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The avoidance of constructive dividends can be of great importance under the German imputational system of corporation tax. The corporate tax system is often not well understood by foreign managers, and German tax advisers frequently find it difficult to explain even in their own language, much less in a foreign one. Obviously, income will be increased for tax purposes when a payment which has been accounted for as a deductible expense turns out to be a constructive dividend. The increase applies both to the trade tax on earnings and to the corporation tax. It is also clear that, aside from criminal sanctions for intentional or reckless conduct (sec. 370, 378 AO), there are no penalties under German law by reason of the underpayment of taxes which occurs until the constructive dividend is determined and corrected. Interest accrues at 0.5 % per month (6 % p.a.) on underpayment of taxes, but does not start to run until 15 months after the end of the year for which the tax is owing (sec. 233a, 238 AO).
Why, then, can it matter so much if a particular payment later turns out to be a constructive dividend? Besides payment of the tax which would have been owing anyway, together with modest 6 % interest for part of the overdue period, what can happen?
The answer is: A constructive dividend can either be harmless or cost 50 % or more of the amount of the dividend in additional tax.
The tax consequences of all dividends (constructive or declared) by a German corporation to its shareholders depend on the equity category (baskets or equity accounts) out of which the distribution is deemed to come. The following table states the general rules:
Source of distribution Consequence Fully taxed earnings Corporation tax refund 15 % + withholding tax Earnings taxed at 30 % Corporation tax unchanged, but withholding tax Tax-free earnings, Corporation tax increase 30 % + withholding generally tax Tax-free foreign source No corporation tax, but withholding tax earnings, dist. to domestic corp.or to foreign person Capital surplus Return of capital, no tax consequences Distribution not covered Corporation tax 30 % + withholding tax by available equity
In order to quantify the above general statements, it is necessary to understand how equity is classified for corporation tax purposes and how the source of a distribution is determined. Equity is grouped in a series of accounts or baskets and distributions are deducted from these accounts in the following order to the extent of the positive balance of each account:
Account name Description EK 50 Earnings after deduction of 50 % corp. tax EK 45 Earnings after deduction of 45 % corp. tax EK 30 Earnings after deduction of 30 % corp. tax EK 01 Tax-free foreign source earnings EK 02 Other tax-free earnings EK 03 Pre-1977 equity (earnings and cap. surplus) EK 04 Capital surplus
The above are tax accounts, not accounts in the company ledger for commercial accounting purposes. The abbreviation "EK" in the above account names stands for "Eigenkapital" or equity and refers to so-called distributable equity, i.e. all equity except stated capital (which by law may not be distributed unless first converted into capital surplus by reducing the amount of stated capital, a cumbersome process).
The four "EK zero" (EK 0) accounts are so-named because amounts in these baskets have not been reduced by creditable corporation tax. Amounts in EK 03 have probably been reduced by pre-1977 corporation tax, but this "old" corporation tax is not creditable under the new system which went into effect in 1977. The EK 04 account (basket) is a particularly important one. It contains all shareholder contributions not constituting stated capital. It not frequently happens that this basket holds sums which, for commercial accounting purposes, are treated as revenue. Cancellation by a shareholder of a loan to his German corporation generally increases the EK 04 basket and therefore attracts no tax.
EK 50 and EK 45 are baskets for taxable earnings at the old 50 % standard rate and the present 45 % standard rate respectively. If corporate earnings (after trade tax, which is a deductible expense for corporation tax purposes) amount to 100, the amount entered into EK 45 will be 55 (100 - 45 = 55). The EK 30 account contains earnings which have borne 30 % corporation tax. The 30 % rate corresponds to the corporation tax on distributed earnings, just as the 45 % rate corresponds to the current corporation tax on retained earnings. One might suppose that earnings are put into the EK 45 basket or the EK 30 basket depending on whether they are retained or distributed, but this is not so. All "normal" earnings are first put into the EK 45 basket, even if they are "immediately" distributed. The EK 30 basket serves a technical purpose, being used essentially for income with respect to which the German corporation tax is less than the standard rate. Since the non-standard rate is seldom 30 %, amounts in this equity basket generally arise by virtue of dividing earnings between EK 45 and EK 30 (for non-standard rates between 30 % and 45 %) or between EK 30 and an EK 01/EK 02 (for non-standard rates under 30 %).
There are two additional basic rules one needs to remember to understand the system.
Rule No. 1, which is subject to two major exceptions, is that whenever equity is distributed, the corporation tax burden is adjusted (if necessary) to equal 30 % of the gross dividend (sum of net dividend and the 30 % corporation tax thereon). This is known as the "distribution adjustment" (Herstellung der Ausschuttungsbelastung). If the distribution comes out of EK 45, this means that a 15 % tax refund is made to the distributing corporation (nota bene: 15 % of the gross dividend, not 15 % of the net dividend, much less of amount taken out of EK 45). If the distribution comes out of EK 30, no adjustment is necessary. And if the distribution comes out of an EK 0 basket, tax must be increased to equal 30 %. The two exceptions to the rule are as follows:
- Distributions from EK 04 are treated as tax-free returns of capital.
