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1. Introduction
2. General effective date
3. New corporation tax system
4. New corporation tax system: effective dates
4.1 25 % corporation tax rate
4.2 Capital gains exemption
4.3 Dividends and dividends-received exemption
5. Transition provisions
6. New corporate tax rate: 25 %
6.1 General
6.2 German permanent establishment
6.3 German subsidiary – retained earnings
6.4 German subsidiary – distributed earnings
6.5 Effect of higher or lower trade tax multiplier
6.6 Summary
7. Dividends-received exemption
7.1 General
7.2 Domestic dividends: § 3c EStG
7.3 Foreign dividends: § 8b (7) KStG
7.4 CFC provisions
8. Capital gains exemption
9. Permanent establishments
10. Reorganisations
11. Depreciation rule changes
12. Thin capitalisation
13. Dividend stripping
14. Loss utilisation and tax consolidation
14.1 Loss utilisation with corporation tax credit
14.2 Need for tax consolidation under the proposed reform
14.3 Relaxed requirements for corporation tax consolidation
14.4 Trade tax and VAT consolidation
15. CFC provisions
15.1 General
15.2 Conflict with EU law?
16. Eurowings
17. More German foreign investment?
18. Concluding remarks
Tax Reform 2000: Corporate Tax Impact
For disclaimer and copyright, see end of this article.
1. Introduction
Articles nos. 196 - 198 examine the political outlook of Tax Reform 2000, summarise its key features, and discuss in some detail the revenue-increasing measures it contains. This article examines the impact of the proposed legislation on corporate taxation with selective focus on issues of interest to foreign investors.
All references to the proposed tax reform are to the legislation in the form passed by the German Federal Parliament on 18 May 2000. Ratification by the Federal Council is still needed for the bill to become law.
2. General effective date
The measures contained in the tax reform package have different effective dates. Many provisions take effect in the 2001 assessment period, that is, at the beginning of the first fiscal year which ends in 2001 (1 January 2001 for calendar year taxpayers). See also sec. 4, 5, 10, 11, and 12 below.
3. New corporation tax system
The new corporation tax system rests on three pillars:
- Uniform definitive 25 % corporation tax rate
- 100% dividends-received exemption for corporations
- 100 % capital gains exemption for corporations selling shares in other corporations
The proposed uniform corporation tax rate of 25 % would apply to all corporate earnings, including those of the domestic permanent establishment (branch) of a foreign corporation. The uniform rate would replace the current triple rates of 40 % for retained earnings, 30 % for distributed earnings, and 40 % for the earnings of domestic branches of foreign corporations. More importantly, the new 25 % corporation tax would not be creditable against the tax liability of a dividend recipient or included in dividend income. For rate structure analysis, see sec. 6 below.
The present imputational tax system, in force in Germany since 1977, would be terminated. Under the imputational tax system, corporate dividends carry a full credit for corporation tax paid by the distributing corporation with respect to the dividend. German residents and foreign persons holding shares in a German corporation in a domestic permanent establishment (including a partnership) are entitled to the credit. This credit and a trade tax participation privilege avoid double taxation on inter-corporate dividends. The dividend recipient includes the creditable corporation tax in his taxable income. For resident individuals, corporation tax thus functions in the same way as a dividend withholding tax.
The new corporation tax system would avoid tax pyramiding by a 100 % dividends-received exemption for corporations and a 50 % dividends-received exemption for individuals. The dividends-received exemptions are effective for trade tax purposes as well. The exemptions in general do not depend on the percentage shareholding, the holding period, or, in the case of foreign dividends, the existence of a tax treaty. There is also no requirement that the distributing corporation carry on an "active" business. Caveats and exceptions, notably the CFC rules, do apply however. See sec. 7 below.
The third pillar of the new tax system is the 100 % capital gains exemption for corporations selling stock in other corporations. Both the dividends-received exemption and the capital gains exemption are also enjoyed by a corporation with respect to its pro rata share of income derived by a partnership in which it is a partner. See sec. 8 below.
A 15 year transition period would be created during which distributions of earnings accumulated under the present corporation tax system would continue to result in a reduction of corporation tax to the distributing corporation. See sec. 5 below.
