I. Introduction to the German Tax System
The German tax system often has a reputation for being complex as it consists of more than 40 different types of taxes; however, it follows very strict and systematic rules. Also, the effective tax burden in Germany is lower in various cases than expected at first sight. Individuals and entities can often benefit from numerous exemptions, deductions and depreciation provisions.
The German tax system usually ties in with the residence of the taxpayer. If the latter has his domicile or residence in Germany, residence tax liability concerning his worldwide income is the consequence. For non-resident investors, non-resident tax liability concerning income from German sources results. The same rules apply for corporate entities; concerning corporate tax and municipal trade tax, the registered office and place of management in combination with a permanent establishment are decisive for resident or non-resident taxation in Germany.
Resident taxpayers are generally divided into two groups; the income is either business profit or non-business profit. However, it must be emphasized that non-business profits have to be re- qualified as business profits if certain criteria are met.
II. Business Taxation
1. Corporate Entities
a) Taxation of Corporate Income
German corporations such as the GmbH, AG and SE are subject to corporate income tax with respect to their entire income, whereas all income always qualifies as business income. Foreign corporations are subject to corporate income tax only with income generated in Germany (unless their registered office or place of management is in Germany; then the foreign corporation is subject to resident taxation). The corporate income tax rate is 15.8 % (including solidarity surcharge).
A distribution of dividends by a German corporation generally triggers withholding tax of 26.4 % which is creditable at shareholder level or equals the flat tax that is due at shareholder level. For dividend income and capital gains from the disposal of shares held by another corporation, Germany offers 95 % tax-exemption at the level of the shareholding corporation for corporate income tax.
The 95 % participation exemption is to be abolished for dividends received by portfolio investments after February 28, 2013, i.e., such dividends are subject to tax at regular rates. A portfolio investment means an investment where the shareholder holds directly less than 10 % of the share capital of the distributing corporation at the beginning of the calendar year in which the dividend is distributed. The 95% exemption with respect to capital gains on such shareholdings remains unchanged.
In case a foreign corporation is subject to non-resident taxation in Germany, the withholding tax can be reduced to 15.8 % if certain substance criteria are met. Exemption from withholding tax applies to distributions to foreign EU corporations (minimum shareholding of 10 % required). Moreover, withholding tax can be reduced to a lower percentage or be eliminated/refunded according to a respective double tax treaty or an EU Directive. However, in these cases, the foreign shareholding corporation must fulfill certain conditions in order to benefit from such favorable rules (see V. 2. below).
b) Trade Tax
A corporate entity is also subject to German municipal trade tax, as it is deemed to generate business income. Businesses which do not have their registered office or place of management in Germany but earn income which is allocated to a German permanent establishment are also subject to a municipal trade tax at a rate of 7 % to 17.2 % (average rate approx. 14 %), depending on the location of the permanent establishment.
For dividend income and capital gains from the disposal of shares held in another corporation, Germany offers tax-exemption for trade tax purposes by excluding this income from the trade income, resulting in an effective tax burden of only approx. 1.5 % for this income (so-called Schachtelprivileg). However, the exemption of dividends for trade tax purposes requires a minimum shareholding of 15 % at the beginning of the fiscal year.
The overall combined tax rate for corporations is approx. 29.8 % for corporate income tax and trade tax.
2. Taxation of Partnerships
a) Taxation of Income
German partnerships are the civil law association (GbR), the general partnership (OHG) and the limited partnership (KG). All assets, liabilities and income of a partnership with regard to taxes are allocated to the partners in proportion to their partnership interest (transparency of the partnership). However, the possibility of offsetting losses generated by a KG at the level of a limited partner is generally restricted to the amount of the respective committed equity.
Partnerships can either obtain business income or conduct private asset management. For business income, the general rules apply; all income related to the business is qualified as business income. Partnerships that solely conduct private asset management (generating interest, dividend income, lease income and capital gains) do not earn business income, except for partnerships that generate deemed business income due to their structure (general partner is a corporation and no managing limited partner).
