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After a stormy passage through parliamentary channels, during which it was forced to both jettison old cargo and take on new, the German 1996 Tax Act received approval on 31 July 1995 from a conference committee of the two houses comprising the German legislature, the Federal Parliament and the Federal Council. This clears the way for enactment of the measure, albeit in a form substantially different from that in which it was originally introduced by the Government in March of this year.
Overall, the Act substantially reduces personal taxes, above all for low-income individuals, and is expected to result in diminished income tax revenue of DM 18.5 billion (reductions net of increases).
The Act is voluminous. The following summary focuses selectively on aspects likely to be of interest. The provisions discussed take effect on 1 January 1996 unless otherwise noted.
1. Content of the bill as originally introduced
As originally introduced, the Act had the following major components:
i. Repeal of the trade tax on capital and reduction of the trade tax on earnings, together with a package of measures increasing taxes to finance these two primary changes.
ii. Reductions in inheritance and gift tax on business property and other tax measures favourable to businesses, including one allowing for retroactive avoidance of constructive dividends.
iii. Constitutionally mandated tax exemption for income needed to support a minimum standard of living.
iv. Tax incentives for investment in the new German States (generally extending existing programs, in some cases with cut-backs).
v. Other measures.
2. Deletion of "third phase" of business tax reforms and outlook for future
The items listed under nos. i and ii above are referred to as the "third phase" of German business tax reforms (the first two phases being the 1990 Tax Reform Act and the 1993 Business Site Protection Act). The "third phase" provisions were excised from the draft legislation at the end of May 1995 when it became evident that the Federal Council would not give its approval. Furthermore, a constitutional amendment was needed in connection with the changes to the trade tax, and this failed to gain the required two thirds majority in a vote in Parliament on 12 May 1995.
The Government, however, remains committed to the "third phase" reforms and there is an understanding with the opposition parties, particularly the Social Democrats, that the reforms will be discussed again this autumn and, depending on the result, reintroduced as a separate piece of legislation taking effect probably not before 1 January 1997. It is in this connection significant that leading Social Democrat politicians made statements in mid-August indicating conditional willingness to accept abolition of the trade tax on capital and reduction of the trade tax on earnings (Handelsblatt 18/19 August 1995, p. 1).
The revenue from the trade tax, both on capital and earnings, is at present remitted primarily to local government (cities and communities). Any changes in the trade tax thus require alternative financing for local government. The Government's proposal was to relinquish some of its current share of the value added tax in favour of local government.
It also appears likely that the Social Democrats will attempt to place the much-discussed "ecological tax reform" on the autumn discussion agenda. The contours of such a reform remain vague, but the basic thrust of the proposal is to restructure the tax system to impose higher tax burdens on ecologically damaging types of behaviour (e.g. possibly carbon monoxide and dioxide emissions or energy consumption) without increasing total taxes overall.
A planned addition to sec. 50c EStG was among the third phase reforms removed from the Act. This would have placed restraints on the depreciation possibilities upon purchase of shares in a German corporation from an individual who, while a German resident, pays no tax on his capital gain on sales outside of the six month holding period because the share held is 25 % or less of the corporation's stock and does not constitute a business asset in the seller's hands. Restrictions already exist for shares purchased from foreign persons, whose gain on sale is generally exempt under a tax treaty. Upon purchase of such shares, no write-down is permitted by reason of distributions made and no step-up in basis is available under the new Tax Reorganisation Act upon conversion to a partnership.
Also removed from the Act was a planned reduction from 30 % to 25 % in the maximum rate of declining balance depreciation for movable property.
For more information, please see our article of April 1995 entitled "German Tax Reform Act of 1996" and our related articles "Retroactive Reversal of Constructive Dividend Distributions under the Draft 1996 Tax Reform Act" and "Share Deal Purchases: Existing and Proposed Anti-Avoidance Legislation".