4. New corporation tax system: effective dates
4.1 25 % corporation tax rate
Generally, the changes made, including the new 25 % corporate tax rate, would apply beginning with the 2001 assessment period for corporations whose fiscal year is the calendar year (calendar-year corporations). Hence, the new tax rate applies from 1 January 2001 onwards for calendar-year corporations.
For corporations whose fiscal year does not coincide with the calendar year (non-calendar-year corporations), the new tax rate generally applies beginning with the 2002 assessment period.
4.2 Capital gains exemption
The exemption for gain on the sale of shares in other corporations applies to sales from the year 2001 onwards ("shares sold after 31 December 2000"). Prior drafts of Tax Reform 2000 contained more complicated rules on this point which would have postponed the capital gains exemption until 2002 in most cases.
4.3 Dividends and dividends-received exemption
A distinction is drawn between declared dividends paid for prior fiscal years (regular dividends) and all other dividends (especially constructive dividends). If the dividend is subject to the new law as regards the distributing corporation, it is also subject to the dividends-received exemption as regards the dividend recipient.
Stated simply: for calendar-year corporations, the new law applies for regular dividends which they distribute from 2002 onwards and for other dividends distributed from 2001 onwards. The rules for non-calendar year corporations are analogous, but more complicated.
5. Transition provisions
As mentioned above, the creditable corporation tax accumulated in retained earnings under the present system will remain creditable during a 15 year transition period. By the same token, the corporation tax burden on "old" retained earnings is to remain at its prior level (generally 40 %) when distributed to other domestic corporations. Only the distribution of old earnings to a resident individual or a foreign person will reduce the prior corporate tax burden – to 30 %, the present distribution rate.
In effect, the old and new corporation tax systems will coexist during a long transition period for companies with old retained earnings. The details are complex and beyond the scope of this article. It is pointed out, however, that switchover to the new corporation tax system would involve conversion of old retained earnings taxed at the 45 % rate in force through 1998 (EK 45) into the retained earning categories EK 40 and EK 02. The conversion formula results in a loss of creditable corporation tax. Corporations should therefore consider avoiding this conversion by distributing all EK 45 prior to the effective date of the new law.
Corporations should seek professional advice concerning this and many other aspects of the conversion to the new corporation tax system.
6. New corporate tax rate: 25 %
6.1 General
The proposed reform legislation would create a uniform corporation tax rate of 25 % for all corporate earnings, whether distributed or retained, whether earned by a domestic corporation, a dual resident corporation, or the domestic permanent establishment of a foreign corporation.
The immediate results of this change for foreign owned operations are threefold:
- Major reduction in the tax burden on domestic permanent establishments
- Major reduction in the tax burden on earnings retained in a German subsidiary (or dual-resident corporation)
- Minor reduction in the tax burden on distributed earnings
The following tables quantify these statements. The calculations assume a trade tax multiplier of 400 %. The trade tax multiplier is set by local government. Most communities have trade tax multipliers in the range from 300 % to 500 %.
6.2 German permanent establishment
For tax purposes, a foreign person is treated as having a German permanent establishment if such person maintains a German branch or holds an interest in a German partnership.
The following table shows the tax burden of a German permanent establishment of a foreign corporation under current law (column "2000") and under the planned 25 % corporation tax rate (column "2001").
Solidarity Surcharge = 5.50%
Trade tax multiplier = 400%
|
|
2000 |
|
2001 |
Change |
|
Before tax income |
100.00 |
|
100.00 |
|
|
Trade tax |
16.67 |
|
16.67 |
0 |
|
|
83.33 |
|
83.33 |
|
|
Corporation tax 40% |
33.33 |
Corp. tax 25% |
20.83 |
-12.50 |
|
Tax wo. sol. surch. |
50.00 |
|
37.50 |
|
|
Solidarity surcharge |
1.83 |
|
1.14 |
-0.69 |
|
Total tax |
51.83 |
|
38.64 |
-13.19 |
At the assumed trade tax rate, the tax reform proposals would reduce the tax burden of a domestic permanent establishment by 12.50 percentage points before solidarity surcharge and 13.19 percentage points after solidarity surcharge.