Exemptions are made for the taxation of dividend income and capital gains. Dividend income and capital gains resulting from a disposal of shares in a corporation are 40 % tax-exempt and 40 % of related costs are non-deductible (so-called Teileinkünfteverfahren). Interest income is not tax-exempt and related costs are fully deductible.
The tax rate for partners is equivalent to the tax rates for individuals (see III.1. below).
b) Trade Tax
If a partnership conducts business activities, the entire income of the partnership is qualified as business income (i.e. also the income from non-commercial activities) and is thus subject to trade tax. To a large extent, the trade tax burden can basically be offset with the personal income tax liability of an individual partner in proportion to its equity interest in the partnership.
3. Anti-Avoidance Rules/CFCs Legislation
In order to prevent the misuse of legal forms, the use of proxies, tax havens and treaty/directive shopping, Germany has passed the Foreign Transaction Tax Act (AStG). Basically, the act gives tax authorities the right to ignore abusive and artificial circumstances which would lead to an untaxed constellation.
III. Taxation of Individuals
1. Resident Taxation
An individual with residence or domicile in Germany is subject to resident taxation, meaning the worldwide income is taxed in Germany, supplemented by a solidarity surcharge. Taxable events are exclusively enumerated in the German Income Tax Act (EStG), e.g., income of business, rental income, income from personal services (self-employed or employed), certain other taxable events listed in the act and capital income.
Income of individuals generated personally is currently (2013) taxed at a rate starting at 14.0 % (taxable income from EUR 8,131 to EUR 13,469), increasing proportionally up to 23.97 % (taxable income from EUR 13,470 to EUR 52,881). The marginal rate for taxable income from EUR 52,882 to EUR 250,730 is 42.0 %; for taxable income of EUR 250,731 and more it is 45.0 %. A solidarity surcharge of 5.5 % is added on to the respective tax rate.
For certain categories of interest income, dividend income and capital gains, a flat tax rate of 26.4 % (including solidarity surcharge) applies (so-called Abgeltungsteuer). Expenses and costs effectively connected with such capital gain are not deductible from the flat rate tax base. Flat rate taxation is not applicable but regular taxation applies in the following circumstances:
- The financial assets generate business income and are thus qualified as business assets.
- With respect to interest income: the borrower is a corporation and the lender holds at least a 10 % shareholding or is a related party of the borrowing corporation.
- With respect to capital gains: the shareholder has a shareholding in a corporation of at least 1 % at one point in time within the last five years.
The taxpayer can opt for standard taxation instead of flat rate taxation concerning dividend income in cases of:
- shareholding of at least 25 %; or
- shareholding of at least 1 % and employment by the corporation (typical MBO structure).
2. Trade Tax
Business income of an individual (sole proprietorship) is subject to trade tax; however, the trade tax burden can largely be offset with the personal income tax liability.
3. Non-Resident Taxation
If an individual is not subject to resident taxation, i.e. has no residence or domicile in Germany, but has income from a German source, he is usually taxed in Germany. The following list specifies the types of taxable events regarding non-resident taxation:
- business income to the extent of the business activities that can be allocated to a domestic permanent establishment or a permanent agent;
- rental income from domestic real estate;
- (if not already included in business income) capital gains resulting from the disposal of domestic real estate, except if the real estate does not qualify as a business asset and was held by an individual or non-business partnership for more than ten years;
- income from personal services which are utilized in Germany and provided by individuals (self-employed or employed) or entities;
- capital gains resulting from the disposal of shares in a German corporation (minimum shareholding of 1 % at one point in time within the last five years required);
- dividends and liquidation proceeds received from German corporations;
- performance-related interest income paid by German debtors and capital gains derived from the disposal of such instruments;
- certain other (non-performance-related) interest income (including capital gains) if the debt instrument is registered in Germany or secured by domestic real estate.
Sometimes double taxation results from such cases. The solution for this issue will be described in the section dealing with double taxation (see V.2. below).
