Click on the above link to visit the KPMG Germany webpage on the Mondaq website
For disclaimer and copyright see end of this article.
1. Applicable taxes on income and capital
2. Corporate forms and classification
3. Credit to shareholder for corporation tax paid
4. Dividend withholding and entitlement to the corporation tax credit
5. Taxable income, resident and non-resident corporations
6. Linkage of commercial and tax accounting
7. Depreciation and amortisation
8. Net worth tax and trade tax
9. Non-deductible expenses for corporation tax purposes
10. Loss utilisation and tax consolidation
11. International tax aspects
12. Shareholder loans and thin capitalisation
13. Insolvency
The following article is intended to provide the potential foreign investor, corporate and individual, with basic orientation concerning German taxation of commercial corporations. Specialist advice should be sought with respect to specific questions.
1. Applicable taxes on income and capital
A commercial corporation is subject to a variety of taxes on its income and capital. The principal taxes are as follows:
Net Worth Tax 0.6 % Trade Tax on Capital up to 1.0 % Trade Tax on Earnings up to 25 % Corporation Tax Non-resident corporations 42 % Resident corporations, retained earnings 45 % Resident corporations, distributed earnings 30 % Solidarity Surcharge (on corporation tax) 7.5 % Withholding Tax on Dividends 25 %The trade tax rates are fixed by local government and thus vary greatly throughout Germany, generally being highest in large cities and developed areas and lowest in rural regions. The trade tax on capital is deductible in determining the trade tax on earnings, which is in turn deductible from its own tax base. A common rate for the trade tax on earnings, considering this self-deductibility, is approx. 17 %. Total trade tax (on capital and earnings) is then a deductible expense for corporation tax purposes. Neither the trade tax on earnings nor the corporation tax has a special tax rate for capital gains.
From 1995 on, the so-called solidarity surcharge is collected on corporation tax. The surcharge is 7.5 % of corporation tax owing. How much corporation tax is owing depends on whether profits are distributed or retained, as is illustrated under section 3 below. The surcharge also applies to withholding tax, but is creditable for domestic shareholders and usually eliminated under tax treaties or European Union law on distributions to foreign shareholders.
2. Corporate forms and classification
There are two types of commercial corporations, the limited liability company (GmbH) and the stock corporation (AG). The minimum stated capital of these entities is DM 50,000 and DM 100,000 respectively. The GmbH is by far the more flexible and organisationally inexpensive of the two corporate forms and is almost invariably preferred by foreign investors.
Corporations are grouped by size (small, medium and large) for purposes of determining their reporting and disclosure requirements. Small corporations are not required to undergo outside audit, whereas this is the case for medium-sized and large corporations. A small corporation is one which does not exceed more than one of the following three limits:
i. Balance sheet total of DM 5,310,000
ii. Sales of DM 10,620,000 in the preceding 12 months
iii. Average work force of 50 persons
3. Credit to shareholder for corporation tax paid
The cardinal feature of the German corporation tax is the full credit of corporation tax against the tax liability (personal or corporate income tax) of shareholders on dividends received.
Upon distribution of a dividend out of fully taxed earnings, the corporation tax owing with respect thereto is reduced from 45 % to 30 %. This results in a refund of corporation tax to the distributing corporation. This refund is part of the distributed dividend. The shareholder pays tax on the sum of the distributed dividend and the corporation tax associated therewith ("grossed-up dividend"). A simplified example of the operation of this system is as follows:
DM
Earnings after trade tax 100,00
Corporation tax 45 % -
45,00
Net fully taxed earnings 55,00
Distribution
Retained earnings 55,00
Corp. tax reduction + 15,00
Distributed dividend 70,00
Corp. tax 45 - 15 = 30 + 30,00
Grossed-up dividend 100,00
Personal income tax (assumed) 25,00
Corporation tax creditable 30,00
Net tax owing (refundable) (5,00)
Inside a domestic corporate group, distribution of fully taxed earnings is always possible without additional tax liability because of the full credit for corporation tax paid. Assuming at least 10 % shareholdings, there is likewise no additional trade tax on earnings. The mechanism by which the corporation tax credit is administered is complex. It is, for instance, necessary to classify equity into certain equity accounts (baskets) which are the subject of a special return each year. The equity accounts (baskets) provide the framework for determining the tax consequences of all distributions. The above example ignores non-deductible expenses, which reduce the amount available for distribution.