Since dividend withholding tax is presently inapplicable to sums transferred by a domestic permanent establishment to its foreign home office, the total tax burden of 38.64 % (37.50 % without solidarity surcharge) is final. The improvement compared with the prior treatment of domestic permanent establishments is dramatic. Previously, permanent establishments were locked into the corporate tax bracket for retained earnings (40 %) without possibility of reduction when earnings were "distributed" (repatriated). In the future, permanent establishments are locked into the low unitary corporation tax rate because dividend withholding tax is inapplicable to repatriated earnings. Their tax burden is thus equivalent to that of a German subsidiary. Germany's tax treaties seldom reduce German dividend withholding tax to under 5 %. However, EU parent companies are exempt from such withholding tax under § 44d EStG (German implementation of the Parent-Subsidiary Directive).
While the improvement is marked, it should be noted that an overall burden of 38.64 % still exceeds the OECD average by roughly 1.5 percentage points.
6.3 German subsidiary – retained earnings
The tax burden of a German subsidiary which retains its earnings is identical to that shown for a domestic permanent establishment in sec. 6.2 above.
6.4 German subsidiary – distributed earnings
The tax burden on earnings distributed by a German corporation to its foreign parent is greatly influenced by dividend withholding tax. The proposed reform would cut the statutory withholding tax rate from currently 25 % to 20 %. This rate is reduced or eliminated entirely under Germany's tax treaties or, for EU parent companies, Germany's implementation of the Parent-Subsidiary Directive – subject in each case to meeting the applicable requirements, such as minimum percentage holding and holding period.
The following table shows the tax burden of a German subsidiary of a foreign corporation under current law (column "2000") and under the planned 25 % corporation tax rate (column "2001").
Solidarity Surcharge = 5.50%
Trade tax multiplier = 400%
Dividend withholding tax = 0%
|
|
2000 |
|
2001 |
Change |
|
|
100.00 |
|
100.00 |
|
|
Trade tax |
16.67 |
|
16.67 |
0 |
|
|
83.33 |
|
83.33 |
|
|
Corporation tax 30% |
25.00 |
Corp. tax 25% |
20.83 |
-4.17 |
|
Tax before sol. surch. |
41.67 |
|
37.50 |
|
|
Solidarity surcharge |
1.37 |
|
1.15 |
-0.22 |
|
Withholding tax |
0 |
|
0 |
|
|
Total tax |
43.04 |
|
38.65 |
-4.39 |
The tax relief for earnings distributed by a German subsidiary to its foreign shareholder is thus modest at best. As dividend withholding tax rises, the change as between present and proposed law declines because the withholding rate is applied to a slightly larger base under the new law, thus leading to a higher withholding tax than under present law. This effect is not dramatic, however. The difference in total tax burdens under present and proposed law is 4.18 percentage points assuming 5 % dividend withholding tax.
While the difference in tax benefit conferred by the new law is not great no matter what the withholding tax rate, the difference in overall tax burden is, of course, significantly affected, depending on whether one must pay 20 % or 0 % withholding tax on distributed dividends. At the unmitigated 20 % rate, withholding tax adds almost 13 percentage points to total tax (assuming the new 25 % corporate tax rate, a trade tax multiplier of 400 %, and solidarity surcharge). For taxpayers not able to obtain complete or virtually complete abatement of dividend withholding tax, branches have an advantage under the new law because they enjoy the same tax rate as subsidiaries with respect to retained earnings without being burdened by dividend withholding tax.
6.5 Effect of higher or lower trade tax multiplier
The relief afforded by the proposed legislation increases somewhat as the trade tax multiplier declines from the assumed 400 % and declines somewhat as the trade tax multiplier increases. This effect is not dramatic. The difference in overall tax burden between a community with a trade tax multiplier of 500 % and a community with a multiplier of 300 % is roughly 5 percentage points.
6.6 Summary
The proposed tax rate changes have major impact only on the taxation of earnings attributable to the domestic permanent establishments of foreign corporate taxpayers(branch income or pro rata partnership income) and the earnings of domestic subsidiaries which retain their earnings. Whereas a domestic subsidiary previously had to distribute its earnings on a current basis in order to obtain the most favourable tax rate available, it now must do the exact opposite. Branches, on the other hand, were previously subject to a high definitive rate of taxation, but would automatically have the optimal available status under the tax reform proposals. Branches would thus in the future become an attractive structure for German business activity, especially for foreign investors unable to secure a complete abatement of German dividend withholding tax, for instance, because they are resident in a non-tax-treaty country.