IV. Indirect Taxes
1. German Real Estate Transfer Tax
a) Direct Acquisition of Real Estate
The direct acquisition of real estate (and certain rights in real estate, e.g. heritable building rights) located in Germany is subject to real estate transfer tax. Real estate transfer tax is already triggered by the legally binding agreement between the seller and the acquirer to transfer title of the real estate (i.e. the sale and purchase agreement (see B.IV.).
In case of an asset deal, the seller as well as the acquirer owes the real estate transfer tax; in practice, the parties usually contractually agree with each other that only the acquirer shall bear the real estate transfer tax.
b) Acquisition of Shares in a Real Estate Holding Company
Real estate transfer tax also becomes due if 95 % or more of the shares in a real estate holding entity (corporation or partnership) are held in one hand, e.g. obtained directly and/or indirectly by one acquirer or by controlling and dependent entities or by dependent entities only (tax group for real estate transfer tax purposes). However, partnership interests are counted by the number of partners and not by the percentage of equity interests held by the partners (so-called per capita rule).
Shares in a real estate holding entity that are indirectly owned via an interposed corporation can only be allocated to an acquirer if the latter holds 95 % or more of the shares in the interposed corporation (indirect investment).
If more than 95 % of the shares in a real estate holding entity are acquired by one acquirer, such acquirer is liable for real estate transfer tax.
Depending on the circumstances, a share deal of a real estate holding corporation may be structured specifically to avoid triggering real estate transfer tax. For example, this could be achieved through an interposed partnership and a third party minority investor in the partnership (so-called real estate transfer tax blocker).
c) Acquisition of Interests in a Real Estate Holding Partnership
Furthermore, real estate transfer tax becomes due if 95 % or more of the equity interests in a real estate holding partnership are transferred directly and/or indirectly to new partners within a five year period. For purposes of this rule, partnership interests are counted by the percentage of equity interests held by the transferring partner. In the case of an entity holding an equity interest in a partnership, this equity interest is deemed to be transferred to a new partner if 95 % or more of the shares in the entity are acquired by a new investor (indirect investment).
The real estate holding partnership is liable for real estate transfer tax.
A transfer of a real estate holding partnership may be structured without triggering real estate transfer tax by a deferred transfer of a minimum partnership interest of at least 5 %.
d) Draft Bill to Inhibit Real Estate Transfer Tax Blocker
According to a 2013 draft bill, the rules determining the participation of at least 95 % in a real estate holding entity (corporation or partnership) in one hand shall be amended, effective for transactions implemented after December 31, 2012. The new rules intend to inhibit a real estate transfer tax blocker.
Any transaction where a taxpayer has – directly and/or indirectly – an economic participation of at least 95 % in a real estate holding entity will trigger real estate transfer tax. The economic participation equals the sum of direct and indirect participation in the capital or assets of the entity. The indirect participation is computed by multiplying the percentages in the capital or assets of the entity. As a consequence, the per capita rule for partnership interests would no longer apply.
e) Tax Rates and Tax Bases
Generally, real estate transfer tax is levied at a rate of 3.5 % - 5.5 % on the tax base, depending on the location of the real estate. In case of a sale and purchase agreement, the tax base is the agreed consideration, i.e. the purchase price. Any part of the purchase price paid for buildings is included in the tax base.
The base for real estate transfer tax levied on taxable transfers relating to real estate holding companies is a certain tax value of the real estate as determined according to the Tax Valuation Act. The tax value is usually lower than the fair market value of the real estate (as a rule of thumb: some 75 % - 85 %).
f) Deductibility of Acquisition Costs
Real estate transfer tax should be deductible for income tax purposes in case of acquisition or unification of shares/interests of 95 % or more. Where 95 % of partnership interests are transferred to new owners within five years, it is under discussion whether the real estate transfer tax is deductible or treated as part of the acquisition costs of the acquired assets and must be capitalized. Like other capitalized acquisition costs, real estate transfer tax is amortized over the standardized life of the buildings to the extent that the tax is allocable to buildings that qualify for depreciation and not to land.
