209. Tax Reform 2000: Final Legislation - Part II

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By Robert E Tromp

Part II. Taxation Of Corporations

Tax Reform 2000 is best thought of as a reform of the corporate income tax system which, in an effort to avoid an undue competitive advantage for corporations, has been extended to the personal income tax sphere by a series of adjustments. Hence, new the corporation tax system is addressed first in this article. Furthermore, it is the changes in the corporation tax area which are of primary interest to international investors, as they almost invariably operate in corporate form.

2.1 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 corporate stock

The uniform corporation tax rate of 25 % applies to all corporate earnings, including those of the domestic permanent establishment of a foreign corporation. The uniform rate replaces the current tripartite rate structure: 40 % for retained earnings, 30 % for distributed earnings, and 40 % for the earnings of domestic permanent establishments of foreign corporations. More importantly, the new 25 % corporation tax is neither creditable in Germany against the tax liability of a dividend recipient nor included in the recipient's dividend income. For rate structure analysis, see sec. 2.4 below.

Tax Reform 2000 puts an end to the present imputational tax system, which has been in force in Germany since 1977. 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 through a domestic permanent establishment (a branch or 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 pays tax on a grossed-up dividend which includes the corporation tax credit amount. For resident individuals, corporation tax thus functions like a dividend withholding tax.

The new corporation tax system avoids 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 dividends-received exemptions generally 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. 2.5 below.

The third pillar of the new tax system is the 100 % capital gains exemption for corporations selling stock in other corporations. Unlike the dividends-received exemption, the capital gains exemption is denied to corporations which have not held the relevant stock for 1 year prior to the sale or other taxable disposition. The 1-year holding period requirement was added to the bill by the Conference Committee.

Both the dividends-received exemption and the capital gains exemption are enjoyed by a corporation, domestic or foreign, with respect to its distributive share of income derived by a partnership in which it is a partner (§ 8b (6) KStG).

A 15 year transition period is created during which distributions of retained earnings accumulated under the present corporation tax system continue to result in a reduction of corporation tax to the distributing corporation. See sec. 2.3 below.

2.2 Effective Dates

2.2.1 25 % Corporation Tax Rate

Generally, the changes made, including the new 25 % corporate tax rate, 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 (§ 34 (1) KStG).

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. Specifically, this is the case if the corporation's first fiscal year to end in the 2001 assessment period commenced prior to 1 January 2001 (§ 34 (1a) KStG). Barring short fiscal years, this condition will be met by all non-calendar year corporations.

2.2.2 Capital Gains Exemption - § 34 (6d) No. 2 KStG

The transition provision governing the exemption of gain on the sale of shares in other corporations (§ 34 (6d) KStG) was changed in committee so as to defer the exemption until 2002 in most cases, whereas under the previous draft it would have applied to all sales from 2001 onwards.

The wording of the new transition provision is complex. Whether the exemption applies depends on the fiscal year of the corporation whose shares are being sold. The exemption applies to sales occurring after expiration of the fiscal year which follows the last fiscal year to end in the last assessment period which falls under the old corporation tax law.

If the corporation whose shares are being sold is a calendar year corporation, the exemption applies to sales occurring from 1 January 2002 onwards (last assessment period to fall under the old corporation tax law is 2000; next fiscal year expires on 31 December 2001; exemption applies from 1 January 2002 onwards).

If the corporation whose shares are being sold is a non-calendar year corporation, the exemption (barring short fiscal years) applies to sales made after the end of the first fiscal year to end in 2002 (last assessment period to fall under the old corporation tax law is 2001; next fiscal year expires e.g. on 30 June 2002; exemption applies from e.g. 1 July 2002 onwards).

