Germany: A Closer Look At Germany's New Reduction Tax Act 2001

One mainstay of the German imputation tax system is that corporate equity is divided into layers according to their embedded corporate tax rates (45% on retained earnings before 1999 (EK45), 40% for retained earnings after 1998 (EK40), 30% for distributed earnings (EK30), 0% on tax exempt foreign dividends, shareholders' equity and other non-taxable income (EK 01 - 04)). This technical classification of equity for tax purposes is one reason why for instance equity disclosed in the commercial balance sheets and tax equity layers are horses of two very different colors. With termination of the imputation tax system currently governed by Part 4 of the Corporate Income Tax Code ("CITC"), the layers are obsolete; Part 4 has been eradicated. These equity layers will not be demolished in one fell swoop, rather, they will be phased out over fifteen years. The transition rules contained in a newly worded Part 6 of the CITC are wordy and involved; the German tax authorities have not yet made model calculations available to the public, leaving several key details open to speculation. It is key that companies assess their equity structures now to ensure a smooth transition, especially one that does not stress company liquidity, when the rules kick in.

For our purposes, it will suffice to outline the main effects of the transition. The point of the exercise is ultimately to eliminate embedded tax credits by allowing companies to use them up gradually. German tax authorities were afraid of triggering panic EK45 distributions at the end of 2001 by taxpayers wanting to get their credits out since that would, much like a run on the banks, have a disastrous effect on the German fisc. Further, although certain elements of equity classification will be maintained (for instance a contribution account for straight non-taxed stockholder's equity similar to current EK04), the transition serves to bring equity for tax purposes closer in line with equity disclosed in the balance sheet.

German equity layers will be phased out in the following order:

1. The available net equity will be assessed according to the rules of the imputation in the last year of the system's applicability (fiscal year = calendar year December 31, 2000).
2. Dividends resolved for the fiscal year 2000 or earlier which are paid by the end of the following year (2001) result in a corporate income tax refund in accordance with the old rules. The dividend less the corporate income tax abatements will be deducted from the available net equity.
3. EK45 must be reclassified into EK40 by the end of 2000. To (at least mathematically) avoid losing imputation credits, EK40 will be increased by 27/22 of the EK45 amount. The remaining 5/22 will reduce untaxed EK02 layers. Given that the book earnings are not increased, the increase of the EK40 layer may not be utilized by paying a dividend unless the shareholder provides a capital contribution which is then used to pay an increased dividend.
4. If all untaxed equity baskets (except shareholders' equity, EK04) are negative at this stage, they have to be deducted from taxed earnings contained in EK30 and EK45, in that order. If the company has no tax exempt income layers at all, the reclassification of EK45 into EK40 results in a negative EK02 amount which (assuming there is no EK30) would then be deducted directly from EK40. In other words, if there is not enough EK02 to absorb the reduction when EK45 is reclassified into EK40, every unit of EK45 will simply become so many units of EK40, resulting in a loss of imputation credits to the tune of 5.8%. This is a trap for the unwary that can only be avoided if the EK45 layers had been paid out before reclassification occurs.
5. Remaining EK03 (pre-imputation system earnings) will be combined with EK01 (tax-exempt foreign source income).
6. The equity baskets at this stage will form the basis for the treatment of equity under the new system. Two layers, EK40 and EK02 will however maintain relevance.
7. In an official assessment, 1/6 of the EK40 layer will be fixed as a "tax credit receivable" (Körperschaftsteuerguthaben). The position does not have the characteristics of a true claim, it is rather a latent receivable. Portions of the tax credit receivable will become a true receivable over the fifteen-year transition whenever a dividend is paid out. In that case, 1/6 of the dividend declared and paid will reduce the corporation's income tax liability in such given year. The remaining tax credits will then be carried forward and expire at the end of 2015.
8. Dividends paid in the future will no longer give rise to the advance corporation tax (prepaid imputation tax) with one exception. As soon as EK02 layers are used for dividend payments, the imputation tax of 3/7 of such dividend will be due. This poses a trap over the next 15 fiscal years. After 15 years from now, even EK02 layers can be paid out without any imputation tax.

