Germany: 2001: A Tax Odyssey?

A Closer Look at the New German Tax Reform Proposal 2001
Last Updated: 11 February 2000

By Eugen Bogenschütz and Kelly Wright*

Cornerstones of the Tax Reform Proposal 2001 *

Proposed Corporate Taxation *

Table 1: Effective tax burdens of a corporation (full distribution of earnings) *

Repeal of Imputation System for Dividends *

Capital Gains Treatment *

Enhanced Need for Group Taxation *

Transitional Rules to Phase-out the Imputation Tax System *

Curtailing Certain Tax Planning Techniques *

Restrictions on Step-up Technique Imposed *

Reduction of Threshold for Capital Gains for Individuals *

Tightening of Thin Capitalisation Rules *

Disadvantages of the German Leasing Industry *

Income Taxation of Partnerships and Sole Proprietorships *

i) Tax Credit for Trade Tax on Income *

Table 2: Trade tax factor = 388.38% *

Table 3: Trade tax factor = 200% *

(ii) Option to be Taxed as Corporation *

Amendment of CFC Rules *

Taxation of Mutual Funds *

Implications for the Mergers and Acquisition Business *

Closing Remarks *

On January 10, 2000, the Federal Ministry of Finance published its draft of a Company Tax Reform and Tax Reduction Act mostly to be enacted with effect of 2001 (in the following referred to as the "Tax Reform Proposal 2001", the "Proposal", or the "Draft"). In its present form, the reform package contains nothing less than revolutionary improvements to the current German tax systems - all the more surprising when one considers the fact that the Proposal came out under a red-green labour government. The Draft penned by the Federal Ministry of Finance lead by Hans Eichel will most likely take a beating for the worse in the course of political sparring. Based on past experience, we can expect a watered down outcome of this business-friendly Proposal after unholy alliances such as the trade unions, the German Länder aiming to protect their share of tax revenues and the Conservative party driven by political opposition tactics get through with it. Readers are thus cautioned not to rely too much on the good tidings discussed in this paper. Where changes for the worse are discussed, taxpayers may, in contrast, consider reacting now to avoid or at least mitigate the implications since these will no doubt not be amended for the better. Given that this survey is designed to alert international taxpayers to the German tax reform development, it focuses primarily on corporate taxation and only very briefly highlights the proposed changes affecting individuals.

Cornerstones of the Tax Reform Proposal 2001

Modelled after many international examples, the inherent strategy of the Tax Reform Proposal 2001 is to broaden the tax base while reducing tax rates. The individual top marginal income tax rate which was reduced from 53 % in 1998 to currently 51% should, according to the proposed Reform, be further reduced to 48.5% with effect of 2001. Unfortunately, a solidarity surtax of 5.5% or the respective tax must always be added to the top marginal income tax rates, hence overall effective top income tax rate for individuals will still exceed 50% (51.2%) in 2001. The Reform currently contains plans to reduce the top income tax rate to 45% in 2005, this may however prove to be a little bit too much long-term planning. Another important change affecting individuals is the taxation of dividends (discussed below).

In Germany, taxes are currently imposed on corporate entities using an imputation tax system. German-resident shareholders of German corporations are entitled to a tax credit on dividends received from a corporation in the amount of the tax paid by that company on the amount of distributed profits (except solidarity surtax). The corporation tax paid by the company thus acts more or less as an advance payment on the German-resident shareholders’ individual income taxes. Compared to a classical tax system as employed in the USA, the Netherlands and in many other countries around the world, the corporate tax paid by companies increases the dividend income of the shareholders. Shareholders residing outside of Germany have never been entitled to the imputation credit unless they do business using a permanent establishment in Germany which is deemed owner of a German subsidiary. This has given rise to legions of tax planning structures allowing non-German shareholders to utilise the German embedded credit such as dividend stripping transactions, security lending or repos. Citing its vulnerability to abusive transactions, the Ministry of Finance now wants to repeal the imputation system completely and reinstate the classical tax system with a flat corporate rate of 25% (plus trade tax on income).

Although corporate taxation is - especially in an international context - not irrelevant, it is important to note that approximately 85% of all businesses in Germany are not conducted by corporations, but rather by partnerships or sole proprietorships. These legal forms are most widely used by the German Mittelstand, the backbone of the German industry. At the same time, a keystone principle of German tax law is that transparent partnership entities are fundamentally different from legally independent corporations. The single most astonishing piece of tax legislation proposed thus far is therefore the introduction of a type of check-the-box scheme, enabling businesses conducted by non-corporations to take advantage of the proposed lower corporate rate of 25%. If the measure goes through, sole proprietors and partnerships, including professional partnerships, may elect to be taxed like corporations in all respects. As a mutually exclusive alternative, they may decide to maintain the current treatment as look-through entities subject to income tax at the partners’ marginal rates but claim a credit for trade tax on income against their income taxes. This trade tax credit is however capped at a certain rate.