There is, however, disagreement as to whether the above rules apply when shares in a foreign corporation are sold. For foreign corporations, there is arguably no last assessment period to fall under the old corporation tax law, because foreign corporations (at least those without a German permanent establishment) are not subject to German corporation tax law in the first place. Hence - so the argument runs - the transition provision of § 34 (6d) KStG is inapplicable to sales of shares in foreign corporations, causing the general transition provisions of § 34 (1) and (1a) KStG to apply by default. Under these provisions, the fiscal year of the corporation whose shares are being sold is irrelevant. If sales of shares in foreign corporations are indeed governed by the general transition provisions, the exemption of § 8b (2) KStG would apply one year earlier than under the stricter rule of § 34 (6d) KStG (in 2001 for a calendar-year selling corporation and generally after the end of the last fiscal year to end in 2001 for non-calendar year selling corporations).

Even if one rejects the above alternative view, on which the Federal Ministry of Finance has yet to take a definitive position, one is still left with a situation in which the fiscal year of a foreign corporation may determine the entry into force of the new exemption. This fiscal year is not governed by German law, hence the consent of the German tax authorities (§ 4a (1) sent. 2 EStG) would not appear necessary in order to change this fiscal year. This may mean that the fiscal year of a foreign corporation ending on November 30th could be changed to end on e.g. January 31st so as to permit a tax-free sale of its shares from 1 February 2002 onwards, instead of from 1 December 2002 onwards (last assessment period to fall under the old corporation tax law is 2001; next fiscal year expires on 31 January 2002; exemption applies from 1 February 2002 onwards).

However, where the foreign corporation is located in a tax treaty state, the above discussed controversy regarding the application of the new rules should be academic in many cases because capital gains realized by domestic corporations on the sale of shares in foreign corporations located in tax-treaty states are frequently tax exempt even under existing law.

The complicated new transition rules can be summarized as follows:

• Sale of shares in domestic calendar year corporation: capital gains exempt from 1 January 2002 onwards
• Sale of shares in domestic non-calendar year corporation: capital gains exempt from some time in 2002 onwards (after close of fiscal year 2001/02 of corporation whose shares are being sold)
• Sale of shares in foreign corporation: capital gains arguably exempt from 1 January 2001 onwards if selling corporation is a calendar year corporation and (barring short fiscal years) from some later time in 2001onwards (after close of fiscal year 2000/01) if selling corporation is a non-calendar year corporation

2.2.3 Dividends And Dividends-Received Exemption - § 34 (6d) No. 1, (10a) KStG

The transition provisions governing the entry into force of the corporate dividends-received exemption were likewise modified in committee and are now considerably more complex than under prior drafts.

A distinction is still drawn between declared dividends paid for prior fiscal years (regular dividends) and all other dividends (especially constructive dividends). If the dividend is no longer subject to the old corporation tax credit system (contained in Part IV of the present corporation tax law) as regards the distributing corporation, it is subject to the dividends-received exemption as regards the dividend recipient. This rule is intended to ensure congruent treatment of the dividend by the distributing and receiving corporations.

Distributing corporations remain subject to the old corporation tax credit system as regards regular dividend distributions made during the first assessment period to which the new corporation tax law otherwise applies (e.g. as regards the tax rate of new earnings - see sec. 2.2.1 above).

For a calendar-year corporation, the new law applies in general from 1 January 2001 onwards. Hence, the corporation must continue to apply the old corporation tax credit system to its regular dividends paid in 2001. These dividends carry a corporation tax credit for the receiving domestic corporation. The distributing corporation applies new law to its regular dividends paid from 1 January 2002 onwards, and these qualify for the dividends-received exemption in the hands of the recipient domestic corporation.

For non-calendar year corporations, the new law generally applies from the beginning of fiscal year 2001/02 (e.g. from 1 July 2001). Hence, regular dividends cease to carry a corporation tax credit and qualify for the dividends-received exemption after the close of the fiscal year 2001/02 (e.g. from 1 July 2002 onwards).

For other dividends, the new law applies one fiscal year earlier than is the case for regular dividends. Hence, a constructive dividend paid by a calendar year corporation in 2001 (e.g. on 1 January 2001) is subject to the new law (the dividend carries no credit, but qualifies for the dividends-received exemption). A constructive dividend paid by a non-calendar year corporation during its fiscal year 2001/02 (e.g. on 1 July 2001) is subject to the new law (the dividend carries no credit, but qualifies for the dividends-received exemption).

