Co-written by Dr. Joachim H. Borggäfe and Mr Andreas Köster-Böckenförde
A Summary For Foreign Investors
On December 21, 1999, German Chancellor Schroeder and Finance Minister Eichel unveiled the German government's proposal for far-reaching tax reform. The proposal contains some long-expected cuts in personal and corporate income taxes, as well as some unexpected changes, such as the introduction of a German national participation exemption.
The proposal was well received by the German and international business community and led to an all-time high on German stock markets before Christmas. Equity analysts see the proposed reform as a vital step to improving Germany's competitiveness since it should give an important impulse for the modernization and reconstruction of German industry. However, foreign investors should be aware that only DM 8.3 billion (approximately US$4.7 billion) of the total DM 32.5 billion (approximately US$18.3 billion) is earmarked for "true" tax relief, while the remainder is offset by several measures broadening the tax base of German businesses.
On January 11, 2000 the German Ministry of Finance released the Tax Reform Bill (the "Bill") containing amendments designed to implement the tax reform proposals. Under the Bill, personal income taxes are to be reduced in a three-step procedure in 2001, 2003, and 2005. The reform of the corporate income tax regime, however, is to come into force in a single step on January 1, 2001. The various amendments to tax laws contained in the Bill are planned to be adopted by the two chambers of the German parliament in the course of the year 2000. Although the opposition, which holds a blocking majority in the Federal Council (Bundesrat), has announced its agreement in principle with the proposed reform, it is not unlikely that the final Tax Reform Act may deviate from the Bill as currently drafted.
Highlights Of The Tax Reform
- The rate of corporate income tax would be reduced to 25 percent (currently 30 - 40 percent).
- The tax imputation system would be abolished. Intercompany dividends between German corporations would be exempt from tax. Individual shareholders would only be taxed on 50 percent of the dividends received from German corporations.
- A national participation exemption would be introduced. All capital gains realized by a German corporation from the sale of shares in a German subsidiary would be exempt from tax (as may already be the case, in a sale of shares in a non-German subsidiary).
- Equity holders of a German partnership would be able to opt for the treatment of the partnership as a corporation ("check the box").
- German thin capitalization rules would be tightened for foreign investors.
- The depreciation of assets would be restricted.
Reform Of Corporate Income Tax
Reduction of Corporate Income Tax Rate
Under the current German system of income taxation of corporations, retained earnings are taxed at a rate of 40 percent, while distributed earnings are taxed at a reduced rate of 30 percent. If retained earnings are distributed in subsequent years, the corporation is entitled to a 10 percent tax credit.
Under the new corporate income tax laws, profits of corporations would be taxed at a rate of 25 percent, regardless of whether or not those profits are distributed. Based on a comparison of corporate income tax rates (including the 5.5 percent German solidarity surcharge) imposed on retained earnings, Germany would, if the Bill is implemented, have one of the lowest corporate tax rates of all industrialized countries. Even if trade tax, which is imposed on German businesses and corporations on a regional basis, is factored into this comparison, German corporate taxes would be lower than those of New York City (see the chart below).
Repeal Of Tax Imputation System
The double taxation of German shareholders is currently avoided by an imputation system, whereby the corporate income tax paid by a corporation is credited against its shareholders' individual income or corporate income tax. While this system effectively avoids double taxation, foreign shareholders cannot participate, and this has frequently led to dividend-stripping activities.
Under the proposed new corporate tax system, the imputation system would be abolished. Individual shareholders in receipt of dividends would no longer benefit from a tax credit for corporate income taxes paid. Instead, only 50 percent of the dividends received by individual shareholders would be considered taxable income for purposes of their individual income tax computation. Intercompany dividends received by German corporations from their German subsidiaries would be exempt from corporate income tax. This exemption will apply regardless of the extent of the interest held in the German subsidiary.
The new system would also apply to pass-through foreign dividends distributed to German individual shareholders. However, additional tax will be imposed in Germany on the profits of the passive activities of a subsidiary resident in a tax-haven jurisdiction, in order to ensure the effective taxation of such dividends at the ordinary corporate tax rate of 25 percent. Therefore, the German Foreign Investment Tax Act (Außensteuergesetz) would be amended so that retained earnings of foreign corporations would be taxed as if dividended to German shareholders if (i) the foreign corporation is resident in a jurisdiction imposing less than 25 percent income tax on retained earnings, and (ii) German resident shareholders hold an interest of 10 percent or more in such foreign corporation.