The proposed income tax reductions will predominantly be financed by reducing depreciation allowances. In particular, yearly declining balance depreciation rates will be reduced from the maximum of 30% to 20% and depreciation for buildings used for business purposes will be reduced from 4% to 3%. By the same token, the capital gains tax base will be broadened by reducing the triggering threshold for capital gains derived from the disposal of stakes in corporations from currently 10% to 1%. Furthermore, certain amendments pertinent to tax planning structures - euphemistically termed technical corrections - will effect relatively few taxpayers. The most important changes are discussed below. Last but not least thin capitalisation rules will be tightened (details below).

Proposed Corporate Taxation

As of its inception in 1977, Germany operates an imputation tax system for corporation tax purposes that provides for split tax rates: retained earnings are currently taxed at 40% while distributed earnings are subject to a corporation tax of 30%. In both cases, solidarity surtax of 5.5% of the corporate rates must be added. German-resident shareholders are entitled to a tax credit for the corporation tax paid on distributed earnings. Subject to certain exceptions, in particular for business years that are different years from calendar years, the imputation tax system will be repealed with effect of the tax year 2001. The split-rate concept would then be replaced by a uniform tax rate of 25% (plus solidarity surcharge) applicable on both retained and distributed earnings. In addition to the corporate income tax, German municipalities are entitled to levy a local trade tax on income which varies depending on the factors set by the local municipalities. Assuming full distribution of income generated in 2000 in the tax years 2000 and 2001 the overall corporation tax burden is illustrated in the following table 1:

Table 1: Effective tax burdens of a corporation (full distribution of earnings)


Tax Years




Profit before income taxes



Trade tax on income



Profit after trade tax



Corporation income tax

2000: 32%

2001: 26.3752




Profit after income taxes



Dividend withholding tax at 5%



Received by shareholder



Effective German income tax burden




Including a 5% withholding tax on dividends as stipulated in many of Germany’s tax treaties, the overall effective German income tax burden would be reduced from 46.6% in the year 2000 to 42.2% in 2001. No withholding tax is imposed on parent companies resident in the European Union, meaning that the overall effective tax burden for these entities would be reduced to approximately 39% and thus would be below the 40% threshold. The Ministry of Finance has promoted its own efforts as a success story in lowering the overall corporate tax burden to 38.6%. However, the Ministry employs a combined rate in its calculation of the overall tax burden and focuses solely on the corporation itself, uses a somewhat lower trade tax factor and does not take into account dividend withholding taxes. The improvement is certainly welcome even though the overall effective tax burden used in the example illustrates that Germany is by no means on the road to becoming an international tax haven. Bearing in mind that other high-tax jurisdictions such as Japan and Italy have reduced their overall tax bill, Germany - though not quite as high as some Canadian provinces - will still be one of the front runners of high-tax jurisdictions.


Repeal of Imputation System for Dividends

Since the imputation credit system, subject to certain phase-in regulations and exceptions for non-calendar business years, is the main feature of German corporate taxation, its total repeal with effect as of 2001 represents a profound change. The government plans to replace the credit system with a classical double taxation system that was in effect in Germany prior to 1977. Under the classical system, shareholders of German corporations cannot credit the corporate tax paid on the dividend against their personal income tax, nor is there a split-tax rate. Modelled after the Austrian system, the new German concept of a corporate taxation will however avoid total double taxation by granting partial tax relief to German shareholders. As long as dividends are paid at a corporate level, there is an overall participation exemption pursuant to which dividends received by a German corporation from another corporation, are exempt from income taxes, regardless of shareholder residency, any minimum ownership or timing requirements and without the necessity to fulfil any requirements set forth in tax treaties. For individual shareholders, only half of any dividend received from a corporation will be subject to German income tax whereby the tax exempt income will be considered to determine the progressive income tax rates. In simple (if imprecise) terms: dividends received by individuals from any corporation, German or otherwise, are subject to only half of the ordinary income tax rates. The logic behind the concept - termed the "semi-income concept" (Halbeinkünfteverfahren) - is that the taxation at the corporate level, plus the tax burden incurred by the individual shareholder incurs a tax liability in the vicinity of the top income tax rate. To ensure that foreign source income carries a sufficiently high income tax burden to avoid competition distortions with regard to Germany, amendments of the controlled foreign corporation ("CFC") regime are also proposed (see below).

