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1. Overview

The following table lists the revenue-generating (counterfinancing) measures contained in the new legislation and indicates the respective projected additional tax revenue based on the government figures released in early February 2000 as revised by the figures appended to the report of the Finance Committee of 16 May 2000. These and all other tax revenue data given in this article refer, unless otherwise stated, to the change in tax owing in the first tax year to which the change is applicable, not to the cash flow effect of the change in a particular period.

Comments on the impact of the various measures on foreign investors follow the table.


Gross revenue impact

(million DM)

1. Reduction of the elective declining balance depreciation rate for movable assets from triple the straight line amount (max. 30%) to double the straight line amount (max. 20%) – § 7 (2) EStG


2. Reduction in the depreciation rate for non-residential buildings held as business property from 4% to 3% – § 7 (4) EStG


3. Lengthening the standard depreciation periods in the tables used by the tax authorities


4. Elimination of special and anticipated special depreciation for small and medium sized companies – § 7g EStG


5. Tightening the corporate thin capitalisation rules – § 8a KStG


6. Reduction of the materiality threshold for taxable "private" sales of shares in a corporation from 10% to 1% – § 17 (1) EStG


7. Elimination of imputational corporate tax system in favour of 50% dividends-received exemption for individuals


8. Progressive switchover to an Euro-based tax rate formula and other adjustments – § 32a EStG


9. Repeal of capping of personal income tax for commercial income – (§ 32c EStG)




The draft legislation in its original form also applied a tax rate progression clause to personal income exempt under the half-income system (50 % exemption system). This provision was deleted from the bill which was ratified by the Federal Parliament.

2. Depreciation rate changes

Depreciation changes account for over 60 % (DM 17.7 billion) of all revenue increases. The impact of these measures will be spread over all domestic businesses in proportion to affected assets held. However. the depreciation rate changes would in general (see below) only apply to assets acquired from 2001 on.

2.1 Declining balance depreciation

The reduction in declining balance depreciation would apply to assets purchased or produced after 31 December 2000. The previous rates would continue to apply to assets purchased or produced on or before this date (§ 52 (21a) EStG-E).

2.2 Non-residential buildings used in a business

The reduction in the depreciation rate of non-residential buildings used in a business would apply to self-constructed buildings if construction begins on or after 1 January 2001 and to purchased buildings for which the contract of purchase (or equivalent act) is not finalised until on or after this date (§ 52 (21b) EStG-E).

2.3 General tax depreciation tables

The general adjustment of the useful lives provided for by the standard depreciation tables issued by the tax authorities would apparently also apply only to assets purchased or produced from 1 January 2001 onwards. Contrary to the surmise expressed in the article on this subject in article no. 187, no intention exists to apply the changes in the year 2000.

The useful lives of most assets for depreciation purposes is a factual, not a legal question, The modifications contemplated by the tax authorities in this area do not involve changes in the law, but rather changes in their own factual estimates. Essentially, the tax authorities believe that their current tables are over-generous to the taxpayer. While taxpayers are free to contest the factual issue of useful life in any specific instance, in practice the useful lives fixed by the tax authorities are generally accepted by taxpayers.

2.4 Repeal of special depreciation

The small business depreciation advantages accorded by § 7g EStG (no. 4 in the above list) are available to corporations as well as individuals. Hence, the German domestic permanent establishment of a foreign corporation can benefit from these provisions. However, limitations apply as to both the size of qualifying businesses and the scope of the benefits. The repeal of this provision will thus by and large affect German resident individuals as the owners of qualifying small businesses.

Special depreciation under § 7g (1) (2) EStG is last available for assets purchased or produced prior to 1 January 2001. Anticipated special depreciation under § 7g (3) - (8) EStG is last possible by reclassification of profits as a tax-free reserve at the close of the last fiscal year which begins prior to 1 January 2001. Tax-free reserves so formed remain subject to the provisions of § 7g EStG in following fiscal years.

