Transferring money abroad became a tradition for Germans after World War II. Political instability forced many to divert their assets toward more secure holdings. The post-war revival that followed saw Germany climb the ranks of the world’s strongest economies, but it failed to stem the outflow of cash altogether. The reason: tax rates – among the highest in Europe. But things have just got better for Germany.
Large-scale tax reforms came into force on January 1, 2008. The German Parliament’s decision – criticised in many quarters as not going far enough to enhance economic development – could have a major impact. Domestic businesses and foreign investment should benefit, but there are doubts over whether the reforms have gone far enough.
The 2008 Company Tax Reform Act was essential for many reasons – not least to make Germany more internationally competitive. In the broadest sense, most believe this is where the government has succeeded. The decision to reduce the corporate tax rate from 25 percent to 15 percent is the key. RP RICHTER&PARTNER – one of Germany’s leading tax, audit, accounting and legal service consultants – provides tailor-made solutions to clients with an international approach.
Managing partner Wolfgang Richter, a former senior partner in and head of the tax department at Ernst&Young Munich, welcomes the positive change, but has mixed feelings about other aspects of the reform. “In our opinion the Company Tax Reform Act 2008 is an important step towards a more internationally competitive tax environment in Germany,” he says.
“However, a simplification of the German tax system, which had been planned, did not become reality.”
Complex legal system
If reducing the corporate tax burden was seen as crucial to Germany’s competitiveness, tackling the complex legal system was one of the several requirements that failed to materialise. But it was not all bad. Some simplification was realised following many months of consultation and talks between experts on all sides.
The non-deductibility of the trade tax as business expense, from the trade tax basis and the corporate-income tax basis, was one such benefit. This non-deductibility had no significant impact on the trade tax burden, because the general multiplier to calculate the taxable amount was decreased from 5 to 3.5 (the abolishment of the progressive tariff of the general multiplier for partnerships and sole proprietorships could have an impact on the trade tax burden, but this change will only affect small businesses).
The improvement of this method was that deductibility of the trade tax was such a complex calculation issue. But German tax reform 2008 has been as much about missed opportunities as improvements.
The failure to abolish trade tax – seen as major step towards simplification – is generally perceived as a serious flaw. There is little doubt the predominance of the municipalities, and the anticipated loss of local tax revenue, forced legislators to think again. Numerous transition rules between the old and new also conspired to undermine the anticipated move from old to new, according to experts such as Richter.
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“After much deliberation, the German tax authorities, including the Ministry of Finance, became anxious because they could not calculate the impact of tax revenue loss from the transition rules,” he explains. “Fearing significant losses could have resulted in tax base, simplification failed to materialise.”
Draft publication
Many had feared the worse during the long months leading up to publication of a final draft and the Act being formally adopted by the Bundestag and Bundesrat. Concerns were not just limited to matters of trade tax. Worries surrounded the thin capitalisation rules (so called interest-barrier rule,) which apply not only to shareholder loans but also to any bank loan. The new rules are seen as a significant limitation for high leverage buy outs/investments.
“The tax legislators listened, but made only few changes,” says Frank Schönherr, tax law expert and another founding partner of RP RICHTER&PARTNER. “New rules for shifting of functions and transfer pricing brought quite some disturbances, especially the question of whether the doubling of functions is a taxable shifting of functions.” But while changes to the final draft were small, some amendments were a surprise.
One example was the interest barrier rule. Many businesses successfully raised concerns about the rule, leading to a change. The draft had been tied to the EBIT, but by the latter stages of the legislation process it was aligned to the EBITDA. This led to a higher amount of deductible interest expenses (30 percent of EBITDA is deductible interest expense).
Winners and losers
So who were the major winners and losers from reform? There are two groups of taxpayers that are expected to benefit most:
The first, benefits most from the reduction of corporate tax rate, which was lowered from 25 percent to 15 percent. Taking the trade tax burden into account, the average corporate tax rate was reduced from about 40 percent to 30 percent varying from 23 percent to 33 percent depending on the municipal rate fixed by the municipality (´Hebesatz der Gemeinde´).