German tax law attaches the same distribution consequences to constructive distributions as to declared distributions. Arm's length transactions between a corporation and its shareholders (or related persons) are recognised for tax purposes and do not lead to constructive distributions. The new thin capitalisation provisions discussed under section 12 below are an exception to this rule.
4. Dividend withholding and entitlement to the corporation tax credit
German corporations are required to withhold 25 % of the distributed dividend. In the example given in section 3 above, the withholding tax would amount to 25 % of DM 70.00 or DM 17.50. The amount actually received by the shareholder would be DM 52.50.
For domestic shareholders (individual and corporate) subject in Germany to tax on their worldwide income, the withholding tax is credited against their personal or corporate income tax liability in the same manner as corporation tax in the above example. For non-resident shareholders, however, the withholding tax is final (unless the shares are held in a domestic permanent establishment including a partnership). This is to say, that non-resident shareholders are not permitted to file a return with respect to their dividend income and thus no deduction of tax paid from tax owing takes place. The same applies with respect to the corporate tax credit. Non-resident shareholders are thus not entitled to a credit for either corporation tax or for withholding tax.
This means that the 30 % corporation tax distribution rate is final for non-resident shareholders. However, under the tax treaties which Germany has entered into with all major trading nations, the withholding tax on dividends is generally reduced to 15 % or, on distributions to foreign corporate shareholders holding a certain share (usually 10 % or 25 %) in the distributing German corporation, often to 5 %.
The 5 % rate also applies to qualified corporate shareholders located in the European Union. From July 1996 on, withholding tax on dividends to such shareholders will be eliminated entirely.
5. Taxable income, resident and non-resident corporations
The corporation tax is imposed on net income. For corporations with either their legal seat (domicile) or their principal place of management in Germany (resident corporations), tax is imposed on worldwide income. For non-resident corporations, tax is imposed on certain German-source income, especially on income earned through a German permanent establishment.
6. Linkage of commercial and tax accounting
The corporation tax act refers for its definition of income to the income tax act, i.e. to the law which governs the income taxation of individuals (natural persons). The income tax act distinguishes between "business income" and other income and specifies how business income is to be determined The income of commercial corporations always constitutes business income and is defined as the difference between net assets at the beginning and the close of a fiscal year as shown in their commercial accounts (after subtraction of shareholder contributions and add-back of distributions to shareholders). This linkage of tax accounting to commercial accounting is a salient feature of German tax law. While there are exceptions to the principle, the tax balance sheet generally must follow the commercial balance sheet. Commercial accounting elections thus have direct tax impact unless an explicit provision of the tax code provides otherwise. Provisions (accruals) for pensions are, for example, an area in which such restrictions exist.
Commercial accounting is in large part statutory in Germany. Commercial corporations are subject to the statutory accounting legislation and to all non-codified German generally accepted accounting principles. These include the principle that losses, unlike gains, are to be accounted for even if unrealised.
7. Depreciation and amortisation
For movable fixed assets (personal property), the taxpayer may choose between straight line and declining balance depreciation of up to triple the straight line rate or 30 %, whichever is less. The buildings of a commercial corporation can be depreciated over 25 years if the building permit was applied for in April 1985 or thereafter. Otherwise, a useful life of 50 years is assumed for buildings constructed from 1925 onwards. The taxpayer may prove a shorter useful life. Self-generated intangible fixed assets are expensed, i.e. not capitalised on the balance sheet. Acquired intangibles are, however, capitalised. Acquired goodwill is depreciated for tax purposes over a period of 15 years. All assets including interests in other companies may be written down to their going concern value. For inventories, this usually means the lower of cost or market.
8. Net worth tax and trade tax
Net worth tax is imposed on a yearly basis on the excess of corporate assets over liabilities. There is, however, a standard deduction of DM 500,000 which avoids net worth tax on corporations with only nominal assets. Furthermore, the tax rate of 0.6 % is imposed on only 75 % of net worth. If the corporation owns real estate, this is valued using a standardised value which is generally 25 % or less of the fair market value. Net worth tax is not deductible for corporation tax purposes.
