Germany’s PartnershipTax Regime: A Response to...

Germany’s Partnership TaxRegime: 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

Volume 47, Number 6 August 6, 2007

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

by Wolfgang Kessler and Rolf Eicke

You can’t blame everything on the Romans. Eventhough they introduced the legal framework of

partnerships and corporations in Germany and farbeyond, the reason why the taxation of partnershipsis so complex is not their fault. Put simply, onceindividuals with different characteristics are taxedbased on their business activities and only on asingle level, the complexity begins.

Time and again, tax jurisdictions target this com-plexity by attempting to assimilate the tax burden ofpartnerships to that of joint stock companies andtheir shareholders. Yet history proves that instead ofpouring water on the fire to alleviate complexity,lawmakers use oil. A prominent example is theintroduction of the check-the-box regulations in theUnited States. Another one is the new Germanpreferential treatment of retained partnership prof-its (Thessaurierungsbegünstigung). One questionswhether the most sophisticated works of JohannWolfgang von Goethe are easier to grasp than this

new rule. Maybe it is impossible for lawmakers toavoid a trade-off between less complexity and moretax neutrality among partnerships and corpora-tions. Rules that provide for more tax neutralityalmost automatically bring more complexity; it’s avicious circle.

From the perspective of a German shareholder orpartner, the different technical treatment for taxpurposes would not be a major problem if the taxrates and the overall tax burden were similar. Yetthis is by no means the case. Partners in Germanyare taxed at their individual progressive income taxrate, while shareholders are taxed on half of theirdividend income (Halbeinkuenfteverfahren) after thedistributing corporation is taxed at about 38.68percent (corporate tax, trade tax, and solidaritysurcharge).

Under the current regime, measuring the perform-ance of one legal form over another is impossibleunless one has scrutinized the individual situationof the shareholder or partner. According to thecurrent regime, a partnership is the better choice ifthe owner has a low marginal tax rate or if thecompany distributes all profits. The total tax burdenon income from a corporation that distributes allprofits is currently higher than 50 percent. That isone of the reasons why 80 percent of all Germancompanies are partnerships.

Nonetheless, the concern regarding partnershipshas been the improvement of international competi-tiveness by increasing the equity quota of partner-ships and the establishment of tax neutrality be-tween the legal forms. The latter means that for tax

Wolfgang Kessler is the director of the taxdepartment of the business and economics fac-ulty at the University of Freiburg and a part-ner with Ernst & Young in Freiburg, Germany.However, the views expressed here are entirelyhis own. Rolf Eicke is his assistant at the taxdepartment of the University of Freiburg.E-mail: [email protected] [email protected]

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purposes, it should not matter whether the taxpayeris a corporation or a partnership, or whether thecompany is financed with debt or equity. Currently,in a comparison of the ownership of partnerships(with corporations at the top end of the tax scale),there is a gap of 7.5 percent in favor of partnerships.Hence, one thing that cannot be derived from thesefigures is the need for more beneficial partnershiptaxation. However, against the background of themajor corporate tax rate cut in 2008 from 25 percentto 15 percent, the tax treatment of partnerships hadto catch up.

New Regime

To reconcile the overall tax burden of partnerswith corporate shareholders, the legislature will en-act a comprehensive set of rules, which are not easyto grasp at first glance. The new regime is expected

to be incorporated in section 34a of the Income TaxAct and to enter into force on January 1, 2008.

In a nutshell, the new regime of partnershiptaxation for retained profits would involve two steps.(See Figure 1.) First, the preferred profits would betaxed at a low preferential tax rate. Second, perhapsafter many years, upon withdrawal, those preferredprofits would be subject to a final withdrawal tax.

Individual partners with a minimum interest of10 percent are taxed at the preferential flat tax rateof 29.8 percent, including the solidarity surchargefor retained regular income from partnerships. Theycan choose what percentage of the retained profitsshould receive the preferential treatment. The ben-eficial treatment does not extend to such tax-exemptprofits as those from a foreign permanent establish-ment.

On withdrawal of the tax-preferred income, theindividual partner will be taxed at 26.375 percent,

Figure 1. Partnership Taxation of Retained Profits

Excess WithdrawalProfits Contribution

Withdrawal

PreferredRetainedProfits

Order of Withdrawal

1 2 2

FinalWith-

drawalTax

First Step:29.8%

Second Step:26.375%

OldReserves

Non-preferredReserves(e.g. tax-exempt

foreign PEprofits)

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including the solidarity surcharge (final withdrawaltax). This is the rate at which dividends of indi-vidual corporate shareholders will be taxed begin-ning in 2009 by way of a flat and final tax (Abgel-tungsteuer).

Importantly, the withdrawn partnership profitsare subject not to the Abgeltungsteuer, but to aprocedure that is similar. We emphasize this factbecause there is a frequent misconception in Ger-man literature. The major difference between thefinal withdrawal tax and the final tax in terms of theAbgeltungsteuer is that the latter provides the op-portunity to the taxpayer to choose an assessment.

On withdrawal, the current profits are deemed tobe withdrawn first; therefore, the profits from non-preferred income or old reserves are only second inline and cannot be withdrawn without triggering thefinal taxation. If the partnership follows the wrongwithdrawal policy, some ‘‘old’’ profits will be trapped.Because of this statutory order of withdrawal, oldretained profits are locked in. Accordingly, the cur-

rent tax planning measure is to take out these oldprofits before the new regime enters into force. Yetthis order does not apply regarding withdrawals forpurposes of estate and gift taxation.

