In the following, we would like to provide you with select and basic tax considerations relevant to you when expanding your business to the German market:
1. General Considerations
In general, German profit taxes consist of two elements: Firstly, the corporate income tax, which is a flat tax at a rate of 15.825% (including thesolidarity surcharge, an extra duty implemented to finance the reunification between West and East Germany); and secondly the trade tax whose rate is set forth by the competent municipality. In total, German profit tax ranges between 31-32%.
Repatriation of profits triggers German tax withholding (standard rate: 26.375%) only in the case of a corporation distributing dividends. The Double Tax Treaty (DTT) between the USA and Germany) provides for substantial relief for most relevant cases bringing down the tax burden to approx. 5% - 15% effectively (see more details below). However, Germany has enacted tax provisions, which may lead to a withholding tax charge irrespective of the DTT provisions.
2. Investment Vehicles and their Tax Treatment in Germany
Foreign entities establishing a presence in Germany may either choose to establish a German subsidiary, a branch or a permanent establishment. For a subsidiary, German law provides for corporations and partnerships as legal regimes.
- Dependent Permanent Establishment and Branches
The presumably tax wise least complex possibility to act on the German market is to establish a dependent permanent establishment (PE) or a branch (Zweigniederlassung) of a US-entity. Both do not form a legal entity themselves but are legally considered as representations of the respective US-entity in Germany. The main difference between a PE and a branch is that the PE counts as a subordinate unit of the US-entity. A branch is given more autonomy by having its own management with executive powers, bank accounts, a balance sheet and independent business assets. Furthermore, a German branch has to be registered with the German Commercial Register.
A PE and a branch may cause a limited corporate income tax and trade tax liability in Germany. This means that only those profits are taxable in Germany, which may be allocated to the PE/branch. The corporate income tax burden is currently 15% plus solidarity surcharge (5.5% of the Corporate Income Tax). The factual trade tax rate is between 7% to 31.5% depending on the municipality where the PE is placed and on certain additions and deductions. The average trade tax rate amounts to approximately 15-16%. Therefore, the cumulative tax burden in Germany is around 31% on average.
In comparison, the corporate tax rate in the UK amounts to 19%. In the Netherlands, the corporate tax rate is 19% for taxable profits up to EUR 200,000. Thereafter, the tax rate is 25%. In France, the corporate tax rate depends on the taxable profit as well as the type of income and amounts to 10%, 15%, 19%, 28%, 31% and 33.33%.
The DTT applies an imputation system to avoid a double taxation with respect to those business profits which are taxed in Germany. This means that the German tax can be taken into account in the course of determining the US tax burden, thereby reducing the latter.
Please note that also when establishing a PE or a branch, the relevant US-entity may have to withhold and pay wage tax in case it engages employees in Germany. The practical implementation can be done by a payroll-provider.
Partnerships are common vehicles for certain investments, e.g. real estate investments. Due to German tax law, it is not the partnership itself but the partners who are subject to income/corporate income tax with respect to any income generated by the partnership. A so-called “pass-through”-approach applies.
It is important to note that such “pass-through”-approach does not apply for trade tax purposes therefore trade tax accrues on the partnership-level and is primarily owed by the partnership. Nevertheless, real estate investments can be structured to achieve a complete trade tax exemption. Furthermore, natural persons are entitled to deduct their trade tax burden, fully or substantially, from their annual income taxes when declaring their tax returns.
Since not the partnership itself is not subject to income tax but rather its partners, the taxation depends on whether the partner qualifies as a natural person or a legal entity. A legal entity is subject to corporate income tax (cf. above), a natural person is subject to German income tax. The maximum income tax burden for a natural person amounts to 42% (plus solidarity surcharge) beginning with a taxable income of EUR 55,961. The so-called “wealth tax”, which causes a tax burden of 45% (plus solidarity surcharge), is applicable to natural persons beginning with a taxable income of EUR 265,327.
The DTT applies an imputation system to avoid a double taxation also with respect to such income derived from a partnership and already taxed in Germany.
If a partnership employs employees in Germany, it has to withhold and pay wage taxes to the competent tax authority.
- AG and GmbH – German Corporations
The third opportunity for investments in Germany is to set up a German corporation. Corporations are subject to corporate income tax and trade tax in Germany (cf. above). If the corporation solely invests in real estate, a trade tax exemption can be achieved with a specific structuring.
Whilst the GmbH is similar to an Anglo-Saxon Limited and can be established under certain requirements with a share capital of EUR 1 , an AG is the German stock corporation and is mainly interesting for larger capital collections and investments.
