Word is spreading that Germany is no longer a high tax jurisdiction. Indeed, with an aggregate profit tax rate of slightly below 30 percent, Germany currently has the lowest profit tax rate among the industrialized G7 countries. This places Germany on the same level as countries generally perceived as low tax jurisdictions – e.g., Luxembourg.
Few people know that it gets even better in the context of German rental income or capital gains from the sale of Germany’s real property. Low taxation combined with Germany’s comparatively low prices and potential for investment growth are quite an attraction for international property players; this is ample reason to take a closer look at the details as well as tax planning options from the perspective of investors outside Germany – who are heeding the call and have accounted for roughly two-thirds of all property transactions in 2007.
If structured diligently, income from real property is only taxed at 15.825 percent in Germany. It is important to note (i) that this rate applies not only to rental income but also to capital gains, (ii) that offshore investors lacking tax treaty protection are not discriminated against and (iii) that private investors should use a corporate entity as a property holding vehicle – and design the structure with care.
The trick is that the investor needs to avoid being treated as a trading or service business. If that can be achieved, rental income and capital gains will be exempt from German Trade Tax of approximately 15 percent. In effect, such Trade Tax exempt investment income would then only be subject to the 15.825 percent mentioned above in the hands of a non-Germany-based corporate holding vehicle.
Given the drastic tax difference between trading income (approximately 30 percent) and investment income (approximately 15 percent), Germany’s tax authorities are not very relaxed in conceding investment income. Quite the contrary – the tax collector is more than happy to take advantage of the most minimal “technicalities” of the property investment, which may trigger trading-type income. A good example is a recent case in which the investor rented out not only real property for €13,000 per month but also movable property for the minuscule amount of €230 per month. The Supreme Tax Court held that the lease of movable property constitutes trade income and that the investor is thus treated as a trader, making him subject to Trade Tax on his entire income including the rental income.
This case shows that avoiding such pitfalls is crucial in order to take advantage of the low tax rate. The idea is to structure the investment with as many defense lines against trading income as possible. Inter alia, the following should be considered in this context:
- Germany-based or foreign acquisition entity – EU acquisition entities, for example, are protected by various EU legislation from discrimination in Germany. The same is true for taxation, as EU entities enjoy tax treaty protection. In contrast, Germany-based entities are subject to any and all negative domestic tax changes – without being protected by an EU or tax treaty – and thus, are subject to greater risk.
- Generate pure real property income – The case above illustrates what risks are involved in mixed income streams.
- New German thin capitalization regulations – These new regulations restrict interest deductions exceeding 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA). It is important to know that these restrictions apply to any kind of interest whether paid to a shareholder or to a bank. Given the traditionally high leverage used in property investments, parties should carefully consider the new thin cap regulations and take advantage of the prescribed annual interest threshold of €1 million per entity. For example, a leverage of €20 million at an interest rate of 5 percent will be completely disregarded and safe as all interest will be deemed deductible no matter what the EBITDA may be. However, if the interest amount exceeds the prescribed threshold only by €1, the general regime is applicable and the 30 percent of EBITDA rule applies to the whole interest amount. We will likely see a trend of splitting or setting up more entities and single property vehicles because the €1 million threshold applies per company.
- EU holding location – Although not strictly required, the traditional EU entry points for offshore investors have been Luxembourg and the Netherlands. Luxembourg has increased its weight by recently signing a tax treaty with Hong Kong through which many funds including offshore funds are channelled. Cyprus is also a jurisdiction to look at as it typically does not tax foreign-source property income or apply dividend withholding tax on the transfer of profits to an offshore location lacking a tax treaty.
- Transaction taxes – These consist of VAT and real estate transfer tax. The latter amounts to 3.5 percent and 4.5 percent (Berlin) of the transaction value. Tax planning opportunities exist – e.g., if the investor is willing to acquire only 94 percent of a property holding company. VAT needs to be managed with care due to the sheer magnitude of the rate of 19 percent on the transaction value.