Tax reforms: the impact on foreign and domestic investors

Author: | Published: 10 Oct 2001
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Tax climate for business investment

Business tax reform

Germany has significantly improved its tax climate for business investment by adopting the revolutionary Tax Reduction Act (Steuersenkungsgesetz) on July 14 2000, which in general became effective January 1 2001. The reform was supposed to reduce the overall tax burden on business activities, to bring the provisions of German tax law into line with European efforts, to equalize the tax treatment of different legal forms of business entities and to simplify the tax system. In effect, only the first two aims could be reached in order to enhance the competitiveness of Germany as a location for business investment and therefore to increase employment. Moreover, Germany has successfully started to play a rather active part in global and European tax competition matters. Now, it may be regarded as an industrial location with a tax system that is also attractive for foreign investors, a corporate tax burden akin to that of other countries and an attractive holding company regime. Nevertheless, additional action is needed to eliminate remaining obstacles to doing business in Germany. Some improvements are already under way in the Business Tax Development Bill (Unternehmenssteuerfortentwicklungsgesetz), which would be largely effective retroactive to January 1 2001. Highlights of the amendments enacted by the Tax Reduction Act and the measures contained in the Business Tax Development Bill are discussed below. Special emphasis is put on their impact for foreign and domestic investors.

European impact

The tax climate for business investment in Germany is also influenced by certain European developments. Although the internal market was introduced in the 1990s, as was the currency union, the European institutions (Commission, Parliament, Council) still have no particular authority in the area of direct tax integration. Hence, member states make autonomous decisions in all questions of direct taxation, subject to unanimous decisions by the Council which are in turn subject to the subsidiarity principle of the EC Treaty. Therefore, only a few measures have become effective on a European level. These include the merger directive, the parent-subsidiary directive, the administrative-assistance directive as well as the arbitration convention. These are all intended to integrate and harmonize the different business tax regimes of the member states, and accordingly reduce and eliminate distortions affecting cross-border economic activities. European tax policy tends to rely on competition between the member states and their tax systems. Nevertheless, the member states have to exercise their fiscal sovereignty in accordance with the non-legally binding Code of Conduct as well as the fundamental freedoms and the state aid rules that are contained in the EC Treaty and enforced by the European Court of Justice and the European Commission, respectively.

Business taxation in Germany

Liability to tax

While German resident individuals such as sole proprietors and partners in partnerships are subject to income tax on their world-wide income, non-resident individuals are subject to income tax solely on income from German sources. German resident companies such as limited liability companies (GmbH) and stock corporations (AG) are likewise subject to corporation tax on their world-wide income, whereas non-resident companies are subject to corporation tax solely on income from German sources, eg earnings derived through a German permanent establishment (PE) or partnership. With regard to German source business income, individuals and companies are also subject to trade tax.

Tax base

The determination of business income is based on the results shown by the annual accounts, as adjusted to comply with pertinent tax provisions. These are amended by the Tax Reduction Act for assets purchased or produced after December 31 2000:

  • lowering of the maximum declining balance depreciation from 30% to 20% for moveable assets;
  • reduction of the depreciation rate for non-residential buildings held as business assets from 4% to 3% for buildings;
  • revision of the official depreciation tables used by the tax authorities to reflect more realistic estimates f standard asset useful lives; and
  • reduction of the maximum amount of anticipated special depreciation on new investments by small and medium sized businesses from 50% of the cost of purchase or production to 40% for assets for which reserves are set up in financial years beginning after December 31 2000.

Tax rates

The Tax Reduction Act significantly reduces the applicable income tax rates during the period 2001 to 2005, see table 1. Moreover, the taxation of companies and their shareholders has fundamentally changed from a split-rate full imputation system to a flat-rate classical system with shareholder relief. The corporation tax rates of 40% for retained and 30% for distributed profits of a resident company are replaced by a lower uniform rate of 25% for all profits, whether retained or distributed, from 2001 onwards. Instead of the 40% flat rate, the 25% rate is also applicable for non-resident companies with regard to earnings they derive through a German PE or partnership. Moreover, the withholding tax rate on domestic dividends is reduced to 20% from 2002 onwards, but remains fully creditable for resident individual or corporate shareholders, whereas foreign withholding taxes on foreign dividends received qualify for a credit only in the case of a resident individual shareholder.

