At the beginning of 2001, the Tax Reduction Act of 23 October 2000 (Steuersenkungsgesetz) Germany implemented sweeping tax changes to improve the international competitiveness of its industry. The tax reform not only reduces income tax rates, but also fundamentally changes the tax regime for German Corporations and the treatment of dividends received from corporations. When it passed the tax reform package 2001 the Federal Parliament requested the Federal Government to submit to the Finance Committee of the Federal Parliament a report on (i) tax treatment of corporate reorganisations, (ii) group taxation principles and (iii) the controlled foreign corporation ("CFC") rules. The Federal Ministry of Finance has submitted this report at the end of March 2001. As a follow-up the German Government has endorsed on 15 August 2001 another tax package to continue the reform of companies’ taxation, in most cases to be effective on 1 January 2002, albeit with some not insignificant exceptions, and that is now going as a bill into the parliamentary process. The purpose of this paper is to provide an overview on where German tax reform activities currently stand and where they maybe going in the near future.
2. Reduction of Corporation Tax and change of the Corporation Tax Regime
2.1 New Corporate Tax Regime
As from 20011 the corporation income tax rate will be cut to a uniform 25% (incl. surtax: 26.375%) no matter whether earnings are retained by a corporation or distributed. The earlier split tax rates have been abolished. In addition to the corporate income tax rates there will still be the municipal trade tax on income which depends on a factor set forth by each town. Assuming a typical average trade tax burden of approximately 17% and taking its deductibility into account, the overall income tax burden in Germany for a corporation since 1 January 2001 is approximately 39%.
The full imputation system was repealed at the end of 2000. Corporation tax abatements between the earlier rates for retained and distributed earnings (40% vs. 30%) are preserved and will be refunded whenever corporations pay dividends to non-corporate taxpayers or to non-resident shareholders over the next 15 years.
2.2 Tax Exemption for Dividends and Capital Gains for Corporate Taxpayers
To avoid double taxation at a corporate level there is only one layer of taxation where the income originates. As a consequence dividends received by one corporation from another corporation are tax exempt. The same holds true for capital gains derived from the disposal of shares in a corporation by another corporation (for further details see below). Expenses incurred by a corporate taxpayer that are effectively connected with tax-exempt dividends or capital gains would be disallowed under the current version of the law (Sec. 3 c para. 1 Income Tax Act "ITA"). The government proposal of 15 August 2001 contains a remarkable change in this respect. Sec. 3 c para. 1 ITA is supposed to be superseded for corporate taxpayers by the new legislation. As a result expenses effectively connected with tax-free dividends and capitals gains would be tax deductible. The rationale of the proposal is to achieve equal treatment. It should not matter whether expenses (in particular borrowing costs) are incurred at the lower level of the corporation or at the upper level of the shareholder.
2.3 Half Income System for Non-Corporate Shareholders
Whenever dividends are distributed to non-corporate shareholders (individuals or partnerships owned by individuals) the new half-income system comes into play. The idea is no longer to employ the complicated mechanism of the imputation system but to take into account the underlying taxes paid by the corporation globally. Thus, dividends from corporations are only subject to income tax at half the amount of the gross dividend. The combined tax burden at the level of the corporation and at the individual dividend recipient in the aggregate adds up to slightly more than 50%, depending on the individual marginal tax rates. In return, only half of any costs incurred that are connected with the dividend income will be tax deductible.
2.4 Limitations of the Capital Gains Exemption
The fact that the disposal of shares in a corporation is tax exempt for corporate taxpayers, whereas the sale of assets is still fully taxable would be an invitation for tax planners to hive down assets to a newly created corporation before a potential sale occurs and to sell the shares in the corporation. As a measure to counter this technique, the new corporate tax regime provides that under such circumstances the newly created shares would not qualify for tax-free treatment for a period of seven years. There have been some rumours that the seven year waiting period may be reduced to perhaps five years, but the most recent government proposal does not include any such amendment.
The second restriction affects banks and often financial services institutions. The tax exemption will not apply for capital gains generated as part of a security trading activity.
