Germany

Author: | Published: 9 Nov 2000
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On July 14 2000, the German Tax Reform Act was finally approved by the Upper House of German parliament (Bundesrat). The Act includes not only a drastic reduction of tax rates, but also a change to the German corporation tax system, which affects the taxation of investment funds in Germany. The following summary introduces the most important changes, particularly those relating to the future taxation of dividend income and realized capital gains.

Taxation of corporations

The split rate of 40% on retained earnings and 30% on distributed earnings will be reduced to a flat rate of 25%. The flat rate of 25% will also apply to German branches of non-resident corporations and to foreign corporations operating through German partnerships that are at present subject to a 40% tax rate.

The 25% rate will be applicable effective January 1 2001 for business years calculated on a calendar year basis and as of 2002 for business years which are not.

The solidarity surcharge of 5.5% on corporate tax will remain unchanged, so that the effective corporate tax rate will be 26.4%.

Taxation of dividends

Under Germany's full imputation system, a German resident (corporate or non-corporate) taxpayer is entitled to a corporation tax credit (of usually three-sevenths of the dividend) on dividends received from German corporations. Therefore, for a German resident taxpayer, the German corporation tax levied at the level of the German corporation was treated in a similar way to a prepayment of tax by the investor, provided the income was distributed by the corporation.

This full imputation system on dividend distributions will be abolished and replaced by a new half-income system. The half-income system will apply to distributions made in 2002 for the business year 2001 (or other previous business years) if the business year of the distributing German corporation equals the calendar year. If the corporation makes advance distributions for the business year 2001 during 2001, the half-income system will already apply to such advance distributions.

If the business year of the distributing German corporation does not equal the calendar year, the half-income system will apply for distributions made during the business year 2002/2003 for business year 2001/2002 (or other previous business years). If the corporation makes advance distributions for the business year 2001/2002 during the business year 2001/2002, the half-income system will already apply for such advance distribution.

Under the half-income system, an imputation tax credit will no longer be available, ie profits are taxed at the level of the corporation and once again at the level of the shareholder on distribution.

The half-income system will also apply to all dividend payments from foreign corporations received by German corporate and non-corporate shareholders.

The changes to the half-income system will result in the income tax effects described below for German corporate and non-corporate recipients of domestic and foreign dividends.

Corporate investors as recipient of dividends

Dividends from domestic or foreign corporate investments received by a corporate investor will be 100% tax-exempt (participation exemption). Without such a participation exemption, the abolition of the imputation system would result in double or multiple taxation of dividends in the corporate chain. There are no minimum holding periods and no minimum holding requirements regarding this participation exemption. At present, only foreign dividend income is tax-exempt in the case of qualifying interests in non-resident corporations, whereas domestic dividend income generally represents fully taxable income for corporate investors.

Special rules apply with respect to investments in foreign passive corporations that are subject to a low tax regime based on German controlled foreign company (CFC) regulations. Low-taxed income will be defined under the Tax Reform Act as income subject to an effective tax rate of less than 25% (30% at present).

Non-corporate investor as recipient of dividends

For non-corporate investors (eg private investors or partnerships), dividends received from foreign or domestic corporations will be included in the tax basis by 50% only. However, income related expenses (eg custody fees or interest for a debt financed portfolio) are also deductible by 50% only.

Under the full imputation system, domestic and foreign dividend income is fully taxable if it does not qualify as a tax-free repayment of capital.

Dividend withholding tax

Dividend payments from a German corporation will be subject to German dividend withholding tax of 20% (reduced from 25%) plus 5.5% solidarity surcharge thereon, ie the new effective tax rate will be 21.10% (reduced from 26.4 %) of the amount distributed. This dividend withholding tax will remain fully creditable for German corporate and non-corporate investors.

With respect to foreign withholding taxes levied on foreign source dividends, non-corporate investors can credit 100% of such tax against their income tax liability. A corporate investor cannot get a foreign tax credit, as the underlying dividend income is fully tax exempted.

Taxation of capital gains from the disposal of shares in a corporation

The new half-income system will also apply to capital gains realized on the disposal of shares in domestic and foreign corporations.

For corporate investors such capital gains will be 100% tax-exempt provided the shares have been held by the seller for at least one year. The new regulation becomes effective for sales effected as of January 1 2002 provided that the corporation whose shares are sold (German target company) has a business year calculated on a calendar year basis. If the business year is not calculated on a calendar year basis, the tax exemption will be available for sales after the end of respective business year 2001/2002. Under the present corporation tax system, such capital gains are only tax-exempt in the case of a disposal of qualifying interests in foreign corporations.