Again, it is possible to argue that the rules should be different for foreign dividends. Foreign corporations are only subject to the old corporation tax credit system in rare instances involving dual residence. Hence, the rule of § 34 (6d) no. 1 KStG (stipulating that the new dividends-received exemption applies to dividends to which the distributing corporation no longer must apply the old corporation tax credit system) is apparently inapplicable to dividends paid by foreign corporations, since these (with rare exceptions) have never been subject to the old corporation tax credit system. This means that entry into force should be governed by the general rules of § 34 (1) and (1a) KStG. Under these rules, the fiscal year of the receiving corporation is controlling. All dividends, regular or otherwise, received from 1 January 2001 onwards by a calendar-year corporation or received after the start of the fiscal year 2001/2002 (e.g. on 1 July 2001) by a non-calendar year corporation would qualify for the exemption.

Again, the controversy should be academic in many cases because dividends received by domestic corporations from foreign corporations located in tax-treaty states are frequently tax-exempt even under previous law.

2.2.4 Capital Losses And Share Writedowns - § 34 (6d) No. 2 KStG

The Conference Committee added a provision on the entry into force of § 8b (3) KStG (denying tax effect to capital losses on the sale of shares in corporations and to writedowns of the value of such shares). The rules are the same as for the entry into force of the 100 % exemption for capital gains on the sale of shares in other corporations (see sec. 2.2.2 above) and depend (with the possible exception of transactions involving foreign shares) on the fiscal year of the corporation whose shares are being sold or written down, not on that of the corporation sustaining the loss or taking the writedown.

2.3 Transition Period

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 are advised to seek professional advice concerning this and many other aspects of the switchover to the new corporation tax system.

2.4 New Uniform Corporate Tax Rate

2.4.1 General

The new legislation creates a uniform corporation tax rate of 25 % for all taxable 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 tables in the following subsections quantify these statements. The calculations assume a trade tax multiplier of 400 %. The trade tax multiplier is set by local government. Most communities have a trade tax multiplier in the range from 300 % to 500 %.

2.4.2 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-based 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 new 25 % corporation tax rate (column "2001").

Tax Burden: German Permanent Establishment
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 subtotal	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 reduces 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 head office, the total tax burden of 38.64 % (37.50 % without solidarity surcharge) is final. The improvement is dramatic compared with the prior treatment of domestic permanent establishments. Previously, permanent establishments were locked into the corporate tax bracket for retained earnings (40 % plus 5.5% solidarity surcharge hereon) 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 which retains its earnings. 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.

2.4.3 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. 2.4.2 above. Hence, corporations which retain their earnings will have considerably more capital to work with than has previously been the case.

2.4.4 German Subsidiary - Distributed Earnings

The tax burden on earnings distributed by a German corporation to its foreign parent is influenced by dividend withholding tax. Tax Reform 2000 lowers the statutory withholding tax rate from 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 new 25 % corporation tax rate (column "2001").

Tax Burden: German Subsidiary - Distributed Earnings
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 subtotal	41.67		37.50
Solidarity surcharge	1.37		1.14	-0.23
Withholding tax	0		0
Total tax	43.04		38.64	-4.40

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 old and new 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 old law. This effect is not dramatic, however. The difference in total tax burdens under present and new 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 is, 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.

2.4.5 Effect Of Higher Or Lower Trade Tax Multiplier

The relief afforded by the new 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.

2.4.6 Summary

The German 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 favorable tax rate available, it must now do the exact opposite. Branches and partnerships, on the other hand, were previously subject to a high definitive rate of taxation, but automatically have the optimal available status under the new tax regime. They have thus 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.

2.5 Dividends-Received Exemption - § 8b (1) KStG

2.5.1 General

The new 25 % corporation tax is a definitive tax not creditable or refundable in Germany. To avoid double taxation on inter-corporate dividends, corporations 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, § 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 companies.

However, the dividends-received exemption is subject to certain limitations and drawbacks, discussed below.