Winners and Losers

On average, the advantage of choosing the pref-erential tax rate is about 11 percent to 18 percent,depending largely on three things: the individual taxrate of the partners, how the company is financed,and how much income is retained. According togovernment figures, the preferential tax treatmentof partnerships decreases revenue by €4 billion peryear. We believe the revenue loss will be higher.

For big partnerships, with partners taxed at thetop end of the individual income tax scale, thepreferential treatment is always the better choice.Even though on aggregate, the preferential tax rateplus the final flat tax is higher than if the profitswere withdrawn in the first place, this disadvantage

Figure 2. KG Model

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will be compensated by timing effects and com-pounded interest advantages.

If the partner is not in the top income tax bracket— that is, an individual marginal tax rate of below29.8 percent — the new regime is not advantageous.If the individual marginal tax rate of a partner is 30percent, profits must be retained for almost 50 yearsfor benefits to be derived under the new regime.

In sum, the preferential tax rate on retainedpartnership profits is more beneficial:

• the higher the marginal tax rate of the partneris;

• the higher the interest advantage is comparedto a private investment; and

• the longer the period of retention lasts.The new regime has managed to bring about a

fairly equal taxation regardless of the underlyinglegal form. It slightly erodes the dualism betweentransparent and nontransparent taxation and itsdifferent consequences for tax purposes. The advo-cates of the diversity justified this different treat-ment by saying that shareholders and companyassets are separated in a corporation whereas theyare linked to each other in a partnership. TheGerman Federal Tax Court recently upheld thisview, ignoring that the underlying company law hasalready accepted a separation between companyassets and partners, distinguishing between a com-pany and a private sphere.

Planning Proposals: The KG ModelThe best of both worlds can be achieved with the

KG model. (See Figure 2.) The advantages of a lowtax rate for corporations (here, GmbH) and thepossibility of crediting the trade tax against theincome tax of the partners in a partnership (here,KG) can be combined. In this model, individualshold 100 percent of the shares of both a GmbH anda KG, of which they are limited partners. The GmbHserves as a general partner of the KG to limit theliability but has not contributed any capital to theKG.

If the partners endow the GmbH with equity (forexample, old retained earnings), the latter can per-form both a liability limitation function and a fi-nance function by granting loans to the KG. Theadvantage is that the interest payments of the KGalleviate its income, and the interest income is taxedat the low corporate tax rate of 15.825 percent,including the solidarity surcharge. Figuring that thepreferential tax rate for retained partnership profitsis 29.8 percent, the advantage of this structure is13.975 percent. Moreover, the complete trade taxcredit, which can be used to set off the partner’sindividual income tax liability, rests with the part-ners. Perfectly planned and implemented, the KG

income equals the total trade tax credits of thepartners. In that case, the partner’s income taxliability would be eliminated by the simultaneousfunneling of a maximum share of profits to thelow-taxed GmbH. However, one of the prerequisitesis that the KG must have high and stable profits tomake this structure successful. To avoid the accruedcapital of the GmbH being subject to full liability, asecond GmbH can be implemented as a limitedpartner.

Above and beyond the KG model, all tax planninghas to focus on the avoidance of the final taxation onwithdrawal to receive a tax-efficient result. From agroup tax planning perspective, the new regimemotivates taxpayers to establish two different units.One unit retains profits and another unit distributesthem. Further, tax planning considerations have topinpoint and assess how the retained profits can bereinvested: either in the company operations or ininvestments that are subject to the new flat andfinal withholding tax (Abgeltungsteuer) of 25 percentplus the solidarity surcharge.

Also, the new low preferential tax rate bringsabout a major planning problem for U.S. investors.By retaining partnership profits, they risk creatingexcess tax credits. Most importantly, the crucial andstill unanswered question is to what extent the finalwithdrawal tax can be credited against the U.S. taxliability according to both the double tax treaty andnational law. A U.S. investor has three questions toconsider:

• How is the partnership income qualified?• If the final withdrawal tax is levied many years

later, what is the effect for the crediting?• Is the new preferential treatment of retained

partnership profits considered a branch profitstax for U.S. tax purposes?

ConclusionAt the top end of the tax scale, the difference in

taxation between a partnership and a corporationwill decrease from 7.5 percent to 0.83 percent infavor of the partnership. But if the income tax rate isnot in the highest tax bracket, a partner will in mostcases be better off than a shareholder. However, ageneral statement concerning the taxpayer groupthat is not at the top end is not possible becausethere are several options to choose from, includingthese two: First, partners in the middle tax bracketwill not choose the new preferential treatment ofpartnership income; second, at the lower end of theindividual income tax scale (meaning a marginal taxrate below 29.8 percent), corporate shareholders willelect the tax assessment instead of the new flatwithholding tax.

In the end, the new partnership taxation in Ger-many is only a response to the U.S. check-the-box


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regime insofar as it also targets unjust tax treat-ment of partnerships compared with corporationsand vice versa. It does not change the transparentnature of a partnership for tax purposes. Plus, thenew partnership regime in Germany is not an optionthat leads to a binding classification for at least acouple of years. Rather, it is a sole ‘‘tax-rate option,’’for it grants a lower tax rate for retained profits that

for a while makes a partner of a big partnership feelas if he is taxed like a corporate shareholder. Weendorse this new regime as a means to enhance bothtax planning and the international competitivenessof German partnerships. Exploiting the new oppor-tunities for partnerships might very well be a re-warding avenue in the tax structure road map. ◆



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