The German Government recently issued a draft bill titled the ‘Corporate Income Tax Modernisation Act’ (German version (PDF)/unofficial English translation (PDF)). If adopted it will, among other things, implement a much discussed structural change in the treatment of German partnership structures for income tax purposes.
Under the new regime, partnerships will be able to opt in to elect to be treated as ‘opaque’, ie regarded as corporate entities, and as a result will be treated as taxable persons under the German Corporate Income Tax Act (CITA). This proposed change will be highly relevant not only for Germany-headquartered companies, but also for inbound investments into Germany. Although the legislative process is still ongoing, the proposed changes are significant enough to warrant early examination.
Paradigm shift in German partnership taxation
Partnerships are in principle treated as fully transparent for German income tax purposes. This concept of full transparency goes as far as to treat certain parts of the assets and income of the individual partners as deemed assets and income of the partnership (Sonderbetriebsvermögen). This is considered to be a peculiarity in the German rules that often results in frictions in a cross-border context as follows:
- Many other countries do not have a system of deemed assets and income of the partnership (Sonderbetriebsvermögen) and some regard partnerships as opaque for tax purposes.
- Such differences in the tax treatment often lead to mismatches in cross-border matters regarding the functional attribution of profits, losses and assets.
- Differing classifications of partnerships as transparent or opaque for tax purposes can result in the risk of double taxation.
However, there are both tax and non-tax arguments for international inbound investors to choose German partnership structures, including for example whether the repatriation of profits from a partnership attracts withholding tax obligations or not and the fact that broader legal requirements, including employee rights and obligations, apply to corporate structures, just to name a couple.
If the Corporate Income Tax Modernisation Act comes into force, German partnerships will, in the future, be able to elect whether to be treated as fully tax-transparent entities or as opaque entities subject to corporate income tax. Even though partnerships with a German permanent establishment have always been subject to German Trade Tax, the ‘opt-in’ election model will also impact the wider treatment of partnerships under the German Trade Tax Act, for example as regards profit determination and the ability to transfer losses on a change of ownership.
Key aspects of the new partnership opt-in election model
Requirements for exercising the opt-in election
In principle all partnerships that qualify either as commercial partnerships as set out in the German Commercial Code or as partnerships as defined in the German Partnership Act (eg limited partnerships – Kommanditgesellschaften) and comparable foreign partnerships can elect to be treated as opaque under the proposed new rules. Only those partnerships that do not fall with the scope of these definitions such as civil-law-partnerships (Gesellschaft bürgerlichen Rechts – GbR) and investment trusts falling within the scope of the German Investment Tax Act (Investmentsteuergesetz – InvStG) are not able to make this election.
Partnerships with a place of management outside of Germany can only elect to be treated as opaque if they are also treated as opaque for income tax purposes under the tax laws of their country of residence as a consequence of making the German opt-in election. This condition could lead to interdependencies between the German partnership election model and the US entity classification regime (which already incorporates a well-established ‘check the box’ election regime).
To be effective, an opt-in election application must be filed with the relevant German tax office dealing with the partnership’s tax affairs in advance of the tax period to which the opt-in election is intended to apply. It is proposed that an ‘opt-out’ election will also be available, in which case the partnership will revert to being treated as fully transparent for income tax purposes. (The draft bill does not currently require a minimum opt-in period.)
Key legal consequences of an election
The election to be treated as opaque for German income tax purposes rather than fully transparent has various consequential legal impacts at the level of the partnership itself, as well as on the tax treatment of the ‘shareholders’ (that is the former partners) in the partnership (this is discussed in further detail below).
Main legal consequences for the partnership
The opt-in election will result in a deemed change of the legal form of the partnership for the purposes of the German Reorganisation Tax Act (Umwandlungssteuergesetz – UmwStG), although the partnership will otherwise retain its partnership status. This will take effect from the end of the last tax year before the opt-in election is made. The same applies in case of an opt-out election or where a partnership no longer satisfies the legal requirements for an opt-in election.
The German Reorganisation Tax Act generally treats the change of legal form from a partnership to a corporation as a contribution of the interests in the partnership to a corporation, which would also be the deemed effect of the opt-in election. The main tax consequences of this include a forfeiture of certain tax attributes and, depending on the individual values and circumstances, a capital gain at the level of the partnership.