According to the Draft's current wording, the "semi-income" concept would not apply if the dividends are received as business income of a partnership or a sole proprietor; rather such dividends would be fully taxable again. Obviously this is an editorial error that will most likely be eliminated. There is no conceptional reason why dividends that constitute business income should not be eligible for the "semi-income" concept. In cases where corporations channel dividends through a partnership (corporate parent è partnership sub è corporate sub) this just may give rise to 1½ times taxation (read: a double taxation of 50%) of the dividend given that partnerships are not eligible for corporate tax privileges even if they are owned by a corporation (comp. sec. 41 para. 2 Corporation Income Tax Regulations). Although this, too, makes no sense, it probably will not be corrected.


Capital Gains Treatment

A proposed comprehensive participation exemption was received enthusiastically by German industry and in particular by German banks and insurance companies who have significant holdings in German industry - the reaction was great enough to boost the stock prices of those corporations that would primarily benefit. According to the Proposal, all dividends received by a German resident corporation, will be tax exempt. In addition capital gains derived from the disposal of shares in a corporation will be tax-exempt for any German resident corporation, irrespective of any participation amount. As a consequence, Germany would have a participation exemption that goes even beyond the famous Dutch regime that excludes portfolio investments. Since 1994 capital gains derived from the disposal of a substantial holding in a foreign corporation, subject to various conditions, have also been exempt. The new capital gains exemption expands the scope of this provision significantly by including German subsidiaries and eliminating any minimum ownership requirements. Taking into account that Germany does not levy any stamp duties, this new rule would give a substantial impetus to set up international holding company structures in Germany. Unfortunately, some scepticism remains whether this fairly generous regime will indeed be enacted. It may well be the target of left wing attack in the course of the legislation process. If leftist manoeuvres are successful, the capital gains exemption may be attached to some minimum holding period requirements. If left as it, the provision would enable German industry to dispose of their investments in other German corporations and realise the substantial inherent capital gains tax-free.

The reverse side of the capital gains exemption for corporations would be the elimination of the tax deductibility of book write-downs for investments in subsidiary corporations. Expenses that have a direct nexus with tax-exempt income are not tax deductible. Given that dividends received from corporate subsidiaries are no longer taxable, any directly related expenses will no longer be tax deductible. If this rule is not changed, intermediate tax planning will be needed to push the debt to the operating subsidiary directly or to implement group taxation. However, a distinction must be made between domestic and foreign subsidiaries. As far as foreign subsidiaries are concerned, expenses equal to only 5% of the dividend income are deemed to be directly related to the tax exempt foreign source income; thus, 5% of the foreign dividend is taxable. In its current wording, the law would render expenses, in particular interest, directly related to German subsidiaries no longer deductible whenever a dividend is paid, whereas expenses related to foreign subsidiaries would qualify for a tax deduction to the extent they exceed 5% of the foreign source dividend. Whether or not this somewhat surprising result is left unbowdlerised remains to be seen.

Enhanced Need for Group Taxation

The repeal of the imputation tax system in combination with a general dividend received deduction makes it necessary to revisit German inbound structures. Interest expenses incurred by an acquisition company or a holding company can no longer be used by virtue of the imputation tax system, rather it will be required to set up a group taxation structure from the outset. The good news is that the organisational and business integration tests, sometimes difficult to fulfil in day to day business, will be abolished with effect of 2001 (ignoring business years which deviate from calendar years). In the future, the so-called financial integration suffices to establish group taxation. The financial integration test is met if the parent company holds the majority of the votes in the subsidiary. As a further alleviation, direct and indirect ownership may in future be cumulated for purposes of the test in the future provided a majority ownership prevails in each company whose voting rights are included into the aggregation.

The current version of the Draft evidently requires a profit & loss pooling agreement for trade tax in the future. This seems to be an editorial error that will hopefully be eliminated.

For VAT purposes, no changes to the group taxation have been proposed. This may be due to Art. 4 para. 4 of the 6th EU Directive which requires not only a financial but also an integration in business and organisational respects. As a consequence, business and organisational integration tests may remain necessary to establish VAT group taxation.

