Germany: 184. Government announces "Tax Reform 2000"

Last Updated: 4 January 2000
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1. Government announces "Tax Reform 2000"

In article no. 165, we reported on the so-called "Brühl Recommendations" of 30 April 1999 for further reform of German business taxation. The German government indicated at the time that it would develop detailed legislation based on the Brühl Recommendations for implementation in the year 2001.

On 21 December 1999, the German Finance Minister Hans Eichel announced the government's plans for what is referred to as the "Tax Reform 2000" at a press conference held in Berlin. He simultaneously released a position paper outlining the proposed changes. While the position paper by no means possesses the specificity of draft legislation, it is more definite than the Brühl Recommendations. Above all, it indicates government resolve to carry through with a fundamental reform of the German income tax system along the lines of the Brühl Recommendations.

Although the planned reform is to be enacted in the year 2000, none of the measures it contains would take effect before 2001. The Tax Reform 2000 package is presently nothing more than a statement of political intention, which is notoriously susceptible to change. Furthermore, the parties forming the current Red-Green coalition government do not command a majority in the Federal Council (Bundesrat), but need the consent of this body to enact the proposed reforms. Hence, the cooperation of the opposition parties is indispensable to the enactment of the government's measures.

Despite the continued uncertainty, it is nevertheless impossible to ignore the announced plans when making decisions for the future. The following article was prepared on the basis of information released by the Federal Ministry of Finance in December 1999. Further information including a draft of the proposed legislation was released on 10 January 2000, but could not be reviewed for purposes of this article.

2. Central features of Tax Reform 2000

2.1 Business versus personal income tax rates

The premise of the Brühl Recommendations is that it is desirable and feasible to reduce income tax rates for businesses while maintaining high tax rates for individuals. Numerous experts and the opposition parties question this premise and advocate instead a general reduction of tax rates for businesses and individuals alike. However, the government has consistently rejected this approach, and its latest position paper shows no sign of wavering on this point. Nevertheless, somewhat surprisingly, the announced tax reform package does contain modest additional reductions in the general personal income tax rates.

2.2 Taxation of businesses and their owners

The following features of the Tax Reform 2000 would take effect in 2001:

• A uniform corporation tax rate of 25 % would replace what are in effect three different current corporate tax rates (resident corporations: 40 % for retained earnings and 30 % for distributed earnings; non-resident corporations: 40 % definitive tax rate).

• A 50 % exemption for dividends received by individuals (natural persons) and a 100 % exemption for dividends received by corporations would largely eliminate tax pyramiding (exemption method). The corporation tax credit available since 1977 to resident individuals, corporations, and permanent establishments would be abolished.

Elective taxation as a corporation would be available to partnerships and sole proprietorships, whether commercial, professional, or agricultural (personal businesses). Personal businesses exercising the election would enjoy the low corporation tax rate of 25 % on their retained earnings. Withdrawals from these businesses would be taxed as dividends.

• A new limited credit of trade tax against personal income tax would be available to the owners of personal businesses which do not exercise the above election.

2.3 Personal income tax rates

The changes in this area should be viewed in the context of the changes already made by the Tax Relief Act for the Years 1999/2000/2002 (see article no. 166). Phase 3 of the changes under this measure, scheduled to take effect in 2002, would be moved up to 2001 under the Tax Reform 2000 proposals. Additional phases for 2003 and 2005 would be added. Below, all references to years before 2001 relate to measures already legislated. Their inclusion facilitates comparison with the situation existing when the current Red-Green government took office in the autumn of 1998.

Reductions in the top personal income tax rates as follows:

i. In 2000, from 53 % to 51 %

ii. In 2001, from 51 % to 48.5 %

iii. In 2003, from 48.5 % to 47 %

iv. In 2005, from 47 % to 45 %

• In phases (1999 - 2005), increases in the zero bracket amounts from DM 12,365 in 1998 to DM 15,000 in 2005 and reductions in the minimum tax rate from 25.9 % in 1998 to 15 % in 2005.

• The tax rate progression of the personal income tax would be made more gradual for low and middle income taxpayers in 2001 and 2005.

The tax rate progression changes planned for 2001 under the Tax Reform 2000 proposals are those already legislated for 2002 under the Tax Relief Act for the Years 1999/2000/2002. While dull-sounding, the tax rate progression changes legislated for 2002 reduce taxes by DM 17.9 billion and represent by far the most important tax reduction measure in the original 2002 package (see article no. 166 sec. 5). The progression changes intended for 2005 appear to be as large or larger.

3. Corporations and shareholders

3.1 Exemption method for avoiding double taxation

The 100 % dividends-received exemption for corporations is not contingent on a minimum percentage holding or a minimum holding period. The exemption also applies to dividends received from foreign corporations (presumably subject to the existing terms of the International Taxation Act). As a result of this system, income would be taxed only in the hands of the corporation which originally earned it and in the hands of shareholders who are natural persons.

