According to 2011 White House figures, US direct investment in Germany has quadrupled since 1989. US exports to Germany support approximately 400,000 US jobs. American headquartered firms employ approximately 700,000 people in Germany. These numbers are likely to increase due to the Trans-Atlantic Free Trade Agreement which is currently being negotiated between the European Union and the US.
However, from a practical point of view, it is impossible to validate these numbers as many investors operate through holding entities in other jurisdictions, such as Luxembourg, Switzerland and the Netherlands.
The preferred investment option should be determined by the individual business strategy. Typical ways for US businesses to invest in Germany are by means of an agency structure or “branch office”, setting-up or participating in a German corporation, and a tax-transparent German partnership structure. International tax treaties, such as the 2008 Double Tax Treaty on income and property taxes between the U.S. and Germany (“Tax Treaty”), need to be considered. In some instances the German tax authorities have difficulties to qualify US entities correctly. This article looks at the structures available and the related tax considerations.
Agency and permanent establishment (not necessarily branch office)
Some US companies choose to start German (and European) operations by hiring one or several individuals based in Germany carrying on their business with job descriptions such as “marketing representative” or “sales representative” without actually renting office space in Germany.
Click here to view diagram.
Example 1: German (permanent) representative
From a German tax compliance perspective such a hire may or may not qualify as a “permanent representative,” thus it becomes a question of whether a “permanent establishment” arises (please see further explanation/information below).
Click here to view diagram.
Example 2: German (permanent) establishment
In another instance, German office space is also rented by the US investor. This raises the question of whether a taxable presence (permanent establishment) can be avoided irrespective of the existence of employment contracts. When setting up a German business presence (e.g. by renting office space) it is not always necessary to register a branch in the German commercial register, as the existence of a registered branch is irrelevant for German tax purposes.
From a practical point of view, a business registration (Gewerbeanmeldung) for business operations in Germany may be required. That procedure normally triggers the involvement of the German tax authorities who will subsequently provide the (potential) new taxpayer with a questionnaire on its tax characteristics.
In both scenarios - permanent representative and permanent establishment - the question is whether a taxable presence is established, consequently triggering tax compliance obligations as well as German tax liabilities. The most relevant German taxes are (i) corporate income tax ("CIT") and (ii) local trade tax ("TT"); whereas VAT should in many cases constitute a transitory item and not trigger a liability for businesses (please see the following sections for current German tax rates.)
Sometimes, such tax liabilities can be minimised or even reduced to zero. For instance, depending on the precise circumstances, if an individual is hired to manage business relationships with customers in Germany, specific wording should be included in the contractual arrangements to minimise the risk of establishing an “agency permanent establishment”.
If premises such as a warehouse or office space are rented, Treaty protection may be available so long as the German establishment only provides preparatory (auxiliary) activities. As the provisions of the applicable tax treaties entered into by Germany are quite similar, this also applies when structure based in another jurisdiction (such as the Netherlands or Luxembourg) is used.
If a permanent establishment in Germany is used, the portion of profit allocated to that establishment must be determined in accordance with the (revised) German tax rules.
German corporation – specifically GmbH
Many investors choose to establish directly (or acquire) a German limited liability company (“GmbH”) for their German business operations.
Click here to view diagram.
Example 3: German GmbH subsidiary
Historically, the founding of a GmbH requires a 25,000 EUR minimum funding and notarization. A Commercial Law Reform in 2008 lowered the statutory minimum share capital to 1 EUR, but certain restrictions still need to be observed. To speed up the process, investors may consider acquiring a shelf-company.
From a corporate perspective, unlike a branch office or other permanent establishments, a GmbH entity offers the benefit of liability being limited to the entity’s registered share capital, thus protecting the shareholder’s (other) assets.
In instances where a business activity in Germany does create a taxable presence (e.g. office space is rented and new customers are actively acquired in Germany), the tax and GAAP compliance obligations are quite similar for a GmbH entity as well as a permanent establishment (please see below).
