What are the options and who can choose?
The option will be available to all partnerships that generate income from business operations, freelance work or agriculture and forestry. As things stand at present, the option would be exercised by the partners passing a resolution. This resolution would have to be adopted unanimously insofar as the partnership agreement did not provide for any other type of majority for transactions beyond the scope of day-to-day business dealings. Subsequently, the legal representatives would have to submit an application to the competent tax office.
The effects of the option
Scope of application
The resolution and the application submitted to the tax office would ensure that for income tax purposes the partnership would be treated like a corporation. The option could be exercised with effect from the end of a financial year and it should be possible to create a short financial year. No impact on other types of tax is expected.
Please note: It should be noted that the term of the option is seven years; it would only be after this period that there would be a possibility to exercise the option to revert back again to being taxed as a partnership.
Notional change of legal form
By exercising the option, the partnership would notionally be turned into a corporation for income tax purposes. In so doing, a situation would be simulated – as in the case of a change of legal form – where the partners would be granted shares in a corporation.
Exception – special business assets
If the partners are natural persons – therefore, neither a corporation nor a partnership – then close attention would have to be paid to the treatment of special business assets. Special business assets are primarily assets owned by a partner and these are made available by the partner for use by the partnership. Examples are let factory buildings and business premises or partner loans.
In the event of the option being exercised, these special business assets would generally be transferred at their fair market value to the private assets. In the case of buildings that a partner lets out to the partnership, the hidden reserves that are realised – the difference between the fair market value and the book value – would consequently have to be taxed. In order to avoid the taxation of hidden reserves it is possible to transfer these assets in a tax-neutral way to the partner’s other business assets.
Regular taxation once the option has been exercised
Classifying and determining income
Once the option has been exercised the principles relating to trade tax and corporation tax for corporations would have to be applied. In accordance with the separation principle, the corporation and the shareholders are independent tax subjects in each case. Contractual relationships governed by the law of obligations (e.g. loan agreements) between the shareholder and the company would now be recognised for tax purposes. This would also apply to the contracts of shareholding managing directors. The income would then no longer be regarded as business income but, instead, as income from employment. Moreover, a social insurance payment obligation could possibly arise.
Please note: A loan that has been transferred to private assets would be deemed to generate income from capital assets for the partner.
Appropriation of profits
In the case of “normal” corporations, profits generally remain in the organisation and are recognised as retained profits in reported equity. It is only when the shareholders explicitly decide to distribute all or part of the profit that capital gains tax (CGT) has to be paid and the net dividends have to be paid out or credited to the shareholder accounts.
By contrast, in the case of partnerships – even after the option has been exercised – it is precisely the other way round. The so-called full distribution principle still applies. As a consequence, the company would have to pay CGT on all the taxed profits and the net dividend would be credited to the shareholder accounts. If there is a desire to retain profits or to strengthen the equity base then, under German company law, there has to be a provision stipulating that the profits – possibly a certain amount – will be credited to a reserve account. Only in such a case would no CGT be levied on retained profits.
Example – A comparison of tax burdens
The following assumptions have been made:
- The partnership generates a taxable profit of € 100,000.
- The following (German) taxes were considered: trade tax (TT) at 13.3%, corporation tax (CT) at 15%, income tax (IT) at a marginal tax rate of 42% and CGT at 25%.
- For reasons of simplicity, tax allowances, church tax and solidarity surcharge were not included in the calculations.
A distinction was made here between three cases:
(1) Taxation without the option – The partnership would pay TT of € 13,300 on the profits and € 86,700 would be credited to the partners’ account. The partners would have business income of € 100,000. The trade tax could be credited against the income tax of € 42,000 and, accordingly, the partners would only pay € 28,700.
Result: After taxes, the partners would have € 58,000 freely available to them while the company would have zero.
(2) Taxation with the option but without profit retention – The partnership would be liable to pay TT of € 13,300 and IT of € 15,000. From the remaining amount of € 71,700, the company would also have to pay CGT of € 17,925. Shareholders would have to pay tax on € 71,700; the tax would be covered by the creditable CGT.
Result: After taxes, the partners would have € 53,775 freely available to them while the company would have zero.
(3) Taxation with the option and with profit retention – The partnership would be liable to pay TT of € 13,300 and IT of € 15,000. € 71,700 could be allocated to reserves.
Result: If the taxed income were retained at the level of the partnership then no amount would be available to the shareholders. It is only once a resolution on the distribution of profit has been passed that capital gains tax would have to be paid and tax would have to be applied at the level of the shareholders – although this tax charge would be covered by the CGT.
Conclusion: The example thus demonstrates that a partnership would not necessarily enjoy tax advantages by opting for corporation tax. The advantage of the option model is that a “company” level is additionally created and if profits are retained then, initially, for each € 100,000 of income approx. € 13,700 less tax would have to be paid and this would be available for internal financing.
International tax law
The principle that a partnership can opt to be treated like a corporation for tax purposes would also apply for German international tax law. Disputes over the classification of income from special business assets can be avoided. Admittedly, the allocation of taxing rights at the level of the foreign shareholder would give rise to questions.
Please note: It remains to be seen what the specific form of the option model will be – this was not yet included in the 2nd Coronavirus Tax-Related Assistance Act – as it is steered through the legislative process. In view of the complexity of the matter, it is likely that this may still take a considerable time.