The 50 % dividends-received exemption (Halbeinkünfteverfahren) for individuals (natural persons) likewise applies in principle to foreign-source dividends. However, if the earnings being distributed are from passive sources, the exemption only applies if they have been subject to foreign taxation equal to the new German corporation tax rate (25 %). Otherwise, look-through taxation under the International Taxation Act would apply. This essentially means disregarding the foreign corporation for tax purposes and treating its earnings as derived directly by its shareholders without regard to distribution. Changes in the International Taxation Act are planned in this connection.

On domestic dividends, an individual receiving a dividend taxed at a marginal tax rate of 51 % in the year 2000 would pay an effective tax (including trade tax at an assumed rate) of approx. 53.6 % on the dividend. This compares favourably with an effective tax of approx. 59 % under the present credit system. On the other hand, small shareholders with a marginal tax rate of under 30 % receive a tax refund as a result of the full corporate tax credit under the present system. Such taxpayers can be worse off under the new system.

The 50 % exemption method will extend to capital gains on private (as opposed to business) sales of stock taxable under § 23 EStG. These would be 50 % tax free as well. However, only half of expenses related to dividend income would be deductible.

3.2 Gain on sale of shares in corporations

Gain derived by a corporation from sale of shares in another corporation, foreign or domestic, would be tax exempt. However, writedowns to going concern value by reason of a dividend distribution would be eliminated entirely for tax purposes.

Half of the gain derived by an individual on sale of corporate shares held as private (as opposed to business) property would, however, be subject to tax if the seller's direct or indirect holding in the corporation whose shares are being sold amounted to 1 % or more. The current threshold is 10 % (§ 17 EStG). The reduction is considered necessary to make it more difficult to accumulate profits in a corporation at the low corporate tax rate and then realise the profits as a tax-free capital gain instead of distributing them.

3.3 Permanent establishments

The domestic permanent establishments of foreign corporations would, as under current law, not be subject to any branch profits tax or taxation on deemed distribution of earnings. This would place the domestic subsidiaries of non-EU corporations at a certain disadvantage vis-à-vis domestic permanent establishments because distribution of earnings by a domestic subsidiary would trigger capital gains tax. However, the subsidiaries of EU corporations would be under no such disadvantage because capital gains tax on their dividend distributions is eliminated under the Parent-Subsidiary Directive and § 44d EStG.

3.4 Treatment of existing retained earnings

Existing corporate retained earnings have in many cases been taxed at the high tax rate for retained earnings in effect at the time the earnings were derived. Under the present corporation tax system, distribution of such earnings leads to a reduction in corporate tax. However, the Tax Reform 2000 proposals would do away with this system and eliminate the tax reduction. The treatment of old retained earnings is therefore of considerable importance.

The transition rules proposed by the government would freeze the accounts kept by corporations on their distributable equity as of the effective date of the new system. During a transition period of 15 years, dividend distributions would continue to result in a reduction of corporation tax to the extent the account or "basket" out of which they were deemed paid had been taxed at a higher rate. The present tracing rules, which determine the basket from which a distribution comes, would continue in effect during the transition period.

The amount of the refund would be determined using the present 30 % distribution rate, not the planned new uniform 25 % rate. Since there seems to be no intention to continue the credit for corporation tax paid during the 15 year transition period, dividends received from "old" retained earnings would be taxed under the exemption method (see sec. 3.1 above).

Distributions are also possible from equity baskets with zero prior taxation (EK 01 - EK 04). Under the transition rules, only distributions from EK 02 would trigger an increase in corporation tax.

3.5 Advantages of the new corporate tax system

In an essay entitled "Corporation Tax for the Year 2000" published in January 1998, Prof. Dr. Norbert Herzig and Ewald Dötsch explored the weaknesses of the current corporate tax system (DB 1998, 15):

• Too complicated?

• Easy for individuals to evade by selling shares (§ 17 EStG) instead of receiving dividends?

• Easy for persons not entitled to the corporation tax credit to evade by dividend stripping?

• Split-rates for retained/distributed earnings outdated?

• Inconsistent with EU law in three respects:

i. Denial of a credit to German shareholders for corporation tax paid by foreign EU corporations?

ii. Denial of a credit to foreign EU shareholders for corporation tax paid by German corporations?

iii. Denial of lower distribution rate to domestic permanent establishments of EU corporations?

Complexity vs. simplification

Herzig/Dötsch believe that the complexities of the German integrated corporation tax system can be considerably reduced without abandoning its basic principle, stating that the Federal Ministry of Finance has long since drafted the necessary laws. They see no reason to abandon the present system for this reason (Herzig/Dötsch at p. 15/1).