2.5.2 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 to the extent of tax-exempt dividends received by X-GmbH from Y-GmbH or Z-GmbH in the same tax assessment period in which the loan interest is incurred. Such interest is directly related to X-GmbH's tax-free dividend income from Y-GmbH or 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 company 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 company 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 capitalization rules for holding structures (§8a (4) sent. 2 KStG - unchanged in pertinent part in the new legislation). Direct loans to the subsidiaries would therefore require undoing the holding structure (or qualifying under the arm's length exception to the thin capitalization 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, may be complicated and rigid from a planning perspective.

2.5.3 Foreign Dividends: § 8b (7) KStG

A provision added to the corporation tax law in 1999 provides that 5 % of foreign source dividends received free of domestic 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 German tax.

The new legislation (§ 8b (5) KStG) 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 (provided the dividend recipient has no expenses directly related to its tax free dividend income) domestic dividends will be completely tax free to German corporations whereas only 95 % of foreign source dividends are tax free.

There is an upside to this downside, however. The prevailing view is that the new statute 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 may be greater than 5 % of the dividend amount.

2.5.4 CFC Provisions

The CFC provisions constitute a third major exception to the general rule that dividends received by a corporation are tax-exempt under the system established by Tax Reform 2000.

The German Foreign Tax Act (AStG) provides that the income of resident persons (individuals and corporations) will under certain circumstances be increased by "passive" income 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 new legislation provides that an amount so added to the income of domestic taxpayers - a "supplemental income amount" (Hinzurechnungsbetrag) - is subject to a flat rate tax of 38 % (not 25 % as originally planned). The dividends-received exemptions created by the new legislation (§ 8b (1) KStG, § 3 no. 40 EStG) do not apply to the supplemental income amount (§ 10 (2) AStG).

The CFC provisions are discussed in more detail under sec. 2.13 below.

2.6 Capital Gains Exemption - § 8b (2) KStG

The most significant single innovation in the Tax Reform 2000 package is a 100 % capital gains exemption for corporations selling stock in other corporations. Liquidations, reductions of stated capital, and constructive contributions are treated as equivalent to sales, as are writeups of stock to going concern value under § 6 (1) no. 2 sent. 3 EStG. This exemption is not contingent on a minimum percentage holding, the existence of a tax treaty, or an activity requirement. However, pursuant to an amendment added by the Conference Committee, a 1 year holding period requirement applies.

Under § 8b (4) KStG, another provision added to the bill in committee, capital gains are only tax exempt to the extent the shares sold were

• not taken in a tax-free reorganization (contribution-generated shares) and
• not acquired directly or indirectly through a partnership by a corporation, association, or fund at a value under going concern value from a contributing person not eligible for the exemption under § 8b (2) KStG.

The above restrictions generally do not apply if the disposition takes place more than 7 years after the time of the share acquisition or if the shares were acquired by the seller pursuant to a transaction defined in § 20 (1) sent. 2 UmwStG (Tax Reorganization Act) involving the contribution of shares in a corporation to another corporation. However, in the latter case the capital gains exemption does not apply if the initially contributed shares themselves 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 share disposition.

Like the more limited capital gains exemptions for sales of shares in foreign corporations already contained in German tax law, the new 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. Under § 8b (3) KStG, no such writedowns are permitted for tax purposes in the future as the logical consequence of the exemption for gain on sale of corporate shares. This applies even if the writedown occurs in the 1 year holding period during which capital gains would be taxable in full. Capital losses on the sale of shares, on reductions in stated capital, and on liquidation of the corporation in which shares are held are likewise ignored for tax purposes under the new corporation tax system.

The capital gains exemption not only liberates corporations from tax constraints in deciding whether to hold or sell shares in other corporations, especially domestic corporations, but also gives them more freedom in reorganizing their group structures. A domestic branch of activity can be spun off into a separate corporation and sold tax free within the group, provided the required holding period is met. Furthermore, cross-border reorganizations by which a German corporation exchanges shares in a foreign or domestic corporation for shares in a foreign corporation are now easier from a German tax perspective. Such transactions were previously possible inside the EU subject to certain restrictions under the Tax Reorganization Act.

