Germany: German Tax Package 2004: A Summary

Last Updated: 6 February 2004

By Joachim Borggäfe, Dr. Thomas A. Jesch, Andreas Köster-Böckenförde, Dr. Andreas Striegel, Martin Weger and Dr. Matthias Kestler

Effective January 1, 2004, the German Tax Legislation has been amended. For foreign investors, the tightened thin capitalization rules are certainly the most important changes. First, the debt : equity ratio for qualified holding companies is reduced to a ratio of 1.5 : 1. Also, the "thin cap" rules apply to partnerships held by corporations. In the future, interest will no longer be deductible in full if the interest expense relates to an intercompany loan received in connection with a share purchase from a related party.

Other measures include restrictions on loss utilization, dividend taxation being brought into line with the Bosal decision of the European Court of Justice, and capital gains being taxed the same way as dividends.

For VAT purposes, strict formal rules will apply in respect of the contents of any invoice. If these requirements are not fulfilled, then input VAT will not be deductible. Finally, factoring companies will be affected by a new, secondary liability for VAT.

Issues

After the German Parliament approved a variety of tax amendments on April 16, 2003, the German Government commenced its initiative for more tax reforms as part of the so-called "Agenda 2010."

The tax proposals published in May, June, and August 2003 addressed the following key issues:

  • Reform of the Trade Tax Act,

  • Reduction of income taxes,

  • Tightening of the thin capitalization rules,

  • Harmonization of dividend taxation,

  • Tightening of capital gains taxation,

  • Introduction of limitations on loss carry-forward utilization,

  • Reduction of benefits for private home owners, and

  • Tax amnesty for tax fraud.

After a long and controversial debate and endless negotiations in the Joint Committee of the Bundesrat and the Bundestag, a compromise between the Government and the Opposition was reached on December 14, 2003. On December 18, 2003, the Bundestag, and on December 19, 2003, the Bundesrat, approved the modified tax bills. Most provisions became effective on January 1, 2004.

The following article aims to structure the new legislation and describe the most important issues it presents for taxpayers.

Impact on Businesses and Corporations

Loss Utilization. In the past, losses could be carried forward indefinitely. In April 2003, the proposal of the Government to restrict loss utilization was rejected.

However, at that time, the Government was forced by the Opposition to reconsider the loss utilization rules. In August 2003, the Government published the so-called "Korb II - Gesetz" (Basket II-Act), which included the new loss utilization proposal. The proposal was more or less the same as that which was rejected in April 2003 and was intended to restrict loss carry-backs to one year and for a maximum amount of € 511,500. Excess losses could thus be carried forward indefinitely, but their utilization was limited to the amount of 50 percent of the profits exceeding € 100,000 of any subsequent year.

The impact of such legislation is that it would require many more years to fully utilize any loss carry-forward such that industries with a high degree of economic volatility might never, in practice, fully utilize their historic tax losses.

The compromise accepts this restrictive structure but increases the limits to 60 percent of the profits in periods following the tax loss years and to the minimum amount of € 1,000.000 per year. As a result, most small and mid-sized businesses should no longer be adversely affected.

This new provision is applicable effective for fiscal years ending in 2004.

As an aside, the utilization of specific losses from silent partnerships, sub-participations, or other forms of partnerships is limited to profits resulting from the same silent partnership, sub-participation, or other forms of partnerships if the partner is a corporation. This new wording is intended to close a hypertechnical loophole in the previous wording.

Thin Capitalization Rules. In the past, the thin capitalization rules applied only to corporations and in situations where the shareholder of a German corporation was not subject to German tax. Therefore, only corporations owned by foreign parents or by tax-exempt German shareholders such as churches, workers associations, charities, municipalities, states (Länder), and the Federal Government were affected.

The "thin cap" rules provide for a limitation of interest deductions on loans from related parties. Specifically, the deduction of interest was limited to loans that did not exceed a debt : equity ratio of 1.5 : 1 or, in the case of defined holding companies, 3 : 1.

For these purposes, the equity has been calculated on the basis of the statutory balance sheet and is used for the entire year following the balance sheet date.

In the year 2002, the European Court of Justice held, in the Langhorst/Hohorst case, that these "thin cap" rules were not in accordance with European law, because of their discriminatory impact on non-German EU parent companies. The Government's draft legislation included amendments in the Korb II-Act as a reaction to the Langhorst/Hohorst case.

The final compromise reached is to reduce the debt : equity ratio for defined holding companies to 1.5 : 1, but the inclusion of the leasing of property and other assets as well as the licensing of rights as debt were taken out. Also, a de minimis threshold below which the "thin cap" rules will not be applicable has been fixed to € 250,000 p.a.

The "thin cap" rules are extended to partnerships, as well as the nondeductibility of interest paid to related parties if the interest is incurred in connection with the acquisition of shares in a corporation from related parties.

