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Dr. Jürgen Hartmann
See disclaimer and notice of copyright at the end of this article
The following article was first published in the February 2001 edition of International Tax Review.
Last minute changes affecting businesses in general and banks in particular were made in the landmark German tax reform package reported on in article no. 209.
- Repeal Of Holding Period For Capital Gains Exemption
The tax legislation adopted in July 2000, and formally enacted in October 2000, creates an exemption for corporate dividends received and for capital gains realised by businesses on the sale of corporate stock. The exemption is partial (50 %) for individuals and total (100 %) for corporations. Generally speaking, the capital gains exemption applies to sales of stock in calendar-year corporations from 1 January 2002 onwards and to sales of stock in non-calendar year corporations occurring after the end of their 2001/02 fiscal year.
Under the original legislation, individuals holding shares as business property and corporations had to meet a minimum one-year holding requirement to qualify for the capital gains exemption. (An extended holding period of seven years generally applies to shares taken in a tax-free reorganisation.)
The one-year holding requirement was, however, repealed by a measure enacted in December 2000 and hence never took effect.
- Protecting Bank Proprietary Trading
The repeal was prompted by objections from German banks that the law as originally enacted would interfere with their proprietary trading in equity (stocks) and equity derivatives (options) and possibly compel them to transfer these operations abroad.
The negative tax impact feared by banks resulted from the planned treatment of losses relating to stock sales. Losses on the sale of stock held for one year or more (long-term capital losses) would have been disregarded for tax purposes as a consequence of the tax exemption for long-term capital gains. Losses on the sale of stock held for less than one year (short-term capital losses) would have been netted only against short-term capital gains. While short-term capital losses could be carried back one year and forward indefinitely, banks feared that income and losses would be mismatched.
Bank sells a two year call option against a certain equity at a strike price of 1,000 and earns a premium of 100 on the transaction. Bank simultaneously purchases the relevant equity at a price of 1,000 (hedge). Since the value of the equity declines from 1,000 to 900 over the term of the option, the option is not exercised. Bank sells the equity for 900 at the end of year 2, losing 100 on the sale. While Bank's true net income on the overall transaction is nil, its net taxable income is 100, because its capital loss is disregarded for tax purposes.
- Capital Gains Exemption Denied To Banks
To address the above problem, two modifications have been made in the legislation enacted in the summer of 2000:
- The exemption for capital gains on the sale of stock is denied to banks, financial service institutes, and financial businesses (hereinafter collectively "financial businesses") with respect to equities held in the context of proprietary trading operations (as defined). The dividends-received exemption is also denied with respect to such equities. These provisions are in principle beneficial in nature and thus extended to financial businesses resident in other member states of the European Union or European Economic Area.
- The one-year holding period is eliminated as a requirement of the stock capital gains exemption for corporations and for individuals holding shares as business property.
Since financial businesses are now fully taxable with respect to their equity trading, they are no longer subject to limitations on the offset of losses related to such operations. The prior limitations on writedowns of stock to going concern value likewise no longer apply to them. This avoids the feared mismatch of taxable income with tax-irrelevant long-term capital losses.
- Concluding Remarks
Corporations (and personal businesses) need no longer meet a one-year holding requirement in order to qualify for the capital gains exemption on the sale of stock. This change is logical, since the original holding requirement was aimed essentially at the equity trading of banks and other financial businesses to begin with.
For financial businesses, the amendments avoid an inequitable and economically unsustainable tax burden on their equity trading, but also introduce additional complexity into Germany's new tax system. The segregation of taxable proprietary trading transactions from other non-taxable equity transactions is based on existing distinctions in bank regulatory law and problematic in some respects. A full discussion of the ramifications of the new law is beyond the scope of this article.
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