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C a nlss20.Alrgt eevd a nlssde o li oyih naypbi oano hr at content. party third or domain public any in copyright claim not does Analysts reserved. rights All 2007. Analysts Tax (C)

Volume 47, Number 6 August 6, 2007

Germany’s Tax Regime: A Response to U.S. Check-the-Box Regs?

by Wolfgang Kessler and Rolf Eicke

Reprinted from Tax Notes Int’l, August 6, 2007, p. 587 (C) 2007. All rights reserved. does not claim copyright in any public domain or third party content. Featured Perspectives

Germany’s Partnership Tax Regime: A Response to U.S. Check-the-Box Regs?

by Wolfgang Kessler and Rolf Eicke

new rule. Maybe it is impossible for lawmakers to Wolfgang Kessler is the director of the tax avoid a -off between less complexity and more department of the and economics fac- tax neutrality among and corpora- ulty at the University of Freiburg and a part- tions. Rules that provide for more tax neutrality ner with Ernst & Young in Freiburg, Germany. almost automatically bring more complexity; it’s a However, the views expressed here are entirely vicious circle. his own. Rolf Eicke is his assistant at the tax From the perspective of a German shareholder or department of the University of Freiburg. partner, the different technical treatment for tax E-mail: [email protected] purposes would not be a major problem if the tax and [email protected] rates and the overall tax burden were similar. Yet this is by no means the case. Partners in Germany are taxed at their individual progressive income , while shareholders are taxed on half of their ou can’t blame everything on the Romans. Even income (Halbeinkuenfteverfahren) after the Ythough they introduced the legal framework of distributing is taxed at about 38.68 partnerships and in Germany and far percent (, trade tax, and solidarity beyond, the reason why the taxation of partnerships surcharge). is so complex is not their fault. Put simply, once Under the current regime, measuring the perform- individuals with different characteristics are taxed ance of one legal form over another is impossible based on their business activities and only on a unless one has scrutinized the individual situation single level, the complexity begins. of the shareholder or partner. According to the Time and again, tax jurisdictions target this com- current regime, a partnership is the better choice if plexity by attempting to assimilate the tax burden of the owner has a low marginal tax rate or if the partnerships to that of joint stock companies and company distributes all profits. The total tax burden their shareholders. Yet history proves that instead of on income from a corporation that distributes all pouring water on the fire to alleviate complexity, profits is currently higher than 50 percent. That is lawmakers use oil. A prominent example is the one of the reasons why 80 percent of all German introduction of the check-the-box regulations in the companies are partnerships. . Another one is the new German Nonetheless, the concern regarding partnerships preferential treatment of retained partnership prof- has been the improvement of international competi- its (Thessaurierungsbegünstigung). One questions tiveness by increasing the equity quota of partner- whether the most sophisticated works of Johann ships and the establishment of tax neutrality be- Wolfgang von Goethe are easier to grasp than this tween the legal forms. The latter means that for tax

Tax Notes International August 6, 2007 • 587 Featured Perspectives (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. Figure 1. Partnership Taxation of Retained Profits Withdrawal Profits Contribution Excess Withdrawal

Order of Withdrawal 1 22 Preferred First Step: Non- 29.8% Retained Profits preferred Reserves Old (e.g. tax- Reserves Final exempt With- foreign PE Second Step: profits) 26.375% drawal Tax

purposes, it should not matter whether the to be incorporated in section 34a of the is a corporation or a partnership, or whether the Act and to enter into force on January 1, 2008. company is financed with or equity. Currently, In a nutshell, the new regime of partnership in a comparison of the ownership of partnerships taxation for retained profits would involve two steps. (with corporations at the top end of the tax scale), (See Figure 1.) First, the preferred profits would be there is a gap of 7.5 percent in favor of partnerships. taxed at a low preferential tax rate. Second, perhaps Hence, one thing that cannot be derived from these after many years, upon withdrawal, those preferred figures is the need for more beneficial partnership profits would be subject to a final withdrawal tax. taxation. However, against the background of the Individual partners with a minimum of major corporate tax rate cut in 2008 from 25 percent 10 percent are taxed at the preferential rate to 15 percent, the tax treatment of partnerships had of 29.8 percent, including the solidarity surcharge to catch up. for retained regular income from partnerships. They can choose what percentage of the retained profits New Regime should receive the preferential treatment. The ben- eficial treatment does not extend to such tax-exempt To reconcile the overall tax burden of partners profits as those from a foreign permanent establish- with corporate shareholders, the legislature will en- ment. act a comprehensive set of rules, which are not easy On withdrawal of the tax-preferred income, the to grasp at first glance. The new regime is expected individual partner will be taxed at 26.375 percent,

588 • August 6, 2007 Tax Notes International Featured Perspectives (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content.

Figure 2. KG Model

Equity

100% 100%

0% 0%

including the solidarity surcharge (final withdrawal rent tax planning measure is to take out these old tax). This is the rate at which of indi- profits before the new regime enters into force. Yet vidual corporate shareholders will be taxed begin- this order does not apply regarding withdrawals for ning in 2009 by way of a flat and final tax (Abgel- purposes of estate and gift taxation. tungsteuer). Importantly, the withdrawn partnership profits Winners and Losers are subject not to the , but to a procedure that is similar. We emphasize this fact On average, the advantage of choosing the pref- because there is a frequent misconception in Ger- erential tax rate is about 11 percent to 18 percent, man literature. The major difference between the depending largely on three things: the individual tax final withdrawal tax and the final tax in terms of the rate of the partners, how the company is financed, Abgeltungsteuer is that the latter provides the op- and how much income is retained. According to portunity to the taxpayer to choose an assessment. government figures, the preferential tax treatment of partnerships decreases revenue by €4 billion per On withdrawal, the current profits are deemed to year. We believe the revenue loss will be higher. be withdrawn first; therefore, the profits from non- preferred income or old reserves are only second in For big partnerships, with partners taxed at the line and cannot be withdrawn without triggering the top end of the individual income tax scale, the final taxation. If the partnership follows the wrong preferential treatment is always the better choice. withdrawal policy, some ‘‘old’’ profits will be trapped. Even though on aggregate, the preferential tax rate Because of this statutory order of withdrawal, old plus the final flat tax is higher than if the profits retained profits are locked in. Accordingly, the cur- were withdrawn in the first place, this disadvantage

