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Sec. 8b KStG was added to the corporation tax act in 1994 in an effort to make Germany a more attractive location for holding companies. This article summarises the benefits conferred by the statute and points out certain difficulties taxpayers can get themselves into.

1. Sec. 8b (1) KStG: Dividends received exemption

Subject to certain limitations, subsection 1 of the statute permits a German corporation to receive tax free dividends from another German corporation provided these dividends are deemed to be funded out of the distributing corporation's tax free foreign-source retained earnings (dividends, branch business profits, income from rental of foreign real property).


X-GmbH is the 100 % subsidiary of Y-GmbH. X-GmbH earns income from its U.S. branch (operating income) and receives dividends from a U.S. corporation in which it holds a 10 % stake. Under Germany's tax treaty with the United States, X-GmbH's U.S. branch profits are tax exempt in Germany. The same is true of its dividends received from the U.S. corporation.

Dividends and branch business profits are placed in a special retained earning account for tax-free earnings (EK 01). X-GmbH may redistribute these earnings to Y-GmbH without tax cost to itself or to Y-GmbH. The distribution does trigger withholding tax (sec. 43 (1) no. 1 EStG), but this is creditable or refundable to Y-GmbH. A dividend is only deemed paid out of EK 01 if there are no positive amounts in the equity accounts for taxed earnings (see article no. 39 for more details).

The exemption for dividends received by a German corporation out of tax-free retained earnings in effect means that German taxation of such earnings is deferred unless and until they are distributed to a German individual. Distribution to a German corporation triggers no net tax. Distribution to a foreign person, legal or natural, triggers only withholding tax. The withholding tax rate of 25 % is reduced under tax treaties. Distributions to qualifying 25 % EU parent companies are free of withholding tax if a withholding exemption request is filed (sec. 44d EStG).

2. Sec. 8b (2) KStG: Capital gain exemption

This provision exempts from taxation the gain realised by a German corporation on sale of shares in a foreign corporation if dividends received by the German corporation from the foreign corporation would have been exempt from German tax under a tax treaty or if the dividends would have qualified for the indirect tax credits of sec. 26 (2) or (3) KStG. The same exemption applies to gain on the liquidation or reduction in capital of a foreign corporation. Again, certain limitations apply. However, the stake required to qualify for the tax treaty participation exemption on foreign dividends received is reduced to 10 % by sec. 8b (5) KStG with respect to those treaties which require a higher shareholding.

3. Sec.8b (4) KStG: Domestic permanent establishments

Subsection 4 of the statute extends certain benefits to a domestic commercial permanent establishment of a foreign corporation with respect to shares in a second foreign corporation held in the German permanent establishment. Firstly, dividends distributed by the second foreign corporation are exempted from German tax in the hands of the domestic permanent establishment if the dividend would have been received tax free by a German corporation under a tax treaty (taking account of sec. 8b (5) KStG). Secondly, the exemption of sec. 8b (2) on sale of shares in a foreign corporation held by a German corporation is extended to shares held in a foreign corporation's German permanent establishment if dividend distributions on these shares would have been exempt.

The benefits of sec. 8b (1) KStG are not extended to a domestic permanent establishment of a foreign corporation (see, however, article no. 101).

4. Pitfalls of sec. 8b KStG

If the requirements for tax free sale of shares in a foreign corporation are met (see section 2 above), a German holding company can reorganise its holding structure at no tax cost by simply selling participations to group companies. For instance, it can sell its shares in Foreign Sub A to Domestic Sub B if this is desirable. However, sales to related parties present certain pitfalls which taxpayers should be aware of.

These are conveniently summarised by Starke/Zurmuehlen in their recent short article entitled "The Sec. 8b Trap" (Die Par. 8b-Falle - DB 1998, 103).

The source of the problem is the tax authorities' refusal to apply the tax exemption of sec. 8b (2) EStG to constructive dividends or constructive contributions (sec. 41 (5) KStR). Whether this position is legally correct is currently the subject of dispute in the German tax literature. Assuming the courts uphold the tax authorities, the following examples illustrate the risks posed:

Example 1

X-GmbH is the German parent of U.S. Corp. and UK Ltd., both wholly owned subsidiaries As part of a worldwide reorganisation of business operations, UK Ltd. is to become the parent of U.S. Corp. X-GmbH therefore sells its shares in U.S. Corp. to UK Ltd. at book value, DM 1 million. However, the shares are actually worth DM 1.5 million. On audit, the tax authorities therefore revalue the shares and assess tax on the resulting gain to X-GmbH of DM 500,000. They claim that this gain is not tax exempt under sec. 8b KStG, even though they admit it would have been exempt had the sales price been fixed at fair market value. The sale at under fair market value constitutes a constructive contribution by X-GmbH to its subsidiary in the amount of DM 500,000, and the basis of X-GmbH in the shares of UK Ltd. is increased accordingly.

Example 2

Same as Example 1, except the sales price is DM 2 million. The price paid by UK Ltd. for the shares of U.S. Corp. is excessive. The gain on sale of DM 1 million reported by X-GmbH is tax free under sec. 8b (2) KStG only in the amount of DM 500,000, according to the tax authorities. The amount of the excess constitutes in their view a constructive dividend paid by UK Ltd. to its parent, X-GmbH. However, this dividend may be tax exempt under the tax treaty with Great Britain.

Example 3

Same as Example 2, except UK Ltd. is replaced by Y-GmbH, a wholly owned domestic subsidiary of X-GmbH, as the purchaser of the shares in U.S. Corp. The tax treaty participation exemption is no longer available. In the opinion of the tax authorities, the constructive dividend cannot be treated as tax exempt under sec. 8b (2) KStG. X-GmbH therefore derives taxable income in this amount. Y-GmbH is also treated as having paid a constructive dividend. This means that its corporation tax is adjusted to reflect the distribution tax rate. X-GmbH is entitled to the corporation tax credit on the constructive dividend.

The above examples can easily be multiplied. The bottom line is that sales of shares in foreign corporations otherwise exempt under sec. 8b KStG may nevertheless trigger tax if made to related parties at prices above or below the fair market value. While the basic position of the tax authorities may ultimately turn out to be invalid, taxpayers who wish to be on the safe side should follow the recommendation of Starke/Zurmuehlen (see above) and have the shares they wish to sell appraised before the sale to make sure the sale price matches fair market value.

Disclaimer and Copyright

This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.