of a contributable pecuniary benefit. By contrast, according to the recent ruling, a constructive dividend would have to be deemed to exist in the amount of the remuneration that was paid.

Recommendation: It remains to be seen whether or not the German Federal Fiscal Court will restrict the view represented by the FG. In the meanwhile, intra-group agreements should be rigorously checked to determine if they stand up to an arm’s length comparison and, in particular, sales-based remuneration for services should be adjusted as a precautionary measure.

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