Table 1: Income and corporation tax reduction
2000 2001 2002 2003/2004

From 2005

Personal allowance DM 13,499 DM 14,093 euro7,235 euro7,426 euro7,664
Lowest income tax rate 22.9% 19.9% 19.9% 17% 15%
Top income tax rate 51% / 43%* 48.5% 48.5% 47%

42%

Top rate applies to taxable income from DM 114,696 DM 107,568 euro55,008 euro52,293

euro52,152

Corporation tax rate: resident companies 40% 25% 25% 25% 25%
Imputable corporation tax distribution burden 30% 30%

Corporation tax rate: non-resident companies with German PE or partnership interest 40% 25% 25% 25% 25%
Withholding tax rate on dividends 25% 25% 20% 20% 20%
* business income subject to trade tax


Exemption privileges

Dividends

Whereas the former 30% corporation tax distribution burden is fully creditable for resident shareholders in the case of a distribution of profits until the end of 2001, domestic dividends will be partially or even entirely tax exempt at individual (50%: half-income system) or corporate shareholder (100%: dividend-received exemption) level from 2002 onwards, irrespective of the percentage shareholding or the holding period. With respect to foreign dividends, these exemption privileges are applicable from 2001 onwards. This is also true with regard to domestic or foreign profits, distributed to a non-resident company with a German PE or partnership, the underlying shares are attributed to. Therefore, multiple taxation of domestic or foreign profits distributed through a chain of companies is entirely eliminated. Refinancing costs

As a consequence of the half-income system, expenses such as refinancing costs related to domestic or foreign dividends received by an individual shareholder are likewise deductible at one half only, irrespective of the amount of dividends actually received in the relevant year of assessment. With regard to the deductibility of business expenses directly economically related to tax-exempt dividends received by a corporate shareholder, it has to be distinguished, whether the dividends are distributed by a foreign or a German resident company. In the former case, such refinancing costs are entirely deductible, although 5% of the respective dividends are always deemed to be equivalent to non-deductible business expenses. In the latter case, the aforementioned expenses are deductible only to the extent they exceed the amount of dividends actually received in the relevant year of assessment. However, according to the Business Tax Development Bill, this restriction would be entirely eliminated in order to prevent multiple taxation of domestic profits. Alternatively, the negative effects described can be prevented individually as either no dividends are to be distributed as long as related business expenses may be deductible (ballooning concept) or the distributing and the shareholding companies form a group for corporation tax purposes.

Capital gains

The dividend exemption privileges also apply to capital gains on the disposition of shares in domestic companies from 2002 onwards and on the disposition of shares in foreign companies from 2001 onwards. Half of the respective capital gains are subject to income tax if the disposed shares are part of the business assets of a partnership or a sole proprietorship, if the individual shareholder holds at least 1% of the respective shares, or if the disposal takes place during the speculation period of one year. Capital gains realized on the disposal of shares through other private transactions are generally not subject to income tax in Germany. Corporate shareholders are generally tax exempt concerning the respective capital gains, irrespective of the percentage shareholding or the holding period. Likewise, foreign resident companies are tax exempt regarding capital gains if the disposed shares are attributed to a German PE or partnership. Corresponding capital losses as well as write-downs to going concern value on shares are similarly taken into account as are capital gains resulting from write-ups reflecting a recovery in value of shares previously written down.

To further equalize the tax treatment of different legal forms of business entities, the Business Tax Development Bill would permit capital gains on the disposal of shares that are part of the business assets of a partnership or a sole proprietorship to be offset against the acquisition costs of other shares acquired in the same financial year. The new roll-over provision would apply from 2002 onwards for income tax purposes. Alternatively, an investment reserve may be set up and carried forward for up to two financial years, after which it must be retransferred to profits and taxed in accordance with the half-income system if not offset against the acquisition costs of shares acquired during that period.