For non-corporate investors, a 50% tax exemption on realized gains on the disposal of shares in domestic and foreign corporations will be available as of January 1 2002 at the earliest, depending on the business year of the corporation the shares in which are sold (as described above). For non-corporate investors, such taxable capital gains arise only if they sell shares:

  • of a corporation of which they hold or have held at least 1% (at present 10%) of the outstanding shares of the company at any time within the five years prior to the sale; or
  • within the 12 month speculative period (also for fund units); or
  • which were held as business assets, eg of a sole trader or a partnership.

German investment funds

The German income taxation of profits received from investments in a domestic fund (distributions and deemed distributed income) follows the transparency principle, which means investors are taxed as if they had directly invested without the interposition of an investment fund. Based on the transparency principle, the half-income system regarding dividend income and capital gains will also become effective for investments via German investment funds (for respective periods of effectiveness see above).

Dividend income

The non-corporate investor's taxable income from German investment funds (distributed and undistributed income) financed by domestic or foreign dividend income received by the fund also qualifies for a 50% tax exemption (as for dividend income received by a non-corporate investor directly).

For a corporate investor, such portion of the (distributed or undistributed) fund income which relates to domestic or foreign dividend income will be 100% tax-exempt.

Distributions financed by domestic dividend income are subject to a dividend withholding tax of 20% plus a 5.5% solidarity surcharge (new effective tax rate 21.10%). This dividend withholding tax will be fully creditable at the level of the (corporate and non-corporate) investor.

Other ordinary income

The distributions and the deemed distributed income of any other fund income (eg interest income and certain income from derivatives) will remain fully taxable for corporate and non-corporate investors.

The portion of the distribution and deemed distributed income relating to interest income is still subject to a 30% withholding tax plus 5.5% solidarity surcharge, ie an effective tax rate of 31.65 %.

Realized capital gains

For corporate investors, distributed realized capital gains from the sale of shares/equity by the fund will be fully tax-exempted if the respective one year holding requirement is fulfilled by the fund. Realized capital gains from the sale of bonds by the fund will still be fully taxable for a corporate investor on distribution.

Realized capital gains from the sale of shares/equity and bonds will be tax-exempted (as under current law) as far as such gains will be accumulated at the funds level.

For non-corporate investors, income deriving from realized capital gains from the sale of shares/equity at the fund's level will remain fully tax-exempt, irrespective of whether the income will be distributed or not

Sale/redemption of fund units

Undistributed realized and unrealized capital gains at funds level increase the net asset value of the fund unit. If the German investor sells fund units containing such undistributed realized and unrealized capital gains, a capital gain at the investor's level would be realized.

Based on the half-income system, for corporate investors capital gains from the sale of fund units will be 100% tax-exempt to the extent they relate to equity investments of the fund, and fully taxable to the extent they relate to other investments of the fund. This tax exemption should also apply to the portion of the capital gain relating to dividend income received at the level of the fund. However, the wording of the law seems not to cover this income portion.

For private investors, gains realized on the sale of fund units, irrespective of whether they relate to equity or bond investments at the level of the fund, will be fully taxable if the sale takes place within the 12-month speculative period. If the sale is made after the 12-month speculative period, gains realized on the sale are fully tax-exempted. For non-corporate business investors (eg a sole trade or a partnership), any gain realized on the sale of fund units will be fully taxable irrespective of any holding period.

Foreign investment funds

The taxation of foreign funds is also based on the transparency principle. However, there are different rules depending on the tax status of the foreign fund. Foreign funds fall into the following three categories:

  • 'white' funds (funds registered for public distribution and which fulfil certain publication requirements for tax purposes);
  • 'grey' funds (non-registered funds with a tax representative and disclosure of all tax relevant data); and
  • 'black' funds (all other funds).

For white funds, taxation is similar to that of German funds, apart from the fact that investors in a white fund cannot receive any German (corporation and withholding) tax credit. The difference between white and grey funds is that capital gains realized by a grey fund always represent full taxable income for corporate and non-corporate investors, irrespective of whether they are distributed or not.

German corporate and non-corporate investors in black funds are taxed on (an unfavourable) lump-sum basis.

The sale/redemption of foreign fund units is a taxable event for corporate investors; for non-corporate investors this is the case only if the sale/redemption takes place within the 12-month speculative period after the respective acquisition.

The basic concept behind the taxation of all three types of foreign funds remains unchanged, ie a 50% tax exemption of dividend income and realized capital gains on disposal of shares for non-corporate investors, and respective 100% tax exemption for corporate investors is not available if the investment is made via foreign funds.

Summary

As in the past, German income taxation favours investments in domestic funds over investments in foreign funds (eg EU domiciled funds), even if they fulfil the highest disclosure requirements (white funds).

The non-implementation of the half-income system for foreign funds too even increases, for German investors, the current tax disadvantage of investments in foreign funds compared to investments made in domestic funds or respective direct investments.




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