In short, the earnings are used in the following sequence:

• First, all assessed EK45, EK40, EK30, EK01 and EK03 layers will be deemed to be used for future distributions under the new system. As mentioned, no imputation tax will be due.
• As soon as the accumulated dividends paid under the new system exceed the total of the EK layers assessed as described above, the dividend is deemed to be financed out of EK02, resulting in 3/7 of imputation tax.
• As shareholders' equity, EK04 will be deemed to be used last for future dividend payments. The EK04 layers will be recategorized as a so-called "contribution account" (Einlagekonto) and carried forward.

When earnings generated under the new concept are distributed to private shareholders as of January 1, 2001, half of the income received will be added to that individual's taxable annual gross income according to the new semi-income concept introduced in place of the imputation system. The other half will not be taxable. By the same token, only those expenses related to taxable income (i.e., half) will be deductible. As now, a capital tax (20% instead of 25%) will be withheld and refunded when the taxpayer files a yearly return. Dividends paid out of earnings by the end of 2001 that accrued under the old system (in most cases by the end of 2000) are treated pursuant to the imputation system rules.

Corporate shareholders will be treated differently. All dividends - whether from active or passive foreign or domestic subsidiaries regardless of holding amount and period - will be tax free. This is an impressive improvement to the current law which renders only certain dividends exempt (in accordance with tax treaties) and excludes non-German shareholders from participation in the imputation credit system. The new rule will be a boon to capital market activity in Germany. From a tax point of view, it will have other positive effects. For one thing, it will no longer matter from what equity layer (i.e., with how high an embedded corporate tax credit) the dividend was financed (some exceptions will apply due to the phase out rules described above). For another, the provision renders complicated rules on indirect foreign credits obsolete. It also means that treaty exemptions will in future only retain meaning for income derived from foreign PEs.

There is a catch: while 95% of expenses related to foreign dividends are deductible (Sec. 8b para. 5 CITC), expenses related to tax free domestic German dividend income are not deductible at all (Sec. 3c para. 1 Income Tax Code, "ITC"). This may give rise to ballooning strategies - in the past reserved for foreign dividend income - for domestic income that originally stemmed from foreign holdings and had been passed from domestic group member to domestic group member. This is one reason why group taxation will retain a greater importance in the future.

The Tax Reduction Act reduces withholding tax on dividends from 25% to 20% (and from 33.3% to 25% if the distributing company bears the tax, Sec. 43a ITC). As before, the shareholder will receive a credit in the amount of the tax withheld, the withholding tax is thus nothing more than a pre-payment on the shareholders' tax burden. In accordance with the EU directive, EU parent companies (at least a 25% stake - 10% in cases of reciprocity - in the company, at least one year) may apply for a withholding tax exemption.

Intercompany dividends paid domestically over the 15 year transition period have other particular features. First it is not possible to reduce the current tax burdens of 45% or 40% of available equity baskets to the new 25% rate by paying intra-group dividends. Dividends sourced out of earnings as at December 31, 2000 are still subject 45% or 40% tax, depending on the equity layer used. Dividends paid out of "new"-earnings result, as mentioned, in a tax refund of 1/6. A corporate taxpayer receiving such a tax-exempt dividend incurs a corresponding tax liability of 1/6 of the dividends and adds such tax liability to its latent tax credit receivable. Put more simply: the tax credit receivable spills over from one corporate taxpayer to another. It only results in an effective cash refund when dividends are paid to non-corporate or non-resident shareholders.

The imputation system acted as a deterrent from using deemed distributions (also termed "constructive dividends") for non-resident shareholders. The distributing company could not claim deduction of the underlying expense. On the other hand, the constructive dividend to a non-resident shareholder carried with it all the negative consequences pursuant to German law. A constructive dividend under the current system must carry the advance corporation tax. As a consequence, a constructive dividend could immediately attract approximately 48% cash tax cost (imputation tax of 42.9% plus an assumed 5% treaty withholding tax rate). This deterring feature of constructive dividends will be gone under the new system because the deemed dividend leg of the constructive dividend will no longer attract the imputation tax. As previously explained, there may however be one exception for EK02 layers. Once the accumulated amount of dividends, including constructive dividends, over the next 15 years has exhausted all other layers before EK02 a constructive dividend could still give rise to the imputation tax of 3/7 until the year 2015.