The capital gains exemption enhances the already considerable advantages which Germany possesses as a location for international holding companies.

2.7 Permanent Establishments

The new law places the domestic permanent establishments (branches and interests in German-based general or limited 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 and partnerships over domestic corporations. Permanent establishments pay no dividend withholding tax and are not subject to the German thin capitalization rules for foreign shareholder financing.

2.8 Reorganizations

Several changes are made in the Tax Reorganization Act by the new legislation. Perhaps the most important is the end of tax recognition of losses on reorganization 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 equalized by increasing the basis of the disappearing corporation's assets (including any goodwill) in the hands of the receiving partnership (step-up model).

The end of the step-up model means that taxpayers able to benefit from reorganization of corporations as partnerships (stepped up asset basis) should consider carrying out such a reorganization before the new law takes effect.

Unfortunately, the provisions on the entry into force of the new law were revised by the Conference Committee. The general rule is now that the amendments to the Tax Reorganization apply to reorganizations having an effective date for tax purposes in a fiscal year in which the new corporation tax law applies to the transferring corporation (§ 27 (1a) UmwStG). Since the new corporation tax law does not take general effect until 2001 (see sec. 2.2.1 above), this would normally cause a reorganization entered in the Commercial Register in e.g. July 2001 which was retroactive to December 2000 (retroactivity of up to eight months is permitted) to fall under prior law. However, an important clause has been inserted to bring such transactions under the new law. Entry in the Commercial Register by the end of the year 2000 is necessary in order for a reorganization to come under the old law and achieve a step-up in basis with tax effect.

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 inside basis (asset basis) to outside basis (basis in shares purchased).

The use of tax-free sales of corporate stock for reorganization purposes was noted in sec. 2.6 above, as was the abolition of writedowns on shares held in other corporations.

2.9 Depreciation Rule Changes

The impact of the depreciation rule changes will be spread over all domestic businesses in proportion to affected assets held. However, the depreciation rate changes in general (see below) only apply to assets acquired from 2001 on.

2.9.1 Declining Balance Depreciation

Elective declining balance depreciation for movable assets is reduced from triple the straight line amount (max. 30%) to double the straight line amount (max. 20%) - § 7 (2) EStG. The reduction applies to assets purchased or produced after 31 December 2000. The previous rates continue to apply to assets purchased or produced on or before this date (§ 52 (21a) EStG).

2.9.2 Non-Residential Buildings Used In A Business

The depreciation rate for non-residential buildings held as business property is reduced from 4 % to 3 % - § 7 (4) EStG. The reduction applies to self-constructed buildings if construction begins on or after 1 January 2001 and to purchased buildings for which the contract of purchase (or equivalent act) is not finalized until on or after this date (§ 52 (21b) EStG).

2.9.3 General Tax Depreciation Tables

The depreciation periods (asset useful lives) contained in the standard depreciation tables used by the tax authorities are to be lengthened. The adjustment would apparently again apply only to assets purchased or produced from 1 January 2001 onwards.

The useful lives of assets for depreciation purposes is generally a factual, not a legal question. The modifications contemplated by the tax authorities in this area do not involve changes in the law, but rather changes in their own factual estimates. Essentially, the tax authorities believe that their current tables are over-generous to the taxpayer. While taxpayers are free to contest the factual issue of useful life in any specific instance, in practice the useful lives fixed by the tax authorities are generally accepted by taxpayers.

2.9.4 Limitation On Anticipated Special Depreciation - § 7g EStG

The government originally intended to abolish special depreciation and anticipated special depreciation by small and medium sized businesses under § 7g EStG. However, the final bill makes no changes in special depreciation and merely reduces the maximum amount of anticipated special depreciation on new investments from 50 % of the cost of purchase or production to 40 % for assets for which reserves are set up in fiscal years beginning after 31 December 2000.

The small business depreciation advantages accorded by § 7g EStG are available to corporations as well as individuals. Hence, the German domestic permanent establishment of a foreign corporation can benefit from these provisions. However, limitations apply as to both the size of qualifying businesses and the scope of the benefits. The repeal of this provision will thus by and large affect German resident individuals as the owners of qualifying small businesses.