7. Dividends-received exemption
7.1 General
The proposed 25 % corporation tax is a definitive tax not creditable or refundable. To avoid double taxation on inter-corporate dividends, corporations will enjoy a 100 % dividends-received exemption irrespective of minimum shareholding, minimum holding period, dividend source (foreign or domestic), and activity requirements. The exemption is also effective for trade tax purposes (§ 8b (1) KStG-E, § 7 GewStG).
Together with the exemption for capital gains on the sale of shares in corporations, the dividends-received exemption enhances the advantages which Germany already offers as a location for international holding corporations.
However, the dividends-received exemption is subject to certain limitations and drawbacks, discussed below.
7.2 Domestic dividends: § 3c EStG
§ 3c EStG, a provision in the income tax law applicable to corporations as well, prohibits the deduction of expenses directly related to tax-free income. In light of the new 100 % dividends-received exemption, dividends received will in the future fall under § 3c EStG. This can lead to the following problem:
Example
X-GmbH borrows money from a bank to finance its equity participations in Y-GmbH and Z-GmbH. After the new corporate tax system takes effect, the interest paid by X-GmbH on the bank loan is no longer deductible because it is directly related to its tax-free dividend income from Y-GmbH and Z-GmbH.
The same problem can also occur in the context of foreign shareholder financing, for instance, where the foreign parent has established a German holding with several subsidiaries to take advantage of the higher debt-to-equity ratio for holding companies. There are three basic solutions:
- Consolidating the subsidiaries under the holding for corporation tax purposes. This is the most effective solution because it ensures that the expenses and the income are concentrated in the same entity. Hence, no denial of deductibility can occur.
- Shifting the debt from the corporation which receives tax-free dividends to the corporation which earns the income. In the above example, this would mean loaning the funds to the subsidiaries instead of to the holding. Direct loans from a foreign related person to the domestic subsidiaries would, however, collide with the thin capitalisation rules for holding structures (§8a (4) sent. 2 KStG – unchanged in pertinent part in the draft legislation). Direct loans to the subsidiaries would therefore require undoing the holding structure (or qualifying under the arm's length exception to the thin capitalisation rules).
- Exploiting a court-created loophole in § 3c EStG by means of "ballooning". As interpreted by the courts, the statute leads to a denial of deductions for expenses incurred to earn tax-free income only to the extent the income and the expenses arise in the same assessment period. In other words, if the income can be bunched in a year in which there are minimal or zero expenses, the impact of the statute can be avoided. This solution, while effective, is complicated and rigid from a planning perspective.
7.3 Foreign dividends: § 8b (7) KStG
A provision added to the corporation tax law in 1999 provides that 5 % of dividends received free of tax under a tax treaty (or under provisions of domestic law extending the scope of what is fundamentally a tax treaty exemption) are deemed to constitute expenses directly related to tax-free income and hence fall under § 3c EStG. The result desired by the tax authorities is that 5 % of such dividends will be subject to tax.
The proposed legislation (§ 8b (5) KStG-E) preserves the same rule in simplified form. It provides that 5 % of dividends received from foreign corporations will be deemed directly related to tax-free income. This means that, while domestic dividends will be completely tax free to German corporations, in effect only 95 % of foreign source dividends are tax free.
There is an upside to this downside, however. The prevailing view is that the statute under discussion pre-empts § 3c EStG. In other words, while 5 % of foreign source dividends are taxable, § 3c EStG cannot be applied to the expenses actually related to such dividends. In many cases, the actual financing expense could be greater than 5 % of the dividend amount.
7.4 CFC provisions
The German Foreign Tax Act (AStG) provides that the income of resident persons (individuals and corporations) will under certain circumstances be increased by "passive" amounts earned, but not distributed, by a foreign corporation in which they hold shares if such passive income was subject to a "low" rate of taxation in the foreign jurisdiction. The term "CFC provisions" is used because of the general resemblance to the "controlled foreign corporation" legislation of other jurisdictions.