Transitional Rules to Phase-out the Imputation Tax System

The planned about-face from an imputation tax system for corporation tax purposes back to a classical system is fundamental enough to require transitional rules. The imputation tax credit will be granted for any distributions relating to earnings generated in the last year for which the imputation tax system still applies. Since the business year agrees in most cases with the calendar year, this last year will be the tax year 2000 for most taxpayers. However, the credit shall only be granted to dividends paid out not later than the end of the first business year that begins after December 31, 2001. In cases where the business and the calendar year are the same, this means that earnings generated by the end of 2000 must be distributed by the end of 2002 to qualify for the old corporation tax abatement at the company's level and for the imputation credit at the shareholder's level. Putting diverging business years aside, the advance corporation tax relating to constructive dividends will be due for the last time by the end of 2000. At the end of 2000, the remaining equity basket "EK45" containing income that has been subject to a corporation tax of 45% will be allocated to the EK40 basket (40% has been in effect since the beginning of 1999) on the basis of a mathematical proportion which insures that no corporation tax abatements are effectively lost. Thus, at the end of the tax year 2000 the only equity basket that carries a higher tax burden than 30% (the distribution rate) will be EK40. Corporation tax credits amounting to the difference between the 40% paid so far and the hypothetical distribution tax of 30% are embedded in this equity layer. The ten-percentage point difference between the retained earnings rate of 40% and the distribution rate of 30% equals a fraction of 1/6 of the EK40 basket. The entire amount of embedded tax credits is separately assessed by the tax authorities and is referred to as the "corporation imputation credit available" (Körperschaftsteuerguthaben). The available credits are not immediately refunded, rather the corporation income taxes for a given tax year when a distribution is made will be reduced by 1/6 of the profits distributed made until the corporation imputation tax credits are exhausted. However, tax credits still remaining after 15 years would be lost.

Conversely, tax exempt domestic source income represented by the so-called EK02 basket may also trigger advance corporation tax amounting to 3/7 of the EK02 earnings used whenever EK02 is distributed over the next 15 years. Existing EK04 layers which comprises shareholders contributions and which do not give rise to any advanced corporation tax payments or dividend withholding taxes under existing rules will retain their character and will be attributed to a special capital surplus account.

Equity baskets generated from foreign source income (EK01) and pre-imputation tax system earnings (incurred by the end of 1976, referred to as "EK03") are not specifically mentioned in the Draft. One may thus conclude that these two equity baskets can be distributed without incurring any advance corporation tax during the transitional period. This makes sense because even under the existing rules EK01 layers can be paid out without advance corporation tax; advance corporation tax levied on the payout of EK03 is at least refunded to non-resident shareholders.

In brief terms, the future sequence of utilisation of retained earnings for tax purposes will be as follows:

1) Earnings generated under the new system plus EK40, EK30, EK01 and EK03 layers available at the end of 2000 (business year = calendar year) will be used first for distributions. These distributions will give rise to a tax refund of 1/6 of the distribution until the corporation imputation credits are exhausted.

2) When all earnings mentioned under 1. above are exhausted, the EK02 layers available at the end of 2000 will be used. Their utilisation gives rise to the old advance corporation tax of 3/7 of the dividend until 2015. After 2015 the EK02 layers can be used without any additional tax cost. Thus one should avoid tapping the EK02-basket for 15 years. There may be planning techniques to pull out EK02 without incurring the advance corporation tax.

For German shareholders the payout of the earnings mentioned under 1. and 2. above will give rise to dividend treatment.

3) Lastly, the EK04 basket will be used. Given that it is shareholder's equity, its distribution will not give rise to the advance corporation or dividend withholding tax, nor will it be dividend income for the shareholder. It is a return of capital.

In particular, non-resident shareholders may have to examine their home country's position for the tax year of 2000 to make a decision whether or not it is advisable to distribute all taxed equity baskets at the end of 2000 to take advantage of all corporation income tax abatements immediately rather than over a period of 15 years.

Curtailing Certain Tax Planning Techniques

As mentioned above, the rate reductions are predominantly financed by reducing depreciation allowances. In addition some widely used tax planning techniques will also be curtailed.


Restrictions on Step-up Technique Imposed

In accordance with the reorganisation tax rules, a tax-free -step up amounting to the difference between the so-called inside and outside basis of a corporation can be obtained whenever a corporation is converted into a partnership. The step-up technique was eliminated for trade tax purposes in 1999 when an amendment of section 18 para. 2 Reorganisation Tax Act ("RTA") was enacted with the Tax Amendment Act 1999 of March 24, 1999. The current Draft contains a further amendment of section 3 RTA requiring that the step-up amount must be taxed by the transferring entity correspondingly. As a result, the step-up technique is virtually effete since the step-up amount will be subject to both corporation and trade tax, but the absorbing entity would not be entitled to receive a step-up for trade tax purposes. Thus, what was once a very positive tax arbitrage is now detrimental. This step-up technique will hence become more or less obsolete. In future, a step-up may still be attainable where the transferring entity has tax losses. Under the current Proposal, the amendments will be effective for reorganisations with a tax effective date in the first fiscal year that begins after December 31, 2000. Since reorganisations can be accomplished with retroactive effect of up to 8 months, December 31, 2000 can be used as the last tax-effective date for transactions that are filed with the commercial court no later than August 31, 2001, assuming this draft phase-out remains unchanged.

Thus, it may pay to take a closer look at existing structures to identify structures where the outside tax basis of shares in a corporation significantly exceeds the inside tax basis of the assets, less liabilities. Provided there is no contamination of the shares pursuant to section 50c Income Tax Act standing in the way of a tax-free step up, taxpayers should implement the step-up with a tax effective date before the new rules apply.