2.10 Thin Capitalization Rules - § 8a KStG

2.10.1 Changes

Germany's thin capitalization rules do not apply for trade tax purposes, but the trade tax law itself denies a deduction for half of interest paid on long-term debt. The new legislation makes the following corporation tax changes:

• The current debt-to-equity safe-haven ratio of 3-to-1 for conventional loans is reduced to 1.5-to-1. A loan is "conventional" if the compensation paid for the use of debt capital is defined solely as a fraction of the principal amount (e.g. fixed and variable interest bearing loans).
• The safe haven ratio of 0.5-to-1 for all other loans (e.g. those earning a share of profits or a percentage of sales - "hybrid" loans) is eliminated entirely.
• For conventional loans, it remains possible to avoid reclassification of the debt payment as a constructive dividend by showing that the borrowing company could have obtained the same debt capital on the same conditions from an unrelated third party (arm's length transaction exception). This exception may be expected to become more important in light of the contemplated safe-haven reduction. The exception for debt incurred in the context of normal banking transactions also remains.
• The current safe haven ratio of 9-to-1 for holding companies is lowered to 3-to-1. The exceptions for arm's length and normal banking transactions apply here as well.
• The legal definition of loans to which the thin capitalization rules apply has been changed. While the law is aimed at non-resident shareholders, the law as currently in effect does not use this term and instead speaks of loans to resident corporations from 25+ % shareholders "not entitled to the corporation tax credit" (or from related persons). Since the corporation tax credit system has been abandoned, the thin capitalization rules in the future apply to all loans from 25+ % shareholders (or related persons) unless the income from the loan is taxable in Germany (in the context of a normal assessment, not just a withholding procedure). In most cases, the revised wording should not change the result reached. See, however, the item to follow.
• As Rödder/Schumacher note in their article on the government tax reform proposals (DStR 2000, 353, 361 in fn. 47), the new legislation inappropriately provides in § 8a (5) (1) KStG that the thin capitalization rules are to apply when the income from the loan is taxable in Germany as income attributable to the shareholder-lender's German permanent establishment. § 8a (5) no. 1 KStG presently provides that the thin capitalization rules shall apply to a lender who is only entitled to the corporation tax credit because the shares in the corporation to which the loan is made are held in a domestic permanent establishment. This provision makes sense, because it is possible for the shares to be held in a domestic permanent establishment without the loan itself being so held, hence the interest on the loan can still escape German taxation. If the income on the loan is actually taxable in Germany, this renders the thin capitalization rules inapplicable under the principle discussed in the preceding item. Since there is no policy reason for an exception, § 8a (5) no. 1 KStG is ill-conceived and should be deleted.

2.10.2 Entry Into Force

The new legislation allows no transition period during which the present thin capitalization rules would remain in effect for existing shareholder debt. Hence, the above changes take effect in the assessment period 2001 for calendar year corporations and in the assessment period 2002 for most non-calendar year corporations (§ 34 (1) (1a) KStG).

Taxpayers whose fiscal year is identical with the calendar year therefore have to review the structure of their current shareholder debt and make the necessary changes by 31 December 2000, since all determinations under the safe haven ratios are based on equity as of the close of the preceding fiscal year. Hence, the new rules will apply in 2001 based on equity as of the close of the fiscal year 2000.

Taxpayers with fiscal years not ending on December 31st have to respond to the changes by the close of the last fiscal year which ends in the year 2001.

2.10.3 Diminished Incentive For Foreign Debt Financing ?

German tax (trade tax, corporation tax, solidarity surcharge, and in some cases withholding tax) presently exceeds the average OECD rate of 37 % by 14.83 percentage points for corporate retained earnings (assuming a moderate trade tax multiplier of 400 %). The excess for earnings distributed to foreign shareholders ranges from 14.59 to 6.04 percentage points, assuming dividend withholding tax of 15 % and 0 % respectively.

