German Tax Reform; good news for foreign investors

Despite fears that the German Tax Reform Bill proposed by chancellor Schroeder's government could fail to win the approval of the Bundesrat (the second chamber of the parliament representing Germany's federal countries, the Länder), the reform bill was passed by the second chamber on 14th July 2000.

The Reform Bill will lead to dramatic changes in German tax law and act as an incentive for foreign investment in Germany. It will have significant impact on the German M&A market. It will certainly encourage UK and other foreign companies to invest in Germany.

For foreign investors, the following amendments to the corporation tax regime are the most important:

• From January 2001, a significant reduction of the corporation tax rate to a flat 25% will lead to an overall tax rate for corporations of approximately 38%;
• Retained and distributed profits will be treated equally;
• The long established but highly complicated tax credit method for dividends (Anrechnungsverfahren) will be abolished;
• From January 2002 complete tax exemption of capital gains derived by corporations from the disposal of shares in corporations provided that the shares have been held for more than one year.

As a result of these radical corporation tax changes, Germany may become a more attractive location for holding companies and may eventually shed its reputation as a high tax country.

Abolition of the Anrechnungsverfahren

Germany's current corporation tax law is driven by the objective of avoiding double taxation, i.e. taxation of profits at the level of the company and taxation of dividends at the level of the receiving shareholder. This is achieved by a) a split corporation tax rate and b) the so called Anrechnungsverfahren.

a) Whereas corporation tax on retained profits is 40% at the level of the corporation, the tax rate on distributed profits is only 30%

b) Whereas dividends paid to natural persons are subject to income tax at the applicable rate, the shareholder is granted tax credit in the amount of the underlying corporation tax, i.e the corporation tax paid by the company on the profits related to the distributed dividends.

Non-resident shareholders, however, are - in general - not eligible for the tax credit method, although they are subject to withholding tax on dividends. Therefore foreign shareholders currently suffer the full impact of the fairly high German corporation tax rates.

Under the new regime proposed by the Reform Bill, corporation tax law will take a different approach more favourable to foreign investors: a uniform tax at the level of the corporation at the rate of 25 % (Definitivbesteuerung) will be introduced. Consequently the Anrechnungsverfahren will be abolished and half of the dividends received by the shareholder will be tax exempted (Halbeinkünfteverfahren) provided that the shareholder is subject to German tax law.

After the tax reform becomes effective, the overall tax rate at the level of the corporation will be approximately 38 %, taking into account the effects of trade tax (Gewerbesteuer) and the solidarity surcharge (Solidaritätszuschlag) - a special tax introduced following the reunification of Germany. Withholding tax remains applicable to dividends paid by German companies to foreign shareholders subject to relevant double taxation treaties or the EU parent/ subsidiary directive. The rate of withholding tax for UK investors can be reduced to 0 % and for US investors to 5 %.

Capital gains tax on corporate disposals

The changes proposed for the taxation of capital gains appear even more radical (but are actually a mere consequence of the above): from 2002 onwards capital gains derived from the disposal of shares in corporations (German or foreign) are completely tax exempt at the level of the company if they have been held for more than one year by the seller (under certain circumstances the qualifying holding period can be extended to seven years).

Without doubt this amendment will lead to a far reaching restructuring of German groups. At the same time, it will become increasingly attractive for investors to establish German holding companies as restructuring and selling subsidiaries is no longer restricted by adverse tax consequences.

The tax exemption for capital gains does not apply to disposals of shares made by partnerships. Initial plans to allow partnerships to elect to be taxed like corporations were dropped during the legislative process. There are, however, plans to introduce further reliefs for small and medium sized companies, which tend to be organised as partnerships, later this year.

Outlook

The Reform Bill is certainly good news for many foreign investors. There is now a fair chance that this reform will break the gridlock that has for many years acted as a deterrent to German inward investment.

For further information please contact Martin Kuhn by telephone on 020 7367 3739 or at [email protected].