Germany: German Dividend Planning Under Tax Reform

Last Updated: 28 January 2003
Article by Hans-Jürgen Hennig

Originally published in March 2001

Germany's tax reform programme requires a fundamental change of the distribution policy of German subsidiaries of foreign corporate shareholders. Due to complex transition rules, there are pitfalls but also opportunities to benefit most from the changes of dividend taxation.

Germany's new tax rules generally enter into force on January 1, 2001. For German companies with a business year other than the calendar year, the provisions first apply for their business year ending in 2002. For the distributing German subsidiary, the old German distribution rate system applies with certain modifications for a transition period of 16 years. Further, the tax retained earnings basket system (vEK) will be continued in a modified form over the transition period.

For maximising the German tax benefits of distributions, it is important to differ between:

  • old system dividends, where the rules of the old German imputation system still apply with certain modifications;
  • transition period dividends; and
  • new system dividends.

This differentiation is important to make maximum use of the opportunities offered by German tax reform and to avoid potential pitfalls. The comments below focus on the German tax planning for a cross-border dividend flow from a German subsidiary to a foreign corporate shareholder. The tax impact of German dividends in the jurisdiction of the foreign shareholder needs specific consideration. Due to the complexities of the German tax reform provisions, the German and foreign tax impact of any major dividend distribution by a German subsidiary needs detailed consideration and calculation of the related tax impact in each case.

Under the German tax system change, already a distribution from a direct German subsidiary to a foreign corporate shareholder gives rise to complex German tax issues. These considerations become even more complex, if there are dividends within a German group of companies. The comments below focus on a direct shareholding in a German subsidiary and do not discuss further tax aspects to be considered in the case of a German group of companies. For simplification withholding tax aspects, non-deductible solidarity surcharge and trade income tax are ignored below.

Old System Dividends

The German imputation system (whereby dividends carry a refundable tax credit for underlying German corporation profits tax) is abolished. Its final application will be to dividends for 2000 distributed in 2001. Therefore tax planning considerations for dividend distributions by German subsidiaries for 2000 in 2001 will focus on the following:

  • maximising the distribution tax rebate;
  • increasing the amount of distributable earnings in the 2000 commercial balance sheet;
  • securing liquidity of the distributing German company by appropriate strategies;
  • circumventing the reclassification trap of EK 45 tax retained earnings.

Maximising The Distribution Tax Rebate By Superdividends

A loss of a potential distribution tax rebate could arise, where the German subsidiary has retained earnings taxed at the 45% corporation profits tax rate that applied before 1999 (EK 45). If not distributed in 2001 as a dividend for 2000, this EK 45 needs to be reclassified into positive EK 40 and negative EK 02. Such a reclassification of say 55 units of EK 45 (pre-tax 100 units less previous 45 corporation profits tax) could result in a significant tax disadvantage in specific tax equity situations, raising the effective distribution tax rate to 36% (instead of 30% standard rate). The following simplified chart illustrates the disadvantage (assuming existence of only EK 45).

 

EK 45

EK 40

EK 02

Distribution tax rebate

Distribution

possible

Taxed earnings

55.0

 

___

15.0

70.0

Reclassification - interim

 

67.5

(12.5)

 

 

Reclassification - final

 

55.0

___

9.1

64.1

Loss of rebate

 

 

 

5.9

5.9

Normal distribution rate

 

 

 

 

30.0

Effective distribution rate

 

 

 

 

35.9

The mandatory reclassification of previous EK 45 into EK 40 results in an effective distribution rate of (rounded) 36%. This disadvantage could be avoided by an EK 45 superdividend for 2000 distributed in 2001.

The tax rebate potential connected with a distribution of EK 40 earnings accumulated in 1999 and 2000 would generally be preserved under the transitional rules. However, there could be a significant disadvantage if the only other earnings basket is a basket of negative EK 02 (generally due to losses in previous years). The negative EK 02 amount will have to be offset against the positive EK 40 amount. This reduces the tax rebate on distribution on only the balance of EK 40 left after such offset. This pitfall could be avoided by an EK 40 superdividend for 2000 in 2001. This requires that the commercial balance sheet is financially restored and allows such dividend.

Maximising Distributable Earnings In The Commercial Balance Sheet

It is possible to avoid the above outlined reclassification traps by an EK 45 or EK 40 superdividend in 2001. However, such superdividend requires an adequate amount of distributable earnings shown in the commercial balance sheet as at December 31, 2000. There are various possibilities to establish such distributable earnings.

Such distributable earnings require, that the necessary amount is shown in the balance sheet as balance sheet profit. If the German subsidiary has the legal form of a GmbH, capital reserves or profit reserves built up in prior years could in principle be easily converted into distributable earnings. However, potential restrictions under German company law or requirements of the German subsidiary's statutes need to be reviewed prior to such dissolution of reserves for the benefit of increasing distributable earnings.

