On January 1 2001, a major tax reform came into force which changed the existing tax system almost beyond recognition. The major points of the reform are the abolition of the tax credit imputation system, which provided for a split corporate income tax rate for retained earnings (40%) and for distributed profits (30%), and which allowed the shareholder to credit the corporate income tax associated to the dividend against his own income tax liability. Under the new classic system, the corporate tax rate is reduced to 25%, but the shareholder may no longer credit the subsidiary's corporate income tax against his own tax liability. To avoid a double taxation dividend income is totally tax exempt on the level of a corporate shareholder, and 50% tax exempt on the level of a private individual shareholder. The solidarity surcharge (5.5% of the corporate income tax) and trade tax on income remained unchanged.
The initial project of the German tax reform also provided for a general tax exemption for capital gains resulting from the disposal of interest in corporations for corporate shareholders and a 50% tax exemption for private investors after a one-year holding period, applicable from January 1 2002 (interest in domestic entities, depending on the fiscal year of the subsidiary). This general rule should also apply to short-term capital gains of banks and other financial institutions, realized in a trading portfolio. The tax exemption is combined with the non-deductibility of capital losses and of business expenses related to this income. However, this implies that a substantial part of the expenses of financial institutions would not be tax deductible.
Therefore, the tax reform act was already partly amended. The amended version now provides that capital gains resulting from short-term investments are not tax free, when realized in a trading portfolio of a bank or financial institution. Consequently, capital losses and business expenses related to these transactions will be deductible without limitations under the new legislation.
This rule also applies to foreign banks and financial institutions whose principle place of business is in the European Union, or a state adhering to the treaty on the European Economic Space. This special rule does not apply to US and Swiss banks and financial institutions. Consequently, branches of US and Swiss financial institutions will be tax exempt with capital gains realized in their trading portfolio, but related expenses will not be tax deductible as well as capital losses.
The initial tax reform act provided for a one-year holding period to qualify for the tax exemption. This holding period was deleted from the final version of the law.