209. Tax Reform 2000: Final Legislation - Part III

By Robert E Tromp

The final income tax rate changes (assuming enactment of the Supplemental Tax Relief Act) are as follows:

The principal change compared with previous drafts is reduction of the top marginal rate to 42 % in 2005 instead of 45 % as originally planned. In 2005, the top tax bracket will apply to taxable income starting at DM 102,000 (roughly US-$ 47,300 at current exchange rates).

The previous system of fully creditable corporation tax will be replaced by the so-called 50 % exemption system ("half-income system" - Halbeinkünfteverfahren) under which individuals will pay taxes on only half of corporate dividends received and, to the extent taxable in the first place (§§ 17, 23 EStG), on half of capital gains realized on the sale of corporate shares (see sec. 3.2.3 regarding entry into force). The 50 % exemptions are contained in § 3 no. 40 EStG.

The exemptions also apply

• to income earned through a personal business (partnership or sole proprietorship) to the extent attributable to corporate dividends received
• to income from the sale or liquidation of interests in personal businesses (§ 16 EStG) to the extent attributable to sales of corporate shares belonging to the business

The capital gains exemption covers gain on writeups of corporate shares to their higher going concern value under § 6 (1) no. 2 sent. 3 EStG except to the extent a prior writedown was counted for tax purposes in full (as opposed to only half under new § 3c (2) EStG - see below) and not reversed by a later tax-effective writeup.

Two holding periods were added by the Conference Committee to prevent abuses. They apply for business income (income earned through a personal business) of the following sorts:

• from the sale or withdrawal of corporate stock and other interests described in § 20 (1) no. (1) EStG;
• from the liquidation of corporations or the reduction of their stated capital;
• from stock writeups under § 6 (1) no. 2 sent. 3 EStG; and
• from the sale or liquidation of a personal business to the extent attributable to the sale of corporate stock.

In the above cases, the 50 % exemption will not apply

• to the extent the stock has not been part of the taxpayer's business property for a continuous period of at least 1 year prior to the transaction;
• to stock taken in a tax-free reorganization (contribution-generated shares within the meaning of § 21 UmwStG), unless the income generating event occurs more than 7 years after the time of contribution or the stock was received pursuant to a contribution covered by § 20 (1) sentence 2 UmwStG. However, in the latter case the 50 % exemption does not apply if the initially contributed stock itself were created pursuant to a transaction defined in § 20 (1) sent. 1 UmwStG or § 23 (1) to (3) UmwStG within the mentioned 7 year holding period prior to the date of the above stock disposition.

With respect to dividend income, the effective date of the 50 % exemption system depends on the fiscal year of the corporation making the distribution and the type of distribution being made. Declared dividends paid by a calendar-year corporation in 2001 for prior fiscal years (regular dividends) fall under the old tax credit system. The 50 % exemption system first applies to regular dividends paid from 1 January 2002 onwards. However, other dividends (in particular constructive dividends) are subject to the 50 % exemption system starting in 2001. If the distributing corporation's fiscal year is not the calendar year, then the 50 % exemption for regular dividends takes effect one tax assessment period later.

The 50 % capital gains exemption under § 3 no. 40 EStG applies to shares sold from 1 January 2002 onwards if the corporation whose shares are being sold is a calendar year corporation. If the fiscal year of the corporation whose shares are being sold is not the calendar year, the exemption generally first applies to gains realized after the close of the last fiscal year ending in 2002.

It is noted that the controversy regarding the possible different treatment of foreign dividends and capital gains on the sale of shares in foreign corporations, which was discussed under sec. 2.2.2, 2.2.3 above with regard to the exemptions available to corporations under § 8b KStG, likewise exists with regard to the exemptions granted to individuals under § 3 no. 40 EStG.

As a consequence of the 50 % exemption granted by § 3 no. 40 EStG, § 3c (2) EStG imposes limits on the deductibility of related expenses. A deduction is allowed for only half of the expenses (and similar items) which are related to the income (and similar items) covered by § 3 no. 40 EStG.

This applies whether or not expenses exceed income in a given assessment period or even if no income at all was derived. Losses realized before expiration of the 1 year holding period on the sale or withdrawal of shares held as business property or on dispositions of contribution-generated shares before expiration of the 7 year holding period are still only 50 % deductible even though gain on such transactions would be taxable in full.

In contrast to previous drafts, the final legislation makes no material changes in § 34c EStG (= foreign tax credit provision). The original intention was to allow a credit for only half of foreign taxes paid. This was criticized as unfair and dropped for this reason. Even though half of foreign dividends are tax-exempt under § 3 no. 40 EStG, foreign withholding tax paid is credited in full.

The allowance granted by § 16 (4) sent. 1 EStG for capital gains realized on the disposition or liquidation of interests in personal businesses (partnerships and sole proprietorships) will increase from 1 January 2001 onwards from DM 60,000 to DM 100,000.