- Distributions from EK 01 (foreign tax-free earnings) result in no increase in corporation tax. The resulting dividend is tax-free if made to domestic corporations or to non-resident persons. Withholding tax does arise and is refundable to resident taxpayers, but generally not to non-resident persons.
Examples 1 and 4 below illustrate the above rule and Examples 2 and 3 its exceptions.
Rule No. 2 is that, if the positive amounts in the various equity baskets are insufficient to cover a distribution, the difference is entered as a negative amount in the EK 02 account. Furthermore, amounts so entered trigger corporation tax at the 30 % distribution rate pursuant to rule no. 1 (see Example 4 below).
It is possible, and frequently happens, that a distribution affects more than one equity account under the above rules (because no single account has a balance big enough to cover the entire distribution). The examples given below are very simple ones and avoid such complexities.
Examples illustrating the above principles
It should now be clear why the tax consequences of a constructive dividend can vary so greatly depending on the structure of the equity accounts at the time of the distribution. We should like to further illustrate this by several examples, all of which assume that a royalty fee paid by a German corporation to its foreign parent in the Netherlands is deemed excessive to the extent of DM 70,000 and hence treated as a constructive dividend in this amount. It is further assumed that the German corporation has net income of minus DM 70,000 in the year in which the constructive dividend is made. Thus, even after add-back of the constructive dividend, corporate income is still zero for the year for purposes of both the trade tax on earnings and corporation tax.
Depending on the structure of the equity accounts, it will be seen that the tax burden triggered by the constructive distribution varies between zero and DM 33,500, i.e. up to almost 50 % of the basic amount of the constructive dividend (Example 4). The examples all ignore the solidarity surcharge (7.5 % of corporation tax). They also assume that the recipient is entitled to a reduced rate of withholding tax. If this were not the case, the tax burden as a percentage of the dividend amount can reach as high as 68 % or even 90 % if the distributing subsidiary assumes the withholding tax liability of the dividend recipient (see Examples 1a and 4).
Balance in EK 45 is DM 100,000; all other EK balances = 0.
Net amount of constructive dividend 70.000 Balance in EK 45 100.000 Amount withdrawn from EK 45 55.000 -55.000 Amount remaining in EK 45 45.000 Corporation tax reduction on distribution 15.000 Dividend 70.000 Latent corp. tax in amount withdrawn from EK 45 45.000 Corporation tax reduction on distribution -15.000 Residual corp. tax on amount distributed (not refundable) 30.000 Above, as percentage of sum of net div. and resid. corp. tax 30,00% Withholding tax 25 % of net dividend 17.500 Withholding tax - EU rate 5 % 3.500 Refundable to foreign parent 14.000 Owing from foreign parent to German sub. 17.500
In Example 1 the constructive dividend results in a net tax saving of DM 11,500. The only tax paid is withholding tax in a net amount of DM 3,500. This is more than offset by the corporation tax refund of DM 15,000 which follows from Rule No. 1 (distribution adjustment, here reduction, of corporate tax on distribution to 30 % of the gross dividend). Please note that, in order to create the amount of DM 55,000 withdrawn from EK 45, the corporation had to earn income of DM 100,000 on which it paid corporation tax of DM 45,000. This corporation tax paid with respect to the amount withdrawn from EK 45 is referred to above as "latent" corporation tax.
Note that the constructive dividend has reduced the balance in the EK 45 account by more than half and hence that insufficient EK 45 is now available to cover a dividend in the same amount next year.
The example is constructed so that the sum of the (net) constructive dividend (DM 70,000) and the corporation tax finally paid (DM 30,000) with respect to the corporate earnings from which the dividend is funded equals DM 100,000. Another way of stating this is that the gross dividend, consisting of the sum of residual corporation tax and the net dividend, equals DM 100,000. The distribution rate of corporation tax (30 %, here DM 30,000) and the corporation tax refund of 15 % (here DM 15,000) relate to the gross dividend, not the net dividend. Note that only DM 55,000 is withdrawn from EK 45 to account for the dividend, the rest coming from DM 15,000 which is refunded to the German corporation as a result of the constructive dividend (reduction from standard to distribution rate of tax).
Withholding tax is, however, calculated on the net dividend. The German corporation owes DM 17,500 in withholding tax, but has a claim for reimbursement in the same amount against its foreign parent. The foreign parent can obtain refund of all but DM 3,500 of this sum. Should, however, the German subsidiary choose to forego its claim for reimbursement of withholding tax paid on behalf of its foreign parent, the amount of the constructive dividend would increase accordingly. This frequently happens in practice and results (based on the equity accounts assumed in the example) in an increase in withholding tax to DM 4,667 as shown in Example 1a. Please note that withholding tax on dividends to 25 % EU parent corporations will be eliminated as of 1 July 1996.