Reduction of Threshold for Capital Gains for Individuals

Individuals are not subject to a general tax on capital gains derived from the disposal of shares in a corporation. Under the existing rule, the capital gains taxation applies whenever an individual shareholder at any point in time during the last 5 years owned 10% or more of the share capital in a German corporation. Under the Proposal, the threshold will be reduced to an ownership of 1% or more. While this rule primarily targets German individuals because it only applies if the shares are not held by a business property (where all capital gains are subject to tax), it also affects inbound ownership structures where the non-resident taxpayer is not protected under an existing tax treaty. This may be of particular importance for private equity structures. Private equity funds which collect money from all sorts of investors - like pension funds or private investors that may not be resident in jurisdictions that maintain a tax treaty with Germany - typically focus on the tax-free realisation of a capital gain without having to invoke on the benefits of a tax treaty given the ever-growing limitation of benefit articles in tax treaties and anti-treaty shopping provisions. With the minimum ownership threshold of at least 10% for capital gains taxation in a German corporation, private equity funds are often formed in offshore tax jurisdictions. Since such funds mostly involve more than ten investors, no single investor will typically own 10% or more in the German corporation when viewed on a look through basis. After the reduction of the capital gains threshold to 1%, this requires on average 100 investors in a private equity fund. It is very well conceivable that based on a look-through-approach investors in private equity funds own 1% or more in a German corporation. Under these circumstances the capital gain may be taxable in the future. It will therefore be necessary to review private equity structures to ensure that none of the investors is encountered with capital gains taxation in Germany because of the change to be effective 2001.

Tightening of Thin Capitalisation Rules

Another revenue raiser will be the amendment of the thin capitalisation rules provided in section 8a Corporation Income Tax Act. At the time being the provision applies to shareholders who are not entitled to the German imputation tax credit. In light of the fact that the imputation tax system will be abolished, the scope of the thin capitalisation rules must change accordingly. Under the new concept, the thin capitalisation rules do not apply if the remuneration paid on the debt is subject to German taxation. Viewed systematically, perspective has been shifted; the result will however be more or less the same as in the past: it primarily applies to non-resident shareholders and some tax exempt German institutions. The new wording is however helpful for financing obtained from tax-resident banks in Germany. The debt / equity ratios are summarised in the following diagram:

Debt / Equity Ratios



· Hybrid debt

0.5 : 1


· Straight forward debt

- Regular companies

- Holding companies

3 : 1

9 : 1

1.5 : 1

3 : 1


Along with the repeal of a safe haven for a hybrid debt (defined as debt where the remuneration is not fixed as a percentage of the face value of the instrument), there will be a non-rebuttable presumption that any remuneration paid on hybrid debt is no longer deductible, but treated as a constructive dividend for corporation income tax purposes. For so-called straight forward debt where the remuneration is expressed as a percentage of the face value of the instrument, the safe havens have been significantly reduced. However, unlike for hybrid debt, interest paid on debt in excess of the safe havens may still be deductible provided the company can prove that it could have obtained the loan from an unrelated party under the same circumstances ("arm’s length"-test). Meeting this burden of proof may however be quite onerous so that one should not necessarily rely on this rule for a tax planning structure.

As in the past, the disallowance of interest expenses under the thin capitalisation rules in section 8a Corporation Income Tax Act does not apply for trade tax purposes since the relevant provision (section 9 no. 10 Trade Tax Act) is, at least for the time being, not affected by the Reform. However, for trade tax purposes, the regular add-back provisions apply. Thus, in most cases, only 50% of interest expenses would be deductible for trade tax purposes. In some cases involving hybrid debt, in particular silent partnership arrangements, interest paid to a non-resident recipient would not be deductible.

In a hearing at the Federal Ministry of Finance on January 28, 2000 expert witnesses voiced concerns that the Proposal does not provide for any grandfather or phase-in rules. If this criticism is not paid sufficient heed, non-resident taxpayers would need to unwind existing hybrid debt financing by the end of this year.

Disadvantages of the German Leasing Industry

The current version of section 8 para 7 Trade Tax Act provides that 50% of lease amounts paid for the use of moveable assets must be added back for trade tax purposes. In accordance with section 8 no. 7 sentence 2 Trade Tax Act, this rule does not apply inasmuch as the rent paid is subject to trade tax at the level of the lessor. As far as pure domestic lease transactions were concerned, the add-back provision did not apply. Rather, it primarily hit non-resident lessors leasing of moveable property inbound to Germany. The airline Eurowings considered this a violation of the anti-discrimination rules in article 59 of the EU Treaty and brought the matter before the European Court of Justice. With its ruling dated October 26, 1999, the court deliberated in favour of Eurowings.