2. German Value Added Tax
The German value added tax is a transaction tax. The delivery and supply of goods and services are subject to such tax. Value added tax conforms to the Council Directive 2006/112/EC on the common system on value added tax; therefore, there are no German specifics concerning the system itself.
The applicable rate in Germany for value added tax is 19 %, although a reduced rate of 7 % applies to certain privileged basic products (such as food and books), while other transactions are value added tax-exempt (such as transfer of shares or transfer of real estate) or non-taxable (such as the transfer of an entire business unit via an asset deal). Input value added tax on purchases is generally refundable if and to the extent that it is not related to non-taxable or certain tax-exempt turnover. Exports are tax-exempt, whereas input value added tax related to such transactions can still be claimed by the entrepreneur.
V. Discussion of Exclusive Tax Challenges
1. Acquisition of a Business
a) Basic Considerations
There are generally two ways to acquire a business:
- the purchase of (all) targets’ assets (asset deal); or
- the purchase of the shares in the target (share deal).
The question of share deal versus asset deal has to be determined by taking all interests of both sellers and purchasers into consideration. Therefore the identification of an appropriate transaction structure is certainly a challenge. However, it is often even more challenging to design and implement an optimized acquisition structure that takes into account the annual tax burden for the purchaser, as well as appropriate taxation of a subsequent exit.
From the purchaser’s point of view, the following aspects regarding taxation are crucial:
- tax-effective depreciation of the purchase price (step-up);
- efficient exit taxation;
- utilization of loss carry forwards of the target;
- deductibility of interest expense for acquisition debt from the tax base of the target;
- minimization of transaction costs (such as real estate transfer tax).
b) Asset Deal/Share Deal of Partnership Interests
aa) Asset Deal
With respect to current taxation, the acquisition of a business by a German acquisition vehicle via an asset deal is mostly more advantageous than a share deal for the purchaser. The purchaser can directly convert the purchase price into a tax-efficient depreciation (so-called step-up) to the extent that the assets are depreciable. The purchase price is allocated to the acquired assets which are entered in the balance sheet as of the acquisition date at their fair ￼market value, including goodwill – if any – and is amortized over the useful lifetime (goodwill: 15 years) of the assets. However, land can be written off only to the extent that the fair market value is permanently lower than the purchase price.
bb) Acquisition of Partnership Interests
With regard to taxes, the acquisition of partnership interests (see A.II.3) is basically equal to the acquisition of the assets from a seller. The same tax principles apply to the acquisition of partnership interests as the entity is transparent for tax purposes.
The acquisition of partnership interests permits the inclusion of certain investors’ expenses in the tax calculation of the partnership income, e.g. interest expenses that arise from the acquisition financing on the partner level. From a German tax point of view, such interest expenses are allocable to the partnership. In the foreign partner’s jurisdiction, however, such interest expenses might be allocated to the business on the partner level and thus provide for a double dip of the interest expenses in Germany, as well as in the foreign investors’ jurisdiction. Case law and tax authorities challenge such structures under certain circumstances.
cc) Exit Scenarios
An exit from a German business investment is subject to income tax/corporate income tax at seller level and, in most cases, is also subject to trade tax. For individuals selling an entire business or partnership interest, tax relief (lower income tax rate) may apply if certain requirements are met. Trade tax is not triggered if:
- an individual or a partnership disposes of its entire assets or a separate business unit (the sale of the business by a corporation is subject to trade tax);
- an individual disposes of its entire partnership interest.
Due to the tax impact for the seller upon exit (taxation at full tax rate), an asset deal is often disadvantageous when compared to a share deal, and investments are thus more likely to be transferred by way of a share deal than by an asset deal.