The proposed legislation provides that amounts so added to the income of domestic taxpayers – the "supplemental income amount" (Hinzurechnungsbetrag) – are subject to a flat rate tax of 25 %. Furthermore, the dividends-received exemptions created by the new legislation (§ 8b (1) KStG-E, § 3 no. 40 EStG-E) do not apply to the supplemental income amount (§ 10 (2) AStG-E).
The CFC provisions thus constitute a third major exception to the general rule that dividends received by a corporation are tax-exempt under the Tax Reform 2000 scheme. The CFC provisions are discussed in more detail under sec. 15 below.
8. Capital gains exemption
The proposed corporate tax system creates a 100 % capital gains exemption for corporations selling stock in other corporations. Liquidations, reductions of stated capital, and constructive contributions (though unfortunately not constructive dividends) are treated as equivalent to sales. This exemption is not contingent on a minimum holding period, a minimum percentage holding, the existence of a tax treaty, or an activity requirement. This is one of the most politically controversial measures in the Tax Reform 2000 plan. It is also its most significant innovation.
Like the more limited capital gains exemptions for sales of shares in foreign corporations already contained in German tax law, the future exemption is subject to a recapture provision where the basis in the shares being sold has been written down in the past with tax effect. No such writedowns will be permitted in the future as the logical consequence of the exemption for gain on sale of corporate shares.
The capital gains exemption not only liberates corporations from tax constraints in deciding whether to hold or sell shares in other corporations, but also gives them considerably more freedom in reorganising their group structures. Any domestic branch of activity could be spun off into a separate corporation and sold tax free. The same will be true of foreign branches of activity provided the tax law of the foreign jurisdiction permits the tax free spin-off and a tax treaty with Germany exists. The gain on the sale of the new foreign corporation will generally be protected from foreign tax by the terms of the tax treaty. Furthermore, cross-border reorganisations by which a German corporation trades shares in a foreign or domestic corporation for shares in a foreign corporation will be feasible from a German perspective. Such transactions were previously possible inside the EU subject to certain restrictions under the tax reorganisation act.
If it becomes law, the capital gains exemption will enhance the already considerable advantages which Germany possesses as a location for international holding companies.
9. Permanent establishments
The new law would place the domestic permanent establishments (branches and interests in German partnerships) of foreign corporations on an equal footing with domestic corporations. Such permanent establishments are subject to the 25 % tax rate and enjoy the dividends-received and capital gains exemptions. These changes enhance the advantages of branches over domestic corporations. Permanent establishments pay no dividend withholding tax and are not subject to the German thin capitalisation rules for foreign shareholder financing.
10. Reorganisations
Several changes are made in the tax reorganisation act by the proposed legislation. Perhaps the most important is the end of tax recognition of losses on reorganisation of a corporation as a partnership. Changes to the law in 1999 had already eliminated the tax recognition of such losses for trade tax purposes. Now, loss recognition is eliminated for corporation and income tax purposes as well. Previously, losses occurred when the shareholders' basis in their shares in the corporation exceeded the corporation's basis in its assets. The loss was equalised by increasing the basis of the disappearing corporation's assets in the hands of the receiving partnership (step-up model).
The end of the step-up model means that taxpayers able to benefit from reorganisation of corporations as partnerships (stepped up asset basis) should consider carrying out such a reorganisation before the new law takes effect. All changes made in the tax reorganisation act apply to reorganisations for which the effective date for tax purposes is after 31 December 2000. Since the effective date may be up to eight months prior to entry of the reorganisation in the Commercial Register, it will be possible to carry out reorganisations in 2001 which fall under the old law.
In the past, buyers of German corporations have been willing to pay a premium reflecting the availability of a step-up in asset basis following a share deal. Under the new law, buyers not able to secure an asset deal will have to discount the price they are willing to pay to take account of the elimination of step-ups from outside basis (basis in shares purchased) to inside basis (asset basis).
The utility of tax-free sales of shares in corporations for reorganisation purposes was noted in sec. 8 above, as was the abolition of writedowns on shares held in other corporations.
11. Depreciation rule changes
Depreciation changes account for over 60 % (DM 17.7 billion) of all revenue increases contained in the Tax Reform 2000 package. The impact of these measures can be mitigated by advancing planned asset purchases to before the effective date of the specific measure. Generally speaking, the effective date is 1 January 2001. See sec. 2 of article no. 198 for more detail.