3. Thin capitalisation rules – § 8a KStG

3.1 Proposed changes

Germany's thin capitalisation rules are described in articles nos. 3, 4, and 116. They do not apply for trade tax purposes, but the trade tax law itself denies a deduction for half of debt interest payments. The pending legislation would make the following changes:

  • The current debt-to-equity safe-haven ratio of 3-to-1 for conventional loans is to be reduced to 1.5-to-1. A loan is "conventional" if the compensation paid for the use of debt capital is defined solely as a fraction of the principal amount (e.g. fixed and variable interest bearing loans).
  • The safe haven ratio of 0.5-to-1 for all other loans (e.g. those earning a share of profits or a percentage of sales – "hybrid" loans) will be eliminated entirely.
  • For conventional loans, it remains possible to avoid reclassification of the debt payment as a constructive dividend by showing that the borrowing company could have obtained the same debt capital on the same conditions from an unrelated third party (arm's length transaction exception). This exception may be expected to become more important in light of the contemplated safe-haven reduction. The exception for debt incurred in the context of normal banking transactions also remains.
  • The current safe haven ratio of 9-to-1 for holding companies is to be lowered to 3-to-1. The exceptions for arm's length and normal banking transactions apply here as well.
  • The legal definition of the loans to which the thin capitalisation rules apply has been changed. While the law is aimed at non-resident shareholders, the law as currently in effect does not use this term and instead speaks of loans from 25+ % shareholders "not entitled to the corporation tax credit" (or from related persons) to resident corporations. Since the corporation tax credit system is to be abandoned, the thin capitalisation rules are in the future to apply to all loans from 25+ % shareholders (or related persons) unless the income from the loan is taxable in Germany (in the context of a normal assessment, not just a withholding procedure). In most cases, the revised wording should not change the result reached. See, however, the item to follow.
  • As Rödder/Schumacher note in their article on the government tax reform proposals (DStR 2000, 353, 361 in fn. 47), the present text of the draft legislation inappropriately provides in § 8a (5) (1) KStG-E that the thin capitalisation rules are to apply when the income from the loan is taxable in Germany as income attributable to the shareholder-lender's German permanent establishment. § 8a (5) no. 1 KStG presently provides that the thin capitalisation rules shall apply to a lender who is only entitled to the corporation tax credit because the shares in the corporation to which the loan is made are held in a domestic permanent establishment. This provision makes sense, because it is possible for the shares to be held in a domestic permanent establishment without the loan itself being so held, hence the interest on the loan can still escape German taxation. If the income on the loan is actually taxable in Germany, this renders the thin capitalisation rules inapplicable under the principle discussed in the preceding item. Since there is no policy reason for an exception, § 8a (5) no. 1 KStG-E is ill-conceived and should be changed.

3.2 Entry into force

The draft legislation presently allows no transition period during which the present thin capitalisation rules would remain in effect for existing shareholder debt. Hence, the above changes would take effect in the assessment period 2001 (assuming they are enacted into law by the end of 2000).

Taxpayers whose fiscal year is identical with the calendar year would therefore have to review the structure of their current shareholder debt and make the necessary changes by 31 December 2000, since all determinations under the safe haven ratios are based on equity as of the close of the preceding fiscal year. Hence, the new rules would apply in 2001 based on equity as of the close of the fiscal year 2000.

Taxpayers with fiscal years not ending on December 31st would have to respond appropriately to the contemplated changes by the close of the last fiscal year which ends in the year 2001.

3.3 Diminished incentive for foreign debt financing ?

Articles nos. 3, 4, and 116 describe Germany's thin capitalisation rules. German tax (trade tax, corporation tax, solidarity surcharge, and in some cases withholding tax) presently exceeds the average OECD rate of 37 % by 14.83 percentage points for corporate retained earnings (assuming a moderate trade tax multiplier of 400 %). The excess for earnings distributed to foreign shareholders ranges from 14.59 to 6.04 percentage points, assuming dividend withholding tax of 15 % and 0 % respectively.

Under the same assumptions, the proposed tax reforms would narrow the gap between the German and average foreign taxes to just 1.65 percentage points for retained earnings. For distributed earnings, the excess of German over average foreign taxes would range from 14.59 to 1.65 percentage points depending on the rate of withholding tax (from 20 % to 0 %), including solidarity surcharge and assuming a moderate trade tax multiplier of 400 %.

Assuming a trade tax multiplier of 300 % and no dividend withholding tax, the total tax burden even falls slightly under the OECD average (by 1 to 2 percentage points depending on whether solidarity surcharge is included in the calculation or not).

Hence, the proposed tax reform would reduce the tax incentive for foreign shareholder financing. Of course, shareholders whose domestic tax regime permits them to accumulate income in low tax jurisdictions will remain keenly interested in debt financing.

3.4 Doing business in branch form?

Foreign groups may wish to consider doing business in Germany in branch form in the future. Loans to a domestic group permanent establishment from an offshore group financing company do not fall under the German thin capitalisation rules as presently in force. Furthermore, the general tax burden on domestic permanent establishments will be improved dramatically as a result of the planned reforms (see sec. 6.2 of article no. 199).