The trade tax is imposed on the capital and earnings of all businesses (corporations, partnerships, sole proprietorships) to the extent operated in Germany through permanent establishments. The tax rates are fixed by local government, generally at around 0.8 % of trade capital and 20 % of trade earnings.
Trade tax on capital is calculated on the same base as is the net worth tax. However the standard deduction is only DM 120,000 and the tax is imposed on 100 % of net worth, not just on 75 %. There are also a number of other adjustments made in arriving at the tax base. Deductions are made for foreign permanent establishments and various interests in other companies, especially when their capital and earnings have already been subjected to trade tax. Real estate is also deducted from the tax base. The most notable addition to the tax base is for one half of all long term debt over DM 50,000. Trade tax on capital is deductible in calculating trade tax on earnings.
Trade tax on earnings is imposed on income as determined for corporation tax purposes. Here as well there are, however, numerous adjustments. The deductions provided for are intended to avoid double-counting. Dividends received from a German corporation are, for instance, deducted provided the receiving corporation holds a 10 % interest in the distributing corporation. Again, the most important positive adjustment concerns interest on long term debt, one half of which is added back to the tax base. Long term debt includes all loans outstanding for more than one year or with a term of more than one year and may include even current account debt under certain circumstances. Trade tax on earnings is deductible from its own tax base. It can be calculated using a simple formula, however. After arriving at final trade tax on earnings, this is deductible in determining income for corporation tax purposes.
9. Non-deductible expenses for corporation tax purposes
The principal non-deductible expenses are as follows:
i. Half of the compensation paid to members of any supervisory board (as opposed to members of management)
ii. Presents to persons other than employees, unless under DM 75 per year
iii. 20 % of reasonable meal and dining expense
iv. All expense conferring personal benefit in excess of what is reasonable
v. Net worth tax
vi. Corporation tax
vii. Solidarity surcharge
viii. Fines
10. Loss utilisation and tax consolidation
Losses can be carried forward indefinitely for both the trade tax on earnings and the corporation tax. Corporation tax losses only may also be carried back up to two years in an amount of up to DM 10 million.
Purchase of a corporate shell with large loss carryforwards is, however, not always sufficient to permit netting of the past losses against future profits. The purchased shell must be "economically identical" with the entity which suffered the losses. The exact meaning of "economic identity" is a subject of controversy. If more than three fourths of the shares in a corporation change hands and it then recommences business with predominantly fresh capital, economic identity is not present.
Distribution of earnings to a domestic parent company with offsetting losses results in refund to the parent of the corporation tax, but not the trade tax, paid by the subsidiary. Complete pooling of losses can, however, be achieved by creating a consolidated tax group. Among other requirements, a profit and loss sharing agreement must be entered into between the dominant member of the group, to which the results of all group members are attributed, and the other consolidated companies.
11. International tax aspects
Germany has one of the most comprehensive networks of tax treaties in the world. In principle, Germany uses the exemption method to avoid double taxation on business income earned through a permanent establishment in another treaty state. This means that the profits of a permanent establishment located in a treaty state are generally exempt from tax in Germany. The same generally applies to dividends received by a German corporation from foreign subsidiaries in which it holds at least a 10 % share and to gains on the sale of such shares.
The tax-free income of a German corporation from its foreign permanent establishments, its foreign dividends, and its foreign capital gains on the sale of shares can also be distributed free of tax to other domestic corporations or to non-resident shareholders (subject only to withholding tax). Upon distribution to a resident individual, however, the tax exemption is lost.
To prevent abuse of German tax treaties, an anti-treaty shopping provision was recently added to the tax code. In addition, certain treaties also contain such provisions.
To prevent German taxpayers from shifting income into tax havens, the German International Tax Act provides for immediate taxation in Germany of certain types of passive income accumulated in foreign base companies located in low-tax jurisdictions. A low-tax jurisdiction is one in which the tax on income does not amount to at least 30 %. Since, in determining the tax rate, the tax base must be calculated under German tax principles, it can be difficult in close cases to determine which side of the line a taxpayer is on. If the foreign base company is located in a tax treaty state, its earnings can be shielded from the International Tax Act in a variety of circumstances. However, the International Tax Act overrides all tax treaties for certain passive income from capital investments, notably interest income.