3. Exemption for minimum personal income
In a decision rendered on 25 September 1992, the German Federal Constitutional Court held the existing taxation of individuals to be unconstitutional in that it subjected to taxation income needed to support a minimum standard of living. Basing its determinations on the value of basic welfare support provided to indigent persons, the Court held that the zero bracket amount should be at least double the amounts then and now allowed (DM 5,616 for single filers and DM 11,232 for joint filers). However, the Court gave the Government until the end of this year to implement its decision.
After heated debate, the solution agreed upon increases the zero bracket amount as follows:
1996: DM 12,095 single / DM 24,190 joint
1997: DM 12,365 single / DM 24,730 joint
1999: DM 13,067 single / DM 26,134 joint
The lowest bracket rate was at the same time raised from 19 % to 25.9 %. However, the tax on higher incomes (above DM 50,000 / DM 100,000) is virtually the same as at present. Tax on amounts between the zero bracket amount and higher income threshold is lower than at present, whereby the tax savings diminish as income rises.
4. Additions to the 1996 Tax Act
The additions to the Act are of two basic sorts:
i. Improvements in the taxation of European Union nationals in Germany
ii. Measures tightening up on certain deductions.
4.1 Improvements for non-resident EU individuals
In its "Schumacker" decision of 14 February 1995, the European Court of Justice held that nationals resident in an EU Member State earning employment income in another EU Member State must be accorded all tax benefits available under the laws of the State of employment if the income there earned constituted all or virtually all of the individual's total income and the income earned in the State of residence was inadequate to permit its taxation to take account of the taxpayer's personal and family circumstances.
This prompted amendment of the draft legislation to include revisions with respect to non-resident EU nationals. Such persons may qualify for all advantages accorded to resident taxpayers including the joint return tax rate (splitting rate) if at least 90 % of their income is subject to German tax, or if the amount not so subject does not exceed DM 12,000 per year (DM 24,000 for joint returns -- new sec.1 par. 3 and sec. 1a EStG). To qualify for the joint return rate, both the non-resident EU taxpayer and his or her spouse must elect to file a joint resident return.
Furthermore, EU nationals not resident in Germany may now elect to file a German tax return with respect to employment income from German sources. Previously, the amounts withheld from their wages were final. The new provision is important in all cases in which tax was overwithheld, e.g. because certain deductions were not taken into account.
The new provisions are electively applicable to years before 1996 as well. They also apply for citizens of Norway, Liechtenstein, and Iceland.
4.2 Restrictive provisions added to the 1996 Tax Act
The principal restrictions added (to reduce the revenue lost through the higher zero bracket amounts) are as follows:
i. Offices in the home
The present generous rules allow both employees and independent professionals to deduct expense related to an office in their home, used e.g. on weekends in addition to another regular place of work. In the future, no deduction is allowed at all unless more than half of the relevant activity is conducted from the home office or if there is no other place of work available. If one of these stiff tests is met, the deduction is still limited to DM 2,400 per year unless the home office is the centre of all independent activities or all dependent employee activities. The wording of the draft statute (new sec. 4 par. 5 no. 6b EStG and revised sec. 9 par. 5 EStG) appears to raise doubt as to how it would apply to someone with dependent and independent activities.
ii. Expense for a second household
Deductions for a second household are limited to a period of two years in all for each location (revised sec. 9 par. 1 sent. 3 no. 5 EStG), instead of the present unlimited duration. Persons who have already claimed expenses for a second household for two complete years prior to 1996 will thus be able to claim none in the future (new sec. 52 par. 11a EStG).
iii. Bribes paid in violation of German law
Such bribes are in the future not deductible as business expenses. No change has been made with respect to bribes violating foreign laws.
iv. Depreciation rates for non-business residential rental property
For building permits applied for from 1996 on, depreciation is over 50 years instead of the present 40. The new rates are 5 % for the first 8 years, 2.5 % for the next 6 years, and 1.25 % in the following 36 years (instead of 7 % for the first 4 years, 5 % for the next 6 years, 2 % for the 6 years to follow, and 1.25 % in the next 24 years).
