On 27 September 2001 the German Council of States (Bundesrat)1 proposed to the German Government that capital gains derived from the disposal of shares in corporations should be subject to trade tax. Should the German government adopt this proposal capital gains derived from the disposal of equities will be subject to trade tax on income again, even though this would represent a partial reversal of the Tax Reduction Act of October 23, 2000. Technically, the trade tax is proposed to be introduced by new add back provisions of Sec. 8 Trade Tax Act (Gewerbesteuergesetz). As far as equity interests in foreign corporations are concerned the proposal would also result in a deterioration because for those capital gains it is clear that the existing tax exemption also applies for trade tax purposes (Sec. 40 para. 2 sent. 8 Trade Tax Regulations). The trade tax on income, depending on the municipal rates, ranges from approximately 13%2 through 20%, before deduction from corporation tax that may alleviate the burden to about from 10% through 15%, if there are other sources of income.3

The Council of States initiative is based on the argument that the non-abolition of the dividend received deductions for trade tax purposes suggests that it was not the intent of the legislating body to implement a trade tax exemption for capital gains either. This assertion is incorrect as can be easily obtained from the official explanations to the Tax Reduction Act of October 23, 2000. Should the German Government adopt the proposal the confidence of international investors in the ability to reform taxation in Germany would be severely damaged. Companies which have already disinvested in anticipation of the capital gains exemption by means of security lending or similar transactions will be deeply disappointed.

The German Government proposes to supersede the provisions pursuant to which expenses directly related to tax exempt dividends and/or capital gains are disallowed. After long and intense technical discussions the Federal Ministry of Finance had ultimately realised that it cannot make a difference, for example, for the tax deduction of interest expenses that are connected to an investment in another corporation whether the interest expenses are incurred at the level of the corporation or at the level of the shareholder. The Council of States is in disagreement with this notion arguing that it would provide a double benefit if expenses connected with tax-exempt income were deductible. This assertion does not hold water either. The so-called tax-exempt dividends are not really tax-free, because they have been subject to tax already at the lower tier corporation’s level.

Another sensible proposal of the German government is being rejected by the Council of States. The German government proposes to introduce an exemption from real estate transfer taxes for intra group restructurings. Real estate transfer tax at 3.5% of certain tax values is more than a nuisance on corporate reorganisations because the tax can be incurred again and again. The argument by the Council of States is that an intra group exemption would not be compatible with the separate legal entity approach of real estate transfer tax, but given that real estate transfer tax has group attribution rules the opposite is true. If the German states are not willing to adopt the government's proposal because they have to foot the bill it would be only fair to abolish at least the group attribution rules to reflect the argument made by the Council of States.

The German government would be well advised not to adopt the proposal to partially rescind the tax reform of 2000 by introducing a partial taxation of capital gains again The Council of States may change their position because the chamber is not bound to their recommendation when ultimately giving their consent to the tax package. There will no doubt be political trade offs.


1 The Council of States (Bundesrat) is the second parliamentary chamber in Germany whose members are delegates nominated by the governments of the sixteen German states (Länder). Most tax bills need the consent of the Bundesrat for most tax revenues are allocated partially or entirely (e.g. real estate transfer tax) to the Länder. The Social Democratic/Green Parties supporting the Federal Government do not have a majority of the votes in the Council of States. The same holds true for the opposition parties. Thus a few states with coalition governments currently tip the scales. Therefore the final voting is difficult to predict.

2 About two very small, rather exotic, villages in Germany can even offer a 0% trade tax on income.

3 If adopted it remains to be seen whether or not the German Revenue Service argues that trade tax is not deductible for corporation tax because it is related to tax-exempt income (see below).

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