General business tax and GAAP considerations
I. German business taxes for corporations and permanent establishments (FY 2014)
Profits (i) generated by a German corporation (such as GmbH) or (ii) allocated to a German permanent establishment of a foreign corporate shareholder are subject to German CIT including solidarity surcharge at a flat rate of 15.825%.
Furthermore, these profits are subject to German TT. The tax base for TT purposes may be different from the tax base for CIT purposes due to specific add-backs and deductions as set out in the German TT Act (e.g. add-backs of interest, rent and leasing expenses). Interest payments exceeding a tax free amount of EUR 100,000, for example, are not fully deductible for TT purposes. However, no TT is triggered if the taxable presence consists of a “permanent representative", because TT is only triggered if a “fixed place of business” exists in Germany.
TT is levied by the local municipality. The TT rate depends on the location of the subsidiary or permanent establishment. The minimum rate is 7%. In general, the TT rate is higher in bigger cities like Frankfurt am Main (TT of 16.1%, FY 2014) compared to smaller communities like Eschborn (9.8%), a municipality in the vicinity of Frankfurt am Main.
For both German corporations and permanent establishments, the overall German business tax burden (CIT and TT) amounts to approximately 30%, depending on the applicable TT burden. It is levied on distributed and retained profits alike.
Subsequent profit distributions by a corporation are, to a certain extent, tax-exempted depending on the recipient and upon request fully or partially exempted from withholding taxes (please see III. below).
II. Use of tax losses
CIT losses in a business year can be off-set retrospectively against the taxable income from the previous business year. Claiming such losses retrospectively is limited to an amount of EUR1 million and only to the previous year. Tax losses cannot be used retrospectively for TT purposes.
Both CIT losses and TT losses can be carried forward without any time limitation. However, in the event of a taxable income exceeding EUR1 million in the accounting period, minimum taxation rules apply. Essentially these are, only EUR1 million plus 60% of the current business year’s income exceeding EUR1 million can be off-set against CIT losses carried forward. Thus, when sufficient tax losses are available to carry-forward and off-set against the profits of the next business year, the liability to tax on profits for the following business year may apply to between nil and EUR1 million taxable income with profits in excess of EUR1 million being liable to tax at approximately 12% instead of 30%.
The rules governing the use of German tax losses apply to German permanent establishments and German sub-tier companies (such as GmbH) alike.
III. Taxation of dividend distributions / repatriation of profits
Dividend distributions by German entities to US shareholders (such as the parent company) are in general subject to German withholding taxes (“WHT”) at a rate of 26.375%.
Technically, WHT is a prepayment on the shareholder’s German CIT and dividend payments to US shareholders are not subject to German TT. However, US shareholders (beneficial owners of the shareholding) may benefit from WHT relief under the Treaty. Three types of WHT reductions are available, depending on the facts of the case:
- In general, German WHT on dividend payments to US shareholders shall not exceed 15%.
- German WHT is also limited to 5% if the US shareholder is a company that directly owns at least 10% of the voting stock of the German entity paying the dividend.
- German WHT may be reduced to 0% if the US shareholder (a) holds at least 80% of the voting stock in the German entity (b) for at least 12 months as of the date of entitlement to the dividend and provided that (c) specific other “limitation on benefits”-tests in terms of Article 28 of the Treaty are being met.
US taxpayers must apply for the respective WHT exemption at the German Federal Tax Office (Bundeszentralamt für Steuern). Alternatively, if the dividend distribution has occurred already, US shareholders can apply for (full or partial) refund of WHT with the same authority.
IV. Dividend distributions to hybrid US entities (“S Corporation”)
On 26 June 2013, the German Federal Fiscal Court had to decide on whether a US company, treated as a transparent entity in the US in accordance with subchapter S of the US Internal Revenue Code (“S-Corporation”), was entitled to the reduced WHT rate of 5% under the Treaty for dividends received from a German GmbH (case no. IR 48/12).
The shareholders of S-Corporation were US tax residents (individuals, not companies). The quota of S-Corporation in the German entity’s shares was 50%, which was less than the minimum 80% shareholding required for an entire WHT exemption available under the Treaty.
Click here to view diagram.