With respect to a tax-efficient exit from an investment in a partnership, a tax-neutral conversion of the partnership into a corporation might be favorable; however, to take full advantage of a subsequent transfer of shares in a corporation, a holding period of seven years must be taken into account.
c) Share Deal of a Corporation
The capital gain resulting from a transfer of shares in a German corporation is 95 % tax-exempt if the seller is a corporation and 40 % tax-exempt if the seller is an individual that holds or has held at least 1 % of the shares at one point in time within the last five years or holds the shares as business assets. If the seller is a partnership, the taxation for income tax/corporate income tax purposes takes place on the partner level and tax exemptions depend on the status of the partner (individual or corporation); trade tax becomes due on the partnership level (if the shares are attributable to a domestic permanent establishment). With respect to foreign investors, a capital gain might be fully tax-exempt in Germany according to the respective double tax treaty (if the shares are not to be allocated to a domestic permanent establishment). Thus, a transfer of shares in a corporation is preferable for both the seller and the investor with respect to a subsequent exit from the investment. By acquiring shares in a corporation, a step-up of the assets of the corporation does not take place, but the shares have to be capitalized at the acquisition costs (no step-up). Shares in a corporation are not depreciable; an extraordinary write down is only possible if the fair market value of the shares is continuously below the acquisition costs. Such write down is 60 % tax- effective only if the shares are held as business asset by an individual (or to the extent that an individual is partner in a business partnership holding the shares) and the shares belong to German business assets. Otherwise, write down is not tax-deductible. Therefore, as a result of the share deal, the purchaser cannot use built-in gains in the acquired business assets through depreciation.
As the acquired corporation qualifies as a separate taxpayer, additional considerations are required to match operating profits of the target corporation with acquisition debt financing costs at the purchaser level.
d) Loss Utilization
According to German rules, tax losses in a financial year can be carried back to the previous year up to an amount of EUR 1,000,000 (as of financial year 2013) for income tax/corporate income tax purposes (not for trade tax purposes) and can be carried forward further (loss carry forwards) without time restrictions (income tax/corporate income tax/trade tax). However, the utilization of loss carry forwards is limited to the minimum taxation rule. According to this rule, a base amount of EUR 1,000,000 loss carry forward can be utilized annually without restrictions and in excess thereof only to the proportion of 40 % of the remaining positive tax base of the respective financial year.
Such loss carry forwards are of value to a legal entity if it generates taxable profits in subsequent financial years (deferred tax asset). However, in the course of a sale transaction, loss carry forwards could cease to exist or be reduced. The most important rules for a forfeiture of loss carry forwards through a change of ownership are as follows:
- Asset deal: loss carry forwards cannot be transferred.
- Direct transfer of a partnership interest: trade tax loss carry forwards at the partnership level will be forfeited in proportion to the transferred percentage of the partnership equity interests. If partnership interests are not all transferred, the remaining loss carry forwards can be utilized only to the extent that a partner remains in the partnership (loss carry forwards for trade tax purpose are personalized). The tax losses for income tax purposes at partner’s level shall be subject to the change of control rule (see next bullet).
- Transfer of shares in a corporation: If within a period of five years more than 25 % and up to 50 % of the corporation’s shares are transferred to one purchaser, related parties of such purchaser or a group of purchasers acting in concert, then the corporation’s loss carry forwards and current losses (corporate income tax/trade tax) will be forfeited pro rata. In case such transfer exceeds the 50 % threshold within five years, the entire loss carry forwards will be forfeited. Both rules shall apply, irrespective of a direct or indirect transfer of the shares in the corporation. An exemption from the loss forfeiture rules applies to the extent that the losses do not exceed the taxable built-in gains of the domestic business assets of the corporation at the time of the harmful transfer. In this case unutilized losses are preserved. In general, built-in gains are determined as the ￼(proportional) difference between the shareholders’ equity of the corporation as computed for taxation and the market value of its shares to the extent that they are subject to domestic taxation.
- The same rules apply to trade tax loss carry forwards of a partnership held by a corporation in case the shares in the corporation are (directly or indirectly) transferred.
- Reorganization: For most reorganization procedures, such as a merger of entities, a spin- off, a contribution of a business unit in kind, a change of legal form from a corporation to a partnership and vice versa, the loss carry forwards of the transferred business unit, respectively legal entity, will be forfeited.