Under the same assumptions, the new tax reforms narrow the gap between the German and average foreign taxes to just 1.65 percentage points for retained earnings. For distributed earnings, the excess of German over average foreign taxes ranges from 14.59 to 1.65 percentage points depending on the rate of withholding tax (from 20 % to 0 %), including solidarity surcharge and assuming a moderate trade tax multiplier of 400 %.

Assuming a trade tax multiplier of 300 % and no dividend withholding tax, the total tax burden even falls slightly under the OECD average (by 1 to 2 percentage points depending on whether solidarity surcharge is included in the calculation or not).

Hence, the new tax reform may reduce the tax incentive for foreign shareholder financing. Of course, shareholders whose domestic tax regime permits them to accumulate income in low tax jurisdictions will remain keenly interested in debt financing.

2.10.4 Doing Business In Branch Form?

Foreign groups may wish to consider doing business in Germany in branch form in the future. Loans to a domestic group permanent establishment from an offshore group financing company do not fall under the German thin capitalization rules as presently in force. Furthermore, the general tax burden on domestic permanent establishments improves dramatically as a result of the reforms (see sec. 2.4.2 above).

2.10.5 Arm's Length Exception

Under § 8a KStG, the taxpayer can avoid constructive dividend treatment of interest paid on conventional loans outside the safe havens by showing that the company in question could have received the loan on the same terms from an unrelated party, generally a bank. This so-called arm's length exception is available for holding structures as well as for loans to individual companies. The reduction of the safe havens may prompt more taxpayers to try to come under this exception.

2.10.6 Pitfall No. 1 For Holding Structures

The present generous 9-to-1 safe haven for holding companies has prompted many foreign groups to establish a German holding with several German operating subsidiaries attached. Frequently, such domestic sub-groups are consolidated under the holding for trade tax purposes, but not for corporation tax purposes (where the requirements are more stringent). The holding pays interest on its loans to a foreign related party and receives dividends from the operating companies. The present corporate tax system allows the holding to set off its interest expense against its dividend income and secure a refund of the corporation tax paid by its subsidiaries. This will no longer be possible in the future (see sec. 2.12 below). The dividend income will be received tax free and the 25 % corporation tax paid by the subsidiaries will be definitive (non-creditable, non-refundable).

Under the new corporation tax regime, corporation tax consolidation of the subsidiaries under the holding is therefore imperative. The requirements for such consolidation are relaxed by the new legislation. For more detail, see sec. 2.12.3.

2.10.7 Pitfall No. 2 For Holding Structures

A problem similar to that discussed in the preceding subsection arises in connection with § 3c EStG, a provision in the income tax law applicable to corporations as well which prohibits the deduction of expenses directly related to tax-free income. Since the new legislation would create a 100 % dividends-received exemption for German corporations (§ 8b (1) KStG), dividends received from other domestic corporations will in the future constitute tax-free income under § 3c EStG. In a typical thin capitalization holding structure where the German group is not consolidated for corporation tax purposes, the dividends received by the holding from its subsidiaries will be tax exempt to the holding under the new regime, hence the holding will - to the extent of dividends received in a particular assessment period - not be allowed a deduction for its interest expense, which was incurred to finance its subsidiaries. Again, the only effective solution to this problem is consolidation of the German group for corporation tax purposes. For more detail, see sec. 2.5.2 above.

2.11 Dividend Stripping

Dividend stripping refers to transactions in which shareholders not entitled in Germany to a credit for corporation and dividend withholding tax paid (corporate and individual non-residents 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. If the buyers are able to offset part or all of the dividend against losses, they will receive a tax refund. Thereafter, the shares are resold to the original holder. Such transactions are eliminated under the half-income system as regards corporation tax because corporation tax will no longer be creditable. Dividend stripping remains possible with regard to dividend withholding tax. The Federal Tax Court recently held that dividend stripping transactions may not be disregarded for tax purposes under Germany's general anti-tax avoidance provision (§ 42 AO - see article no. 202).

