The 2009 Annual Tax Act has changed the tax treatment of non-resident corporations generating income from renting out immovable properties in Germany (sec. 49 para. 1 no. 2f aa German Income Tax Act (ITA)). According to the new provision, ongoing rental income is qualified as German-sourced business income (instead of so called income from rent and lease) if it is generated by a foreign corporation. The new rule came into effect on January 1, 2009.
Before this recent change in law, only gains resulting from the sale of German immovable property by a foreign corporation were qualified as business income.
As the annual statements and tax returns for the fiscal year 2009 have to be filed by the end of this year, the described changes have to be applied now. In the following, possible advantages of the new provision shall be described; but it must be pointed out that there are many areas of uncertainty on how to put those changes into practice in day to day accounting. Due to the fact that the new provision has only been in force since 1 January 2009 there have been no court rulings or fiscal decrees on this issue – yet. The issues outlined in the following therefore are based on the prevailing view in literature and the (non-binding) information given by a member of the Federal Ministry of Finance.
Consequences
(i) Income determination
As a result of the qualification of rental income as business income, a different income determination method has to be applied. For business income, there are two different methods to determine taxable income: The balance sheet method and the cash flow method. Sec. 140 and 141 of the General Tax Code (GTC) specify which companies are obliged to use the balance sheet method. The prevailing view in literature is that foreign companies are only obliged to use the balance sheet method if they have a permanent establishment or a permanent representative in Germany. Since most foreign corporations renting out immovable property in Germany neither have a permanent establishment nor a permanent representative, they – according to this view – can choose between the balance sheet method and the cash flow method. However, the view of the Federal Ministry of Finance on this issue seems to be different. It is assumed that Sec. 140 GTC does apply and therefore the application of the balance sheet method is compulsory.
Even though the member of the Federal Ministry of Finance could not give us certainty on the view of the Ministry – which is currently trying to coordinate the finance ministries of the federal states and to prepare a decree on this issue – his view should be taken as a good indication on the views the Ministry may hold. To be on the safe side one should therefore consider using the balance sheet method which – as will be shown below – will in the most cases be advantageous anyway.
(ii) Valuation and tax treatment of the building
a) Valuation/depreciation base
The transformation from rental income to business income results for tax purposes in the transfer of the immovable property from the private to the business sphere which would usually be treated as a capital contribution at fair market value. However, the prevailing view on this issue is that the immovable property already entered the business sphere when the foreign corporation bought the rental object, since the immovable property was always – even before the change in law – considered to be a business asset for taxation purposes at the time of its sale. Therefore, the book value of the immovable property does not change due to the change in the qualification of the rental income as business income. Hidden reserves do not have to be disclosed.
According to the prevailing view, the depreciation base changes. The new depreciation base is the historical cost of the immovable property less the depreciation deducted up to 2009.
Example
A building was purchased at a purchase price of €1,000,000.00
(not including land) in November 2006; depreciation rate 2 percent:
Acquisition costs 1,000,000.00
Depreciation 2006 3,333.33
Depreciation 2007 20,000.00
Depreciation 2008 20,000.00
Book value on 1 Jan 2009 956,666.67
Deprecation from 1 January 2009 on will be accomplished from a depreciation base amounting to €956,666.67.
b) Depreciation rate
In case the immovable property is rented out for private residential use only, the depreciation rate does not change and depreciation continues at a rate of two percent per year, but from the new depreciation base.
In case the immovable property is rented out for other purposes than private residential use, the depreciation is now conducted at a rate of three percent per year, again from the new depreciation base. The reason for the increase in the depreciation rate is the change in the qualification of the generated income.
Transfer of hidden reserves
Under certain circumstances German tax law allows tax payers using the balance sheet method to transfer hidden reserves from one asset (e.g. land and buildings) that has been sold, to a similar new asset the taxpayer might acquire in the future. This avoids the realisation of hidden reserves from a sale and therewith a tax burden on capital gains.
However, sec. 6b and 6c ITA state that this possibility only exists for assets that are part of a German permanent establishment. However, the prevailing view in literature is that this provision does not comply with European law, since it discriminates foreign companies in comparison to domestic ones. In case a foreign corporation owning immovable property in Germany does consider selling the real estate at some point in time and to re-invest the cash in a new project in Germany it may be possible to do so free of tax. As long as this issue has not been ruled over by a court ruling or fiscal decree, we would suggest filing for a binding ruling at the competent tax office before such sale and re-investment measure.
Write-down to fair value
If taxable income is determined with the balance sheet method, assets can be written down to their fair value, if the asset’s fair value is expected to remain below the book value. If in the future and against the prognoses at the time of the write-down, the value of the asset increases again, the asset has to be revaluated up to its new fair value, as long as the new fair value is below the historical cost less accumulated depreciation. However, there is a minor view in literature which denies the application of the write-down.
Trade tax
There are no implications for German trade tax. The qualification of the rental income as German-sourced business income does not trigger trade tax. As previously, trade tax only applies for profits derived through a German permanent establishment. In general immovable property in Germany does not constitute a permanent establishment in the sense of the German Trade Tax Act.
Interest barrier
There is no consensus on the issue whether the interest barrier applies for income generated by a foreign corporation in Germany that does not undertake its business activities through a permanent establishment. In case a concerned foreign corporation’s interest burden per year does not exceed the threshold of €3,000,000.00, the interest barrier is not applicable anyway.
Conclusion
As a result it can be said that foreign companies generating rental income in Germany will have to use the balance sheet method for the determination of its taxable income, once this is demanded by the tax authorities. Changing the income determination method from the currently used cash flow method to the balance sheet method straight away, i.e. for the year 2009, may be advantageous for the following reasons:
– The balance sheet method results in an advantage with regard to liabilities, deferred income, accruals (e.g. for management fees, interest) and provisions exceeding receivables and deferred expenses, since only when the balance sheet method is applied, the former can be deducted from taxable income.
– Write-downs on the fair value can only be deducted from taxable income if the balance sheet method is applied.
– Should the change of the income determination method result in a loss for the fiscal year 2009, this loss can be carried forward and set off with future profits.
– In many cases the figures determined through the cash flow method for German tax purposes have to be coordinated with the consolidated accounts of a group. This is usually very time-consuming. After switching to the balance sheet method, the figures can simply be copied into the consolidated accounts. This is easier, quicker and therefore cheaper even though the change in the income determination method requires a transitional calculation, which may trigger additional costs. Due to the savings and advantages described above those additional costs should easily be balanced.
Hemmelrath & Partner/Marccus Partners, is a professional partnership of lawyers and tax advisors, offering tailored solutions to entrepreneurs and decision makers, with cross-border investments as their core area of practice.