Since partnerships are not subject to corporation or income tax, the law introduces a fiction by which loans taken up by a partnership are deemed to be granted to the corporate shareholder. At the level of the corporate shareholder, the "thin cap" rules are then applied as normally.

The nondeductibility of interest related to intra-group share acquisitions will affect not only intra-group reorganizations aiming at reducing German taxable income but will also affect international reorganizations in the case of, for example, an acquisition of an international group and its corresponding funding and the subsequent allocation of third party loans to the local operating company. Because no grandfathering provisions are envisioned, all existing corporate structures should be carefully re-examined to determine if they will pass muster under these new rules for fiscal years beginning after December 31, 2003, regardless of when the acquisition took place. Again, if the parent company has given a purchase price guarantee in favor of the acquisition vehicle, as is often standard in M & A transactions, the share purchase will be treated as an intra-group share purchase.

Dividend Taxation. In the past, dividends received by corporations directly (or received by corporations indirectly via a partnership) have been tax-exempt. Expenses (up to the amount of the tax exemption) connected to the dividend income were not deductible. When a foreign subsidiary has paid dividends to a German parent company, the amount of 5 percent of such dividend income is a deemed expense connected to the tax-exempt income and therefore non-deductible. In such cases, all factual expenses are fully deductible.

The draft Korb II-Act extended the 5 percent provision to dividends received from domestic corporations, but also would permit the full deduction of the related expenses. As there was no debate in respect of this draft provision, and after the Bosal decision of the European Court of Justice was published in September 2003, it was clear that the proposal brings German dividend taxation rules in line with European Law.

Consequently, that provision has become effective for fiscal years ending in 2004.

Capital Gains Taxation. In the past, capital gains incurred by a sale of share have been exempt in the hands of a corporation. If a tax-effective write-down on shares has taken place prior to the introduction of the exemption system, a claw-back provision exists, with the result that capital gains up to the amount of any tax-effective write-down are taxable.

The Korb II-Act proposal aimed to reduce the capital gains tax exemption. As with dividend taxation, an amount of 5 percent of the capital gain will be deemed to be a nondeductible expense and, consequently, result in taxable income. The proposal was agreed in the joint committee and is therefore effective for fiscal years ending in 2004.

During the parliamentary process, special rules were introduced for life and health insurance companies. These rules allow life and health insurance companies to deduct capital losses from the sale of shares, and are aimed to support the insurance industry in the current, poor economic environment. On the other hand, life and health insurance companies do not benefit from the exemption system on capital gains. Life and health insurance companies are only entitled to elect such status, retroactive as of the year 2001, under specified conditions.

Trade Tax. In the past, all businesses (including but not limited to corporations) are subject to trade tax, which is levied by the local municipalities. The taxable income for trade tax purposes is based on the income for corporate or income tax purposes adjusted by some add-backs of expenses and certain extra deductions.

The Government's proposal of the Trade Tax Reform Act was aimed at excluding the non-profit-related elements from the trade tax basis. This was in line with the Eurowings decision, which held that the add-back of lease payments to the tax base was not in accordance with European law. Many elements of the Trade Tax Reform Act were thought to be controversial and were debated, and the Opposition insisted on the abolition of the trade tax and proposed to introduce a local surcharge on income and corporation tax to replace the trade tax.

The compromise more or less keeps the trade tax as it was before, but limits loss utilization for trade tax purposes in the same way as for corporate tax purposes. Losses incurred prior to the formation of an Organschaft are frozen for the term of the Organschaft and the "thin cap" rules are also applicable for trade tax purposes.

Essentially, the Trade Tax Reform Act ended in anything but a reform.

Reduction of Depreciation. The current depreciation rules permit a 12-month depreciation deduction if a movable asset is purchased in the first six months of a fiscal year; in all other cases, a six-month depreciation deduction applies.

The 2004 Federal Budget Securing Act proposed to abolish these rules. Consequently, depreciation would have been deductible only on a ratable monthly basis for movable assets.

The final compromise also reduced depreciation for buildings constructed or purchased after December 31, 2003, in the first seven years by 1 percent p.a.

The new provision became effective on January 1, 2004.

VAT. The second Tax Amendment Act of 2003 was approved by the Bundesrat on November 28, 2003, without public debate.

It contains measures to reduce VAT fraud and many technical amendments as to the content of invoices and other administrative issues. The most important new provisions relate to the introduction of a secondary VAT liability in specific cases. One is the assignment and transfer of accounts receivable. In particular, forfeiting and factoring transactions are affected. Specifically in the future, a factoring company purchasing a receivable will be liable for VAT if the assignor does not pay to the tax authority the VAT reported on an invoice to its customer.

A similar provision applies for leasing transactions.

Thus, all factoring and leasing transactions must be carefully structured to reduce the potential for unintended VAT liability. According to a letter ruling, this new provision does not apply to ABS structures.

