Types of Business Entities Commonly Used, Their Residence and Their Basic Tax Treatment
Corporate Structures and Tax Treatment
Businesses generally adopt the form of a limited liability company (GmbH) or a joint stock company (AG). These corporations are taxed as separate legal entities. The key differences between the two relate to the treatment each receives under commercial law.
Under a GmbH the shareholders are authorised to give instructions to a managing director, there is a low degree of fungibility of shares and there is a wide range of possibilities for the design of the articles of association.
Under an AG a supervisory board and a management board are mandatory, with both operating independently from the shareholders regarding the business decisions. There is personal liability for the management and supervisory board, and there is a high degree of fungibility of shares.
The type of partnership most commonly used for transparent entities is the Kommanditgesellschaft (KG). The KG is most commonly adopted for investment purposes due to its limitation of liability. Only one shareholder (Komplementär) is unlimitedly liable as the General Partner (GP), while the liability of the other shareholders (Kommanditist) is limited to their compulsory contribution. It is also possible to choose a GmbH as the GP; this means that no individual is subject to unlimited liability. This kind of partnership is referred to as GmbH & Co. KG is usually chosen for private equity structures.
According to German tax law, the residence of incorporated businesses depends on the question of where the following are situated: (i) the place of management; and (ii) the statutory/registered seat. Usually, the double taxation treaties provide regulations that the place of effective management is decisive in the case of a double residence of a corporation (the “tie-breaker rule”).
Corporations with a registered seat or place of management based in Germany are subject to unlimited tax liability in Germany. Non-resident corporations are only taxed on their German-sourced income. The income of a corporation is qualified as business income that is subject to corporate tax and municipal trade tax at an approximate total rate of 30%.
The corporate tax rate (including a solidarity surcharge) stands at 15.825%. A special tax rate applies for shares held in other corporations. Dividends received (as of 1 March 2013, only where the shareholding exceeds 10%) and capital gains recognised from the disposal of shares are tax-exempt, although 5% of the proceeds are deemed non deductible expenses, resulting in an effective corporate tax burden of approximately 0.7%.
Municipal trade tax rates range from 13% to 17%, depending upon the municipality the business operates in. For trade tax purposes, capital gains from the sale of shares are generally tax-exempt, whereas dividends received from a German-located corporation are only tax-exempt if the shareholding amounts to at least 15% (or 10% if the shareholding is received from an EU company). However, 5% of the proceeds are deemed non-deductible expenses, resulting in an effective trade tax burden of approximately 0.7%.
However, it is being discussed that the tax exemption for capital gains for corporate income tax, as well as trade tax purposes, will only apply for shareholdings of at least 10% in future.
Partnerships such as a KG are transparent for income/corporate tax purposes so that profits and losses are taxed at the partners’ level. Assets, liabilities and income of the partnership are generally allocated to the partners in proportion to their partnership interests. Municipal trade tax, however, is levied at the level of the partnership (if it conducts a trade or commercial activity).
The taxation of the income of individuals (who own a business or are a partner in a transparent partnership carrying out a business), generated either by themselves or through the partnership, generally depends upon their personal tax rate; tax rates are up to 47.5%, including a solidarity surcharge of 5.5%, and also possibly a church tax. However, dividend payments, as well as capital gains from the sale of shares which are realised in the context of a business, are subject to so-called “partial-income procedures”, so that only 60% of the income deriving from dividends or capital gains will be taxed.
Key General Features of the Tax Regime Applicable to Incorporated Businesses
Calculation for Taxable Profits
As corporations are legally obliged to keep records, they have to determine their income through the comparison of business assets and annual financial statements. Generally, tax accounts depend on the financial accounts according to the principle of “decisiveness” (“Maßgeblichkeitsgrundsatz”). However, there are some deviations of tax accounts from financial accounts, such as the restriction of the application of current value tax depreciation to cases of permanent depreciation, the prohibition of provisions for onerous contracts, and the discounting requirement for long-term interest-free liabilities, with interest at below the market rate.
Where taxpayers are obliged to balance (eg, corporations), profits are taxed on an accrual basis (the “realisation principle”).
Special Incentives for Technology Investments
As yet, there is no specific, comprehensive support for R&D by way of special tax treatment in Germany. However, on 27 June 2019 the German Parliament passed a draft law to support R&D with tax benefits (“Forschungszulagengesetz”). The Federal Government intends to use this to encourage primarily small and medium-sized enterprises to invest more in their own research and development activities. Essentially, all companies are entitled to subsidies, but projects shall benefit only if they fall into the categories of basic research, applied research or experimental development within the meaning of this Act. The subsidy consists primarily of a proportionate reimbursement of the wage costs for the employees of the respective beneficiary. The maximum grant is EUR 500,000.
Other Special Incentives
Germany provides special investment incentives to small and medium-sized companies by way of an additional capital allowance of up to 20% of the original costs and investment, and a deduction of up to 40% of the prospective original costs.