Tax Notes International August 6, 2007 • 589 Featured Perspectives will be compensated by timing effects and com- income equals the total trade tax of the (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. pounded interest advantages. partners. In that case, the partner’s income tax If the partner is not in the top income liability would be eliminated by the simultaneous — that is, an individual marginal tax rate of below funneling of a maximum share of profits to the 29.8 percent — the new regime is not advantageous. low-taxed GmbH. However, one of the prerequisites If the individual marginal tax rate of a partner is 30 is that the KG must have high and stable profits to percent, profits must be retained for almost 50 years make this structure successful. To avoid the accrued for benefits to be derived under the new regime. capital of the GmbH being subject to full liability, a second GmbH can be implemented as a limited In sum, the preferential tax rate on retained partner. partnership profits is more beneficial: Above and beyond the KG model, all tax planning • the higher the marginal tax rate of the partner has to focus on the avoidance of the final taxation on is; withdrawal to receive a tax-efficient result. From a • the higher the interest advantage is compared group tax planning perspective, the new regime to a private investment; and motivates to establish two different units. • One unit retains profits and another unit distributes the longer the period of retention lasts. them. Further, tax planning considerations have to The new regime has managed to bring about a pinpoint and assess how the retained profits can be fairly equal taxation regardless of the underlying reinvested: either in the company operations or in legal form. It slightly erodes the dualism between investments that are subject to the new flat and transparent and nontransparent taxation and its final withholding tax (Abgeltungsteuer) of 25 percent different consequences for tax purposes. The advo- plus the solidarity surcharge. cates of the diversity justified this different treat- Also, the new low preferential tax rate brings ment by saying that shareholders and company about a major planning problem for U.S. investors. assets are separated in a corporation whereas they By retaining partnership profits, they risk creating are linked to each other in a partnership. The excess tax credits. Most importantly, the crucial and German Federal Tax Court recently upheld this still unanswered question is to what extent the final view, ignoring that the underlying company has withdrawal tax can be credited against the U.S. tax already accepted a separation between company liability according to both the double and assets and partners, distinguishing between a com- national law. A U.S. investor has three questions to pany and a private sphere. consider: • Planning Proposals: The KG Model How is the partnership income qualified? • If the final withdrawal tax is levied many years The best of both worlds can be achieved with the later, what is the effect for the crediting? KG model. (See Figure 2.) The advantages of a low • Is the new preferential treatment of retained tax rate for corporations (here, GmbH) and the partnership profits considered a branch profits possibility of crediting the trade tax against the tax for U.S. tax purposes? income tax of the partners in a partnership (here, KG) can be combined. In this model, individuals hold 100 percent of the shares of both a GmbH and Conclusion a KG, of which they are limited partners. The GmbH At the top end of the tax scale, the difference in serves as a general partner of the KG to limit the taxation between a partnership and a corporation liability but has not contributed any capital to the will decrease from 7.5 percent to 0.83 percent in KG. favor of the partnership. But if the income tax rate is If the partners endow the GmbH with equity (for not in the highest tax bracket, a partner will in most example, old retained earnings), the latter can per- cases be better off than a shareholder. However, a form both a liability limitation function and a fi- general statement concerning the taxpayer group nance function by granting to the KG. The that is not at the top end is not possible because advantage is that the interest payments of the KG there are several options to choose from, including alleviate its income, and the interest income is taxed these two: First, partners in the middle tax bracket at the low corporate tax rate of 15.825 percent, will not choose the new preferential treatment of including the solidarity surcharge. Figuring that the partnership income; second, at the lower end of the preferential tax rate for retained partnership profits individual income tax scale (meaning a marginal tax is 29.8 percent, the advantage of this structure is rate below 29.8 percent), corporate shareholders will 13.975 percent. Moreover, the complete trade tax elect the instead of the new flat , which can be used to set off the partner’s withholding tax. individual income tax liability, rests with the part- In the end, the new partnership taxation in Ger- ners. Perfectly planned and implemented, the KG many is only a response to the U.S. check-the-box

590 • August 6, 2007 Tax Notes International Featured Perspectives regime insofar as it also targets unjust tax treat- for a while makes a partner of a big partnership feel (C) Tax Analysts 2007. All rights reserved. does not claim copyright in any public domain or third party content. ment of partnerships compared with corporations as if he is taxed like a corporate shareholder. We and vice versa. It does not change the transparent endorse this new regime as a means to enhance both nature of a partnership for tax purposes. Plus, the tax planning and the international competitiveness new partnership regime in Germany is not an option of German partnerships. Exploiting the new oppor- that leads to a binding classification for at least a tunities for partnerships might very well be a re- couple of years. Rather, it is a sole ‘‘tax-rate option,’’ warding avenue in the tax structure road map. ◆ for it grants a lower tax rate for retained profits that

Tax Notes International August 6, 2007 • 591