The new system may take away the motivation for domestic taxpayers to carry out constructive dividends (such as higher than arm's length salaries) given the potentially lower tax burden at the corporate level. This depends however vastly from the income tax status of the domestic shareholder.

One change that made headline news and sent stocks of major German investors like Deutsche Bank AG, Allianz or Munchener Re soaring is the blanket exemption on capital gains from the sale of stock by corporate shareholders. The new capital gains exemption is contained in Sec. 8b para. 2 CITC. In contrast to the original plan, the capital gains exemption is effective as of January 1, 2002 (and for corporate shareholders with a deviating fiscal year even correspondingly later in 2002). The capital gains exemption applies to stock held by one corporation in another corporation, including German corporations (existing law only covers non-German corporations). There is no minimum ownership requirement. As a result, as of January 1, 2002 Germany's capital gains exemption will go beyond the Dutch participation exemption. The exemption was the source of controversy and - strange at it may seem, largely in the hands of the traditionally business-friendly conservative opposition - took a turn for the worse during the course of the parliamentary legislature process. While the exemption is a major improvement, one should be aware of the following pitfalls:

1. Distributions made by a subsidiary must result in dividend income for the parent. The requirement seems straight forward enough in a plain vanilla situation, but what about group taxation? This prerequisite sheds not insignificant doubt on the question of whether or not a controlled member of a German tax group is eligible for the capital gains exemption when its stock is sold. In a tax group, the income of the subsidiary is not transferred to the parent by virtue of a dividend, but rather automatically under the different concept of a profit / loss pooling agreement. This issue had been addressed in parliamentary hearings. Unfortunately the tax administration did not take any step to clarify the law. It is hard to believe that members of a tax group can't qualify for the capital gains exemption; the authorities' position remains to be seen.
2. To the extent the stock in the subsidiary was written down with tax effect in previous years, the capital gain would still be taxable.
3. At the time of the sale, the stock must have been owned by the corporate taxpayer for an uninterrupted period of one year (minimum holding requirement one year).
4. The stock must not have been contributed to the corporation as part of a tax-free reorganization by a taxpayer who is not eligible for the capital gains exemption (individuals and partnerships held by individuals). The reason is simply to prevent individual from avoiding tax by transferring his stock in a corporation tax-free into another corporation and subsequently having his corporation dispose of the shares.
5. The shares must not have been issued to the corporation as a result of a tax-free reorganization that would not have qualified for a tax-free disposal (einbringungsgeborene Anteile). For these kind of shares (einbringungsgeborene Anteile) a waiting period of seven years has to be observed before they are eligible for the capital gains exemption.

If a corporation owns untainted shares in another corporation it can contribute those shares tax-free to a lower tier corporation without triggering the seven year waiting period. However, it would not be possible for a corporation to hive-down a branch of activity into a new subsidiary and subsequently sell the shares of the new subsidiary. Here the seven year waiting period must be observed. If the branch of activity also happened to hold stock in another corporation, this stock would also be covered by the waiting period. Contributions to European corporations are further not excluded from the seven year waiting period. If, for example, a German corporation contributes shares in a German domestic to a European corporation at book value in exchange for new shares in accordance with merger and parent/subsidiary directives before the new German rules apply, the new shares received from the European corporation will fall under the seven year waiting period. If they had not created the shares (einbringungsgeborene Anteile) in this way, the shares in the German corporation would have qualified for a tax-free disposal on January 1, 2002. As a result, taxpayers will have to think twice before they carry out reorganizations over the next two years. As a general observation it is important to avoid creating these tainted einbringungsgeborene Anteile as a result of tax-free reorganizations.