Group taxation

A controlling parent may form a group for corporation tax, trade tax and value added tax (VAT) purposes with one or more German resident subsidiaries. To qualify for corporation tax consolidation from 2001 onwards, it is necessary only that the group parent own the majority of voting rights in the consolidated subsidiaries (financial integration), and that the parties enter into a profit and loss pooling agreement. For trade tax and VAT purposes, a profit and loss pooling agreement is not strictly necessary, whereas economic and organizational integration of the subsidiaries into the parent are still required to form a group. Under the Business Tax Development Bill, a group which is consolidated for corporation tax purposes would automatically be consolidated for trade tax purposes as well from 2001 onwards. In addition, the trade tax consolidation could be achieved by meeting the above described requirements under present law.

Moreover, for corporation and trade tax purposes the earnings of a subsidiary of a multi-parent group will no longer be attributed to the group parents. Instead, the draft legislation would allocate the respective earnings to the intermediary partnership that enters into the required profit and loss pooling agreement with the consolidated subsidiary and is interposed so as to achieve financial integration by pooling the voting rights of the various group parents. Therefore, for trade tax purposes, a set off of profits and losses between the consolidated subsidiary and the respective group parents is retroactively no longer possible. However, other solutions should be sought.

The Business Tax Development Bill further provides that, from 2002 onwards, no real estate transfer tax will be levied on taxable transfers carried out between the members of a group within the meaning of company law if the acquiring member does not leave the group within five years.

Income tax credit

To equalize the tax treatment of different legal forms of business entities, the Tax Reduction Bill contained a check-the-box option permitting unincorporated businesses, such as partnerships and sole proprietorships, to elect taxation as companies. However, this option was not enacted in the final Tax Reduction Act. Therefore, unincorporated businesses are still treated as transparent for corporation and income tax purposes. Nevertheless, to reduce the overall income and trade tax burden of individual sole proprietors and partners deriving business income, the Tax Reduction Act introduced a standardized credit against their personal income tax liability for trade tax paid from 2001 onwards (although trade tax also remains deductible as an operating expenditure for income and trade tax purposes). The income tax will be reduced by an amount corresponding to 1.8 times the trade tax basic assessment amount. The credit is allowed against that part of the income tax liability that is attributable to the business income portion of the taxable income. Accordingly, the preferential 43% top income tax rate for business income has been abolished.

German tax burden on inbound investments

Whereas the German tax reform significantly reduced corporation and income tax rates, the municipal trade tax burden (16.7% on average) was not so amended, thus becoming even more important. Moreover, the tax reform generally eliminated discrimination of foreign companies investing in Germany through a PE or partnership as opposed to a subsidiary. Since the repatriated profits of a PE or partnership are not subject to withholding tax, it may be preferable from 2001 onwards to structure inbound investments through a German PE or a partnership rather than through a subsidiary, where the applicable tax treaty and the unilateral provisions transforming the EU parent-subsidiary directive permit withholding tax on subsidiary dividends. See table 2 regarding a US versus an EU corporate investor.

Table 2: German tax burden on Inbound Investments
100% German subsidiary German PE/Partnership
2000 2000 From 2001 From 2001 2000 From 2001
Profits before taxes
./. Trade tax
(16.7% on average)
100
16.7
100
16.7
100
16.7
100
16.7
100
16.7
100
16.7
./. Corporation tax
(30%/30%/25%/25%/40%/25%)
25.2 25.2 20.8 20.8 33.3 20.8
./. Solidarity surcharge
(5.5%)
1.4 1.4 1.1 1.1 1.8 1.1
./. Withholding tax
(5% according to US tax treaty)
2.8 0.0* 3.1 0.0*
= Income after German taxes 53.9 56.7 58.3 61.4 48.2