Example 4: S- Corporation owning GmbH shares
Hence the issue was whether S-Corporation, transparent for US tax purposes, was still entitled to the reduced 5% rate even though its shareholders were individuals.
The court held that, according to the general Treaty rules on residence, a vehicle transparent for US tax purposes may itself not claim Treaty relief. However, a lack of tax residence of the fiscally transparent S-Corporation was “compensated” by the fact that the income was taxed in the hands of other US residents. The court argued with the wording of Article 1 (7) of the Treaty, according to which for Treaty purposes in case of a fiscally transparent vehicle the income items attributed to its shareholders (resident in the same jurisdiction) are deemed to be derived by that transparent vehicle itself.
This case law is good news for similar WHT exemption procedures for US investors. Unfortunately, during the interim the German legislator has reacted to this decision and amended the domestic German tax law regulations for dividends paid since 1 July 2013. Under the new provisions, only the shareholders of fiscally transparent US vehicles are entitled to Treaty relief. It remains to be seen in future tax disputes whether the German tax courts will accept these revised tax law provisions.
V. Exit taxation
The profit from a sale of shares in a German corporation may be partially or entirely exempted from German taxes.
- Under domestic German tax laws, 95% of the profit from the sale of GmbH shares is exempted from German CIT. This exemption does not currently require a minimum shareholding in the company’s registered share capital. Even though German tax laws do not provide for a minimum holding period to qualify for the exemption, taxpayers should be careful with short-term transactions.
- Treaty protection against German taxation of the profit from the alienation of company shares should generally be available unless the German shareholding of the US shareholder is (a) attributed to a German permanent establishment or (b) the assets of the German company consist wholly or principally of immovable property.
In addition, if 95% or more of the shares in a company directly or indirectly owning German immovable properties are being transferred, German Real Estate Transfer Tax (“RETT”) may be triggered. Local RETT rates vary from 3.5% up to 6.5% of the value of the real estate, calculated according to a specific method. RETT may be triggered even in a scenario where the German property is held by a non-resident corporation. From a practical point of view, RETT is being overlooked in many scenarios where multinationals, consisting also of entities holding German properties, reorganize their group structures, thus amending the direct or indirect shareholding in the company owning the German real property.
German tax transparent - partnership – such as GmbH&Co. KG
For tax reasons as well as non-tax reasons, partnership structures, specifically “limited partnerships” with the general partner being a corporation, play an important role in Germany’s business life. The most prominent example is the GmbH&Co. KG partnership with a (German resident) GmbH corporation being the general partner and (e.g. non-resident) corporations being limited partners.
Click here to view diagram.
Example 5: German limited partnership
Partnerships are transparent for German income tax purposes. The foreign partner’s profits allocated to the partnership’s German business are subject to German CIT at a flat rate of 15.825%.
As the profits are directly taxed in the hands of the partners, no WHT on profit distributions is applicable. On the other hand, profits from the alienation of a partnership interest do not profit from Treaty protection.
Tax Treaty and international tax planning aspects
Some US and other investors choose to implement a European holding entity managing its European subsidiaries. Traditionally, Luxembourg has been a popular jurisdiction basing such a structure.
Click here to view diagram.
Example 6: LuxCo interposition into holding structure
It should be noted that the German tax authorities thoroughly review the substance of Luxembourg shareholders, applying anti-abuse provisions of domestic German tax laws before granting relief under the applicable tax treaties or pursuant to the EU Parent Subsidiary Directive. Further, as of 1 January 2014, a revised tax treaty has become effective between Germany and Luxembourg. In general, the revised treaty challenges traditional structures.
The structuring of cross-border investments in Germany should be consistent with business decisions. Revised domestic tax laws and revised tax treaties must be considered. Indirect taxes (such as RETT) are increasingly significant.
Finally, German tax authorities are not comfortable with offshore structures. Even though a GmbH entity is normally not transparent for German tax purposes, its shareholders may be scrutinized by the German tax authorities although only in specific scenarios, such as (i) dividend payments, (ii) sale of GmbH shares or (iii) in other transactions potentially suitable to repatriate profits / take money out of the company (e.g. by means of “business expenses”).