These changes became effective on January 1, 2004, and also apply to existing factoring and leasing agreements.

The 2004 Budget Securing Act introduces the "reverse charge" method for real estate transactions if the seller has opted for VAT. In such case, the notarized agreement must set out such an election.

The "reverse charge" method for cleaning companies was rejected, but agreed upon for construction supplies if the recipient is a construction company. This provision will become effective after the EU has approved the new provision.

Other. The tax package also included provisions to close loopholes in respect of the beneficial tax regime of international shipping as well as certain loopholes in the German CFC legislation.

Impact on Individuals

Reduction of Tax Rates. In the past, German residents have been faced with an income tax rate of 19.9 percent that applies to a taxable income of € 7,236 per annum. All income below that threshold was not taxable. The tax rates then increased corresponding to the increasing income, with the highest marginal rate being 48.5 percent and applying to all income above € 55,007. For married couples, the flat tax-free amount and the income amounts related to a particular tax rate doubled.

The Income Tax Act already provided for reduced tax rates (17 percent in 2004) and increased flat tax-free amounts (€ 7,426 in 2004 and to € 7,664 in 2005) for the years 2004 and 2005 (15 percent). The highest tax rates were already to be reduced to 47 percent in 2004 and 42 percent in 2005.

As part of the 2004 Federal Budget Securing Act, the Government proposed to reduce the tax rates and the flat tax-free amount immediately to the rates and amount fixed for the year 2005. Because of the immense budget deficit, however, the Opposition did not agree with this proposal.

The final compromise is for the lowest tax rate to be reduced to 16 percent, a flat tax-free amount of € 7,664 and a highest tax rate of 45 percent applicable on income exceeding € 52,151, all for the year 2004. There are more tax reductions available in 2005 because the Income Tax Act has not been amended to eliminate these already foreseen.

Reduction of Home Owners Benefits. In the past, owners of private homes or apartments that were used as their habitation could apply for an annual state grant. These benefits were granted for one piece of property per person for a period of eight years, and amounts to € 2,556 for new private property per annum and to € 1,278 for old/used private property, again per annum. It is increased for each child living in the household in the amount of € 767 annually.

As part of the 2004 Federal Budget Securing Act, it was the intention of the Government to abolish this state benefit.

Instead, the amended legislation now makes no distinction between new and old private property and reduces the annual state benefit to € 1,250. The special benefits for children are increased to € 800, however.

The new legislation applies for all property for which contracts are signed after December 31, 2003.

Reduction of Travel Deductions. In the past, every employee and self-employed individual was permitted to deduct expenses incurred for travelling between one's home and place of work.

The amounts were limited to € 0.36 per kilometer up to a distance of 10 kilometers and € 0.40 per kilometer for all additional distances. For these purposes, only the shortest distance between the home and place of work counts. If public transportation was used and the cost exceeded the above-mentioned flat rates, the actual expenses were deductible.

The compromise now reduces the amount per kilometer to € 0.30, irrespective of the actual distance covered. Also, any excess public transportation expenses will not be deductible. Therefore, the maximum amount of deduction is limited to the distance in kilometers multiplied by € 0.30 per day travelled.

Tax Amnesty. Many German residents have deposited funds in jurisdictions such as Luxembourg, Austria, or Switzerland because no information exchange takes place between the German tax authorities and banks located in these countries. Those individuals who do not declare their interest or dividend income in Germany are obviously committing tax fraud.

The German Government would like to repatriate such funds so it has sought to incentivize taxpayers to disclose the tax fraud in exchange for amnesty. Because all tax fraud prior 1993 is already barred, only the period from 1993 to 2001 is covered by the new legislation.

German residents who would like to benefit from the new legislation must disclose completely all relevant information relating to the 10-year period in order to obtain the benefits of the amnesty. If they have to amend or correct their initial disclosure, they will then be outside of the scope of the amnesty.

The incentive to disclose all income-generating assets is increased by favorable tax rates that will apply until December 31, 2004, as follows:

Income and Corporation Tax

25% tax on 60% of undeclared revenues

25% tax on wrongly declared expenses

Trade Tax

25% tax on 10% of undeclared expense

25% tax on wrongly declared expenses

VAT

25% tax on 30% of undeclared turnove

25% tax on wrongly deducted input tax

During the period January 1, 2005 to March 31, 2005, all these tax rates will be increased to 35 percent. Thereafter, no amnesty and favorable tax will be available.

Other. The loss utilization limitation (see above) also applies for individuals. For married couples, the amount is doubled. However, the loss limitation provision avoiding a netting of losses from one type of income with profits from other sources of income has been abolished because it was not practical to implement.

There are obviously many other small amendments, such as those on tax-free severance payments, tax-free amounts for capital gains in partnership, etc., of which the tax-free amounts have been reduced to increase the tax income of the state and federal budgets.

Further Information

This article is a publication of Jones Day and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship.

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