12. Thin capitalisation
The tax reform proposals couple the lower tax burden for German corporations with tighter thin capitalisation rules for corporations (§ 8a KStG):
- Elimination of the safe haven for shareholder loans linked to profits, sales, or some factor other than loan principal ("hybrid debt")
- Reduction of the safe haven for conventional debt from 3-to-1 (debt to equity) to 1.5-to-1
- Reduction of the holding company safe haven for conventional debt from 9-to-1 to 3-to-1
The new rules would take effect beginning with the assessment period 2001. Hence, action would be necessary to bring debt and equity into line with the new rules by the end of this year for calendar year taxpayers.
The lower tax rates discussed above may reduce the incentive for debt financing by certain foreign shareholders. In connection with the favourable overall tax burden on domestic permanent establishments under the planned future regime, taxpayers should recall that the thin capitalisation rules are not applicable to corporate permanent establishments.
The problems described under sec. 7.2 above and sec. 14 below can be acute in the context of a domestic group established to take advantage of the higher safe haven for holding corporations.
See sec. 3 of article no. 198 for more detail.
13. Dividend stripping
Dividend stripping refers to transactions in which shareholders not entitled to a credit of corporation and dividend withholding tax (foreign persons not holding the shares in domestic permanent establishments) sell their shares to persons so entitled (generally, residents) so that the latter may receive the dividend and the credits attaching thereto. Thereafter, the shares are resold to the original holder. Tax Reform 2000 would end such transactions as regards corporation tax because this tax will no longer be creditable. Dividend stripping would remain possible with regard to dividend withholding tax. See sec. 5.2 of article no. 198 and article no. 202 for more detail.
14. Loss utilisation and tax consolidation
14.1 Loss utilisation with corporation tax credit
Under the present corporation tax system, corporation tax paid by the distributing corporation is fully creditable to the receiving shareholder (whether an individual or a corporation) provided the dividend as such is subject to German taxation (§ 51 KStG, § 36 (2) no. 3 EStG). This in effect permits the profits of a subsidiary to be offset by the losses of its domestic parent without meeting the requirements for tax consolidation.
Example (ignoring solidarity surcharge and dividend withholding tax):
A U.S. multinational has a German 100 % subsidiary, Loss GmbH, which in turn holds a 100 % stake in another German corporation, Profit GmbH. Profit GmbH distributes a dividend of 70 (profit of 100 less 30 corporation tax) to Loss GmbH. This dividend carries a corporation tax credit of 30. Loss GmbH reports a grossed up dividend of 100. This dividend income is offset by losses of 100, leaving zero taxable income. The tax credit of 30 is therefore refunded to Loss GmbH by the tax authorities. Loss GmbH accordingly receives cash of 100 (70 dividend and 30 tax refund) tax free.
Such structures are common, although inefficient in that the losses of Loss GmbH do not offset the profits of Profit GmbH for trade tax purposes.
14.2 Need for tax consolidation under the proposed reform
Tax Reform 2000 would do away with the corporation tax credit. In the above example, Profit GmbH would pay a definitive 25 % corporation tax on its profits. If Profit GmbH distributed a dividend of 75 (profit of 100 less 25 corporation tax) to Loss GmbH, Loss GmbH has no taxable income for trade tax or corporation tax purposes because of the new 100 % dividends received exemption for entities subject to corporation tax. Profit GmbH therefore receives cash of 75 tax free.
This result is markedly less favourable than under the present system. A better result can be obtained by causing Loss GmbH and Profit GmbH to qualify as a consolidated tax group (Organschaft) in which, for instance, Loss GmbH is the lead or dominant entity and Profit GmbH is a consolidated group member.
14.3 Relaxed requirements for corporation tax consolidation
Current law permits a domestic corporation to be consolidated for corporation tax purposes under any domestic commercial business (whether operated in corporate or non-corporate form) subject to four principal requirements:
- profit-and-loss pooling agreement
- financial integration of the group member into the lead company
- economic integration of the group member into the lead company
- organisational integration of the group member into the lead company
Pursuant to the profit-and-loss pooling agreement, the lead entity undertakes to equalise any losses incurred by the group member and the group member undertakes to transfer any profits to the lead entity. This is a binding contractual agreement with civil law consequences. In particular, in the event of the bankruptcy of the member company, the obligation to equalise losses can be enforced against the lead company by a trustee in bankruptcy.