3.5 Arm's length exception

Under § 8a KStG, the taxpayer can avoid constructive dividend treatment of interest paid on conventional loans outside the safe havens by showing that the company in question could have received the loan on the same terms from an unrelated party, generally a bank. This so-called arm's length exception is available for holding structures as well as loans to individual companies. The reduction of the safe havens may prompt more taxpayers to try to come under this exception.

3.6 Pitfall no. 1 for holding structures

The present generous 9-to-1 safe haven for holding companies has prompted many foreign groups to establish a German holding with several German operating subsidiaries attached to it. Frequently, such domestic sub-groups are consolidated under the holding for trade tax purposes, but not for corporation tax purposes (where the requirements are more stringent). The holding pays interest on its loans to a foreign related party and receives dividends from the operating companies. The present corporate tax system allows the holding to set off its interest expense against its dividend income and secure a refund of the corporation tax paid by its subsidiaries. This will no longer be possible in the future. The dividend income will be received tax free and the 25 % corporation tax paid by the subsidiaries will be definitive (non-creditable, non-refundable).

Under the contemplated corporation tax regime, corporation tax consolidation of the subsidiaries under the holding will therefore be imperative. The requirements for such consolidation are relaxed by the proposed legislation. For more detail, see sec. 14 of article no 199.

3.7 Pitfall no. 2 for holding structures

A problem similar to that discussed in sec. 3.6 above arises in connection with § 3c EStG, a provision in the income tax law applicable to corporations as well which prohibits the deduction of expenses directly related to tax-free income. Since the proposed legislation would create a 100 % dividends-received exemption for German corporations (§ 8b (1) KStG-E), dividends received from other domestic corporations will in the future fall under § 3c EStG. In a typical thin capitalisation holding structure where the German group is not consolidated for corporation tax purposes, the dividends received by the holding from its subsidiaries will be tax exempt to the holding under the new regime, hence the holding will not be allowed a deduction for its interest expense, which was incurred to finance its subsidiaries. Again, the only effective solution to this problem is consolidation of the German group for corporation tax purposes. For more detail, see sec. 7.2 and 14 of article no 199.

4. Threshold of § 17 EStG lowered to 1 %, but at least DM 5,000

4.1 Present law and proposed change

Under German tax law, capital gains on the sale of "private" as opposed to "business" property have traditionally been tax exempt if realised outside of certain minimum holding periods. This tradition is, however, rapidly becoming one more honoured in the breach than in the observance after the 1999 Tax Relief Act made the tax exemption for sales of real property contingent on a 10 year holding period and reduced the materiality threshold of § 17 EStG for tax exempt private gains on the sale of shares in a corporation from "more than 25 %" to "10 % or more".

The 2000 Tax Reduction Act would now reduce the threshold still further to "1 % or more, but at least DM 5,000 stated capital." Since the threshold no longer has anything to do with "materiality," this term is dropped. The threshold is crossed if the vendor has held the stated percentage and the stated minimum absolute amount of share capital in the corporation in question within the five years preceding the sale. Indirect shareholdings are included making the determination.

The provision permitting tax free capital gains on sales of stakes of more than 1 % if the pro rata share of stated capital does not amount to at least DM 5,000 was added to the bill in committee. Since the minimum share capital of a corporation is DM 50,000 (for a GmbH), stakes of up to (but not including) 10 % can still be sold tax free if the corporation has the statutory minimum of share capital. It goes without saying that there is no necessary connection between a corporation's share capital and its value. For corporations structured to take advantage of this loophole, the threshold for tax-free capital gains stays where it is, at 10 %.

4.2 Impact on domestic and foreign shareholders

Reduction of the threshold of § 17 EStG is a long-standing tax reform suggestion (see e.g. Herzig/Dötsch DB 1998, 15; BFH DB 1997, 507 - 23 Oct. 1996). The high threshold has in the past permitted owners of closely held corporations to realise the profits accumulated inside the corporation free of tax. To curb this practice somewhat, § 50c (11) EStG was added to the income tax code in 1997.

The contemplated drastic reduction in the threshold of § 17 EStG is primarily intended to prevent German resident individuals from using tax-free sales of shares to realise profits accumulated inside closely held corporations at the future 25 % corporate rate.

However, the change will also have an impact on foreign shareholders in German corpora-tions. § 17 EStG applies in conjunction with § 49 (1) (2) (e) EStG to dispositions of shares in German corporations (corporations with either their legal seat or principal place of management in Germany) by foreign legal and natural persons who do not hold the shares in a German permanent establishment (including the permanent establishment of a partnership in which they hold an interest).

