On Friday, May 25, 2007 the German Parliament (Bundestag) passed the German Tax Reform 2008 bill. The new law needs final approval from the German upper house (Bundesrat). The Bundesrat is scheduled to vote on the bill on July 6, 2007. There are no reasonable doubts that the Bundesrat will pass the new law. The new rules will become effective as of January 1, 2008 (except where stated otherwise).
This memo informs you in brief about the seven changes that are most important for international investors in Germany.
1) Significant cut in tax rates
Today, the average combined corporate income tax and trade tax rate for corporate taxpayers is around 39 percent. As trade tax rates are set by municipalities, the exact rate depends on the municipality where the business is located. After the tax reform 2008, the combined average corporate income tax and trade tax rate will be around 29 percent. Whereas trade tax rates will stay more or less unchanged, the corporate income tax rate will be reduced from 25 percent currently to 15 percent.
2) Tax deductibility of interest expenses
The tax reform 2008 implements new German thin-capitalization rules. Business taxpayers (e.g., corporations, German permanent establishments of non-resident taxpayers and partners of commercial partnerships) will be allowed to deduct interest expenses only in an amount not exceeding 30 percent of a given business year’s EBITDA. Interest expenses that could not be deducted in a given business year because of the percentage limitation will be carried forward to be deducted in future business years to the extent the limitation is not exceeded in those years.
The 30 percent limitation does not apply if :
- total interest expenses do not exceed 1 million Euro per year (so-called “escape clause 1”) or
- the taxpayer is not part of a group of companies (so-called “escape clause 2”) or
- the taxpayer is part of a group of companies but can prove that its debt-equity ratio is not higher than the debt-equity ratio of the other group companies (so-called “escape clause 3”).
In the case of corporate taxpayers, escape clauses 2 and 3 do not apply, if more than 10 percent of the total annual interest expenses are paid to a major shareholder (i.e., a shareholder who holds more than 25 percent), a party related to such major shareholder or a third party that can take recourse against such shareholder or related party.
3) Tax deductibility of lease payments, rents and license fees
Lease payments, rents and license fees paid by a business will remain deductible without limitation for purposes of computing the corporate income tax base.
For trade tax purposes, a certain percentage of such expenses is added back to compute the trade tax base.
- Lease payments/rents for long term movable assets: 5 percent
- Lease payments/rents for real estate and buildings: 18.5 percent
- License fees: 6.25 percent
To the extent interest expenses do not fall under the new 30 percent limitation (see under 2 above) and are thus deductible without limitation, 25 percent of them is added back to compute the trade tax base. Until now, 50 percent was added back, but only of long-term interest expenses.
4) Trade tax participation exemption
If a German business taxpayer receives dividends from another German or foreign corporation or realizes capital gains from the disposal of shares in the corporation, such dividend income or capital gains are generally subject to German trade tax. In the case of non-portfolio shareholdings, such dividends or capital gains are exempt from trade tax (the so-called “trade tax participation exemption”). The tax reform now increases the minimum participation for a non-portfolio shareholding from 10 to 15 percent. That means that only if a business taxpayer holds at least 15 percent of the shares of another corporation, dividends or capital gains from such corporation are exempt from trade tax at the level of the shareholder. For corporate income tax purposes, dividends and capital gains from the disposal of shares are always tax exempt regardless of any minimum participation.
5) Limitation on the use of tax loss-carryforwards
Under current law a corporation can no longer use its tax loss-carryforwards if more than 50 percent of its shares are transferred directly and the corporation continues its business with predominantly new assets. After the tax reform of 2008, a corporation will no longer be able to use its tax loss-carryforwards to offset future taxable income if more than 50 percent of its shares are directly or indirectly transferred to a single purchaser or a person related to such purchaser within a five-year period. If more than 25 percent but not more than 50 percent of the shares are transferred, the loss carryforwards are denied on a pro rata basis. It will be treated as a transfer to a sole purchaser if the shares are transferred to several purchasers acting in concert.
Because the new rules also apply to an indirect transfer of shares, even the reorganization of the top tier companies of a group of companies can prevent the German group companies from using their tax loss carryforwards.
Similarly, the indirect transfer of shares in a company that owns German real estate can trigger German real estate transfer tax. Therefore, in the future if a group of companies that includes German subsidiaries is reorganized or shares are transferred, two German tax implications must be always kept in mind: (i) whether German real estate transfer tax is triggered and (ii) whether the German subsidiaries’ tax losscarryforwards are affected.
6) Transfer pricing rules
German transfer pricing rules no longer only require arm’s length terms but also demand that arm’s length be measured on the basis of the comparable uncontrolled price, if available. If such prices are not available, indirect comparisons must be extrapolated from whatever comparables can be found, using one of the recognized transfer pricing methods.
The lawmakers intend to target companies that develop new products in Germany and thus deduct research and development expenses in Germany but transfer the subsequent production and distribution of the products to low tax countries to avoid the taxation of profits in Germany. Therefore, the transfer of these transfers of such functions.
7) Taxation of private capital investment income
Private investors’ capital investment income will (effective Jan 1, 2009) no longer be subject to their progressive individual income tax rate but will instead be subject to a 25 percent flat tax rate. Capital investment income is defined as interest and dividend income as well as capital gains (except from real estate).
Currently, capital gains realized from the disposal of shares that are not held as business assets are only taxable if (i) the disposal takes place within one year after the acquisition of the shares or (ii) the participation is equal to or exceeds 1 percent of the stated share capital of the company. The new rules abolish these exemptions, which means that capital gains realized from the disposal of shares will always be taxable. such functions out of Germany will be taxed on the value of the opportunity exported at standard corporate income tax and trade tax rate. It will obviously be difficult to find appropriate transfer prices for