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5.1. Tax Base for Resident Entities

Resident companies are liable to corporate income tax in Germany on their worldwide income. In application of many German tax treaties, foreign-source income, such as income attributable to a permanent establishment in the treaty partner State, is usually excluded from the German taxable base. In the absence of a treaty, unilateral relief provisions allow a foreign tax credit subject to conditions.

Dividends

Dividends received by German companies (as well as German branches and PEs of foreign companies) qualify for a participation exemption regime whereby 95% of the dividends received are excluded from taxable income for corporate income tax purposes (the remaining 5% being treated as expenses related to the participation and subject to tax). The exemption applies without a minimum holding duration, but there is a minimum holding threshold of at least 10% of the shares in the subsidiary. There are two exceptions under which the participation exemption is disallowed. Under the first exception (“anti-hybrid rule”), the dividend must not have been treated as a deductible expense at the level of the paying entity. Under the second exception (“held for trading rule”),  the exemption is not available to banks, financial institutions, insurance undertakings, pension funds or financial companies (including holding companies with respect to participations held with the intention to realize short-term gains), unless the EU Parent-Subsidiary Directive applies or a tax treaty provides otherwise.

The German Federal Fiscal Court, in a decision issued on 30 January 2019, has ruled that the 5% add-back for the dividend participation exemption regime violates the free movement of capital under EU Law. The case involved the distribution of dividends by an Indian company held for 25.17% by a German company. As per the double taxation relief provision of the tax treaty, the dividends were exempt from taxation in Germany based on meeting a minimum 10% capital ownership condition. However, the German tax authority applied the domestic exemption provision and added back 5% for deemed non-deductible expenses. On appeal, the Federal Fiscal Court found in favor of the German Company. Citing prior EU case law, the Court determined that it was the free movement of capital that is violated. The Court also determined that participations in a third country are also protected by the free movement of capital and that this protection is infringed by the blanket fiction of non-deductible expenses.

The participation exemption for dividends also applies with respect to the trade tax, but the minimum holding threshold is then increased to at least 15% and the subsidiary must meet a substance test (except if the subsidiary is resident in another EU Member State, in which case the substance test need not be met and the minimum holding threshold remains at 10%). On 20 September 2018, the Court of Justice of the European Union (CJEU) issued a decision holding that the participation exemption conditions for trade tax purposes constitute a restriction on the free movement of capital since stricter conditions are applied in relation to dividends paid by subsidiaries established in third countries outside the EU. In this connection, Germany's Ministry of Finance has issued guidance which relaxes the participation exemption conditions for trade tax purposes in relation to third countries, including that the 15% shareholding condition only needs to be met at the beginning of the period concerned and that the substance test need not be met. The guidance applies to all open cases until new statutory provisions are implemented.

Capital gains

Capital gains from the disposal of business assets are treated as ordinary business income. However, gains on the disposal of shares in domestic or foreign subsidiaries are exempt from tax under the participation exemption regime for 95% of their amount. Unlike for dividends, the 95% capital gains exemption is not made conditional on a minimum holding threshold.

Interest

German law provides for limitations on net interest deduction (see Sec. 13.2. for detailed discussion).