Corona pandemic: tax pitfalls for corporations

Mobile working in a home office is playing an increasingly important role in the modern working world and has been further intensified by the COVID 19 pandemic. In particular, the relocation of activities of managing directors to the home office leads to complex tax issues, e.g. whether the place of management of a corporation also shifts as a result or whether a permanent establishment is established in a state other than the state of residence. This can lead to an additional tax burden at the company level, to the fiscal entanglement of assets in Germany and possibly to a withholding tax liability on profit distributions.

Decisive: the place of management

In national as well as international tax law, the term “place of management” is used for the determination of the residence of a corporation. The place of management determines whether a company is subject to limited or unlimited tax liability.

According to German law (§ 10 of the Fiscal Code), the place of management is regularly where the management makes the essential, ongoing operational decisions. This can be any institution, i.e. also the domicile of the management. It is not decisive where the decisions of the management take effect or where they are executed.

The place of management is not the place where the company’s registered office is to be located, but rather where the decisive will is formed with regard to the day-to-day business – in Corona times, therefore, possibly the private residence of the management. The registered office (§ 11 AO) of the company as stated in the articles of association or partnership agreement is only an indication in determining the place of management.

If a company meets the requirements for residence under the tax laws of two countries (double residence), the place of residence must be determined in accordance with the substantive law of the agreement. In this case, it depends on which double taxation agreement within the meaning of the Organisation for Economic Cooperation and Development (OECD) the bilateral agreement is based.

If the applicable double taxation treaty was concluded between the contracting states based on the OECD-MA 2014, the so-called “tie-breaker rule” prevents double residency by focusing on the “actual place of management”, which can only be in one of the contracting states. Double taxation treaties based on the OECD-MA 2017 optionally also take into account the place of incorporation in the case of dual residence. Thus, if a managing director of a foreign corporation carries out his or her activities at his or her domestic residence in the home office due to the pandemic, the place of management may shift to the home office.

In order to prevent this risk and the associated consequences under tax law,

the OECD published a guideline according to which the place of residence is to be equated with the place where the relevant strategic decisions are normally made. Accordingly, temporary deviations due to location would have no effect. However, due to the entry restrictions during the pandemic, there can hardly be any question of a “temporary deviation” from normality. Rather, the managing directors were homeworking for weeks and months at a time, so that relevant strategic decisions were also made in the home office. This could therefore speak for a shift of the location of the management to the home country.

Risk of establishing a permanent establishment during the pandemic

The pandemic-related entry restrictions and protective measures entail the risk that the home office activities of the managing directors could establish a permanent establishment with an accompanying limited tax liability (§ 49 para. 1 no. 2 letter a EstG). According to German law, a permanent establishment is “any fixed place of business or plant serving the activities of an enterprise. “There must be a fixed relationship to the earth’s surface that is of a certain duration.

The definition of a permanent establishment under tax treaty law differs from the national definition primarily in the use of the facility (in this case, the private rooms of the shareholder-director) and the fact of the power of disposal. Whereas under national law the facility must merely serve the purpose of carrying out the business activity, according to the OECD-MA the business activity must be carried out in whole or in part in the business facility.

With regard to the “power of disposal” over the facility, national case law refers to the actual power of disposal: i.e. if access to the facility is permanent or for a certain period of time and can be denied to third parties. A shareholder-director of a foreign corporation resident in Germany can grant the company unrestricted access to his private premises and exclude third parties from using them, which would constitute a power of disposal. If the corporation has several shareholders who hold a management position, the decisive factor is where the current operational decisions are made. However, if a managing director is not a shareholder, it can hardly be assumed that he grants others access to his private premises. Thus, there would be no actual right of use on the part of the company.

At the level of treaty law, the requirements regarding the power of disposition with comparable to those of national law. However, the OECD is increasingly distancing itself from the actual power of disposal, which is an essential element of national jurisdiction for is the definition of permanent establishments. Thus, according to the OECD (Art. 5 para. 18 OECD-MK 2017), the home office is to be considered a permanent establishment if the company instructs the managing director, who is bound by instructions, to use the home office on a regular or continuous basis or if no office is available to him. However, the OECD admits that the decision to carry out the activity from the home office in the course of the Corona pandemic did not arise intrinsically from the company. Rather, the Corona pandemic represented a higher force acting from outside. However, the OECD guidelines are not applicable law, but merely an interpretative aid. It is therefore necessary to examine each individual case.

In order to establish a permanent establishment, it is also necessary to have a fixed place of business of not only of temporary duration. According to the OECD, the relevant period is at least six months. The nationally applicable BFH case law also follows this. However, there is no specific legal regulation for the facts of a “certain duration”. Moreover, not only the actual duration is relevant, but also the original plans or intentions of the company (before the pandemic). In most cases, the companies did not plan to relocate the activities of the managing director to Germany. However, it remains to be seen whether the tax authorities will follow this interpretation.

Risk of establishing a management permanent establishment during the pandemic

The risk of establishing a management permanent establishment in the home country through homeworking is significantly higher than the establishment of a permanent establishment, because the management permanent establishment is much lower requirements are made with regard to the premises. Thus it requires

According to the established case law of the Federal Fiscal Court (Bundesfinanzhof, BFH), a business facility does not have to be a “fixed place of business” that serves to carry out the business activity of the enterprise. The business premises also do not have to constitute business assets of the enterprise. However, a location is required from which the management directs the enterprise and at which it is present with a certain regularity. For example, a management permanent establishment can be established in the private residence of the management.

The establishment of a management permanent establishment under national law is conceivable due to the state-induced home office obligation, provided that the domestic management of a foreign corporation followed the state-induced protective measures. If there is a domestic management permanent establishment under national law, there must also be a management permanent establishment under treaty law. This is determined by the place of management, which regularly also constitutes the place of management (Art. 5 para. 2 letter a OECD-MA) – i.e. where the decisive management will is formed. Here, too, there is no need for a fixed place of business, so that the private residence of the management can come into question. A “certain duration” and “power of disposal” are again relevant for the existence of a management permanent establishment under agreement law.

Due to the pandemic situation, the establishment of management permanent establishments is therefore quite conceivable. If the Federal Republic of Germany has the right of taxation (according to the applicable DTA), the company would consequently have to comply with the domestic registration and declaration obligations. Likewise, the potential consequences of German entanglement taxation would have to be taken into account.

How can such relocations be avoided?

The relocation of the place of management to the home country as well as the establishment of a domestic (business management) permanent establishment in times of pandemic entail considerable tax risks for a foreign corporation. In order to avoid this, it is advisable to have a complete and comprehensible documentation of the meetings of the managing directors or the board of directors – especially the meetings in which the current, relevant decisions are made in the state of residence of the corporation.

It must be documented on which days the current, relevant decisions were made in the state of residence of the corporation and on which days these were made in the state of residence of the (shareholder) managing director or the executive board. The periods of validity of entry restrictions that made it impossible for the management to carry out activities in the country of residence of the corporation must also be recorded. This documentation serves as evidence for tax audits and assessments in the 2020 and 2021 financial years.

In principle, it remains to be seen how domestic case law will develop and how the tax authorities will assess the risks described in the long term. However, if there are concrete indications of a shift of the place of management to Germany or the establishment of a (management) permanent establishment, it may be appropriate to register for tax purposes in Germany and to comply with the corresponding tax declaration obligations. Upon receipt of the tax assessment notices, there is the possibility of proceeding with appropriate arguments within the framework of the appeal procedure. At our law firm, we are very familiar with the relevant framework conditions and will be happy to advise you on your personal case.