New option model for partnerships – Part IV – The option under Section 1a of the ‘KöMoG’ in the light of international tax law
In the previous reports in our series of detailed explanations of the German Act on the Modernisation of Corporation Tax Law (KöMoG) we provided information on the basic principles of exercising the option, the real estate transfer tax aspects as well as the particularities that apply to the treatment of special business assets. In this Part IV we discuss selected international aspects of the option to be treated as a corporation for tax purposes. In the course of this, the circular on exercising the option, of 10.11.2021, which was recently published by the Federal Ministry of Finance (Bundesministerium der Finanzen, BMF), will be taken into account.
Application of double taxation agreements
Partnerships, by virtue of their fiscal transparency, are normally not ‘corporations’ within the meaning of double taxation agreements (DTAs). In such a case, the application of a double taxation agreement has to be on the basis of the residency of the direct or, possibly, indirect shareholders insofar as these are ‘persons’ (i.e., natural persons, companies or associations of persons).
In the view of the fiscal administration, for the purposes of applying a DTA, the company that has elected to exercise the option is a legal entity that is treated as a legal person for tax purposes (cf. BMF circular, of 10.11.2021, margin no. 54). Consequently, it has to be regarded as a ‘corporation’ within the meaning of a DBA. If the place of the management of the corporation is Germany, then, according to the respective DTA, it is also domiciled in Germany.
This strict view, from a German perspective, might not be one that is shared by all countries with whom Germany has concluded DTAs. This could lead to disputes over the classification of specific types of income. In order to prevent the non-taxation of income arising out of this, in the course of the introduction of the option, a new Section 50d(14) was created in the Income Tax Act (Einkommensteuergesetz, EStG) with the aim of ensuring the taxation of dividends and gains from disposals in Germany by way of a treaty override. This means that Germany will implement taxation if the other country makes an assessment that deviates from the one under the German legislation and, therefore, waives taxes.
Capital gains tax relief for foreign shareholders
Under Section 1a(3) sentence 5 of the Corporation Tax Act (Körperschaftsteuergesetz, KStG), the profit shares from a company that has elected to exercise the option will only be deemed to have been distributed if the payment has occurred or may be claimed. The capital gains tax that arises on the distribution date has to be declared and paid to the competent tax office by the company that has elected to exercise the option.
Unlike a shareholding of at least 10% in a ‘normal’ corporation with unlimited tax liability, in relation to companies that elect to exercise the option there is no provision under the law for their shareholders to be able to apply for a certificate of exemption. Therefore, first of all, capital gains tax at the statutory rate would be incurred. Any reduction in capital gains tax would then have to occur in a subsequent step.
It should be noted here that, in the view of the fiscal administration, a company that has elected to exercise the option would not meet the requirements for it to be treated as a ‘subsidiary company’ within the meaning of the Parent-Subsidiary Directive (Directive 2011/96/EU) (BMF circular of 10.11.2021, margin no. 52). Consequently, it would not be possible to reduce the capital gains tax to 0%.
Please note: It remains to be seen whether or not this view will be confirmed by an ECJ ruling if respective proceedings are brought before the court.
Therefore, essentially, there remains the possibility of applying for a refund of the capital gains tax by referring to the section on dividends in the respective DTA. However, this presupposes that the other country would regard the company that has elected to exercise the option as a taxable entity subject to corporation tax and would tax the profit distribution accordingly. If the other country continues to act on the assumption that the organisation is a transparent partnership and waives taxes, then Section 50d(14) sentence 1 EStG would apply (see segment 1 above). As a result, Germany would secure at least the full amount of withholding tax on the profit distribution.
Issues related to taxable disjunction
Exit tax (Section 6 of the External Tax Relations Act [Außensteuergesetz, AStG])
The general aim of the option is for the company that has elected to exercise the option to be treated as a corporation for income tax purposes. Furthermore, “for income tax purposes, a shareholding in the company that has elected to exercise the option will be deemed to be a shareholding of a non-personally liable shareholder in a corporation” (Section 1a(3) sentence 1 KStG).
The tax administration has concluded from this that all the regulations under the relevant laws (e.g., KStG, EStG, Trade Tax Act [Gewerbesteuergesetz, GewStG], Reorganisation Tax Act [Umwandlungssteuergesetz,Umw-StG], AStG) are applicable if they pertain to all corporations regardless of their specific legal form (BMF, margin no. 50). This would also expressly apply for the exit tax regulated in Section 6 AStG (BMF, margin no. 62).
Recommendation: Thus, if taxpayers with unlimited tax liability have significant shareholdings - within the meaning of Section 17 EStG - in the company that has elected to exercise the option then any potential re-location to a foreign country would also have to be carefully considered from the point of view of Section 6 AStG.
Retention periods in Section 22 UmwStG
Under a statutory direction in Section 1a KStG, the transition to corporation tax is deemed to be a change of legal form within the meaning of the UmwStG. As a consequence, all the relevant provisions of the UmwStG have to be applied. Besides the requirements in Section 1 Umw-StG that relate to the shareholders and the legal entities to be transformed, these also include the regulations in Section 20 ff. UmwStG, in particular, with regard to exercising the option to roll over the carrying amounts and to the retention periods that are triggered as a consequence.
If, in connection with exercising the option, the hidden reserves in the company’s business assets are not fully realised then, pursuant to Section 22(1) and (2) UmwStG, a seven-year retention period will start; during this period, a sale of the shares in the company (or if specific substitute realisation situations materialise) would trigger retroactive taxation of the hidden reserves. Here, the so-called ‘contribution gain’ on the date the option is exercised would be reduced by 1/7th for each completed year.
Rolling over the carrying amounts in connection with exercising the option would then also be possible if some or all of the shareholders are resident in a foreign country on the date the option is exercised. However, for this, specific requirements would have to be complied with, namely, either at the level of the shareholders or, in respect of the right to tax, of the shares in the company that has elected to exercise the option.
(a) Shareholder level
- domicile or place of habitual residence in the EU or EEA (natural persons), or
- incorporation in accordance with the law of an EU/EEA country as well as headquarters and management in an EU/EEA country (corporation)
b) alternatively, no exclusion or restriction of Germany’s right to tax the capital gain from the sale of shares.
Therefore, on the one hand, compliance with the respective EU/EEA references by the shareholders would be sufficient in order to enable a tax-neutral option. On the other hand, if shareholders are resident in a third country this would likewise not be considered to be detrimental (from a tax point of view) if Germany’s right to tax the capital gain from a sale of the shares is maintained.
Please note: This also means that, for example, the move from Germany to an EU/EEA country by a shareholder of a company that has elected to exercise the option would generally not however constitute a breach of the retention period; it is likewise possible that a move would trigger legal consequences under Section 6 AStG.
The interaction of Section 22 UmwStG with Section 6 AStG
As indicated above, various exit tax rules could potentially be applicable in parallel. In the final section, we have provided examples in order to make it clear how these rules could interact with each other.
Example: The taxpayer S moves from Germany to the UK almost 3 years after the option was exercised.
- First of all, subsequent taxation is triggered in the amount of 5/7ths of the hidden reserves (Section 22 UmwStG; reduction by 2 full-year periods = 2/7ths).
- The taxed amount is deemed to be the subsequent acquisition cost for the shares.
- The next step involves checking the applicability of Section 6 AStG.
- Should Section 6 AStG be applicable, then the calculation of the notional capital gain from the sale - within the meaning of Section 17 EStG - would have to include the subsequent acquisition costs from the subsequent taxation of the hidden reserves; this means that multiple taxation of these hidden reserves would be prevented in this respect.