12. Shareholder loans and thin capitalisation
To prevent foreign shareholders from draining off the earnings of their German subsidiaries in the form of interest on loans (or other compensation paid for debt capital), an anti-earnings-stripping provision was recently added to the German tax code (new section 8a of the Corporation Tax Act).
The new thin capitalisation rules apply from 1994 on to loans received by German corporations from foreign shareholders holding, directly or indirectly, more than 25 % of the shares in the corporation or from foreign persons related to 25 % shareholders. They also apply to loans made by unrelated third parties (e.g. banks) if such third party has any recourse against a foreign 25 % shareholder or foreign persons related to him (or against a domestic related person if the shareholder is a foreign person).
The new rules establish safe havens in differing amounts depending on whether the compensation paid for the use of the debt capital is measured in terms of the loan principal (i.e. interest, either fixed or variable), or in terms of some other factor (e.g. profit or gross sales). To the extent shareholder loans exceed the safe haven, deductibility is denied for corporation tax purposes for the interest (or other compensation) paid or accrued on the excessive part of the debt capital. Furthermore, when such non-deductible interest (or other compensation) is paid, this constitutes a constructive dividend and leads to dividend withholding tax at the applicable rate (statutory rate 25 %, current rate inside the European Union for qualified shareholders 5 %, tax treaty rates varying generally from 5 % to 15 %).
For fixed or variable interest bearing loans, the interest paid is non-deductible to the extent the loan amount exceeds three times the pro rata capital of the 25 % shareholder (safe haven). In addition to the safe haven, the taxpayer may make a showing that it could have obtained the loan on the same terms from an unrelated party. If this burden of proof can be carried, interest bearing loans will escape the new rules even if the debt-equity ratio permitted under the safe haven is exceeded.
Banks are exempted from the 3 : 1 limit with respect to interest bearing loans taken out to finance their own standard banking transactions.
For loan compensation linked to profits or sales, the applicable debt-equity ratio is 1 to 2 instead of the more generous 3 to 1. Furthermore, there is no opportunity to show that an unrelated third party would have made the same loan and no exemption for banks.
For German holding companies, a higher 9 to 1 ratio applies to interest bearing debt, but this must suffice to finance all of the subsidiaries under the holding as there is no safe haven for shareholder loans made directly to them. If an interest bearing loan is made to such a subsidiary, the possibility remains to demonstrate that an unrelated third party would have made the same loan.
Since the applicable debt-equity ratio for purposes of the safe haven is determined at the outset of each fiscal year, considerable planning may be necessary to ensure that adequate equity is injected in time. While equity added during the fiscal year will not count for safe-haven purposes until the start of the following year, any increase in debt during the year can lead to a loss of safe-haven status. There are special provisions regarding declines in equity due to operating losses.
The new rules do not apply for purposes of the trade tax on earnings, where, it will be recalled, half of all long term interest is non-deductible in any event irrespective of whether it is paid to a shareholder. The new rules also do not apply to partnerships, even to partnerships with a corporation as sole general partner.
13. Insolvency
As a final topic, we wish to draw attention to certain insolvency provisions which often surprise foreign investors. The management of German corporations is required to provide formal notice to the shareholders when half of the stated capital has been consumed by losses. What is more, if the liabilities of the company exceed its assets, the management is required to file a petition in bankruptcy within three weeks at the most. While the company's assets may be valued at fair market value for purposes of determining whether it is insolvent, this is often not enough to avoid insolvency for companies in the start-up phase. There are a number of methods for restoring solvency, including injections of capital, subordination agreements with respect to shareholder loans, and cancellation of shareholder debt. It is possible to cancel (forgive) debt conditionally so that it is reinstated when and if the company recovers. While cancellation of debt has obvious advantages, especially in its conditional form, a case pending before Germany's highest tax court casts doubt on its advisability.
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. 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.