Dividends distributed to foreign corporate shareholders would effectively benefit from the reduction of the corporate income tax rate in Germany. Parent companies resident in the European Union would receive dividends distributed by German corporations free from withholding taxes. Shareholders resident outside the EU would receive the dividends subject to the withholding taxes stipulated in any applicable double taxation treaties. Profit transfers between a German permanent establishment and a foreign parent corporation will not be affected by the new rules.
With respect to existing retained earnings of German corporations, the Bill contains transitional rules pursuant to which available corporate tax credits may be claimed for a 15-year period commencing on January 1, 2001. For that purpose, the total tax credit available for each German corporation will be calculated as at the end of the last fiscal year ending on or before December 31, 2000. In the following years, the tax credit of the corporation is used up in accordance with the dividends distributed to its shareholders.
Introduction Of National Participation Exemption
While capital gains derived from the sale of shares of foreign subsidiaries have generally been exempted from corporate income tax on German corporations since 1984, capital gains derived by German corporations from the sale of shares of German subsidiaries have always constituted taxable income.
Under the new corporate income tax system proposed, a national participation exemption would be introduced, so that capital gains derived from the sale of holdings in German subsidiaries would also be tax-exempt for a German parent corporation. In turn, the possibility of write-downs on holdings based on dividend distributions (Ausschüttungsbedingte Teilwertabschreibung) will, for tax purposes, be abolished.
The consequences for foreign investors of the introduction of the national participation exemption are ambiguous. On the one hand, existing German participations held under German holding companies may be disposed of in the future at a significantly lower tax exposure than at present. On the other hand, however, it is likely that the Tax Reform Act would limit the existing opportunities to convert, on a tax-free basis, acquisition costs incurred on the purchase of shares into depreciation potential (e.g., through the transformation of the target company into a partnership and an immediate step-up of the tax basis of its assets to their fair market value). Moreover, it is questionable whether, and to what extent, finance costs and other expenses incurred in connection with an acquisition of shares in German companies will remain deductible in the future. It is not unlikely that, in connection with the amendment of the thin capitalization rules discussed in Section II.F below, the model of debt push-down frequently utilized for acquisitions of German target companies will no longer be available after the enactment of the Tax Reform Act. However, as the Bill will probably not amend the relevant paragraph of Section 3c of the Income Tax Act, "ballooning" of dividends of newly acquired German subsidiaries might remain possible in order to preserve the deductibility of financing costs incurred in connection with the acquisition.
Introduction Of Check-The-Box Rule
Under existing German tax law, a partnership is treated as a transparent entity for tax purposes, so that the partners are taxed on their pro-rata share of the overall partnership's profit regardless of whether or not the profits have actually been withdrawn from the partnership. This transparent character of the partnership may presently only be changed through a formal transformation of the partnership into a corporation.
Under the proposed new rules, the equity holders of a partnership may opt for the treatment of the partnership as a corporation without actually changing the legal form of the entity. The option will, for tax purposes, be deemed a legal transformation of the partnership into a corporation. The option may only be exercised unanimously by all partners. Once the option has been exercised, the partnership will be treated as a corporation for all tax purposes, so that contractual relationships between partner and partnership (such as loans) will be fully acknowledged, and withdrawals of profits to corporate partners will be exempt from tax. The option may be reversed at any time.
Even if a partnership has exercised the option to be taxed as a corporation, the disposal of an equity interest in that partnership by a corporation would not attract the benefit of the proposed national participation exemption. Any capital gain on the partnership interest would be taxed at the time of disposal.