3. Non-corporate Business Entities
3.1 New Tax Credit for Municipal Trade Tax on Income
About 85% of all business enterprises in Germany are conducted in non-corporate form typically in the form of a limited partnership in which a corporation acts as the accommodating managing general partner (usually referred to as "GmbH & Co. KG"). The German Government has been heavily criticised by lobbyists of the medium sized industry that non-corporate business entities are the losers in the tax reform because the capital gains exemption does not apply to them for the reasons explained above. Some medium size companies have initiated court proceedings to bring their presumed discrimination to the Constitutional Court. While it is true that non-corporate business entities do not benefit from the corporate income tax reductions or from the capital gains exemption because of their fiscal transparency they benefit from the rate reductions for individuals (see below) and from a standardised tax credit for trade tax on income. At an effective trade tax rate of approximately 15% and assuming a marginal income tax rate of 50% individuals can fully offset the trade tax on income as if it had been repealed by the new system. For effective trade tax rates below 15% trade taxes are overcompensated by the credit, whereas for rates over 15% they are not fully compensated.
3.2 Proposed Legislation
As a result of the widespread criticism over the insufficient reform measures for non-corporate business entities the government has recently proposed improvements for these taxpayers.
a) Section 6 b para. 10 Prop. ITA provides that non-corporate taxpayers can roll-over capital gains on the disposal of shares in another corporation to newly acquired shares in corporations. The roll-over period is the year of the disposal and the subsequent two fiscal years.
b) The rules for tax free partnership reorganisations in effect until the end of 1999 will be re-instituted. In accordance with these rules – unlike in a corporate entity situation – it is possible to transfer single assets tax free from the business property of a partner to the partnership itself in exchange for new partnership interests and vice versa. Similarly the tax-free partnership split-up rules will be broadened to include single assets again. This proposal re-establishes the status quo ante in effect until the end of 1999. With effect of 1 January 2000 the eligibility of tax-free partnership split up had been limited to branches of activity or partnership interests.
c) On the other side of the coin, it will no longer be possible to enjoy trade tax exemption and preferential tax treatment2 for the disposal of a portion of a partnership interest.
4. Individual Taxpayers
4.1 Rate reductions
The basic rate for income tax has fallen from 25.9% (1998) to 19.9% (2001). The top marginal rate will also be cut, in steps, from a high of 53% (1998) to 48.5% in 2001. There will always be a surtax of 5.5% on these rates. The same period will also see the increase basic personal allowance from approximately DM 12.300 to DM 14.000. This will further be increased from 1 January 2003 to DM 14.500 with the basic tax rate being cut to 17% and the top rate falling to 47%. On 1 January 2005 the basic personal allowance will be further increased to DM 15.000 while the basic tax rate will be reduced to 15% with the top marginal rate falling to 42%. It must however be noted that the top marginal rate already applies at a taxable income in excess of approximately DM 102,000.
4.2 Capital Gains Treatment
Capital gains other than those effectively connected with a trade or business are generally not taxable in Germany because they are regarded as belonging to the personal property sphere that is beyond the scope of income taxation. The taxable personal capital gains are contained in the income tax law and taking into account recent changes, are as follows:
a) Capital gains derived from the disposal of real property, where the period between purchase and disposal is not more than 10 years.
b) Capital gains derived from the disposal of other assets, in particular securities, where the period between purchase and disposal is not more than one year (short term capital gains).
c) Forward sales under various conditions.
4.3 Special Rules for Capital Gains derived from the disposal of Shares in Corporations
Whenever a taxpayer, directly or indirectly owns 1% or more of the share capital in a domestic or foreign corporation, any capital gain is deemed to be business income (even though not subject to trade tax) in accordance with Sec. 17 ITA. Thus, such a capital gain is taxable. The threshold has been reduced to 1% under the Tax Reduction Act 2000 and is effective for domestic corporations on 1 January 2002 and for foreign corporations since 1 January 20013 . Before these dates the ownership threshold had been at least 10% since 1 January 1999; and before then the threshold had been "more than 25%". Thus, the disposal of shares in another corporation might be taxable as deemed trading income pursuant to Sec. 17 ITA or as short term capital gain. The short term capital gain rules take priority. In both cases the new half-income concept applies so that only half of the capital gain is taxable thereby reducing the effective tax rate to approximately half the ordinary rates. It follows that only half of any expenses related to the half-income will be deductible.
5. Other proposed Amendments
In addition to the proposed amendments explained above the tax package endorsed by the German Government on 15 August 2001 includes the following most important changes4 .