Upon request, the withholding tax rate on distributions to parent companies within the European Union will be reduced to 5 % or, for dividends after 30 June 1996, eliminated entirely if the parent holds a 25 % share in the distributing company. In some cases, a 10 % share is sufficient. This would mean that withholding would be at the 5 % rate or eliminated entirely from the start and no refund procedure would be necessary (sec. 44d EStG).
Same as Example 1, except distributing corporation assumes withholding tax liability of parent.
Net amount of constructive dividend 70.000 Additional const. div. from withholding tax 23.333 Total constructive dividend (net) 93.333 Balance in EK 45 100.000 Amount withdrawn from EK 45 73.333 -73.333 Amount remaining in EK 45 26.667 Corporation tax reduction on distribution 20.000 Dividend 93.333 Latent corp. tax in amount withdrawn from EK 45 60.000 Corporation tax reduction on distribution -20.000 Residual corp. tax on amount distributed (not refundable) 40.000 Above, as percentage of sum of net div. and resid. corp. tax 30,00% Withholding tax 25 % of net div. 23.333 Withholding tax - EU rate 5 % 4.667 Refundable to foreign parent 18.667 Owing from foreign parent to German sub. 0
Assumption of the withholding tax has two consequences. Firstly, the amount of the non-refundable withholding tax increases by DM 1,667. More importantly, the amount of the net dividend increases to include the entire withholding tax. The withdrawal from EK 45 increases as a consequence. In the above example, the balance of EK 45 is still large enough to cover the increased dividend. If this were not the case, the excess amount would have to be taken from the next equity account in line with a positive balance or, if all have zero or negative balances, from EK 02 (see Example 4 below).
Inside the European Union, the filing of the request under sec. 44d EStG as explained at the end of Example 1 would greatly alleviate (and from June 1996 on eliminate) the above problem.
Balance in EK 01 = DM 100,000; all other EK balances = 0. Distribution to foreign parent.
Amount of constructive dividend 70.000 Balance in EK 01 100.000 Amount of net dividend 70.000 Amount withdrawn from EK 01 70.000 -70.000 Amount remaining in EK 01 30.000 Corporation tax increase/decrease 0 Residual corporation tax 0 Withholding tax 25 % of net div. 17.500 Withholding tax - EU rate 5 % 3.500 Refundable to foreign parent 14.000 Owing from foreign parent to German sub. 17.500
The distribution out of EK 01 represents foreign tax-free earnings. German law allows the distributing corporation to pass along the tax exemption to its foreign parent, subject to withholding tax in the same amount as in Example 1.
Balance in EK 04 = DM 100,000; all other EK balances = 0.
Net amount of constructive dividend 70.000 Balance in EK 04 100.000 Amout of net dividend 70.000 Amount withdrawn from EK 04 70.000 -70.000 Amount remaining in EK 04 30.000 Corporation tax increase/decrease 0 Residual corporation tax 0 Withholding tax 0
This transaction is a mere return of capital without any tax consequence except the reduction of the amount in EK 04.
All equity accounts have zero opening balances. This is a situation in which many corporations in the start-up phase can find themselves. It is also the situation in which a constructive dividend inevitably leads to considerable tax expense.
Net amount of constructive dividend 70.000 Balance in all equity accounts 0 Amount of net dividend 70.000 Corporation tax increase 30 % 30.000 Amount withdrawn from EK 02 100.000 -100.000 Amount remaining in EK 02 -100.000 Residual corporation tax (not refundable) 30.000 Above, as % of sum of net div. + resid. corp. tax 30,00% Withholding tax 25 % of net div. 17.500 Withholding tax - EU rate 5 % 3.500 Refundable to foreign parent 14.000 Owing from foreign parent to German sub. 17.500
In Example 4 the constructive dividend results in imposition of German corporation tax even though the company had no net income for the year. The German tax cost of the dividend is DM 33,500 (sum of corporation tax increase and non-refundable withholding tax) or 48 % of the net dividend paid of DM 70,000. Please note that the constructive dividend of only DM 70,000 reduces the balance in EK 02 by DM 100,000. This is because the tax increase is also deducted from EK 02, the closing balance of which is DM -100,000. The residual corporation tax burden after the distribution is the same as in Example 1 (DM 30,000).
For the reasons explained under Example 1a, the tax owing would climb to roughly 64 % of the net dividend if the subsidiary assumed the withholding tax associated with the dividend. Assumption of the withholding tax on a dividend as to which no reduction in the withholding tax rate was available would send the tax soaring to over 90 % of the net dividend.
Please remember that our calculations ignore the solidarity surcharge and are based on facts in which the constructive dividend does not trigger trade tax. They are thus closer to a "best case" than to a "worst case" scenario.
We hope that foreign managers find the above explanations useful the next time their German tax advisers try to explain to them the consequences of a dividend, whether constructive or declared.
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. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. 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.