In the absence of such capital or profit reserves to be converted into distributable profits, other possibilities need to be looked into in the course of setting up the balance sheet. However, timing requirements may need to be observed for the respective appropriate transaction. Assuming, the German subsidiary had insufficient distributable earnings (e.g. due to losses incurred in 1999 or 2000), a cash contribution made prior to December 31, 2000 by a foreign corporate shareholder resulted in a non-taxable increase of the German subsidiary's distributable profit (so-called contribute/cash-out strategy).

Another possibility to increase distributable profits is a waiver of intercompany payables. Under certain circumstances, such waiver can be viewed as a non-taxable shareholder's contribution increasing the distributable profits. This requires, that such waiver is declared at latest as at December 31, 2000. In such case, the distributable earnings in the balance sheet as at December 31, 2000 would be increased accordingly (so-called waiver/cash-out strategy).

A further possibility exists, if the German subsidiary in turn owns majority shareholdings in other German companies which distribute their earnings by way of dividends. By accelerated recognition of such intergroup dividends as at December 31, 2000 the distributable profits at German parent company level would increase. The accelerated recognition of intergroup dividends already prior to actual distribution is bound to certain requirements (majority shareholding, distribution proposal, financial statements audited prior to the financial statements of German parent company etc.).

By appropriate transactions it is therefore possible to increase the distributable earnings per commercial balance sheet to secure a superdividend out of EK 45 or EK 40 earnings for 2000 in 2001.

Securing Liquidity Of The Distributing German Subsidiary

A cash distribution of the above superdividend may be unwanted under cash-flow reasons. A further reason may be statutory equity requirements existing e.g. in the case of German subsidiary banking operations. In such a case, the superdividend will be resolved but not distributed in cash. Instead, it will be retained by the German subsidiary (so-called distribute/retain strategy). In order to benefit from the distribution tax rebate, however, additional criteria have to be met.

The above dividend distribution/retention strategy is not per se considered by the German Fiscal Authorities as an abuse. The distribution tax rebate will be granted, provided certain equity quality criteria are met. In essence, this requires, that the dividend amount based on proper dividend resolution is retained in the form of preferably capital reserves. The German fiscal courts have acknowledged, that profits distributed but not cashed out and retained as capital reserves qualify for the distribution tax rebate. This strategy requires an appropriate wording of the respective dividend resolution.

Strategies

The complex mechanics of the change over provisions for dividends require detailed calculations in each case. Dividend policy considerations for the distributing German subsidiary will generally focus on the following:

  • full distribution of EK 45 by way of a superdividend in 2001 for 2000. This avoids a disadvantageous reclassification of EK 45, which otherwise results in an effective distribution rate of 36% instead of only 30%;
  • maximum distribution of EK 40 in 2001 for 2000 if there is a major negative EK basket to avoid the reduction of the underlying distribution tax rebate through the offset of EK 40 with the negative EK baskets;
  • increasing distributable earnings by appropriate transactions (i.e. shareholder's contributions, waiver of intercompany payables etc.);
  • securing liquidity or retention of statutory equity as applicable by resolving a dividend distribution but retaining the otherwise distributable amounts by addition to e.g. the capital reserves of the German subsidiary.

Transition Period Dividends

The changeover to the new tax system requires a mandatory reclassification of EK 45 earnings as above. After system change, any tax retained earnings prior to 2001 will be only composed of EK 40. The tax rebate potential connected with the distribution of EK 40 earnings will be preserved under the transitional rules. A memorandum account will be set-up notifying a latent distribution tax rebate equal to 1/6 of the balance of EK 40. This is the factor which reduces the corporation profits tax on distributed EK 40 from 40% down to 30% (i.e. the present distribution tax rate). The distributing German subsidiary cannot apply the new 25% corporation profits tax rate to distributions from retained earnings accumulated prior to 2001.

In addition to the EK 40 basket, there could be a positive EK 02 basket (i.e. untaxed income from domestic sources - usually from investment grants) and a positive contribution account (i.e. previous tax - free shareholder's contributions).

In the case of distributions during the transitional period of 15 years, retained earnings with the highest tax burden (i.e. EK 40) are considered to be distributed first and qualify for the above distribution tax rebate of 1/6. The distribution of EK 02 will produce an additional distribution tax charge of 30%. A distribution out of the contribution account will be treated as a non-taxable repatriation of shareholder's capital and will be deemed to be used last for future dividends.

The German subsidiary resolving a dividend in 2001 or later over a 15 year period will receive in the year of distribution a corporation profits tax rebate of one/sixth of the EK 40 dividend, until the EK 40 amount is exhausted. Any unused distribution tax rebate will expire at the end of 2016. Hidden distributions do not qualify for the tax rebate. The German subsidiary will be able to set-off such rebate against its corporation profits tax liability for the year in which the distribution is made.