The German change of control rules provide for an intra-group reorganization exception: An exemption from the loss forfeiture rules applies if the same person is – directly or indirectly – the sole shareholder in both the transferring and acquiring entities. Nevertheless, restructuring and reorganization measures within a group might negatively affect the utilization of loss carry forwards.
To avoid this consequence, the seller may realize built-in gains before carrying out the transaction by utilizing loss carry forwards and then selling a business via a share deal with increased tax book values of the assets. Minimum taxation rules need to be considered.
A tax-efficient utilization of losses is also possible by establishing a tax group (see e) below). Within a tax group, profits and losses are taxed at top entity level and can thus be offset. However, it must be taken into consideration that losses of a tax group entity (subsidiary) incurred before the time of the group taxation (loss carry forwards from former financial years) cannot be utilized with profits within the tax group. Such loss carry forwards are frozen at subsidiary level as long as the tax group exists; however, they are subject to the German change of control rules.
e) Acquisition Structures
The deductibility of interest expenses for acquisition debt financing is a crucial issue in the tax structuring of acquisitions by means of a share deal. If the acquisition vehicle is financed with respect to the purchase price for the acquisition of the shares of the target entity, bank loans and/or shareholder loans will be provided in addition to equity of the investor to achieve a leverage effect. Interest expenses on the acquisition loan shall be deducted from profits of the operating target in order to reach a tax base that is as low as possible in net terms. Generally, a German acquisition vehicle is implemented to ensure that both the target entity and the acquisition vehicle are subject to German taxation. In particular, the following tax structures are usually recommended:
- Merger: The acquisition vehicle and the target entity are tax-neutrally merged. As a result, the interest expenses occur directly at target level.
- Tax group: Between the acquisition vehicle and the target, a tax group (Organschaft) is established. This requires that – inter alia – (i) the target entity is a corporation, (ii) the majority shareholder (controlling entity) is an individual or partnership conducting business activities or a corporation and (iii) a profit and loss transfer agreement is concluded for a period of at least five years. In a tax group, the taxable profit of the subsidiary (controlled corporation) is transferred and taxed at shareholder level (tax group parent).
- Target entity is a partnership: The target is a business partnership or will be tax neutrally converted into a partnership (change of legal form). Interest expenses for debt financing to acquire the shares of the target partnership are then allocated to the taxable income of the partnership (see b) above). Accordingly, the interest expenses are part of the tax base of the target partnership.
f) Interest Deduction
Interest deduction for business income in Germany is limited by thin capitalization rules, in particular from 2008 onwards, by the so-called interest barrier (Zinsschranke).
As a general rule, the net interest expenses (after balancing of interest income) are deductible in the financial year of expenditure only up to 30 % of the businesses’ tax accounting-based EBITDA (earnings before interest, tax, depreciation and amortization).
Non-deductible interest expenses are carried forward to subsequent financial years and can only be deducted within the limits of the interest barrier rule. The interest carry forwards are forfeited according to the rules for a forfeiture of tax loss carry forwards (see d) above).
The interest barrier is not applicable if:
- the net interest expenses (excess of interest expenses over interest income of a financial year) of a business unit are less than EUR 3,000,000 (threshold); or
- the business (whereby a tax group qualifies as one single business despite the fact that separate legal entities are included) is not (or only partially) consolidated in the consolidated financial statements of a group (IFRS, German GAAP, other EU-GAAP or even US-GAAP can be applied); or
- the business is fully consolidated in the consolidated financial statements of a group, but the equity ratio of the business unit on a stand-alone basis is not lower than two percentage points of the equity ratio of the group in the consolidated financial statements (certain tax-related adjustments of GAAP to tax equity must be considered).
With respect to a corporation or a partnership held by a corporation, the last two exemptions above only apply if no harmful shareholder financing is in place. The financing of a stand-alone business entity is harmful if a shareholder with more than 25 % shareholding, a related party of such shareholder or a third party (e.g. bank) with recourse (back-to-back financing) to such shareholder or related party grants loans to the entity and the interest for these loans exceeds 10 % of the net interest expenses of the entity. Concerning a group entity, financing is harmful if a non-consolidated but more than 25 % shareholder of any group entity, or a related party or a bank with recourse to such shareholder or related party grants loans to any (domestic or foreign) entity belonging to the group and the interest for these loans exceeds 10 % of the net interest expenses of this specific entity.