Individuals holding shares in corporations as private (as opposed to business) property will still be able to dispose of these tax free after expiration of the 1-year "speculation" holding period, provided the shareholding does not cross the threshold of § 17 EStG. The threshold at which taxation is triggered is being reduced from its present level of 10 % to 1 %. In the future, taxable dispositions (whether within the holding period or by reason of the size of the shareholding) are subject to the 50 % exemption system. See also sec. 3.4 below.

Capital gain of up to DM 10 million on stock sales taxable under § 17 EStG and dispositions of interests in personal businesses will in the future be eligible for taxation at half the otherwise applicable average income tax rate (§ 34 (3) EStG - Supplemental Tax Relief Act). Individuals either 55 years of age or older or permanently disabled may elect to apply the preferential rate to one eligible transaction in their lifetime starting in 2002 (§ 52 (47) EStG). This change benefiting the owners of small and medium sized businesses was crucial in obtaining the votes needed to carry Tax Reform 2000 in the Federal Council.

Under German tax law, capital gains on the sale of "private" as opposed to "business" property have traditionally been tax exempt if realized outside of certain minimum holding periods. This tradition is, however, rapidly becoming one more honored in the breach than in the observance after the 1999 Tax Relief Act made the tax exemption for sales of land contingent on a 10 year holding period and reduced the materiality threshold of § 17 EStG for tax exempt private gains on the sale of shares in a corporation from "more than 25 %" to "10 % or more".

Tax Reform 2000 now reduces the threshold still further to "1 % or more." Since the threshold no longer has anything to do with "materiality," this term is dropped. The threshold is crossed if the vendor has held the stated percentage and the stated minimum absolute amount of share capital in the corporation in question within the five years preceding the sale. Indirect shareholdings are included making the determination.

A provision permitting tax free capital gains on sales of stakes of more than 1 % if the pro rata share of stated capital does not amount to at least DM 5,000 was deleted from the bill in its final form.

The effective date of the change depends on the fiscal year of the corporation whose shares are being sold (§ 52 (34a) EStG). If this fiscal year is the calendar year, the changes apply to sales from 1 January 2002 onwards. For sales of shares in most non-calendar year corporations, the changes apply to sales after the start of the corporation's fiscal year 2002/03 (e.g. from 1 July 2002 onwards for a corporation with a fiscal year ending on June 30th).

Reduction of the threshold of § 17 EStG is a long-standing tax reform suggestion. The high threshold has in the past permitted owners of closely held corporations to realize the profits accumulated inside the corporation free of tax. To curb this practice somewhat, § 50c (11) EStG was added to the income tax code in 1997.

The contemplated drastic reduction in the threshold of § 17 EStG is primarily intended to prevent German resident individuals from using tax-free sales of shares to realize profits accumulated inside closely held corporations at the future 25 % corporate rate.

However, the change will also have an impact on foreign shareholders in German corporations. § 17 EStG applies in conjunction with § 49 (1) and (2) (e) EStG to dispositions of shares in German corporations (corporations with either their legal seat or principal place of management in Germany) by foreign legal and natural persons who do not hold the shares in a German permanent establishment (including the permanent establishment of a partnership in which they hold an interest).

Germany's right of taxation of foreign individual and corporate shareholders under § 17 EStG is excluded, however, under most of Germany's tax treaties. The shares, provided not part of a German permanent establishment, fall under "other property," for which the shareholder's state of residence has the exclusive right of taxation.

By the same token, foreign shareholders not entitled to the protection of an OECD model tax treaty (taking account of applicable limitation on benefits and anti-treaty shopping provisions) would be affected by the change. For instance, closely held foreign investment funds with 100 or fewer investors on a look-through basis can be affected by the change in the law if located in a non-treaty jurisdiction.

Critics of the half-income system such as Unvericht (BB 2000, 797, 798) point to the annual increase in revenue of some DM 5 billion projected to result from shifting to the new system (see item 7 of table in sec. 1.4 above) and contend that the bulk of this sum results from an inequitable increase in the taxation of small shareholders. It is noted that the half-income system would disadvantage individual shareholders with marginal tax rates under 40 %. Such taxpayers are better off paying tax on the grossed up dividend with a full credit for corporation tax than paying tax on half of the dividend received without such a credit. The following table borrowed from Unvericht illustrates this effect using simplified calculations without withholding tax or solidarity surcharge and assuming a uniform 25 % corporation tax rate:

Other changes in the Income Tax Act below include the following:

• Reintroduction of the so-called "Co-Entrepreneur Directive" (Mitunternehmererlaß), which had been abolished by the Tax Relief Act for the years 1999/2000/2002. Starting 1 January 2001, it will thus again be possible for taxpayers to transfer business assets tax-free between their various personal businesses (§ 6 (5) EStG).
• Amendments to § 15 (4) EStG provide that losses on the disposition of corporate stock (and the other interests described in § 20 (1) no. 1 EStG) held by the taxpayer as business property for less than one year may not be set off against other positive commercial business income or against income of any other type. Such losses may no longer be carried backwards or forwards under § 10d EStG.
• Similar loss utilization limitations apply to losses from futures transactions under which the taxpayer receives the difference between two values or a cash amount or benefit determined with respect to the value of some variable. An exception exists for transactions in the normal course of business by banks, financial service providers, and similar entities and for hedges other than stock hedges with respect to transactions in the normal course of business. The changes are designed to eliminate the "privileged treatment" of stock hedging transactions since gains on the sale of stock now qualify for either a 50 % or a 100 % exemption under § 3 no. 40 EStG and § 8b KStG respectively. Another purpose is to prevent abusive schemes under which losses would be deductible in full despite the exemptions accorded to gains.
• The cap on the income tax rate for commercial business income pursuant to § 32c EStG has been repealed. The new credit of trade tax against income tax takes the place of the previous tax rate cap.
• A new § 35 EStG permits a limited credit of trade tax against personal income tax liability (see sec. 3.7 below on trade tax relief).
• The elimination of the corporation tax credit system results in changes to withholding on income from capital (§§ 43 ff. EStG). These include lowering the dividend withholding rate to 20 %. Withholding tax remains fully creditable against income qualifying for a 50 % exemption under § 3 no. 40 EStG.
• The anti-abuse provisions contained in § 50c EStG are no longer needed since the schemes this provision was intended to combat depend on the availability of a corporation tax credit, which is eliminated under the 50 % exemption system. § 50c EStG continues to apply, however, to corporations subject to a so-called "§ 50c blocking amount" (Sperrbetrag) under prior law.

Inclusion of personal businesses in the tax reform was a political and economic necessity. More than 80 % of German businesses are operated in partnership form and hence do not benefit from reductions in the corporate income tax rate and other changes in the corporate tax area.

The most important change with regard to the personal income tax compared with previous drafts of Tax Reform 2000 is the elimination of the so-called "elective regime" for relief from trade taxation. Under the elective regime, personal businesses (sole proprietorships and partnerships, whether commercial, professional, or agricultural) would have been able to elect taxation as corporations, thus entitling them to the new low 25 % corporation tax rate for retained earnings. This proposal was criticized as unworkable and unlikely to benefit any but the largest personal businesses. The mere availability of the option, the exercise of which would have required a unanimous vote by all partners in a partnership, would have confronted the owners of small and medium sized businesses with the complex and potentially divisive issue of whether exercise of the option was in their best interest. The tax authorities, on the other hand, would have had to scrutinize all transfers between personal businesses and their owners to determine whether they were to be treated as dividends subject to a dividends-received exemption (50 % or 100 % depending on whether the recipient was a corporation or an individual) or as compensation for services, capital, or assets provided. The elimination of the elective regime simplifies the tax system under which Germany intends to operate until the trade tax can be repealed (at present, a political impossibility).

The "basic regime" of trade tax relief was left largely intact. The basic regime grants a partial credit of trade tax against personal income tax. Hence, the introduction of the basic system makes no change in the taxation of personal businesses (partnerships and sole proprietorships) which pay no trade tax to begin with. Trade tax is paid by businesses engaged in commercial activity (as defined). Farming, forestry, and professional service businesses (doctors, lawyers, architects, etc.) do not involve commercial activity.

The credit created under the basic system is difficult to understand without some knowledge of the German trade tax. The trade tax is imposed on the earnings of commercial businesses, whether operated in corporate or partnership form or as sole proprietorships. A number of adjustments to income for corporate or personal income tax purposes apply in arriving at trade taxable earnings. Graduated trade tax rates from 1 % to 5 % are applied to the taxable earnings of individuals and partnerships; a 5 % rate applies to corporations. Individuals and partnerships are also entitled to an exemption amount of DM 48,000 in calculating taxable earnings. The product of taxable earnings and the trade tax rate is referred to as the "trade tax basic assessment amount" (Gewerbesteuermeßbetrag). Local political subdivisions (which receive the revenue from the trade tax) are entitled to fix a trade tax multiplier and apply it to the basic assessment amount to arrive at trade tax owing. The multipliers vary from approx. 300 % to 500 %.

The product of basic assessment amount and the applicable multiplier is not the trade tax owing because trade tax is deductible as an expense from its own tax base. If the applicable multiplier is 400 %, trade tax owing is arrived at by dividing the product of base assessment amount and multiplier by a factor of 1.2. The trade tax so arrived at reduces taxable income for income tax purposes. Tax Reform 2000 makes no change in the deductibility of trade tax from its own tax base and from the income tax base.

Irrespective of the trade tax multiplier, the credit against income tax allowed under Tax Reform 2000 is 1.8 times the trade tax basic assessment amount. Together with the deductibility of the trade tax from its own tax base and its deductibility from the income tax base, this limited credit substantially reduces, but in most cases does not entirely eliminate, the net tax impact of trade tax on individuals deriving commercial business income. However, in communities where the trade tax multiplier is very low (well under 400 %, such as is the case in certain parts of the new German states, for instance), the relief provided by the flat rate trade tax credit may even exceed the net trade tax burden and in effect reduce total tax to a level below that which would be owing if the trade tax did not exist.

This is Part III of a five-part article which treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG. Distribution to third persons is prohibited without our express written consent in advance.