Tax planning for the transition period will generally focus on:

  • maximising the distribution tax rebate of EK 40;
  • avoid the additional distribution tax charge by retention of previous EK 02.

Maximising The Distribution Tax Rebate Of EK 40

EK 40 dividends distributed by the German subsidiary during the transition period qualify for a distribution tax rebate of one/sixth. Assuming that not all EK 40 earnings have been distributed until December 31, 2001, there will still be a residual amount of EK 40 earnings. At the same time, under the new German corporation profits tax provisions, earnings will arise which are taxed under the new system at 25% corporation profits tax. Any distributions made for 2001 in 2002 and thereafter will therefore comprise EK 40 components as well as profits accumulated under the new German tax system.

Under the tax equity sourcing rules, dividends will be deemed to be first made out of the EK 40 basket until the EK 40 amount is exhausted. Any distribution deemed to be made out of the EK 40 basket qualifies the German subsidiary for a distribution tax rebate of one/sixth. The following simplified chart illustrates the impact.

 

Tax rebate

account

Profits taxed at 25%

Tax payable

EK 40 of 600 - (not yet distribu-ted) - tax rebate 1/6

100

 

 

2002 pre-tax profits

 

400

 

25% tax thereon

 

 

100

Dividend in 2002 of total 300

 

 

 

Tax rebate 1/6 of 300

(50)

 

(50)

Residual tax rebate

50

 

 

Tax payable 2002

 

 

50

Increasing Distributable Earnings In The Commercial Balance Sheet

The distribution tax rebate will be available for the year in which the distribution is made. In order to benefit as fast as possible for the potential distribution tax rebate, dividends should be high enough to utilise to the greatest extent possible the EK 40 basket over a short period of time. If due to specific circumstances, the distributable earnings as per commercial balance sheet are inadequate, shareholder's contributions as outlined above (cash contributions, waiver etc.) may be considered.

Avoid Additional Distribution Tax Charge

As explained above, there could be a positive EK 02 basket at the time of the changeover to the new German tax system. The distribution of EK 02 will produce an additional distribution charge of 30%. Therefore, distribution of EK 02 should be avoided. If the EK 02 amount is not distributed over a 15-year period an additional distribution tax charge will not arise. Any unused EK 02 amounts will expire at the end of 2016.

German Dividend Withholding Tax Lowered

Starting 2002, the German dividend withholding tax will be reduced from 25% down to 20% (plus 5.5% solidarity surcharge thereon). A withholding tax reduction or a tax exemption applies, among other things, to EU parent companies or under a tax treaty. The withholding tax reduction will only have a rather moderate impact on the after tax dividend amount but may be relevant for corporate shareholders in a non-treaty country.

Strategies

Over the transition period dividend tax planning considerations may concentrate on:

  • maximum distribution of EK 40 as soon as possible and in any case full distribution of EK 40 during the transitional 15 year period;
  • as the distribution of positive EK 02 results in additional 30% distribution tax for the German subsidiary, it should only be distributed after expiry of the above 15 year period; and
  • additional actions required in connection with planned dividend distributions, i.e. additional shareholder's contributions necessary to release the full amount of EK 40.

For foreign corporate shareholders, any tax planning relating to dividend distributions of the German subsidiary must consider the tax impact of the dividend distribution in the other jurisdiction.

New System Dividends

Under the new German tax system, a final and uniform corporation profits tax rate of 25% will apply to retained as well as distributed profits of German subsidiaries. As the deductible trade income tax and non-deductible solidarity surcharge continue, the aggregate German corporate income tax charge will normally exceed 35% and can go up to 40%.

Dividends will be generally subject to a 20% withholding tax (instead of 25% at present).

As the same corporation profits tax rate applies for retained as well as distributed profits and as there is no longer a distribution tax rebate available, dividend policy is of less importance for German tax planning considerations. In the case of German subsidiary operations, other tax issues are becoming more important:

  • changing the financing and the corporate structure as a reaction to the tightened thin capitalisation rules;
  • preparing at an early stage for future divestitures to make maximum use of the tax exemption for capital gains;
  • reviewing acquisition strategies and pricing for share acquisitions to minimise the negative impact of the changed step-up rules.

Conclusions

The German tax reform results in a clear tax relief of retained profits. However, there will still be a total tax on corporate income of up to 40% including unchanged deductible trade income tax and non-deductible solidarity surcharge.

Making best use of the transitional rules for dividend distributions of tax retained earnings accumulated prior to 2001 constitutes a complex tax planning exercise.

Dividend planning considerations will have to start now to initiate the major steps in the right direction. By careful and detailed planning, it is possible to make best use of the opportunities offered by the tax reform.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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