Foreign corporations could do even better. Non-resident corporations for example, holding German real estate (PropCos), could under some circumstances be free of trade tax. They will have to calculate with an aggregate tax burden of 15 percent instead of 25 percent. And the losers: highly debt financed companies with low income. This is primarily due to the interest-barrier rule.
“The so called German ‘Mittelstand’ could also be loser of the reform if they do not adjust their structure to the new rules,” says Schönherr. “The Mittelstand is organised generally as the partnerships. “The partnership is liable to trade tax, the individuals holding an interest in the partnerships are liable to income tax. The progressive tax tariff had been increased from 42 percent to 45 percent (so called Rich Tax).” No compensation has been introduced for this increase despite earlier reassurances by the government. To equalise the tax burden of partnerships and corporations, the tax reform introduced a special tax rate for retained earnings of partnerships.
However, if these monies are distributed, the aggregate tax rate on the income derived from the partnership is higher than the taxation of income derived from the partnership at the new top tax rate of 45 percent (plus solidarity surcharge, plus church tax, if any).
Estimates over whether the reforms will result in an aggregate rise in total tax revenues remain in the balance.
“It cannot be excluded that the counter financing of the tax rate reduction through broadening the tax base (new thin capitalisation rules, new add-backs for trade tax purposes) could lead to a higher aggregate tax revenues in total,” explains Schönherr. “But the government is of the (official) opinion that the broadening of the tax base equals the lowering of the tax revenue, resulting from the reduction of the corporate tax rate finally.”
Although Schönherr agrees the impact of reform is likely to be positive, he warns it is impossible to rule out the possibility that broadening might have a negative impact on key sectors of the economy. Real estate investors and real estate leasing companies in particular could suffer from the new interest-barrier rule and the new add-backs for trade tax purposes, he says. Highly leveraged investments are likely to be affected negatively too.
Thin capitalisation rules
There is less doubt about the ‘negative impact’ of the new thin capitalisation rules. When European courts issued a ruling in 2002 declaring German thin capitalisation rules contrary to law, change became inevitable. The first solution of the tax legislators after the Lankhorst-Hohorst case in 2002 was to broaden the scope of application by including loans from domestic shareholders. Due to problems with these early amendments, the Company Tax Reform Act 2008 introduced additional changes to thin capitalisation rules.
The new system applies to any loan irrespective of the status of the lender, as a shareholder or not, and irrespective of whether the lender is a domestic or a foreign one. The effect is that general loans could lead to the non deductibility of interest expenses, according to Claus Lemaitre, international tax partner at RP RICHTER&PARTNER.
“In our opinion many of the unsolved application problems of the old thin capitalisation rules will still arise by the application of the new thin capitalisation rules,” says Lemaitre. “The new rules have a negative impact on the economy in Germany in our opinion because a tax burden could arise even in cases where no positive income is earned by the company.”
The application of the new thin capitalisation rules, flawed or otherwise, meant the legislators did make a significant step towards preventing a shift of interest to foreign countries. But alongside the changes of the add-backs on trade tax, thin cap’ rules will have the most affect on how companies operate in future.
Worrying changes
Changes of the rules regarding the loss of loss carry-forwards have proven a worry too. “This new rule will lead to many unexpected tax issues in the M&A and restructuring context,” Mr Lemaitre says. The write-offs of shareholder loans were ruled by changes of the Tax Act 2008 ‘Jahressteuergesetz 2008’.
In many cases shareholder loans can no longer be written-off. The German tax authorities’ description of this ‘change’ as a ‘clarification’ has not been universally accepted.
“In our opinion and in the opinion of many other tax practitioners the change is not a clarification but the implementation of an unfavourable new rule,” Mr Lemaitre explains. The legislators will perhaps demur, arguing their reforms have certainly made Germany more attractive to overseas companies looking to invest. As for the domestic market – despite the reform set backs, 2008 could be the year that sees the Germany economy out perform some of its rivals.
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