Dividend payments of a German corporation to a US-shareholder are subject to a privileged income tax treatment in Germany. The tax burden amounts to only 5% (plus solidarity surcharge), if the shareholder is a company that holds at least 10% of the voting rights of the German corporation. According to the DTT, in any other cases, the tax burden amounts to 15% (plus solidarity surcharge). Under certain conditions, it is possible to achieve a full tax exemption in case a shareholder is a company that has held at least 80% of the voting rights for the last 12 months. However, Germany has enacted anti-avoidance provisions, which may lead to a higher withholding tax rate. The standard withholding tax rate amounts to 26.375%. The DTT relief will be granted if the foreign shareholder passes a “business purpose test”. These provisions aim at preventing “treaty shopping structures”. Although they do not affect most of the US investments or acquisitions, this aspect should be considered thoroughly.
Capital gains accrued due to a sale of shares held by a US based shareholder in a German corporation are only taxable in the USA.
Interest payments on loans are generally only taxable in the USA . In Germany, interest expenses are generally deductible if the annual interest amount will be less than EUR 3 million. This also applies to shareholder loans. Otherwise, the interest barrier provisions will apply and will limit the deductible amount.
Tax losses can be carried forward but will be forfeited if more than 50% of shares in a corporation owning these losses are transferred. In an acquisition scenario, it is advisable to use a structure which preserves tax losses carried forward to a maximum extent. In most M&A transactions in Germany, a buyer will not compensate the cash value of tax losses to a seller.
In many cases, a tax driven acquisition structuring is recommendable.
Sales and purchases in Germany are generally subject to German VAT with a tax rate of 19%. The tax rate is reduced to 7% for certain products, such as groceries. Please note, that entrepreneurs generally can claim input tax in the same amount wherefore German VAT has no economic impact on entrepreneurs.
Setting up a branch or a PE should generally not trigger German VAT.
While the purchase of shares is VAT-exempt in Germany, the purchase of assets is subject to German VAT. When purchasing an entire business, such purchase is generally tax-exempt.
Due to a new provision in the German VAT code, online market place providers may be held liable for VAT, if not properly remitted to the German tax authorities by the online market place participants.
4. European Holding?
Holding structures often work with an interposed English Ltd., a Luxembourg S.à r.l. or a Dutch B.V. between an American corporation and a German corporation, being the local operating entity.
At first sight, this appears tax-effective: Due to the European Parent-Subsidiary Directive implemented in the German Income Tax Code dividend payments distributed by a subsidiary to its parent company within the European Union shall be tax-exempt. The German Income Tax Code requires that the parent company holds at least 10% of the subsidiary and is domiciled in another EU member state. The parent company can be tax-exempt in such EU member state.
Factually, the subsidiary can apply for an exemption certificate to achieve the tax exemption. Such exemption certificate has to be presented by the parent company in the course of an application towards the competent tax authority. Otherwise, the subsidiary has to withhold and pay the withholding tax of in total 26.375%, which the parent company has to reclaim in a second step.
A second glance reveals a practical issue though: A foreign entity – regardless of whether EU or US based – cannot claim the reimbursement if such entity does not have a sufficient tax relevant “substance”. The requirements for sufficient substance, e.g. an office space, employees and a factual economic activity, are currently not completely clear. Therefore, we recommend planning such tax structure in advance to avoid any tax detriments related herewith. In essence, interposing a shell company would not work.
The treatment of capital gains from a German tax point of view depends on the applicable DTT and on the domestic participation exemption. The aforementioned anti-abuse provisions do not apply to capital gains.
Even without any treaty relief, Germany offers a 95% tax exemption on domestic share transfers (not applicable to transfers of partnership interests or assets). Therefore, implementing a German holding company is a simple and efficient tax structure.
5. US-Flip – Dos & Don`ts
If a German entity, e.g. a start-up formed as a GmbH, shall be financed by US based investors and converted into a US-entity for that purpose, a so-called “US-flip”, certain factors should be considered from a tax perspective.
Example: Three German resident individuals set up a GmbH. Two years later, a US based VC fund wants to invest in the GmbH (pre-money valuation EUR 10 million). For several reasons, the VC fund requests the founders to interpose a US-entity for it to invest the funds through such US-entity. Typically, the founders are recommended using a US Delaware C Corp. Hence, the founders would have to create this US-entity and exchange their shares in the GmbH against receiving shares in the US-entity.
The German tax law starting point is that a share swap is a fully taxable event. Each of the three shareholders will be treated as if he/she had sold his/her shares at fair market value. This generates taxable income; illiquid though as it cannot be partially used to pay off the resulting tax duty (also known as “dry income”). The tax rate will amount to approx. 28%. Hence, the three founders would have to pay approx. EUR 2.8 million in cash to satisfy the resulting tax burden.
Some founders would seek to resolve this by relying on a low valuation for German tax purposes. This approach implies a number of considerable risks, indirectly affecting also the VC fund. Depending on the concrete situation, there may be feasible structures to avoid dry income.
What we note in this framework is a general trend that fewer US based VC funds require a US-flip for their non-US investments and more of them gain experience with directly investing in non-US-entities. This is in particularly true for Germany, where the standard US flip would not be an obvious founders’ choice, and the investor may, at the same time, generally trust that its investment is embedded in a reliable legal environment.