Germany's right of taxation of foreign individual and corporate shareholders under § 17 EStG is excluded, however, under most of Germany's tax treaties. The shares, provided not part of a German permanent establishment, fall under "other property," for which the state of residence has the exclusive right of taxation.

By the same token, foreign shareholders not entitled to the protection of an OECD model tax treaty (taking account of applicable limitation on benefits and anti-treaty shopping provisions) would be affected by the proposed change. For instance, closely held foreign investment funds with 100 or fewer investors on a look-through basis can be affected by the change in the law if located in a non-treaty jurisdiction.

5. Shift from credit to exemption system

5.1 Small shareholders

As stated above (sec. 1 table, item 7), the government is estimating increased revenues of almost DM 5 billion from abandonment of the corporation tax credit in favour of the half-income (50 % exemption) system.

Critics of the half-income system contend that the bulk of this sum results from an inequitable increase in the taxation of small shareholders (Unvericht BB 2000, 797/2, 799). They note that the half-income system would disadvantage individual shareholders with marginal tax rates under 40 %. Such taxpayers are better off paying tax on the grossed up dividend with a full credit for corporation tax than paying tax on half of the dividend received without such a credit. The following table, modelled after Unvericht, illustrates this effect using simplified calculations without withholding tax or solidarity surcharge and assuming a uniform 25 % corporation tax rate:


Corporation tax credit system

Half-income system


Corp. earnings (after trade tax)




Corporation tax




Net dividend




Corporation tax credit




Taxable income




Personal income tax at marginal rate


















Overall tax at personal rate




25.00 + 23.50 = 48.50




25.00 + 15.00 = 40.00




25.00 + 0.00 = 25.00




25.00 – 25.00 = 0.00



The government does not call attention to this source of additional tax revenue. It does, however, cite two other sources of the estimated additional tax revenue:

  • elimination of dividend stripping for corporate tax purposes
  • elimination of loss equalisation at the parent corporation level

Both of these consequences affect foreign shareholders.

5.2 Dividend stripping

Dividend stripping refers to transactions in which shareholders not entitled to a credit of corporation and dividend withholding tax (corporate and individual non-residents not holding the shares in domestic permanent establishments) sell their shares to persons so entitled (generally, residents) so that the latter may receive the dividend and the credits attaching thereto. If the buyers are able to offset part or all of the dividend against losses, they will receive a tax refund. Thereafter, the shares are resold to the original holder. Such transactions are eliminated under the half-income system as regards corporation tax because corporation tax will no longer be creditable. Dividend stripping remains possible with regard to dividend withholding tax. See article no. 202 for a report on a major Federal Tax Court decision holding that dividend stripping transactions may not be disregarded for tax purposes under Germany's general anti-tax evasion provision (§ 42 AO).

5.3 Loss equalisation

Loss equalisation at level of a domestic parent corporation is possible under the current imputational corporate tax system because the corporate tax paid by the distributing corporation is creditable at the parent level. If the parent has losses which offset the dividend amount, the corporate tax paid by the subsidiary is refunded to the parent. Under the proposed system, the dividend received by the parent would be 100 % exempt, but there would be no credit (refund) of tax paid by the subsidiary. The parent's loss could not be offset against the dividend received and would thus be carried forward.

Under the proposed exemption system, loss equalisation can no longer be achieved through distribution of dividends. It is instead necessary to form a consolidated tax group (Organschaft). This consequence of the proposed tax reform is discussed under sec. 14 of article no 199 along with the planned relaxation of requirements for corporate tax consolidation.

The government figures do not allocate the estimated DM 5 billion tax revenue increase among the three sources discussed above (increased taxation of small shareholders, elimination of dividend stripping with respect to corporation tax, end of offset of dividends received against losses incurred).

6. Other measures

The technical adjustments in the tax rate formula (see sec. 1 above, item 8) are interesting above all for the example the government is setting by taking advantage of the conversion to the Euro to increase taxes.

The individual income tax rate for income above (currently) DM 84,834 which has been subject to trade tax is currently capped by § 32c EStG. Repeal of this provision (see sec. 1 above, item 9), which is probably unconstitutional at any rate (see article no. 165), can by definition only apply to natural persons. Some foreign individuals may be affected as partners in partnerships doing business in Germany.

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 You may also send an e-mail to KPMG Germany by clicking the Contract Contributor button on this screen.

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