Reduction Of Depreciation Rates
As mentioned above, the proposed tax reforms would mainly be financed by measures broadening the overall tax base. Such measures will include, inter alia, the reduction of depreciation rates by extending the useful life of depreciable assets and the amendment of depreciation methods. For example, the depreciation of buildings will be extended from currently 25 years to 33 years after the year 2000. Moreover, the Bill reduces the maximum downward depreciation of movable goods from 30 percent today to 20 percent in 2001. Finally, certain accelerated and special depreciations presently available will be abolished. The effects of these reductions will differ from industry to industry. However, in capital-intensive industries, the reduction of depreciation rates may well absorb any benefit derived from the reduction of the corporate income tax rate. Consequently, leasing structures may gain importance in such industries once the Tax Reform Act has been enacted.
Amendment Of Thin Capitalization Rules
One of the most important changes for foreign investors in Germany contained in the Bill is the tightening of the German thin capitalization rules. Presently, many foreign investors take advantage of the liberal German rules on shareholder financing to manage their tax exposure in Germany. Such rules currently allow the deduction of interest payments by German corporations on loans granted by their foreign shareholders if a debt:equity ratio not greater than 3:1 (9:1 for qualified holding companies) has been maintained in the last annual financial statement of the German corporation. As a consequence, foreign investors could adjust the tax burden of their German operations almost at their discretion.
The Tax Reform Bill would substantially restrict these possibilities. According to the Bill, the maximum acceptable ratios would be reduced to debt:equity ratios of 1.5:1 for corporations and 3:1 for qualified holding companies, respectively. Foreign investors presently operating with "debt-loaded" German operations should therefore carefully follow developments in this area and, as soon as the new thin capitalization rules have been adopted, adjust their tax planning accordingly.
Reform Of Personal Income Taxation
Reduction Of Income Tax Rates
The main reform of personal income taxes relates to the reduction of individual tax rates in the years 2001 through 2005 and would have only indirect effects on businesses. However, it is expected that the buying power of German individuals' consumption would slightly increase once the amendments have been effected. The proposed changes are briefly summarized as follows:
Reductions in Personal Income Tax
Credit for trade tax paid by entrepreneurs operating through a partnership or a sole proprietorship will be granted.
Tax-free allowance of individuals increases to DM 14,500; reduction of entrance level of progressive tax rate to 17 percent; reduction of marginal tax rate to 47 percent.
Tax-free allowance of individuals will be increased to DM 15,000; reduction of entrance level of progressive tax rate to 15 percent; reduction of marginal tax rate to 45 percent; and downward adjustment of all intermediate tax rates.
Taxation Of Capital Gains
In addition to such general tax relief for individuals, the proposal contains one specific amendment to the German tax laws that could directly affect foreign investors interested in acquiring a family-owned corporation in the near future. In the past, German individual shareholders could realize capital gains derived from the sale of non-material shareholdings in corporations free from income tax, unless the capital gain was realized during a six-month speculation period. Effective January 1, 1999, the threshold for non-material holdings was reduced from 25.1 percent to 10 percent; in addition, the holding period was extended to 12 months. Moreover, existing opportunities for a tax-exempt stock-swap were substantially limited.
The Bill further diminishes the possibilities of a tax-free capital gain by reducing the threshold of non-material holdings to 1 percent effective January 1, 2001. Consequently, only minor shareholdings mainly in publicly listed companies may be disposed of tax-free in the future. In contrast to these revenue-raising measures, the German government has announced plans that any income tax on capital gains realized during the 12-month holding period will be imposed only on 50 percent of the capital gain.
Foreign investors should note that these amendments will probably result in increased purchase prices both for acquisitions of family-held corporations and tender offers for publicly listed companies. As German companies, also publicly listed ones, are frequently held by families or family trusts (almost 80 percent of all companies in Germany), foreign investors can expect that potential purchasers will be requested to at least partially contribute to the increased tax exposure of the family members. Acquisitions of family-held corporations in Germany should therefore be planned carefully and, where possible, completed prior to the end of the year 2000.
Summary And Conclusion
The German Tax Reform Bill would clearly increase Germany's competitiveness and attractiveness for inward investment by aligning its historically high nominal tax rates with those of its big trading partners. However, foreign investors currently operating in Germany through structures suitable for the present tax system should carefully analyze whether and to what extent a restructuring of their corporate set-up would be necessary to benefit most from the proposed revision of the German tax regime.
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