In spite of the downside, the new capital gains exemption clearly gives multinationals good reason to form holding companies in Germany. Taking the add-back provision of Sec. 8b para. 5 CITC into account, 95% of dividends received from foreign subsidiaries is tax free. Related expenses, especially interest expenses, are however fully tax deductible. This advantage may tip the balance away from traditional holding company locations because it allows global corporations to set up a leveraged German holding company, contribute the domestic corporations as necessary equity (see, however, the thin capitalization rules discussed below) and finance the acquisition non-German subsidiaries exclusively with debt. The German interest disallowance rules regarding domestic subsidiaries contained in Sec. 3c para. 1 ITC mentioned above of can be overcome by establishing group taxation between the German HoldCo and the German subsidiary. Aside from minor considerations such as the fact that Germany does not levy any stamp duties, forming a European holding company in Germany may now make sense because of the tax capacity that many MNCs have in Germany they may not have in classic holding company locations. One may have to watch out for the German CFC rules, addressed below. Thin Capitalization Rules

When the German government introduced relatively generous thin cap rules in 1994 to make Germany a more attractive holding company location, investors took the opportunity to refinance and restructure their German and other European portfolios. Now, in an effort to raise more revenue, the rules, applicable to loans made by shareholders or related parties, have been tightened. The new law - effective as of January 1, 2001 (or 2002 for fiscal years other than calendar year that began before January 1, 2001) - disallows any safe haven for hybrid debt; payments on hybrid debt will be considered constructive dividends for corporate tax purposes. Further, the debt / equity ratios on straightforward debt have been lowered from 3:1 to 1½:1 for normal subsidiaries and from 9:1 to 3:1 for holding companies.

The law does not apply to shareholders if they are taxable in Germany on the remuneration derived is taxable by process of filing income tax returns (as opposed, for example, to withholding tax procedures or no taxability at all).

Since the Tax Reduction Act 2001 contains no amendments to Sec. 9 no. 10 Trade Tax Act, the German subsidiary will still be allowed to deduct interest on the loans for trade tax purposes (in most cases only 50%).

Partnerships are still not covered. Thus it would be conceivable to finance as follows:

There is currently no restriction to finance the German partnerships with debt. There is a however a trade off: while the stock of a corporation may be sold tax-free, shares in German Partnership may not.

When the original draft Tax Reduction Act hit the shelves in January, new rules pursuant to which a German partnership, traditionally a fiscally transparent entity, could opt for taxation as a corporate entity made waves among mid-sized German partnerships and international tax planners alike. The commotion was for nothing, the new regime proved to be a flash in the pan. Citing difficulties the new rule may bring in an international context, the German government scrapped its original plans to introduce check-the-box type rules for German partnerships. All in all, Germany's smaller, often family-run businesses, mostly partnerships (Mittelstand) feel left out of the tax reform and this change in schedule doesn't help matters. International tax planners too, with visions of new-fangled structured finance transactions dancing in their heads also may have been sorry to see their plans thus interrupted. With an eye toward difficulties caused by check-the-box rules in the US, many German practitioners however are less disappointed that the German government has refrained from opening what may have turned out to be more a Pandora's box.

We may note that individuals who are partners in a partnership or receive business income directly are, subject to various conditions, entitled to an income tax credit equal to 1.8 times the amount of the trade tax basic taxable amount. In effect, the refund will neutralize the trade tax at municipal trade tax multiples of 380%.

What the German government began in 1998 with the its Tax Reduction Act 1999/2000/2002 and its restriction on write-offs (read: obligation to write the shares up instead of maintaining the lower value) of non-depreciable assets including shareholdings, it tightened with the Tax Reduction Act 2001. Of foremost concern is the fact that losses at the level of subsidiaries are not recognizable for tax purposes unless there is group taxation. German parent companies will no longer be able to claim write-offs on shareholdings. This will make it necessary to look at investments very carefully this year so as not to omit the last opportunity for stock write-downs.

In addition, the government has placed restrictions on depreciation amounts for depreciable business assets. Notwithstanding the fact that the German government has yet to come out with overhauled depreciation tables – detailed lists of machines, machine parts, and industrial mechanisms with indications of their useful lives – which the taxpayer can expect to contain longer periods than now, the Tax Reduction Act 2001 has curtailed accelerated depreciation rates from an annual 30% to 20% across the board. In addition, linear rates for corporate buildings assets have been lowered from an annual 4% to 3%.