The requirements for an escape are challenging to meet and careful tax planning is recommended.
To the extent that interest expenses are deductible for income tax/corporate income tax purposes, a 25 % add-back to the trade tax base is generally applicable.
g) Debt Push-Down to Foreign Subsidiaries
In some cases, the interest barrier rule might limit the interest deduction in Germany. In this situation, one should consider whether a debt push-down of financing costs to foreign group entities could be beneficial. This can be achieved by cross-border intercompany loans, as well as via distributions and third party debt recapitalization of the foreign group entities.
2. German Prevention of Double Taxation
Double taxation in Germany, as well as in a foreign jurisdiction, is mitigated by double tax treaties which are in place with more than 90 countries (bilateral agreement). If a double taxation treaty does not apply, Germany allows crediting of foreign taxes paid abroad in its income tax return (unilateral measure). If a double taxation treaty exists, business income and rental income is usually taxed in the jurisdiction in which the permanent establishment or real estate is located; capital income (interest, dividends and capital gains from the disposal of financial assets) is generally taxed in the jurisdiction of the foreign investor’s residence. In some cases of capital income, Germany has the right to levy withholding tax.
Since income from dividends is of great importance to investors, emphasis will be placed on the following rules applying to them.
aa) General Rule: Withholding Tax
Dividends distributed by a German corporation are generally subject to 26.4 % withholding tax, which is creditable to the German income tax/corporate income tax liability of the domestic shareholder. The withholding tax rate is reduced to 15.8 % for foreign corporations receiving dividends if the provisions under bb) are fulfilled. Furthermore, most double tax treaties provide that (i) such dividend income is subject to taxation in the jurisdiction of the shareholder’s residence only and (ii) the withholding tax is limited to a lower rate of typically 15 % or (iii) the withholding tax is even reduced to 0 % if certain conditions are met (basically, the shareholder must be a foreign corporation holding a certain minimum shareholding in the German corporation). Moreover, withholding tax does not occur if the shareholder is a non-domestic EU- based corporation with a minimum direct shareholding of 10 % for at least 12 months uninterrupted.
bb) Treaty Shopping
According to German anti-treaty-/anti-directive-shopping rules, a foreign company is only entitled to (full or partial) relief from withholding tax under a EU Directive/Double Tax Treaty to the extent that:
- the company is owned by shareholders that would be entitled to a corresponding benefit if they earned the income directly (individual relief entitlement); or
- certain substance requirements (factual relief entitlement) are met (non-harmful income).
Income is not harmful, if:
- it consists of gross receipts generated by its own business activities; or
- with respect to income generated by non-business activities, there are non-tax related reasons for interposing the foreign company and the company has adequately equipped business substance.
The lack of an individual relief entitlement excludes indirect relief of higher-tier shareholders. Moreover, indirect domestic shareholders are not entitled to relief.
If a foreign company earns income on which withholding tax is imposed, this withholding will be reduced – unless there is an individual relief entitlement applicable – only to the extent that there are non-harmful gross receipts compared to the overall gross receipts earned (Pro Rata Test). Contrary to the previous rules, an all-or-nothing principle does not exist and only pro rata relief will be granted insofar as there is harmful income.
Earnings that are economically functionally linked to the own business activities (e.g. interest income generated by income which was subject to relief) qualify as gross receipts generated by own business activities.
For purposes of the Pro Rata Test, the gross receipts of the year in which the income is earned is generally decisive (withholding tax refund) or the gross receipts of the application year (withholding tax exemption). The tax administration must be notified about a (partial) loss of the requirements for withholding tax relief, whereby a de-minimis rule is provided.
