Use of Finance Subsidiaries in Malta And Belgium
From a financing perspective, German and US multinational companies are facing similar challenges.
First, both countries are so-called high-tax jurisdictions — Germany with an effective tax burden of 30% and the US with a corporate tax rate of 35% — and multinational companies in both countries with investments abroad want to defer domestic taxation of foreign earnings until repatriation in the form of dividends, interest, royalties or other payments. Hence, many multinational companies hold their foreign assets though offshore holding companies in countries with lower tax rates in order to minimize the global effective tax rate.
Second, both countries have “controlled foreign corporation,” or “CFC,” statutes that prevent domestic corporations from delaying taxes on foreign earnings. Both countries look through offshore holding companies and tax any “passive” income received by the offshore holding companies without waiting for the earnings to be repatriated.
One significant difference between Germany and the United States is the membership of Germany in the European Union, which provides German companies with access to a common market without any tax obstacles.
Reducing the Costs of Financing
In Germany, companies are permitted under tax law to structure their investments in ways that minimize their tax liabilities, provided that they do not violate the letter or the intent of law. To minimize current tax liabilities, taxpayers often attempt to defer the recognition of taxable income.
If a direct or indirect subsidiary of a German company requires funds, a straight-forward, plain-vanilla loan from the German parent company to the foreign subsidiary would give rise to interest income in Germany. Such interest income would be subject to German taxation at approximately a 30% rate. Given the high tax rate in Germany, German companies usually prefer equity contributions to their foreign affiliates, assuming the effective tax rate abroad is lower than 30%, as dividends coming back to the German parent on the equity investment would generally be 95% exempt from German taxation. Thus, such dividends are taxed at a 1.5% rate (5% of 30%)). Hence, taxation of interest income would be avoided in Germany and the foreign source income could be deferred from German taxation in the case of a foreign subsidiary.
If significant financing is needed abroad and also if the German company is sitting on lots of cash, the German company will consider establishing a foreign finance subsidiary in order to reduce its global effective tax rate further. German companies frequently use Maltese and Belgian finance structures for this purpose.
Financing Through Malta
Malta is an archipelago situated centrally in the Mediterranean Sea. Malta covers just over 115 square miles in land area, making it one of Europe’s smallest and most densely-populated countries. Its de facto capital is Valletta. Malta has been a member of the EU since May 2004, and it adopted the Euro in January 2008.
Many German companies use Maltese “international trading companies” as financial subsidiaries. Maltese ITCs are normal onshore companies that are established by non-residents and that deal only with non-residents. While the Maltese ITC pays the normal company flat rate tax of 35% on its profits, the non-resident shareholders’ ultimate tax liability is 4.17% through a system of tax refunds. In practice, a double Malta structure is generally used, which is illustrated below.
The Maltese finance company — referred to as “Malta FinanceCo” in the diagram — earns interest income of, say, 1,000 that is subject to tax at 35% ( 350) and distributes the net interest income as a dividend ( 650) to its Maltese parent company (“Malta Parent” in the diagram). The Malta Parent receives a credit for the tax paid by Malta FinanceCo ( 350) and is subject to tax at 27.5% ( 275). However, a tax refund of two thirds of the tax paid by the Malta FinanceCo (2/3 of 350 = 233.33) is provided to the shareholder. Thus, the ultimate tax liability is 4.17% ((350 -350 + 275 — 233.33) divided by 1,000). Thus, Malta Parent can distribute a dividend of 958.33 to the German parent company and it ends up paying a tax in Malta on 1,000 in income received from an offshore affiliate in the form of interest of only 41.67.
As of today, the Maltese financing structure should not be caught by the German CFC statute, as the Malta FinanceCo earning the passive income (interest income) is not subject to low taxation, meaning an effective tax rate — computed according to German tax principles — of less than 25%, and while the Malta Parent is subject to a low tax rate (27.5% tax minus the credit for 35% plus a 2/3rds tax refund), it does not earn any passive income, as dividend income is deemed to be active income under the German CFC statute.
The German tax authorities are aware of the double Maltese structure and focus in audits on whether they have grounds to ignore the Maltese companies for lack of substance or to treat the Maltese companies as subject to direct taxation in Germany because they have their places of management in Germany.
The German government proposed in March as part of the 2010 annual tax bill (Jahressteuergesetz 2010) to amend the rules for determining the foreign effective tax burden under the CFC statute. Based on the latest draft of May 28, 2010, any refunds of taxes paid by Malta FinanceCo that are granted to the Malta Parent (a foreign corporation) would be considered when computing the effective tax burden of the Malta FinanceCo. It will not be clear whether the structure remains viable until the draft bill is finalized. More analysis will be required at that time.
Even if the structure would be caught by the new rule, meaning the three conditions for the CFC statute — German control, passive income and low taxation — would then be fulfilled, the present tax benefits will remain available if the seat or the place of management of the controlled foreign corporation is located in the EU or the European Economic Area and it can be proven that the controlled foreign corporation carries on genuine economic activities there (a so-called motive test). This exception has been a feature of German tax law since 2008 following the European Court of Justice judgment in the Cadbury Schweppes case (C-196/04) on November 18, 2006.
Financing Through Belgium
Belgium is a country in northwestern Europe, and is a founding member of the EU. Belgium covers an area of 11,787 square miles, and it has a population of about 10.7 million people.
Belgian tax law has provided since January 2007 for a deduction from the Belgian tax base in the amount of fictitious interest calculated on shareholder equity (net assets) (a so-called “notional interest deduction”). The deduction is available to Belgian companies, Belgian branches of foreign corporations, non-profit organizations and foundations subject to Belgian corporate tax and foreign companies that own real estate located in Belgium or hold property rights in such real estate.
The notional interest rate for the tax year 2010 (meaning the accounting year ending on December 31, 2009 or later) is 4.473%.
It is 4.973% for small and medium-sized enterprises, referred to as “SMEs.”
For 2011 and 2012, the rate will be 3.8% (4.3% for an SME).
The notional interest rate is not allowed to deviate more than 1% from the rate in the previous tax year and must not exceed 6.5%. The deduction is allowed to the Belgian company and is the rate times the qualifying equity, which is the equity capital according to Belgian accounting principles but after subtracting three items: the net value of financial fixed assets qualifying as “participations and other shares” (non-portfolio participations), the net equity assigned to foreign permanent establishments or real estate property or rights (only if situated in a country with which Belgium has concluded a double tax treaty) and the net value of own shares held on the balance sheet.
For example, the balance sheet of a Belgian subsidiary of a German parent company might show that the share capital of 10,000 has been fully used for group financing. Applying an intra-group interest rate of 5% per annum, the profit before taxes amounts to 500. Before the introduction of the notional interest deduction, the Belgian corporate tax would have been 169.95 (33.99%). Considering the notional interest deduction, the Belgian entity could deduct 447.30 ( 10,000 x 4.473%) from its tax base resulting in taxable income of just 52.70 ( 500 – 447.30) and a tax liability of only 17.91 (33.99% on 52.70). Thus, the tax on income passing through Belgium is only 3.58% (17.91 divided by 500).
Although the Belgian entity in the example earns low-taxed passive income, the income should escape German CFC taxation provided that the Belgian entity complies with the motive test, meaning that it carries on legitimate business activities in Belgium.
The European Commission sent a letter to the Belgian government in February 2009 as a preliminary step toward an investigation into the compatibility of the notional interest deduction with the European Union treaty and the European Economic Area agreement. The Belgian Finance Ministry responded in April 2009. It is unclear whether the European Commission accepted Belgium’s arguments or whether infringement proceedings will be continued.