Financial integration requires that the lead company hold a majority of the voting rights of the group member. Majority voting rights may be held either directly or indirectly, through a chain of one or more entities, each of which holds a majority share of the voting rights the next entity in the chain. Economic integration of the subsidiary into the lead company requires that the lead company's business be supported or furthered by the subsidiary's business. Organisational integration requires the lead company to exercise strategic management control over the group member.
The proposed tax reform would abolish the requirements for economic and organisational integration, leaving only the requirement of a (direct or indirect) majority shareholding and the necessity of a profit and loss pooling agreement. Furthermore, it would in the future be possible to add voting rights held directly and voting rights held indirectly (through a chain of one or more entities, each of which holds a majority of the voting rights of the next entity in the chain) to arrive at the necessary majority.
Thus, while the elimination of the corporation tax credit increases the need for group corporation tax consolidation, this will in the future be available on fairly easy terms.
14.4 Trade tax and VAT consolidation
The requirements for consolidation for trade tax purposes have always been the same as those for corporation tax purposes except that no profit-and-loss pooling agreement was necessary. The Tax Reform 2000 bill as enacted by the Federal Parliament would change this by retaining the requirements of economic and organisational integration (in addition to financial integration) for trade tax purposes – § 2 (2) GewStG-E. A profit-and-loss pooling agreement continues to be unnecessary for trade tax purposes.
Financial, economic, and organisational integration (but not a profit-and-loss pooling agreement) continue to be required for VAT consolidation (§ 2 (2) no. 2 UStG). The proposed legislation makes no change with respect to VAT consolidation.
15. CFC provisions
15.1 General
The German Foreign Tax Act provides that the income of a domestic shareholder (individual or corporate) in a controlled foreign corporation (CFC) is increased for German income tax purposes by the shareholder's pro rata share of sums earned by the CFC ("supplemental income amount") if three conditions are met:
- the CFC's income is "passive";
- the CFC's income has enjoyed a "low" rate of taxation in its home jurisdiction (presently, under 30 %, to fall to under 25 %; determined under German tax rules); and
- resident persons cumulatively hold, directly or indirectly, more than 50 % of the CFC's share capital or voting rights (or at least 10 % if the CFC earns "designated passive income").
"Supplemental income amounts" added to the income of resident corporations are tax-exempt if a corresponding dividend would have been tax exempt under the terms of a tax treaty. However, where the CFC's income is designated passive income, the tax treaty exemption is disallowed (treaty overriding).
The proposed legislation provides that the new dividends-received exemptions (100 % for corporations, 50 % for individuals) do not apply to the supplemental income amount, which is subject to a flat rate tax of 25 %. If dividends are actually paid by the foreign corporation to a domestic corporation, these will benefit from the standard dividends-received exemption, subject to the mandatory 5 % taxability for foreign dividends (see sec. 7.3 above). (The treatment of dividends actually paid to a resident individual is more complicated.)
The CFC provisions constitute a major exception to the general rule that inter-corporate dividends are tax-exempt under the Tax Reform 2000 scheme. Contrary to initial plans, the draft legislation leaves the participation threshold for operation of the CFC rules unchanged at 50+ % (10 % or more for designated passive income) and makes no change in the definition of "designated passive income." Prior versions of the bill would have dropped the threshold to 10+ % and greatly expanded the scope of "designated passive income" (by eliminating the exception of § 10 (6) sent. 2 no. 2 AStG), thereby extending the reach of the CFC provisions.
15.2 Conflict with EU law?
A peculiarity of Germany's CFC rules – one leading commentator calls this their "birth defect" – is that the determination whether income earned by a CFC has been subject to low taxation (in the future, "under 25 %") is made solely with respect to the tax paid in the jurisdiction in which the CFC is located. Furthermore, dividend income always falls into the "designated passive" category. Despite various exceptions contained in the complicated CFC rules, the failure to take account of tax paid below the second-tier level is a serious obstacle to the creation of multi-tiered foreign holding structures owned by German residents (corporations or individuals).