The drafters of Tax Reform 2000 regard corporation tax simplification as one of its major advantages. They also believe that a simpler system with a lower corporation tax rate will increase Germany's attractiveness as a business location by making it easier for investors to plan their German investment. Herzig/Dötsch concede that a system like Tax Reform 2000 is inherently simpler than any credit system (Herzig/Dötsch at p. 19/1).

Tax-exempt sale of shares and dividend stripping

Herzig/Dötsch state that the avoidance of corporation tax by realisation of tax-free capital gains is not indicative of any weakness in the integrated corporate tax system. They suggest reducing the threshold of § 17 EStG to fix the problem. After reducing the threshold from 25 % to 10 % in the Tax Relief Act for the Years 1999/2000/2002, the Red-Green government now proposes to lower it to 1 %.

Dividend stripping involves the sale of shares by persons not entitled to the corporation tax credit (and to credit of withholding tax) to persons so entitled shortly before dividend payment dates followed by subsequent repurchase of the shares. Herzig/Dötsch consider dividend stripping a serious compliance problem difficult to solve in light of the anonymity of modern stock exchange transactions.

The drafters of the Tax Reform 2000 believe that the new corporation tax will be harder to evade than the old one. By lowering the threshold of § 17 EStG, tax-free sales of shares are minimised. By abolishing the corporation tax credit, dividend stripping is eliminated with respect to this credit, though, of course, not with regard to dividend withholding tax.

Split-rate system

Herzig/Dötsch advocate abandonment of the split-rate system in favour of a uniform rate. They see marginal utility to a split-rate system with but a narrow difference between the two rates. Furthermore, they explain that multinational groups can avoid the effects of the higher retention rate (Herzig/Dötsch p. 20, at fn. 56).

Compatibility with European law

Of the three problems referred to above, Herzig/Dötsch regard only the different taxation of permanent establishments as a potential problem. Otherwise, they believe that the grandfather clause in Article 73d of the EC Treaty would protect German corporate tax law against challenge. Herzig/Dötsch note that corporation taxes are not harmonised in the EU and that objections based on European law are raised against the corporation tax laws of nearly all member states (Herzig/Dötsch at 19/2). They note that abandonment of the present system would mean abandonment of the protection of Article 73d and obligate Germany to enact a system which complies in all respects with EU law while other member states retain their old systems. Conceivably, subsequent harmonisation of EU corporation tax law might then compel Germany to change its system twice in succession (Herzig/Dötsch at p. 20/1). In light of these considerations, they urge caution.

The drafters of the Tax Reform 2000 definitely consider that their system does not distort competition and is compatible with European law.

4. Personal businesses and their owners

4.1 Need for inclusion of personal businesses

Inclusion of personal businesses in the tax reform was seen as a political and economic necessity. More than 80 % of German businesses are operated in partnership form. Small and medium sized business is seen as the true backbone of the German economy. In fact, Germany possesses more independent (non-group-owned) businesses than the United States, although the United States economy is much larger than that of Germany.

Changes in the corporation tax alone would not benefit personal businesses, the tax burden of which is largely determined by the personal income tax, which the government is loath to reduce substantially (see sec. 2.1 above). Hence, an alternative solution had to be devised.

The solution now proposed consists of a "basic system" and an "elective system" for taxation of income from personal businesses. The basic system applies as long as the option to enter the elective system has not been exercised.

4.2 Basic system: trade tax credit

The essential innovation of the basic system is a partial credit of trade tax against income tax. Hence, the introduction of the basic system makes no change in the taxation of personal businesses (partnerships and sole proprietorships) which pay no trade tax to begin with. Trade tax is paid by businesses engaged in commercial activity (as defined). Farming, forestry, and professional service businesses (doctors, lawyers, architects, etc.) do not involve commercial activity. The basic system is thus irrelevant for the owners of these businesses. Nevertheless, the Tax Reform 2000 is still important for them in that it gives them the option of entering the elective system (see sec. 4.3 below).

The credit created under the basic system is incomprehensible without some knowledge of the inner workings of German trade tax. In brief, the trade tax is imposed on the earnings of commercial businesses, whether operated in corporate or partnership form or as sole proprietorships. A number of adjustments to income for corporate or personal income tax purposes apply in arriving at trade taxable earnings. Graduated trade tax rates from 1 % to 5 % are applied to the taxable earnings of individuals and partnerships. Individuals and partnerships are also entitled to an exemption amount of DM 48,000 in calculating taxable earnings. The product of taxable earnings and the trade tax rate is referred to as the "trade tax basic assessment amount" (Gewerbesteuermeßbetrag). Local political subdivisions (which receive the revenue from the trade tax) are entitled to fix a trade tax multiplier and apply it to the basic assessment amount to arrive at trade tax owing. The multipliers vary from approx. 300 % to 500 %.

