On the basis of an Act on the Reduction of Tax Rates and Reform of Business Taxation (Steuersenkungsgesetz) approved by the two chambers of the German parliament on July 7, 2000 and July 14, 2000, major changes to the income taxation regime applicable in Germany will take place. Some of the changes will become effective as of January 1, 2001, others only over a period of until 2005. Below, certain effects from the new tax regime are described in a summarized form.
1. Ongoing Taxation
1.1. Reduction of Tax Rates
For individuals, the taxation of income on the basis of a progressive scale will be maintained. The maximum personal income tax (PIT) rate (applicable to taxable net income in excess of DM 102,000) will be reduced from presently 51% to 42%, such reduction taking place in several steps until the year 2005. The minimum tax rate will be reduced from presently 22.9% to 15%, starting from approximately DM 15,000 (personal income less than this amount will not be taxed).
For corporations, the present split income tax rates of 40% for retained profits and 30% for distributed profits will be abolished and replaced by a uniform corporation income tax (CIT) rate of 25% for all profits. This tax rate applies to all "new" profits generated by corporations in the business years starting in 2001 and thereafter.
1.2. Change of Corporation Income Tax Regime
The former imputation tax system under which the CIT paid by the German corporation was credited to the income tax (PIT or CIT) liability of the shareholder in case of a dividend distribution will be abolished. Instead, a definite CIT at a rate of 25% will apply to the taxable net income of the German corporation (or German permanent establishment of a foreign corporation), regardless of whether such profits are retained or distributed. This CIT is definitive, i.e. no tax credit is granted to shareholders upon distribution. Local trade tax and solidarity surcharge come in addition.
In addition to the company's CIT, dividends are taxed at the shareholder level. German resident individuals are taxed only on half (50%) of the German or foreign dividends received by them at the applicable PIT rate. In order to avoid a multilevel taxation of corporate profits, dividends received by entities subject to German CIT are tax-exempt on the level of the receiving company. This tax exemption applies to dividends paid by German as well as foreign corporations. Furthermore, no minimum holding or waiting periods are required in order to benefit from the exemption. The basic idea is that profits are only taxed once at a corporate level and, in addition, in the hands of the individual shareholder upon a dividend distribution.
Consequently, the tax reform encourages to retain profits (taxed with a 25% CIT rate) rather than to distribute profits, which are then taxed in addition on the individual shareholder's level.
Withholding tax (20 %) will continue to be charged on distributions by German corporations, with full tax credit for the German resident shareholder. No withholding tax or at a lower rate may be charged to foreign parent companies under applicable tax treaties or EU-regulations.
Under the CIT system with a split CIT rate, a distribution of ordinary corporate profits to the companies' ultimate individual shareholders leads to a reduction of the applicable CIT rate from 40% to 30%, i.e. to a claim of the company vis-à-vis the fiscal authorities for a credit or repayment of the difference. Special rules apply, however, in case of a distribution of tax-free foreign source income or for distributions to German parent companies organized as a corporation. For CIT purposes, retained profits generated in periods before the new CIT regime (i.e. including all business years starting before the end of the calendar year 2000), will be separated from profits of future business years for a 15 years transition period. In case of dividend distributions during this transition period, it is assumed that all "old" profits are distributed first before profits generated under the new CIT regime are used in order to fund the respective dividends. To the extent "old" profits are distributed, the distributing company will still be entitled to benefit from the former split CIT rate, i.e. the reduction from the 40 % tax rate to a 30 % tax rate will be granted to the company.
On the shareholders' level, however, an equivalent 15 years transition period will not be available. The tax credit under the current imputation tax system for the 30 % CIT paid by the distributing company will only be granted to the shareholders, if the distributed profits have been generated by the company under the current CIT rules and will be distributed as a dividend (hidden profit distributions will not be covered) during the first business year, for which the new CIT regime applies to the company. This means that the 30 % income tax credit is available for dividends paid out during the calendar year 2001, provided the company's business year complies with the calendar year. For all following distributions of "old" profits during the 15 years transition period, a reduction of CIT to 30 % will still be possible at the company's level, although a respective credit will not be granted to the shareholders under the old imputation tax system. Instead, 50 % of all dividends received will be taxable in the hands of the individual shareholders as described under 2. above.
As a general guideline, from an individual shareholder's point of view, it might be more beneficial to receive old profits of a company as a dividend until the end of the company's first business year starting in 2001 rather than later. This situation may cause some German corporations with individuals as shareholders to pay to its shareholders a "superdividend" in order to use up as much of their "old" profits as possible before the end of the first business year starting in 2001.