This aspect of the CFC rules is criticised in the literature and considered to violate EU law and German constitutional law (Wassermeyer IStR 2000, 114, 116/1). The same author (loc. cit. p. 118/2) also sees a violation of EU law in the new rule by which income derived by a CFC from a German domestic corporation will be disregarded for CFC purposes, but income derived from a German permanent establishment would still be counted (§ 13 (2) AStG-E). Cf. the St. Gobain ruling of the European Court of Justice (article no 191).
16. Eurowings
Tax Reform 2000 does not modify German tax law to bring it into line with the Eurowings decision of the European Tax Court. A statutory response to Eurowings, which affects international leasing operations, is probably in the works. For more detail, see article no. 206.
17. More German foreign investment?
The changes in the corporation tax system may prompt German companies to shift their business operations to foreign countries and incline German investors to purchase stock in foreign corporations. An understanding of the tax treatment of dividends paid to resident individuals under the present system is necessary to understand this prediction.
Under the present imputational tax system, the tax burden on retained earnings is generally adjusted to 30 % upon distribution. For retained earnings previously taxed at the standard retained earning rate (currently 40 %), this leads to a reduction in corporation tax. However, if sufficient earnings in this equity basket (called "EK 40") are not available to cover a dividend, the dividend is deemed paid out of other "baskets," which include earnings previously exempt from German tax. Tax exempt earnings are of two basic sorts: amounts received tax-free under or in connection with a tax treaty (foreign branch profits, foreign dividends, and capital gains on the sale of shares in foreign corporations) – equity basket "EK 01" –and other tax-exempt income – "EK 02."
Dividends paid to a resident individual out of EK 01 carry no corporation tax credit because no German tax has been levied on the respective earnings. However, these earnings have in many cases been subject to foreign taxation. This foreign tax burden together with the individual shareholder's personal tax liability on the dividend may well exceed the total tax on a comparable dividend paid out of taxed domestic profits (EK 40). In any case, distribution of these earnings increases total tax.
Dividends paid out of EK 02 lead to imposition of 30 % corporation tax on distribution. If the domestic recipient's personal marginal tax rate exceeds this amount, the total tax burden increases still further as a result of the distribution.
Since dividends paid out of EK 01 or EK 02 have disadvantages compared with dividends paid out of taxed domestic profits (EK 40), German corporations presently plan their activities so as to ensure that they have sufficient EK 40 to cover their dividend needs. This means that they structure their activities so that profits of a certain magnitude are earned domestically.
In the future, there will be no tax reason to prefer domestic profits over foreign profits. The decision as to where to locate the operative business will be based on economic considerations (and foreign tax considerations). This may result in a shift of business operations away from Germany over time.
In addition, domestic taxpayers may be inclined to invest in foreign corporations in the future in order to earn dividends which have been subject to lower pre-distribution taxes. The German pre-distribution tax is approx. 37.5 % without solidarity surcharge (see sec. 6.2 above). Since the exemptions enjoyed by corporations and individuals are the same for foreign earnings as for domestic earnings, their net income increases if derived from a foreign corporation subject to a lower tax burden.
While the German CFC rules (see. sec. 15 above) are intended to equalise the tax burden on foreign earnings and remove the incentive here discussed, commentators such as Unvericht (BB 2000, 797, 798) consider the CFC provisions unworkable in practice, so that many taxpayers will derive tax advantages to which they are not entitled in theory. Unvericht furthermore points out that the CFC rules are inapplicable to "active" income. Hence, tax advantages from situating active business operations in low tax jurisdictions are legitimate.
While the same weaknesses are present to some degree under Germany's present corporation tax system, the distribution of profits to individuals in all cases triggers full taxation. This will be different in the future.
18. Concluding remarks
In the corporate tax realm, Tax Reform 2000 would end the discrimination against foreign taxpayers, who are denied the corporation tax credit on dividends and subjected to high rates of taxation with regard to their German branch operations. By reducing the corporate tax burden on retained earnings, it would strengthen the global competitive position of German corporations. The capital gains exemption for sales of shares in other corporations would facilitate economically sound mergers and reorganisations and give Germany a streamlined, modern corporation tax system well suited to the demands of global economic activity. Germany would become more attractive still as the location of international holding corporations.
The political fate of Tax Reform 2000 still hangs in the balance, however, and will not be decided until some time this summer, at the earliest.
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