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Variable compensation payments to external shareholders only possible to a limited extent

In a recent circular, the Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) dealt in detail with issues related to the application of Section 14(2) of the German Corporation Tax Act (Körperschaftsteuergesetz, KStG). These concerned, among other things, the maximum amount of compensation payments and the so-called business test.

The Federal Fiscal Court on the agreement of variable compensation payments

The Federal Fiscal Court (Bundesfinanzhof, BFH), in it ruling from 10.5.2017 (case reference: I R 93/15) took a decision that was contrary to previous administrative opinion that the agreement of variable compensation payments by a controlling enterprise to an external shareholder is an obstacle to the recognition of consolidation for tax purposes if the compensation payments are ultimately calculated on the basis of the profit of the controlled company. As a result, the German government, via the amended version of Section 14(2) KStG - which was part of the 2018 Annual Tax Act (cf. PKF Newsletter 12/2018 p.3) - provided rules that determined the conditions, besides the fixed amount pursuant to Section 304(2) clause 1 of the Stock Corporation Act (Aktiengesetz, “AktG”), under variable compensation payments that had been additionally agreed and made would be permissible.

Important elements of the BMF circular from 4.3.2020

In the BMF circular, from 4.3.2020, the fiscal authority discussed, in particular, the following issues:

  • the scope of application of Section 14(2) KStG,
  • the maximum amount of compensation payments,
  • the business test and
  • the legal consequences.

(1) The scope of application of Section 14(2) KStG - Firstly, the fiscal authority clarified that it is unimportant whether the compensation payments are made by the subsidiary company or the parent company. Section 14(2) KStG may only be applied if compensation payments are agreed and made. However, for the recognition of consolidation for tax purposes it would not be detrimental if, besides the minimum amount under stock corporation law, as defined in Section 304(2) clause 1 AktG, other profit-related compensation payments have been agreed but these variable components of the amount could not be paid or likewise were not actually paid in a specific financial year because, for example, the subsidiary company’s earnings were low or negative.

(2) The maximum amount of the compensation payment - In this regard, the BMF holds the view that the compensation payment may not exceed the share of profits that could have been paid in the absence of a profit transfer agreement. For the calculation, using the net income for the period under commercial law before the profit transfer as the basis, adjustments will have to be made. The following items, in particular, will have to be deducted: additions to reserves, amounts subject to a payout block and notional amounts of tax on earnings. Amounts that have to be added back will be, primarily, those that have resulted from the reversal of reserves that were created during the period as a consolidated tax group.

Please note: The calculation of the maximum amount has to be carried out separately for each financial year and it is not possible to do this retroactively.

(3) Business test - According to this test, the amount in excess of the (fixed) minimum amount, as defined in Section 304(2) clause 1 AktG, has to be justified on economic grounds on the basis of a reasonable commercial assessment. In particular, purely tax-driven variable compensation payments for which there is no objective justification would not satisfy this so-called business test. If there is no close relationship between the parent company and the minority shareholder then, due to the clash of interests that exists, there will generally be objective reasons for the agreement of additional compensation payments so that, normally, the business test would not be an obstacle to the recognition of consolidation for tax purposes.

(4) Legal consequences - If the overall compensation payments made to an external shareholder exceed the maximum permitted amount under Section 14(2) KStG then this would be an obstacle to the recognition of consolidation for tax purposes.

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