1.4. Taxation of Partnership Income
German partnerships performing business activities are subject to German trade tax but not German CIT. Instead, the partnership income is attributed as business income to the respective partners and taxed at their individual income tax rates (PIT or CIT, as the case may be). As a consequence of this concept, partnership profits may be subject to a maximum income tax rate of 42 % (future maximum PIT rate, see 1. above), while profits of a German corporation are only taxed at the uniform CIT rate of 25 %. Both, partnerships and corporations, are subject to German trade tax at the same rates.
In order to compensate partners in a German partnership for the potential disadvantage of higher income tax rates, the German legislator allows the individual partners to reduce their PIT to be paid on the partnership profits by the trade tax to be borne by the partnership itself. The credit for the individual partners is calculated in a more general way and does not consider the actual trade tax payments effected by the partnership or the exact individual PIT rates of the partners. Since trade tax is a local tax and tax rates vary between the different German municipalities, and, furthermore, not all partners in a German partnership are taxed at the same PIT rate, this concept may not result in a full compensation or may result in an overcompensation of the trade tax paid.
If profits are distributed, individuals acting as partners in a German partnership are always taxed at lower income tax rates compared to individual shareholders in a German corporation.
2. Implications for M & A Transactions
2.1. Share Sale by Individual Shareholder
In case an individual sells shares in a share deal, basically half (50 %) of the capital gain realized will be taxed at the applicable PIT rate (maximum 42 %).
Shares held as a business asset can only be sold under the 50 % rule after a minimum holding period of 1 year after the acquisition of the shares expired. If shares belong to a business property and are sold before the 1 year holding period expired, the full realized capital gains become taxable in the hands of the selling individual.
If shares in a corporation are privately held, the capital gains realized from the sale are only subject to the 50 % capital gain taxation rule, if the shares are sold within a period of 1 year after the acquisition of the respective shares or if the shareholdings in the respective corporation by the individual was 1 % or more in the nominal capital of the foreign or German corporation within the last 5 years before the sale. In all other cases, privately held shares in a corporation can be sold totally tax-free by German resident individuals.
Under certain anti-abuse rules, the sale of shares in a corporation are taxable under the 50 % rule if the respective shares are received by the individual as a compensation for a tax-free (or partly tax-free) contribution to the respective corporation within a period of 7 years prior to the sale of the newly issued shares.
Losses from the sale of shares in a corporation can only be used if a capital gain would also be subject to German taxation. Furthermore, potential capital losses can only be used in order to balance capital gains resulting from the same kind of transactions.
The rules with regard to the taxation of capital gains will, basically, become effective for share sales during the first business year of the respective company starting during the calendar year 2002, i.e. share sales are covered as of January 1, 2002 for shares in companies whose business year complies with the calendar year.
Foreign shareholders resident in a country which entered into a tax treaty with Germany usually can realize capital gains on the disposition of shares in German corporations free from German capital gains tax.
2.2. German Corporation as Seller of Shares
In case a German corporation sells shares in a German or foreign corporation, the capital gain realized by the seller on this sale will be exempt from tax in Germany. This tax exemption applies to dispositions realized after the end of the first business year starting in 2001; i.e. in general, disposals after January 1, 2002, if the business year is the calendar year. The exemption applies for CIT as well as for trade tax purposes. A minimum one-year holding period for the shares disposed of has to be observed.
Furthermore, anti-abuse provisions apply. In particular, a sale of business assets can not be realized tax-free by first contributing those assets to a corporation, and subsequently selling the shares of this new corporation. In those contribution situations, a waiting period of seven years needs to be observed before a tax-free share sale is possible.
As regards the application of the favorable capital gains treatment as of the year 2002, tax structuring is available to ensure tax-free realization of capital gains on the disposal of shares even if contractual arrangements on the disposition are made before 2002.
2.3. Disposition of Partnership Interests
Dispositions of partnership interests, in principle, are subject to full CIT or PIT on the capital gain realized, i.e. up to a maximum tax rate of 42 % for individuals. However, an individual as seller is entitled to the application of a reduced capital gains tax rate once in a lifetime, which is 50% of the tax rate that would otherwise be applicable to this capital gain.
2.4. German Reorganization Tax Act
From the perspective of a purchaser in a share sale transaction, it is important to note that, basically, a tax-free step-up of the book values of the company's assets and a subsequent depreciation (and amortization in case of goodwill) of the stepped-up values will no longer be possible by converting the company to a German partnership. This may either result in lower purchase prices for shares in German companies or in pre-acquisition restructuring activities to be required from the selling party.