Thanks to laudable lobby efforts undertaken by the German leasing industry, the government succumbed and threw out a draft rule that would have required taxpayers to add 50% of all leasing payments on moveable assets back to calculate the modified yearly results used for figuring the trade tax burden. The draft change was motivated by the so-called Eurowings decision handed down by the European High Court in 1999. In that case, the airline Eurowings asserted that the old rule was a discriminatory violation of the EU Treaty.

In retraction to the Tax Reduction Act 1999/2000/2002, the new law re-introduces the availability of tax-neutral transfer of individual assets between partners and their partnerships under certain conditions as of January 1, 2001. In effect, the body of rules formerly known as the "Mitunternehmererlass" has to a great extent been reinstated in the form of codified law (Sec. 6 para.5 ITC). However, corporations will have to face restrictive anti-abuse provisions.

On the other hand, the Tax Reduction Act 2001 has introduced changes to Germany's Reorganization Tax Code effectively precluding the use of a step-up in the course of a corporate reorganization. When a corporate entity is transformed into a non-corporate entity, investors no longer have a chance to receive a higher basis in the assets. Although economically, share deals may still be more attractive than asset deals, the new Sec. 4 para. 6 Reorganization Tax Code brings the heyday of the step up technique to an end. Other minor changes to the Code reflect the switch from the imputation system to the semi-income method.

In addition, German tax law allows for streamlined tax neutral restructurings such as divestiture, split-up, contributions to a corporation, contributions within the EU and contributions to a partnership, when the reorganization involves structured company divisions or branches of activity ("Teilbetriebe"), vaguely defined by law as "a business unit which is endowed with a certain independence and self-sustenance." 100% participations in corporate subsidiaries are also considered Teilbetriebe. Industry and practitioners have long complained that the legal definition, and especially the extraordinarily restrictive interpretation of the term by the fiscal courts, is too narrow. The Tax Reduction Act 2001 unfortunately provides no relief. Further, German tax law is still ill equipped to handle international restructurings, placing unwarranted restrictions on international concerns doing business (or wanting to do business) in Germany.

The German Government was determined to make the German group taxation rules easier with the Tax Reduction Act 2001. Unfortunately they made a U-turn half way down the road. What has happened is that the requirements for group taxation for corporation tax purposes have been facilitated by eliminating the so-called economic (business) and organizational integration tests. Thus, group taxation for corporation tax purposes can now be employed if a subsidiary is financially integrated into a German resident parent (majority of the votes) and parent and subsidiary enter into a profit / loss pooling agreement. The elimination of the business and organizational integration test is certainly helpful because it has happened more than once that a holding company structure could not be implemented due internal frictions at company management levels caused by the requirement to fulfill both integration tests mentioned. Especially where holding companies are involved, one must bear in mind that a parent of a German tax group must conduct a trade or business. The fact that the corporation by its very definition always generates trading income is not sufficient. In the past, German case law has somewhat co-mingled the requirement for the parent to conduct trade or business with the business integration test. If one looks however at the older case law, it is obvious that the Supreme Tax Court understands the phrase "to conduct a trade or business" in such a manner that a managing holding company must manage at least two subsidiaries. Therefore, it will still be required that German parents which only act as holding companies to hold at least two active subsidiaries (this is also required for thin capitalization purposes). However, it is no longer necessary to prove that the subsidiaries are integrated in organizational and business respects.

Unfortunately for trade tax purposes all three requirements, financial, business and organizational integration have still to be fulfilled because the law has cemented this requirement for trade tax purposes. The requirement is evidently based on the concern that in situations of ownership between 51% and 75%, group taxation could otherwise be inadvertently established because a pooling agreement is not required for trade tax purposes. Lobbies thus requested the right to elect group taxation for trade tax purposes in cases of holdings between 51% and 75%, and the Government was obviously not willing to concede. What they got is the status quo ante for trade tax purposes. The same holds true for value added tax purposes where also all three integration requirements continue to apply. The reason named was that these integration requirements are listed in the Sixth European Directive even though we believe that they could have been interpreted differently. If a parent holds the majority of the votes in a subsidiary, one can at least presume that the subsidiary is controlled and thus also economically and organizationally integrated. The Government was not receptive to these arguments.