The product of base assessment amount and the applicable multiplier is not the trade tax owing because trade tax is deductible as an expense from its own tax base. If the applicable multiplier is 400 %, trade tax owing is arrived at by dividing the product of base assessment amount and multiplier by a factor of 1.2. The trade tax so arrived at reduces taxable income for income tax purposes.

Irrespective of the trade tax multiplier, the credit allowed under the basic system is double the trade tax basic assessment amount. According to information from the Federal Ministry of Finance, which we have not verified, this credit, plus the above discussed deductibility of trade tax from its own assessment base and its deductibility for income tax purposes, results in zero net trade tax burden if the applicable trade tax multiplier is 400 % and the taxpayer's marginal income tax rate is 50 %. If the multiplier is higher, the combined effect of credit and deductibility will not entirely offset the tax. If the multiplier is lower, which is often the case in the New German States (former East Germany), the credit will over-compensate trade tax and act to reduce the otherwise payable income tax.

4.3 Elective system

Commercial partnerships and sole proprietorships may also elect to be taxed as corporations. In the case of partnerships, all partners must exercise the election. The election is also open to taxpayers with income from farming and forestry or from independent personal services, provided they determine their profit on an accrual basis.

The consequences of exercise of the election are basically as follows:

• The business in question is deemed to be a corporation for tax purposes and treated as such in all respects.

• The partner or proprietor is treated for all tax purposes as holding shares in a corporation.

• The income from the business activity is subject to trade tax.

• Retained earnings are subject to a corporation tax of 25 %.

• Contractual obligations such as employment, loan, or rental agreements between the business and its partners or proprietor will be respected for tax purposes.

• Withdrawals are deemed to be distributions and are taxable in the hands of the partner/proprietor in accordance with the exemption method (see sec. 3.1 above).

• The switchover to taxation as a corporation is treated as the contribution of a partnership interest or sole proprietorship in exchange for new shares in a corporation (contribution-generated shares). As such, the switchover is in general subject to the rules of the tax reorganisation act.

• Existing special business property does not become part of the business property of the deemed corporation and is instead treated as having been withdrawn (mandatory tax realisation event). Any gain thereby realised may be spread over several years.

• The taxpayer's tax basis in the contribution-generated shares he is deemed to take at the time of transfer is increased or decreased to reflect the amounts shown on any supplemental balance sheets in existence at the time.

• The corporate shares deemed to have been acquired are also treated as such for purposes of gift and inheritance tax.

5. Revenue-increasing measures

The following revenue-increasing measures are planned to finance the above reforms:

• The rate for declining balance depreciation of movable assets will be decreased from 30 % to 20 %.

• The depreciation rate for non-residential buildings held as business property will be reduced from 4 % to 3 %.

• Special depreciation and anticipated special depreciation will be eliminated as tax relief measures for small and medium-sized companies.

• The capping of income tax on commercial income will be repealed (§ 32c EStG).

• The present capital gains materiality threshold of 10 % will fall to 1 % (see sec. 3.2 above).

• The thin capitalisation rules of § 8a KStG will be tightened considerably. The intention is to abolish both the safe haven of 0.5-to-1 for result-linked remuneration and the 9-to-1 safe haven for holding companies. There is also talk of reducing the "standard" 3-to-1 safe haven and extending the thin capitalisation rules to cover partnerships and permanent establishments, although these latter changes may prove impossible for technical reasons.

• The depreciation tables used by the tax authorities to determine standard depreciation periods may be "adjusted moderately". See also article no. 187.

6. Fiscal impact of the proposed reforms

According to figures supplied by the Federal Ministry of Finance, the fiscal impact of the above reforms would be as follows (all figures refer to the fiscal impact in the year the measures go into effect):

Reform of taxation of corporate and personal businesses

 

DM billions

Tax relief, corporate businesses

17.5

Tax relief, personal businesses

15.0

Total tax reduction

32.5

Tax increases (incl. revised dep. tables)

– 24.2

Net tax reduction

8.3

Changes in income tax rate structure

 

DM billions

2001: moving up 2002 reforms

27.4

2003

13.1

2005

21.1

Total tax reduction

61.6

Total reduction excluding already legislated 2002 reform


34.2

The tax authorities estimate (assuming passage of Tax Reform 2000) the total tax reduction from measures passed by the Red-Green government since taking office at DM 73 billion through 2005. They estimate the socio-economic distribution of this tax reduction as follows:

 

DM billions

Private households

54.3

Small and medium sized business

17.1

Large corporations

1.6

Total

73.0

For further information, please send a fax or an e-mail stating your inquiry to KPMG Frankfurt, attn. Christian Looks: Fax +49-(0)69-9587-2262, e-mail cLooks@kpmg.com. You may also send an e-mail to KPMG Germany by clicking the Contact Contributor on this screen. 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. Distribution to third persons is prohibited without our express written consent in advance.

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