Transactions between corporations and their shareholders under German tax law

German tax law is a labyrinth of regulations and statutes that have significant implications for corporations and their shareholders. Among the key aspects of German tax law is the treatment of transactions between corporations (Körperschaften) and their shareholders (Anteilseignern or Gesellschaftern). This complex relationship warrants an in-depth analysis, as it plays a pivotal role in the operational and financial strategies of corporations. This article delves into the intricacies of such transactions, the principle of arm’s length transactions, implications of corrections, and more.

Example of transactions between corporations and their shareholders

Consider a German GmbH, or limited liability company. The GmbH engages in a transaction with one of its shareholders, an individual or an entity. The transaction could be in the form of a loan from the shareholder to the company or the purchase of goods and services. The terms of these transactions, especially the prices, interest rates, or other financial conditions, are subject to scrutiny under German tax law.

Other relevant transactions could be for example salaries, leasing agreements or license contracts. Also a sale of assets is relevant.

Arm’s Length Principle

The „Arm’s Length Principle“ (Fremdvergleichsgrundsatz) is a fundamental concept in German tax law. It stipulates that transactions between related parties, such as a company and its shareholder, should be conducted at market terms – as if the parties were unrelated and acting solely in their own economic interest. This means that the conditions of the transaction should be comparable to those of a transaction between independent third parties.

The arm’s lengt principle is a key principle in international tax law. It is also applied for German domestic tax law purposes.

Adjustemts through hidden distribution and hidden contribution

If transactions don’t comply with the arm’s length principle, they may lead to tax adjustments. Two such adjustments are verdeckte Einlage (hidden contribution) and verdeckte Gewinnausschüttung (hidden distribution of profits).

A „verdeckte Einlage“ happens simpliefied when a shareholder provides economic benefits to the corporation without receiving adequate compensation. Conversely, „verdeckte Gewinnausschüttung“ arises simpliefied when a company transfers economic benefits to a shareholder without receiving an appropriate compensation.

These hidden contributions and distributions can result in significant tax implications for both the company and the shareholder, affecting corporate income tax, trade tax, and potentially leading to penal consequences.

Differences between controlling shareholders and non-controlling shareholders:

There’s a noteworthy differentiation in German tax law between controlling shareholders (beherrschende Anteilseigner) and non-controlling shareholders (nicht beherrschende Anteilseigner). Controlling shareholders, given their substantial influence on the company, are often more rigorously scrutinized for arm’s length compliance, as the potential for non-market conforming transactions is perceived to be higher.

However, this doesn’t mean non-controlling shareholders are exempt from scrutiny. Both groups are subject to the arm’s length principle, but the intensity and the outcomes of examinations may differ.

Application also on cross-border transactions

Hidden distributions and hidden contributions does not only apply to domestic transactions. When it comes to cross-border transactions between a German corporation and its foreign shareholder, § 1 of the Foreign Tax Act (AStG) comes into play besides those two adjustment instruments.

This section covers also the arm’s length principle and concretize conditions in case of international transactions, ensuring that Germany doesn’t lose tax revenue through non-arm’s length transactions that shift profits out of the country. German transfer pricing rules follow the OECD transfer pricing guidelines.

Arms’s length principle is a big risk in tax audits

One of the primary mechanisms for ensuring compliance with these regulations is through operational audits (Betriebsprüfungen). During these audits, tax authorities scrutinize the transactions between corporations and their shareholders for compliance with the arm’s length principle, among other things.

Non-compliance can lead to back-taxes, interest, and penalties. Therefore, corporations should meticulously document their transactions, ensuring they can provide a strong defense during these audits.

Review of your transactions necessary?

Transactions between corporations and their shareholders under German tax law are complex, governed by various statutes and principles. Adhering to the arm’s length principle is paramount, both for domestic and international transactions.

With hefty consequences awaiting those who don’t comply, it’s essential for corporations to remain diligent, documenting every transaction and ensuring they stand up to scrutiny. As the global business landscape becomes more intertwined, understanding and abiding by these laws isn’t just a legal necessity but a strategic imperative.