The German tax reform's generous dividend and capital gains exemption on German and non-German holdings, the long term simplification of corporate taxation and the new semi-income concept are tempered by the government's new concern for the treatment of non-German passive income. Germany's CFC rules contained in Secs. 7 – 14 Foreign Transactions Tax Act ("FTTA") have long abandoned their original aim to disregard the corporate veil and create deemed dividends where passive low-taxed non-German subsidiaries sheltered income from the long arm of the German fisc. Now the German tax authorities have turned their attention to ensuring that foreign dividends have been subject to a reasonable level of income taxation while at the same time drumming up new tax potential.

At first blush, the final outcome is not as alarming as preliminary drafts lead taxpayers to believe (see our report, Tax Notes Int'l 14 February 2000, p. 710). Under the existing rules, CFC taxation for regular passive income kicks in when a foreign corporation is controlled (more than 50%) by German resident shareholders. For passive portfolio income, CFC taxation applies for any resident taxpayer who owns at least 10% in a foreign corporation. This threshold remains unchanged.

Passive foreign income will now have to have been taxed at a rate of at least 25% to be excluded from the CFC regime. Neither the dividend and capital gains exemptions nor the semi-income taxation method will be extended to such income. Rather as of 2001, the CFC income will be taxed at a flat rate of 38%. This rate is designed to cover corporate tax of 25% plus an average trade tax; thus the income will exempt from trade tax. This is a clear deterioration for income from intra-group financing that has been exempt from trade tax so far. The lump-sum taxation of 38% of CFC income will most likely also apply if the parent is in a loss position.

What is alarming is the new wording of Sec. 10 para. 6 FTTA, the provision dealing with passive portfolio income. Defined as passive foreign income derived from holding or managing securities, participations, cash or cash equivalents, monetary claims or similar assets, German CFC rules provide for a treaty override when this portfolio income is allocated to the German parent. German CFC rules used to contain a holding company privilege: the income fell out of the portfolio income category and back into the normal passive income treatment if the direct parent held at least 10% of the company (former Sec. 10 para. 6 sent. 2 no. 2 FTTA). The same held if the income was derived from services to group company's for which the service provider charged an arm's length fee (former Sec. 10 para. 6 sent. 2 no. 3 FTTA). The Tax Reduction Act 2001 has done away with these two exceptions. In their place, the law now calls for a quasi-holding privilege which puts portfolio income back into the normal passive income category if the foreign holding company holds 10% and the income was subject to at least 25% tax at the level of the holding company's direct subsidiary (i.e., the German parent's second-tier subsidiary). In the real world of complicated global holding structures that extend over more than a total of three tiers, the new law is eyewash. It will be practically impossible for German-based multi-nationals to avoid added tax.

Furthermore the taxable portion of intra-group financing income has been increased to 80%. In combination with the lump-sum taxation of 38% intra-group financing income will now be subject o 30.4% (80% of 38%) as opposed to 18% so far. In both cases the surtax at 5.5% needs to be added.

All in all, the CFC rules are become tighter. More and more commentators believe that the rules are discriminatory under European law. We have only little hope that an overhaul of the CFC rules in general - already on the agenda for next year - will bring meaningful improvements.

At the close of Germany's third major tax reform legislation in as many years it is clear that it was no easy task freeing German tax law of many of the shackles of times gone by and correcting major errors made in the preceding packages. Of course, German tax law embodied by the Tax Reduction Act 2001 as heir apparent to the old regime is not without flaw. Especially troublesome are the restrictive deduction of expenses related to tax-free income, worsened conditions for depreciation deductions, and drastic deterioration in relief for passive portfolio income in the scope of the German CFC rules. Some may further bemoan the late effective dates of tax exemption on sales of shares, but this exemption along with the blanket exemption of dividends, the more streamlined and international investor-friendly modified classical corporate taxation system are a leap in the direction of a modern and globally open tax law.

Haarmann, Hemmelrath & Partner, July 20, 2000

Eugen Bogenschütz and Kelly Wright are both in the Frankfurt/Main office of Haarmann, Hemmelrath & Partner.

Tel: 069 / 92059-0

Fax: 069 / 92059-133

This article first appeared in Tax Notes International, July 31, 2000 p. 499 and is reprinted with kind permission of the publisher