When testing, the German authorities pursue a bottom-up approach and will stop the analysis if a (higher-tier) shareholder meets all of the conditions or is resident in a non-treaty country. In the latter case, no partial or full relief from German withholding tax is granted.
According to these rules, foreign direct shareholders who solely perform "pure" asset management or whose business activities are conducted by related or third parties can generally not take advantage of withholding tax relief in Germany.
The restrictions do not apply to a direct foreign shareholding corporation whose shares are publicly traded or that qualifies as an investment fund.
In order to take advantage of the withholding tax relief, the substance and activities of the foreign shareholder require careful consideration.
b) Transfer Pricing
aa) General Aspects
Transfer pricing in the following refers to the pricing of transactions (tangible and intangible assets, services, funds, etc.) between affiliated companies or related parties across national boundaries. The valuation of such a transfer is of special interest for tax purposes, since the affiliated companies or related parties are separately subject to taxation in different jurisdictions. In cases of such transactions, the typical market mechanisms that establish prices at arm’s length between third parties may not apply.
bb) Arm’s Length Principle
According to the arm’s length principle, transfer pricing methods have become the accepted approach in dealing with cross-border intercompany transactions. The arm’s length principle requires that consideration of any intercompany transaction must conform to the level that would have applied had the transaction taken place between unrelated (third) parties under similar
￼conditions. However, different countries may accept different methods (e.g. comparable uncontrolled price method, resale price method, cost plus method or profit split method) of calculating appropriate transfer prices.
If and to the extent that the arm’s length principle is not met with respect to (national as well as international) transactions, the tax base of the respective German entity might be adjusted (at the latest in the course of a tax audit), resulting in an additional income tax/corporate income tax/trade tax burden (adjusted tax base) and additional withholding taxes (hidden profit distributions), as the case may be. Moreover, penalty charges may result.
German tax authorities basically accept the most common intercompany transfer pricing standards, in particular the comparable uncontrolled price method, resale price method and cost plus method.
cc) Exit Charge
In 2008, significant changes to Germany’s transfer pricing legislation were introduced: A transfer of functions will be deemed to have taken place when a function performed by one entity is transferred cross-border to another group entity, even if the transfer is partial or temporary. In this context, "functions" are defined as the aggregation of similar operational tasks, including corresponding opportunities and risks, executed by certain departments of the enterprise. Under certain conditions, an appropriate transfer price is determined based on the discounted cash flow value of the functions transferred. The transfer price for the functions is deemed to be the average of the supplier’s minimum price and the recipient’s maximum price. Such transfer price will be subject to regular tax rates (so-called exit charge).
dd) Transfer Pricing Documentation
German tax law requires that the taxpayer maintains proper transfer pricing documentation in cases of intercompany cross-border transactions with regard to the type and content of his business relationships with related parties, including details on the calculation of transfer prices. For material business transactions, the entity must fulfill the documentation requirements in a timely manner (6 months after the end of the financial year) or in other cases, upon request by the tax authorities only. If no or insufficient documentation is available, the tax authorities are authorized to assume (estimate) a higher tax base at the German entity’s level and in addition, assess penalty payments.
3. Taxation of German Real Estate Investment Trusts (REIT)
As in many other countries, the establishment of real estate investment trusts is now also available in Germany. The German Real Estate Investment Trusts Act of 2007 created significant opportunities for real estate holding entities and investors in German real estate. Real estate investment trusts are real estate holding companies in the legal form of an AG listed on a stock exchange. The business purpose of a real estate investment trust is limited to acquiring, holding, managing by renting out and leasing, and selling real estate (or rights of use of real estate), and acquiring, holding, managing, and selling shares in real estate business partnerships. Sale-and-lease-back structures are also permitted.
Income of real estate investment trusts is exempt from income tax/corporate income tax at the entity level if certain requirements are met (such as a minimum free float rate of 15 % (25 % at the time of listing), maximum individual shareholder participation of 10 %, minimum profit
distribution of 90 %). However, distributions of a real estate investment trust are fully subject to taxation on the investor level (without tax exemptions) and trigger withholding tax of 26.4 %.