Basic Rules on Loss Relief
Regarding income and corporate tax, loss relief is granted through the application of the following instruments.
Firstly, the positive and negative income of one year is netted.
Secondly, taxpayers may choose to carry back the losses to the previous year, or they may choose to carry forward the losses indefinitely. In the case of carry-back, any losses may be offset against the profits of the preceding year up to EUR 1 million. An offset by way of carry-forward is possible up to EUR 1 million annually without restriction. Regarding negative income that exceeds the EUR 1 million threshold, in each subsequent year only 60% of additional income can be offset against such losses carried forward. The transfer of a share percentage over 50% may result in a total forfeiture of carry-forward not yet offset. These rules exceptionally do not apply if there are hidden reserves taxable in Germany reaching the amount of the carry-forward not yet offset. Furthermore, these regulations do not apply in the case of intra-group acquisitions of shareholdings (ie, group relief). However, the requirements for this are very strict and hard to meet.
A case is currently pending before the Federal Constitutional Court in which it is to be clarified whether the 50% limit is unconstitutional or not. It is likely that this regulation is also declared unconstitutional. In the case of trade tax, trade earnings may be reduced by loss carry-forward; carry-back is not provided. An offset is possible without restriction against losses of up to EUR 1 million; regarding losses exceeding EUR 1 million annually, only 60% of losses may be offset against subsequent trade earnings. The rules regarding forfeiture of carry-forward are the same as for corporate tax.
However, there is another possibility to prevent the forfeiture of the loss carry-forward not yet offset if more than 50% of the shares are transferred. This requires that strict conditions are met cumulatively (eg, time-limited application in the tax declaration, continuation of the same business). Furthermore, no so-called “harmful event” must have taken place (eg, discontinuance of the business, an additional business area is added). When these strict conditions are met, the loss carry-forward not yet offset is determined separately as so-called “accumulated loss carried forward” (“fortführungsgebundener Verlustvortag”) and can be offset against the profits. This accumulated loss carried forward is determined annually. As soon as one of the strict conditions is no longer met, the accumulated loss carry-forward is fully lost unless it is covered by hidden reserves subject to domestic tax.
Imposed Limits on Deduction of Interest
German tax law provides interest barrier regulations. Interest expenses may be deducted without restriction up to the amount of interest income obtained in the same business year; amounts in excess are only deductible up to the amount of 30% of EBITDA. This restriction does not apply if interest income does not exceed EUR 3 million each business year, or if the company is only partially part of a group of companies (“standalone clause”), or if an equity comparison shows an equity equal to or higher than the equity of the group of companies (“escape clause”).
The standalone clause does not apply to corporations in the case of harmful debt financing (interest payable to the shareholder exceeding 10% of such interest payable that exceeds interest income) by shareholders/persons related to shareholders/third parties with considerable influence on shareholders holding more than 25% of shares in the corporation. The escape clause is not applicable in the case of harmful debt financing within the whole group of companies. Interest exceeding the 30% threshold may be carried forward indefinitely, except in the case of the sale of more than 50% of the shares within five years.
Basic Rules on Consolidated Tax Grouping
Consolidated tax grouping (“Organschaft”) enables groups of companies to offset the losses and profits within a group of subsidiaries against the profits of their parent company (and profits transferred to the parent company from other subsidiaries). It requires that:
- the parent company holds the majority of voting rights in the subsidiary;
- the parent company has unlimited tax liability in Germany; and
- a profit transfer agreement has been concluded and executed for at least five years prior.
However, it should be noted that the parent company is also liable for the losses of its subsidiaries.
Capital Gains Taxation
Effectively, 95% of capital gains deriving from the sale of shares in other corporations are tax-exempt, resulting in an effective tax rate of 1.5%. However, from time to time it is discussed that the tax exemption for capital gains will only apply for shareholdings of at least 10% in future.
Other Taxes Payable by an Incorporated Business
If immovable property is transferred, real estate transfer tax (RETT) becomes due. The applicable tax rate depends on the question of where the immovable property is situated in Germany and varies between 3.5% and 6.5%. If at least 95% of the shares in a corporation or, similarly, at least 95% of the partnership interest in a partnership owning real estate situated in Germany is directly or indirectly transferred to one purchaser or a group of related parties then the transaction could trigger RETT. Furthermore, if at least 95% of the partnership interest in a partnership owning real estate situated in Germany is directly or indirectly transferred to new shareholders within five years, RETT could be triggered.
The Annual Tax Act 2019 provides (i) to lower the thresholds to 90%, (ii) to extend the period for partnerships from five to ten years and (iii) to apply that ten-year period to corporations as well. The Federal Government has suspended the implementation of these changes; originally 1 January 2020 was planned, but implementation is now expected at some point in the first half of 2020.
Incorporated Businesses and Notable Taxes
Incorporated businesses are generally subject to VAT; however, they are usually able to claim input VAT as well.
This article was first published in: Chambers, Global Practice Guide Corporate Tax 2020
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