After the ruling, it would have been reasonable to expect the Federal Ministry of Finance to put an end to the discrimination of EU member states by eliminating the add-back rule. Not one to pass up a chance to eliminate discrimination and raise revenue at the same time, the Ministry's Draft rather calls for applying the add-back provision in future to all recipients of lease payments, whether German or foreign, subject to trade tax or not. As a result, there would be 1.5 times trade taxation with regard to such income; 50% at the level of the lessee and 100% at the level of the lessor. This Proposal has moved the German leasing industry to mobilise its resources to stop a measure that would impose such a significant competition distortion. The proposed rule is estimated to increase the cost of leasing by approximately 10%, virtually forcing domestic leasing companies out of business by leaving them non-competitive. Furthermore, since no grandfather or phase-in rules have been included, it would hit existing contracts with effect of the tax year 2001. If these rules were enacted so suddenly, the German leasing industry would now find itself discriminated against foreign lessors that are not subject to German trade tax. It is therefore hard to believe that this provision will be enacted as currently drafted.

Income Taxation of Partnerships and Sole Proprietorships

As already mentioned, approximately 85% of all businesses in Germany are conducted either as partnerships or sole proprietorships. Traditionally Germany treats partnerships as fiscally transparent and thus, partnerships and sole proprietorships are taxed at their progressive marginal income tax rates. Since the top marginal income tax rate will be reduced to 48.5%, while the corporation income tax rate is lowered to 25%, the reform runs the risk of giving corporations a favoured treatment. Trade tax on income, again, does not discriminate; it applies indifferently to both kinds of business undertakings. To avoid constitutional challenges because of this inherent preferential treatment for corporations, the Tax Reform Proposal 2001 provides for two mutually exclusive options for partnerships and sole proprietorships to remedy any imbalance: (i) a limited tax credit for trade tax on income or (ii) the option to be taxed as a corporation.

i) Tax Credit for Trade Tax on Income

Individuals who are partners in a partnership or receive business income directly are, subject to various conditions, entitled to an income tax credit that equals twice the amount of the trade tax basic taxable amount. Ignoring the rather insignificant sliding scales at the beginning, the basic taxable amount for trade tax purposes equals 5% of the income subject to trade tax. Each municipality applies its trade tax factor set by local municipal law to this basic taxable amount. The trade tax is deductible when determining the income subject to trade tax. The interrelations can be worked out even with some medium level of mathematics, but the usual spreadsheet functions are faster. As shown in the following table 2 a full relief for trade tax will be achieved if the local municipal trade tax factor happens to be approximately 388%. Indifference in this sense means that from the point of view of the taxpayer, he has the same total income tax bill (without surtax) as if trade tax had been repealed entirely.

Table 2: Trade tax factor = 388.38%


No Trade Tax

Including Trade Tax

Profit before tax



Trade tax on income




Income tax at 48.5%



Trade tax credit
(83.74 x 10%)



Total income taxes paid



Given that the income tax credit for trade tax equals twice the basic taxable amount or a municipal factor of 200%, it is interesting to look on such a situation where, as a matter of fact, the tax paid to the municipality can be fully credited against income tax. However, given the fact that trade tax continues to be deductible, there is even a benefit resulting from such situation as shown in table 3.

Table 3: Trade tax factor = 200%


No Trade Tax

Including Trade Tax

Profit before tax



Trade tax on income




Income tax at 48.5%



Trade tax credit

(90.91 x 10%)





Total income taxes paid





As a result of the new system, the individual taxpayer is in an even better situation given that trade tax has not been abolished. Without any trade tax his total income taxes paid would have been 48.5. Under the new concept, his total tax bill is reduced to 44.09; the difference of 4.41 is caused by the deductibility of trade tax which is still allowed notwithstanding a full credit. There are very few municipalities in Germany that levy trade taxes at a lower factor than 200% (there may even be a municipality that has a factor of 0%) in which case the income tax credit even has the character of a tax-sparing credit because it is always based on a factor of 200%. Indeed this is somewhat surprising and will undoubtedly give rise to domestic municipal trade tax planning.

(ii) Option to be Taxed as Corporation

As an alternative to availing themselves of an income tax credit for the trade taxes paid, a proposed section 4a Corporation Income Tax Act provides sole proprietors or partners of a partnership with an option to be taxed as a corporation in all respects. Given the German tradition of a strong fiscal transparency of partnerships, these limited check-the-box rules represent a major change in German tax law.