A change of the legal form from a corporation into a partnership is generally treated as a merger of a corporation into a partnership – this would also be the deemed effect of an opt-out election. The main consequences include (again) a forfeiture of certain tax attributes and – depending on the individual values and circumstances – a capital gain at the level of the partnership.
Subject to certain requirements, in the case of either an opt-in or an opt-out election, the partnership might prevent a capital gain from being triggered by opting for a roll-over of the tax book values – as is possible in the case of a ‘real’ change of legal form. In contrast to a ‘real’ change of legal form, however, neither the opt-in election nor the opt-out election can be exercised retroactively.
Main legal consequences for shareholders
The deemed changes of the legal form for income tax purposes described above will also have consequences at the partner level, which are similar to the tax effects of a contribution of shares into a corporation (in the case of an opt-in election) and a merger of a corporation into a partnership (in the case of an opt-out election), including:
- in case of an opt-in election, the shareholder receives so-called ‘tainted shares’, which are subject to taxable contribution gains in the event of a subsequent transfer or similar event during a vesting period of seven years; and
- in case of an opt-out election, certain parts of the partnership’s equity are treated as having been distributed to the shareholders and are subject to dividend taxation at the level of the shareholder.
In addition, the individual taxation status of the ‘partnership shareholder’ will undergo substantial changes from the time the opt-in election is effective. These include the following:
- The interests in the partnership will cease to be treated as a stake in a co-ownership vehicle; instead they will be treated as a share in a corporate entity – this will have substantial effects for German capital gains tax purposes (eg (partial) exemption or reduced rates apply);
- The partnership’s distributions will be treated as dividends subject to withholding tax and capital income taxation at the level of the shareholder (eg (partial) exemption or reduced rates) – whereas, in contrast, distributions received from a transparent partnership are in general tax neutral (as a consequence of being subject to tax at the level of the shareholder);
- Remuneration paid by the partnership to a shareholder for management services on an arm’s-length basis will not be treated as business income and will instead be regarded as employment income subject to applicable payroll taxes; and
- Interest on shareholder loans on an arm’s-length basis will qualify as capital income and rents received for assets leased to a partnership will in principle qualify as rental income, whereas under a transparent taxation regime, these amounts are treated as deemed business income.
Partnership election model opens up structuring possibilities
If the proposed opt-in election model is implemented in practice, new domestic and cross-border structuring possibilities will become available. The often favourable German legal framework for partnerships can be used if legally and/or operationally beneficial while at the same time offering the tax benefits of being treated as a company (ie opaque) for German income taxation purposes. This includes:
- The tax treatment of a company is often beneficial when earnings are to be retained in the company: undistributed income is taxed at a comparatively low rate (approximately 30 per cent) at the company level while income of a tax-transparent partnership is generally taxed at the normal income tax rate at the level of the partner (up to approximately 48.5 per cent). Where a partnership elects to be treated as opaque for tax purposes, as is the case in a company/shareholder structure, a tax charge at partner level will only arise (at a reduced effective rate) when there is a distribution from the partnership;
- Tax transparency-related entity-classification conflicts, which (at least after Germany has introduced anti-abuse rules to avoid double-dip structures and the upcoming implementation of the ATAD hybrid-mismatch rules) are often a reason for tax inefficiencies, cross-border disputes and an imminent danger of double taxation, should become less common; and
- Investors will no longer have to choose between the potentially more beneficial tax treatment of a corporate structure versus the operational/non-tax advantages of a partnership structure (including less onerous, wider legal requirements as regards employees, a high degree of influence over the ownership structure and a strong level of resistance against hostile takeovers), as the ‘opted-in’ entity will continue to be treated as a partnership from a civil law perspective.
On the other hand, new entity-classification conflicts could arise in cases where a Germany-based partnership elects to be treated as opaque for corporate tax purposes, but at the same time is treated as a transparent partnership in a foreign jurisdiction. The consequential international taxation effects occurring as a result of making an opt-in or opt-out election will need to be carefully analysed on a case-by-case basis.
The German Federal Ministry of Finance recently circulated the draft bill to more than 100 interested associations and requested official opinions on the partnership election model as outlined above. This phase will show whether the current draft could become binding law in the near future. The indicative timetable published by the Federal Government sets out that implementation of the new partnership election model could take place during the current election period, which ends on 26 September 2021.