5.1 Tax free Reorganisation of Branches of Foreign Corporations
A tax free transfer of a German branch (permanent establishment) of a foreign corporation by means of a transaction that is akin to a German merger is permitted, provided that the built-in gains of the branch remain within the German tax net.
5.2 Curtailing the Benefits from the Disposal of Partnership Interests
It is proposed that for transactions after 31 December 2001 only the entire disposal of a partnership interest will qualify for preferential tax treatment. Preferential tax treatment could mean only half of ordinary rates up to DM 10 million under certain circumstances and exemption from trade tax. Likewise the disposal of partnership interests made by a corporation would be subject to trade tax from the same date.
5.3 Adoption of Corporation Tax Grouping Rules for Trade Tax Purposes
Because of various imponderables the conditions for group taxation for corporation and trade tax purposes moved in opposite directions with the implementation of the Tax Reduction Act 2000. Under the new rules there is a proposed irrebuttable presumption that trade tax grouping will always apply whenever group taxation for corporation tax purposes is in effect. If no group for corporation tax exists it is still required to satisfy the financial, organisational and business integration tests for trade tax purposes.
5.4. Consortium Tax Grouping
Consortium tax grouping is possible if two or more parent companies are going to pool their ownership interests in a civil law partnership (the "Consortium") to exercise uniform control. Whilst the partnership is fiscally transparent for corporation tax purposes there is a long established administrative practice to regard the partnership as the taxpayer for trade tax purposes. Thus, potential trade tax losses were locked in at the level of the partnership. The Supreme Tax Court has overturned this practice by its decision of 9 June 1999 confirming that trade tax losses also flow through to the parent companies. The government proposes to retroactively reverse the Supreme Tax Court ruling and reinstitute the tax authorities’ position by an amendment to the law. It remains to be seen whether this will be accepted by Parliament and, if enacted, whether it holds water before the Constitutional Court. Consortium grouping will also be restricted from 2003 onwards in such a manner that each consortium member must own at least 25% of the share capital of the potential consortium subsidiary.
5.5 Revision of CFC Rules
The proposal contains various revisions of the CFC rules which are steps in the right direction. The idea is to ensure that the CFC income is only taxed once at the level of the CFC by a one-time imputation of the deemed dividend to the German shareholder. Subsequent dividend distributions should however be tax neutral and therefore, dividends are generally excluded from CFC income.
5.6 Exemption from Real Estate Transfer Tax for Intra-Group Transfers
A long overdue proposal is to be implemented for transactions after 31 December 2001. Real Estate Transfer Tax levied at 3.5% of the fair market value of the real estate or certain standard tax values is more than a nuisance on corporate reorganisations because it creates a trap for the unwary. Whenever a foreign parent, directly or indirectly (irrespective of how many tiers are in between) acquires 95% or more of the share capital of a German company that owns real estate, Real Estate Transfer Tax is incurred. The existing rules are illogical because to incur the tax there are group attribution rules whereas in downstream transfers within a group, Real Estate Transfer Tax can arise again and again.
It is now proposed that intra-group transfers are exempt from Real Estate Transfer Tax. There is however a recapture provision if the real estate leaves the group within a period of five years.
However, for the time being taxpayers can only be cautiously optimistic that the proposal will be enacted. The revenues from Real Estate Transfer Tax go to the German States (Länder) whereas this proposal has been made by the Federal Government. Thus, it is a cordial invitation to somebody else for them to foot the bill which the states are unlikely to find intriguing. The states have to give their consent.
The proposed changes will be discussed in a hearing on 10 October 2001 organised by the Finance Committee of the Federal Parliament. It is not hard to predict that the political bickering beginning soon will result in various compromises.
In conclusion German tax reform is still a moving target and it is thus essential to monitor all developments very closely.
London / Frankfurt am Main, 20 September 2001
1For taxpayers with a business year oter than calendar year the new tax regime may be applicable later.
2Only half of the ordinary rates up to an amount of DM 10 million once in a lifetime provided the taxpayer is 55 years or older or disabled.
3As indicated above always assuming that the business year of the corporation is identical to the calendar year, otherwise different phase in rules apply.
4The proposal includes many other technical corrections that may be relevant under particular circumstances. It would go far beyond the scope of this overview to address these technical corrections in detail.
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.