v. Lump sum taxation of certain benefits
Currently, certain benefits, such as employer contributions to long-term full-life insurance policies, can be taxed at a lump sum rate of 15 % on a benefit amount up to DM 3,000 per year. The tax rate has been raised to 20 % and the benefit limit to DM 3,408.
vi. Other restrictions
The other restrictions added concern reductions in deductions allowed to individuals on sale of a business or shares in a corporation in which they hold more than 25 % of the shares, the elimination of an exemption for sale of less than 1 % of such a 25+ % stake, limitation to DM 300,000 of the special depreciation amount allowed under sec. 7g EStG, and increasing private capital gains within the speculation period by the amount of depreciation taken.
5. Tax incentives in the New German States
The 1996 Tax Act extends a number of programs designed to benefit the five New German States. This includes exemption of property located there from the net worth tax. Furthermore, it now appears likely that a separate measure will be introduced extending the exemption of business property in the New German States from the trade tax on capital.
More detail on the provisions of the Act relating to the New German States is contained in a separate article entitled "1996 Tax Act: Incentives for New German States".
6. Other significant provisions
6.1 Provisions affecting German source income earned by foreigners
i. Taxation of foreign athletes and entertainers
Income earned by athletes and entertainers for performances in Germany is subject to tax under German domestic and tax treaty law. The withholding tax rate under sec. 50a par. 4 EStG has been increased from 15 % to 25 %. A reduction of this rate may be obtained if it can be shown to be too high. If the athlete or entertainer is acting as the dependent employee of a an employer required to remit German wage withholding tax, the earnings of the athlete or entertainer are subject to such withholding in the future, and the flat withholding rate under sec. 50a EStG does not apply.
ii. Withholding tax in special cases
Sec. 50a par. 7 EStG authorises the tax authorities to require withholding by persons making taxable payments to non-residents in situations for which there is no general withholding requirement if this is expedient to ensure compliance with the tax law. This provision has been revised to make the payor liable in case of failure to withhold.
iii. Consideration of tax exempt income for tax rate purposes
Germany's tax treaties generally use the exemption method to avoid double taxation on certain sorts of income and generally reserve the right to take such tax exempt income into account when determining the tax rate of its residents (Progressionsvorbehalt). The mechanism by which this is done has been simplified to the disadvantage above all of taxpayers who have negative tax exempt income.
6.2 VAT changes
The Act contains provisions changing the place of performance of repair work between EU countries from the repairer's location (current rule) to the location of the owner of the repaired goods (new rule), provided the owner uses his VAT ID number when commissioning the repair work in another EU country.
The Act also abolishes an exemption previously existing for certain services performed by the lead member of a bank syndicate in connection with syndicated loans. The input VAT charged to the other banks in the syndicate by the lead member is often not recoverable by them because the related output service is VAT exempt. Direct invoicing to the borrower may avoid the problem, as the borrower will generally be entitled to a full input tax credit.
6.3 Government child support contributions
The amounts paid by the Government to parents with children have been increased to DM 200 per child per month for the first two children, DM 300 per month for the third child and DM 350 per month for each additional child. These amounts are, as before, tax free. Unlike the previous system, however, child support contributions are now alternative to the standard deduction for dependent children which has long been part of the German tax system. Parents thus now must choose between the support contributions and the standard deduction, depending on which provides the greatest net benefit. The standard deduction amount for 1996 for joint filers will be DM 6,264 (in 1997, DM 6,912), as compared with the 1995 standard deduction of DM 4,104. The current child support contributions start at DM 70 per month for the first child and rise depending on income to as much as DM 240 per month for the fourth child and each additional child.
Furthermore, employers will in the future have to pay out the child support contributions to their employees on behalf of the Government. The employer is permitted to deduct the amount from wage tax remitted each month to the tax authorities. Firms with not more than 50 employees can opt out of the system.
The provisions relating to child support contributions have been added to the income tax law as new sec. 62 ff. EStG.
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. 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.