61.4

Overall tax burden 46.1%
US
43.3%
EU
41.7%
US
38.6%
EU
51.8%
US or EU

38.6%
US or EU

corporate investors

* EU parent-subsidiary directive


Acquisition of German companies

The Tax Reduction Act has drastically changed the environment of acquisitions in Germany for both sellers and buyers of German entities. The main implications are that capital gains realized on a sale of shares by individual or corporate shareholders enjoy half or even complete tax exemption in Germany from 2002 onwards, whereas no such preferences are granted for capital gains realized on the sale of business assets by companies or, except in certain limited exemptions, by individuals. Therefore, most owners of German business entities will have an even stronger interest in selling shares instead of business assets. Moreover, all tax planning strategies that are based on the assumption that a tax neutral step-up of the transferred assets can be realized by a conversion of the target company into a partnership are in principle made obsolete from 2001 onwards. Apart from the curious gap of one year between the demise of step-up structures and the advent of new capital gains exemptions for shareholders, there are two possibilities to carry out acquisitions of resident companies tax efficiently in the future: first, the acquirer may claim "his share" of the above mentioned advantages from the seller, for which reason a decline in the share prices is expected. Second, new favourable acquisition structures have to be found by revitalizing the tax neutral step-up technique.

Financing German companies

The Tax Reduction Act considerably tightened the thin capitalization provisions in order to further restrict tax driven international debt financing activities of foreign investors with German resident subsidiaries. However, the general system of thin capitalization rules will remain unchanged, subject to certain amendments regarding the abolition of the imputation system and a pending request of the Tax Court of Münster to the European Court of Justice for a preliminary ruling on their compatibility with European non-discrimination provisions.

The thin capitalization provisions still distinguish whether the respective interest payments are calculated on the basis of a fraction of the corresponding debt capital. Whereas the deductibility of interest payments concerning profit or sales related remuneration is abolished from 2001 onwards, interest payments with regard to remuneration not related to profit or sales may still be deductible if the shareholder's proportionate debt-to-equity ratio does not exceed the reduced safe haven of 1.5:1 (previously 3:1) or, in the case of a holding company, of 3:1 (previously 9:1). Higher leveraging is still allowable under arm's length conditions (see table 3). Inbound investors that operate through a German PE or partnership are not presently covered by the thin capitalization rules.

Table 3: Thin capitalization provisions

Maximum debt-to-equity ratios (safe haven)

Profit or sales
related remuneration
Non-profit or non-sales
related remuneration
Up to 2000 From 2001 Up to 2000 From 2001
German resident company 0.5:1 - 3:1* 1.5:1*
German resident holding company 0.5:1 - 9:1* 3:1*
* Higher leveraging possible under arm's length conditions


Holding company taxation

Germany is to be regarded as a very attractive holding company location within the EU. The tax climate has become even more favourable because of the changes made by the Tax Reduction Act and the improvements provided for by the Business Tax Development Bill. However, to review the German holding company regime applicable at present, a detailed analysis has to be carried out concerning several tax issues (see also the figure below):

  • participation exemption regarding domestic and foreign dividends and capital gains including write-ups reflecting recovery in value of shares previously written down: case 1;
  • no deduction of capital losses and write-downs to going concern value on shares;
  • participation exemption regarding income and capital gains of foreign PE: case 4;
  • no deduction of income and capital losses of foreign PE: case 4;
  • full deductibility of financing costs related to tax-exempt foreign dividends (5% of the dividends are deemed to be equivalent to non-deductible business expenses): case 8;
  • deductibility of financing costs related to tax-exempt domestic dividends insofar as they exceed the dividends actually received; the Business Tax Development Bill would eliminate the aforementioned restrictions: case 9;
  • wide German network of tax treaties that substantially reduce or eliminate withholding taxes on foreign and domestic dividends, interest and royalties received or paid: cases 2, 3;
  • Germany being a member state of the EU, G7, OECD and WTO;
  • Generous thin capitalization rules for shareholder loans granted to holding companies: case 7;
  • no capital contribution tax on the contribution of equity in exchange for shares;
  • no capital transfer tax on the transfer of shares;
  • no real estate transfer tax on taxable transfers carried out between the members of a group according to the Business Tax Development Bill;
  • no taxes on capital subject to real estate tax;
  • overall tax burden of holding companies akin to other countries;
  • unlimited carry-forward of current and capital losses;
  • group taxation for corporation tax, trade tax and VAT purposes: case 10;
  • top marginal income tax rate of resident individual stakeholders akin to other countries: case 6; and
  • supplemental taxation of operational subsidiary dividends channelled through a chain of foreign holding companies, in accordance with the controlled foreign companies regime, subject to extensive amendments provided by the Business Tax Development Bill: case 5.