When the option is exercised by all partners of a partnership or by a sole proprietor, the business is deemed to be converted into a corporation subject to corporation tax at the rate of 25%. Applying the Reorganisation Tax Rules accordingly, the transformation into a corporation is deemed to be effective at the beginning of the fiscal year for which the option is exercised. The option can retroactively exercised up to a maximum of 8 months hence, assuming the fiscal year agrees with the calendar year, the taxpayers have to make up their minds for the first possible option in 2001 by August 31, 2001. The option is irrevocable for a given tax year. In accordance with the explanations to section 4a CITA an option back to partnership taxation is for subsequent years possible at any time. Thus, notwithstanding the somewhat unclear language of the Draft in this respect, it would be conceivable to switch every year from the corporation tax regime to the partnership tax regime and vice versa.


The change to the corporate tax regime occurs at book values and thus does not result in taxation of any inherent built-in gains except for so-called supplementary assets (Sonderbetriebsvermögen). Non-resident partners in a German partnership must, however, be aware of certain issues: Under the existing rules, section 20 para 3 Reorganisation Tax Act provides that gain must be recognised whenever a partnership is transformed into a corporation and Germany does not have a right to tax the capital gain derived from the disposal of the shares in the corporation that substitute the partnership interests. This is the case in most treaty situations pursuant to article 13 para. 4 OECD Model Convention types of treaties. Thus, non-resident partners in an OECD treaty type of country could not convert a partnership tax-free into a corporation. In such situations, the new rules provide for an interesting planning possibility. Unlike in the past, the capital gain that occurs pursuant to section 20 para. 3 RTA can be deferred until the shares in the absorbing deemed corporation are sold, with no interest expenses. If in the meanwhile the partnership that has opted to be taxed as a corporation returns to the partnership tax regime, the income tax on the deemed conversion gain is forgiven. As a consequence, partnerships owned by non-resident partners that experience disadvantages as far as the ongoing taxation is concerned can - at least for purposes of the recurring taxation - adopt the corporation tax regime for a certain period of time and opt back for partnership taxation whenever it is beneficial again.

The limited check-the-box rules that Germany plans to introduce may certainly provide very interesting tax planning opportunities given the different tax regimes of partnerships and corporations. It goes without saying that it poses many unresolved questions in particular in treaty situations especially since Germany, because of its long-lasting tradition to treat partnerships as "look through"-entities, has usually refrained in treaty situations to define partnerships as persons in the meaning of article 3.1.a OECD Model Convention. It is now interesting to see how treaty partners will react if a German partnership - not defined as a person under the tax treaty but all of a sudden subject to tax - claims treaty relief. For German resident individual partners, the option may have serious draw-backs (e.g. joint and several liability of any partner for all income taxes, higher estate taxes, deemed disposal of supplementary assets) so that each partner must examine very carefully whether or not he or she gives the consent for exercising the option.

Amendment of CFC Rules

Given the comprehensive participation exemption for any corporation with regard to dividends received no matter whether from a German or foreign subsidiary, and the semi-income taxation concept for dividends paid to individuals, the proposed amendments of the CFC rules aim to ensure that dividends have been subject to a reasonable level of income taxation. Under the existing rules, CFC taxation for regular passive income kicks in when a foreign corporation is controlled (more than 50%) by German resident shareholders. For passive portfolio income, CFC taxation applies for any resident taxpayer who owns at least 10% in a foreign corporation. Under the Proposal, this distinction will no longer be made. The CFC rules will in general apply whenever German resident taxpayers own more than 10% in a foreign corporation that generates CFC income. The reduction of the ownership threshold is not very practicable. If, for example, a foreign corporation is listed on a German stock exchange (which is more and more the case for the New Market) the rule would apply whenever German shareholders aggregately own more than 10%. There is no control situation that would enable each shareholder to obtain the required information whether or not the corporation generates passive income. Pursuant to the revision of section 10 para. 6 Foreign Relations Tax Act, the portfolio income definition is broadened by eliminating the substantial holding exclusion pursuant to which dividends received from another subsidiary in which the CFC owned at least 10% is shifted into the regular passive income basket under the existing rules. In future, dividends received from lower tier companies will thus belong to the portfolio income basket. For portfolio income, the German CFC rules override any treaty participation exemption, thus this is a significant change for the worse, because the proposed change would have a very negative impact on international holding structures of German multinational corporations. Inasmuch as dividends are received by a CFC from subsidiaries that conduct an active trade or business, the participation exemption as provided in section 13 Foreign Relations Tax Act, does however still apply. Likewise, the portfolio income exclusion for intra-group financing of active related parties is also preserved.