2.12 Loss Utilization And Tax Consolidation

2.12.1 Loss Utilization 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.

2.12.2 Need For Tax Consolidation After The New Legislation

Tax Reform 2000 does 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 distributes 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 favorable 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.

2.12.3 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:

• conclusion of a 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
• organizational integration of the group member into the lead company

Pursuant to the profit-and-loss pooling agreement, the lead entity undertakes to equalize 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 equalize 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 must 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 of 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. Organizational integration requires the lead company to exercise strategic management control over the group member.

The new tax reform abolishes the requirements for economic and organizational integration, leaving only the requirement of a (direct or indirect) majority shareholding and the necessity of entering into a profit and loss pooling agreement. Furthermore, it will 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, consolidation will henceforth be available on fairly easy terms.

2.12.4 Trade Tax And VAT Consolidation

The consolidation requirements 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 enacted changes this by retaining the requirements of economic and organizational integration (in addition to financial integration) for trade tax purposes - § 2 (2) GewStG. A profit-and-loss pooling agreement remains unnecessary for trade tax purposes.

Financial, economic, and organizational integration (but not a profit-and-loss pooling agreement) continue to be required for VAT consolidation (§ 2 (2) no. 2 UStG). The new legislation makes no change with respect to VAT consolidation.

2.13 CFC Provisions

2.13.1 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 income earned by the CFC ("supplemental income amount") if three conditions are met:

• German 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").
• the CFC's income is "passive"; and
• the CFC's income enjoys a "low" rate of taxation in its home jurisdiction (presently, "under 30 %," to fall to "under 25 %"; determined using German tax rules).

"Supplemental income amounts" added to the income of resident corporations are tax-exempt if a corresponding dividend paid by the CFC would have been tax exempt under the terms of a tax treaty (§ 10 (5) AStG). However, where the CFC's income is designated passive income, the tax treaty exemption is disallowed (treaty overriding - § 10 (6) AStG).

The dividends-received exemptions created by the tax reform (100 % for corporations, 50 % for individuals) do not apply to supplemental income amounts, which are subject to a new flat rate tax of 38 % (not 25 % as originally planned). 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. 2.5.3 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 new legislation leaves the participation threshold for operation of the CFC rules unchanged at 50+ % (10 % or more for designated passive income). Prior versions of the bill would have dropped the threshold to 10+ %.

Furthermore, the government originally sought to expand the scope of "designated passive income" and extend the reach of the CFC provisions by eliminating the 10 % participation exception of § 10 (6) sent. 2 no. 2 AStG, on which numerous holding structures currently rely. These provisions were jettisoned by the Finance Committee in mid-May 2000, but surprisingly resurfaced in modified form in the bill enacted in early July 2000. While income derived by a CFC from companies in which the CFC holds a stake of 10 % or more nominally continues to escape treatment as designated passive income, this will in the future be contingent on a showing that the CFC is subject to tax of at least 25 % in its home jurisdiction. This is tantamount to abolishing the participation exception to the designated passive income rules.

2.13.2 Conflict With EU Law?

A peculiarity of Germany's CFC rules 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 in principle always falls into the "designated passive" category no matter how it is generated. Despite various exceptions contained in the complicated CFC rules (notably § 13 (1) AStG), 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 criticized 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 by a CFC from a German permanent establishment would still be counted (§ 13 (2) AStG). Cf. the St. Gobain ruling of the European Court of Justice (case C-307/97 - 21 September 1999).

2.13.3 Other Changes In The CFC Rules

The new legislation changes numerous other aspects of the CFC rules. The details of these changes are beyond the scope of this article.

2.14 Eurowings

Tax Reform 2000 does not modify German tax law to bring it into line with the Eurowings decision of the European Tax Court (case C-294/97 - 26 October 1999 - see article no. 206). A statutory response to Eurowings, which concerns the trade tax treatment of international leasing operations, will probably soon be forthcoming.

2.15 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. Some knowledge 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 corporation 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 event, 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. 2.4.2 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. 2.13 above) are intended to equalize 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 current corporation tax system, the distribution of profits to individuals in all cases triggers full taxation. This will be different in the future.

This is Part II 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.