March 25, 2021
German Government agrees on draft bill introducing “check-the-box” elections for partnerships and further changes
On 24 March 2021, the German Government agreed on a bill implementing a “check-the-box” system for entity classification for tax purposes. With this bill, commercial partnerships (in Germany a KG or an OHG, but not a de-facto partnership) may elect to be treated as corporations for income tax purposes.
The bill also includes further measures. If enacted, the German Reorganization Tax Act would be further globalized. Also, a so-called “contribution solution” would be introduced to reflect tax group book/tax differences. In addition, losses from exchange rate fluctuations in connection with shareholder loans would become deductible expenses.
The likelihood for the proposal’s enactment is generally high. However, given the early stage of the proposal, there may be further amendments within the legislative process. Approval of the Federal Council (Bundesrat) is expected on 25 June 2021.
A new Sec. 1a of the Corporate Income Tax Act (CITA) is intended to enable an application for certain partnerships to be taxed as a corporation and their shareholders to be taxed like shareholders of a corporation. The transition to corporate taxation would be deemed to be a change of legal form within the meaning of the German Reorganization Tax Act (RTA). The mechanism would also allow the ability to reverse the election at a later point in time.
The option to be treated as a corporation must be submitted by means of an application to the competent tax office. Since the filing of the application affects the taxation of all shareholders, all shareholders must agree. However, a three-quarter majority decision of the shareholders may be sufficient, if such a provision is provided in the shareholders' agreement and if the subject matter of the decision (here: the option to check-the-box) is included in the relevant provision. This majority must then amount to at least three quarters of the votes cast. The application shall be made before the beginning of the fiscal year as of which the taxation as a corporation is to apply. A possibility for a retroactive election is not envisaged. The effective date of the election shall be the end of the fiscal year immediately preceding the fiscal year for which the election is filed.
The scope of eligible partnerships is determined by Sec. 25 RTA. Investment funds are excluded. This means that the election is in principle also available for foreign partnerships. However, if the partnership is not subject to corporate income tax in its country of management, the election would not be possible to avoid the artificial creation of foreign hybrid companies. As a result, foreign companies already subject to a tax comparable to German corporate income tax in their country of residence are eligible to file the election.
At the shareholder level, remuneration paid by the company to the shareholder (e.g., interest, rent, wages/salary etc.) is to be treated as such and no longer as advance income allocation/special partnership income (Sonderbetriebseinnahmen).
The draft bill further provides for an option to reverse the election, namely, to return to partnership taxation (transparent taxation principles). The application should be made before the beginning of the fiscal year, as of which the entity is to be taxed as partnership again. “Unchecking” the box shall also be deemed to be a change of legal form pursuant to the RTA and may also not have retroactive effect. Since there is no provision for the exercise of the option for sole proprietors, it is intended that an automatic reversal of the election shall take place without an application if the partnership is deemed to be dissolved upon the withdrawal of the penultimate partner.
The election would be available for fiscal years ending in 2022 or later years. However, it needs to be noted that the election does not affect the treatment for inheritance tax or real estate transfer tax.
Globalization of Reorganization Tax Act
Currently, tax neutral reorganizations of corporations are only possible for European Union (EU)/European Economic Area (EEA) companies in Germany except for specific types of mergers between third-country companies in the same jurisdiction.
The bill foresees a repeal of Sec. 1 (2) RTA without replacement. This effectively removes the requirement that the involved entities are EU/EEA companies for various types of reorganizations, namely:
Consequently, Sec. 12 (2) CITA (specific mergers of third-country corporations in the same country) and flanking rules are to be eliminated, since these mergers would be integrated in the scope of the RTA. Their integration into the RTA goes along with the omission of the requirement that the merger must take place between corporations of the same third country.
Exchange rate fluctuations
Under the current corporate tax rules, losses in connection with shares are not deductible. This also applies to impairments in connection with loan receivables of a shareholder if the shareholder owns at least 25% in the borrower (directly or indirectly) and to impairments arising from certain comparable circumstances.
The draft bill proposes to exclude exchange rate-driven losses from the deduction limitation in the future. This is intended to eliminate the asymmetry that has prevailed to date in the tax treatment of exchange rate gains and losses when determining taxable income (taxability of gains and non-deductibility of losses).
The “check-the-box” system for tax purposes for partnerships represents a further important step towards strengthening the competitiveness of German partnerships. Many family businesses operating successfully on international markets are organized in the legal form of a partnership. However, it needs to be noted that the election does not affect the treatment for inheritance tax or real estate transfer tax.
The “globalization” of the RTA would significantly increase the flexibility for reorganizations involving third countries and Germany. However, the general requirements of the RTA for tax neutral reorganizations still apply.
The long-awaited elimination of the asymmetry that has prevailed to date in the tax treatment of exchange rate gains and losses is a positive development.
For additional information with respect to this Alert, please contact the following:
Ernst & Young GmbH
Ernst & Young LLP (United States), German Tax Desk, New York