The high-tax kick-out is reduced from 30% to 25%. Bearing in mind that the German corporation tax rate will be 25%, the move appears half-hearted; a reduction to 20% would have been more realistic. Under the Proposal, foreign income - whether active or passive - that has been subject to an income tax burden of 25% or more will be excluded from the scope of the CFC regime. The same holds true for active income subject to lower tax burdens. The combination of the proposed participation exemption in sec. 8b para. 1 Corporation Income Tax Act with the proposed CFC rules provides new interesting options. It used to be that whenever a German parent company had an active subsidiary in a treaty location (e.g. manufacturing in Ireland or in Switzerland), low taxed income not subject to the CFC regime could always be repatriated without any additional German tax cost to a corporate level pursuant to treaty participation exemptions. In future, however, this would even be possible for non-treaty locations. Thus, under the Proposal, a German corporate parent could maintain, a manufacturing subsidiary in non-treaty locations such as Liechtenstein, Puerto Rico or Hong Kong and repatriate dividends tax-free. In the past, this result was only attainable by interposing a holding company in a good treaty location, mostly in the Netherlands.

Taxation of Mutual Funds

The Draft also proposes to fundamentally change the income taxation of mutual funds. Under the current tax system, mutual funds are treated as fiscally transparent entities. Under the new concept, mutual funds will be subject to corporation tax, its income will thus be taxed at 25%. Distributions by mutual funds will be taxed as dividends and will thus be eligible for the semi-income tax concept. Those dividends sourced from the disposal of assets that would be tax exempt under the capital gains rules applicable for individuals if individuals held them directly (sec. 23 ITA) are tax-exempt for individuals (sec. 3 no. 40 sentence 2 ITA). This exclusion does however not apply for dividends received by a trade or business. The proposed changes would severely damage funds that have invested in bonds or real estate.

The mutual fund industry has already voiced serious concerns and there are strong indications that this part of the Proposal will not be enacted.

Implications for the Mergers and Acquisition Business

It would go beyond the scope of this initial brief outline of the Proposal to discuss in detail the implications on the M&A business. The most obvious impacts are briefly highlighted:

1) Capital gains from the disposal of shares in a corporation derived by another corporation may be tax-exempt in the future. In view of the fact that a corporation will be in a position to transfer either the entire business, a branch of activity (Teilbetrieb), or a partnership interest into another corporation in exchange for shares at book values, a German corporation could not only sell any stake held in another corporation tax-free. It would also be possible to transfer a branch of activity to a lower tier corporation and subsequently dispose of the shares received in exchange tax-free. Opponents may introduce minimum holding periods to dilute the Proposal.

2) The threshold for capital gains derived from the disposal of shares in a corporation for individuals will be reduced to an interest of at least 1%. The capital gain falls within the scope of the semi-income concept and thus is effectively taxed at half of the ordinary income tax rates. One may expect taxpayers to thus put off selling stock until 2001.

3) As a matter of principle, the purchaser will no longer be in a position to step-up the tax basis of the underlying assets whenever shares in a corporation are acquired. Because of the change in section 3 Reorganisation Tax Act, the German step-up that still requires a corporation to be transformed into a partnership works very similarly to the US section 338 (h) 10 IRC election. The step-up amount must be taxed by the transferring entity and thus would only make sense if the transferring corporation has tax losses.

4) Whenever interests in a partnership are concerned, the acquirer is still entitled to a step-up in basis of the underlying assets provided the partnership is treated as a fiscally transparent entity. Under such circumstances, the capital gain be fully taxable -- except for trade taxes -- for the sellers who will not be eligible for the semi-income taxation concept.

5) If a partnership is taxed as a corporation, it is no longer treated as a fiscally transparent entity. The rules described for corporations apply accordingly.

If this fundamental reform is enacted, it will render known tax-efficient models for structuring acquisitions and divestitures generally useless, leaving us to rewrite the book.

Closing Remarks

The German Tax Reform Proposal 2001 made by the Ministry of Finance introduces profound changes to the German tax system that, however, in no way help simplify the German tax system. Although some tried and true tax planning measured are curtailed, other new planning tools are offered. As stated at the very beginning of this article, the Proposal has a long way to go before it is published as new legislation in the Federal Law Gazette - most likely in the fall of this year. Given that the ruling social democratic / green parties do not have an overriding majority in the Council of States - the second parliamentary chamber, whose consent will be needed - the Government has no choice but to negotiate. The Christian Democratic opposition parties are opposed to abolishing the imputation tax system and do not agree with the introduction of a schedule-type taxation pursuant to which business income receives preferential tax treatment. The tax authorities led by the Federal Ministry of Finance are most likely to adamantly pursue the repeal of the imputation tax system because they see the imputation tax credit system open to too much abuse. For now, the Council of States is in a deadlock. Upcoming state elections in Schleswig-Holstein and the densely populated, key state of North Rhein Westphalia may tip the balance in the Council either way. At present there is no way of predicting the final outcome. Taxpayers, practitioners and potential investors alike will have to keep a weather eye open between now and September when this political tax tug-of-war will hopefully be over.


* Eugen Bogenschütz and Kelly Wright are both in the Frankfurt/Main office of Haarmann, Hemmelrath & Partner

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