Controlled foreign companies regime

The Tax Reduction Act also tightened the controlled foreign companies (CFC) regime in order to prevent the application of the exemption privileges for dividends received by individual or corporate shareholders with regard to certain investments in low-tax jurisdictions. Accordingly, from 2001 onwards the net profits of a CFC will be proportionately attributed to its domestic individual and/or corporate shareholders and subject to a supplementary tax at 38% if the CFC derives passive income taxed at a rate of less than 25% (previously 30%) and the German resident shareholders cumulatively hold more than 50% of the CFC's share capital or voting rights. On application, the foreign tax of the CFC actually levied may alternatively be credited against the supplementary tax due on the proportionately attributed gross profits of a CFC. The tax rate of 38% corresponds to the average tax burden on earnings of resident companies. The supplementary tax is a final burden applicable also in loss situations. Neither the half-income system nor the dividend-received exemption apply. However, the supplemental income amount may be tax exempt for resident corporate shareholders pursuant to the provisions of an applicable tax treaty, as are profits distributed by the CFC according to the dividend-received exemption. Dividends distributed by a CFC to resident individual shareholders are subject to income tax like any other dividends in accordance with the half-income system; supplementary tax already imposed on the supplemental income amount will be deducted from the dividends.

Income derived by a CFC from another non-resident company which meets certain activity requirements is exempt from the supplemental income amount. If dividends are distributed to resident shareholders of that CFC, they are tax exempt or subject to the half-income system, as the case may be. However, dividends of an operational subsidiary channelled up to a resident parent through a chain of more than one subordinated foreign resident holding company (CFC) may also be caught and taxed as supplemental income at 38%.

If the income of a foreign CFC consists of passive income with capital investment character, additional deemed income rules apply if a resident shareholder holds at least 10% of the share capital or voting rights. In this case, relief under a tax treaty is not applicable with regard to corporate shareholders. However, these rules do not apply if the passive gross income with capital investment character does not exceed euro62,000 ($57,400) and 10% of the total gross income of the CFC. The Tax Reduction Act has further tightened these specific rules on passive income with capital investment character insofar as the holding company privilege may be claimed from 2001 onwards only if the foreign holding company holds at least 10% in its subsidiary, the income of which is subject to tax of at least 25%. Moreover, the preferential treatment of low-taxed intra-group financing income is limited. Such income will now be assessed at 80% and taxed at 38%, resulting in an overall tax burden of 30.4%.

The Business Tax Development Bill would make major changes in the CFC regime in order to adapt it to the internationalization of the German economy. The supplementary tax would be abandoned. Instead, the supplementary income amount would be treated as part of the taxable income that is subject to income or corporation tax from 2001 onwards. Moreover, foreign dividends (from lower tier companies) would generally be treated as active, as would capital gains on the disposal of shares, subject to certain exemptions concerning assets that are used for activities with passive capital investment character by the company the shares of which are disposed of. Therefore, dividends of an operational subsidiary channelled up to a resident parent through a chain of more than one CFC would no longer be caught and taxed as supplemental income. However, dividends distributed by a CFC to resident individual shareholders would no longer be reduced by the income tax already imposed on the supplemental income amount. With regard to a foreign CFC, the income of which consists of passive income with capital investment character, the additional deemed income rules would already apply if a resident shareholder holds at least 1% (previously 10%) of the share capital or voting rights or if the gross income of that CFC consists exclusively or almost exclusively of passive income with capital investment character. Moreover, the holding company privilege would be abolished, whereas the preferential treatment of low-taxed intra-group financing income would be extended and assessed only at 60% for corporation tax and also for trade tax purposes.

Conclusion

The amendments enacted by the Tax Reduction Act and the measures contained in the Business Tax Development Bill will fundamentally change the tax climate for foreign and domestic business investment in Germany. Now, Germany may even be regarded as a location with an international investor-friendly tax system playing an active part in European and global tax competition matters. Nevertheless, further action is still needed in order to eliminate remaining obstacles to doing business in Germany and to develop a modern and globally open tax system.


KPMG
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Frankfurt-am-Main
D-60439, Germany
www.kpmg.com
Tel: +49 69 9587 2718
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