On Wednesday, February 9, 2000, the German government published its draft tax reform proposals. These proposals will be submitted to the German Parliament in May and are expected to be presented to the Bundesrat for final approval in June. Should the legislation be accepted as currently drafted, the German taxpayers should realize tax savings of DM 44.2 billion annually once the tax reform proposals have been fully implemented in the year 2005.
The major provisions foresee that, beginning in the year 2001, the corporation income tax rate shall drop to 25%. The individual income tax rates shall range between 19.9% and 48.5%. These individual income tax rates will be reduced in two further steps until, as of January 1, 2005, they will range between 15% and 45%.
More specifically, the draft legislation provides:
Individual Income Tax
Originally the individual income tax reductions were to be implemented as of January 1, 2002. This tax reduction, however, has been moved forward to January 1, 2001. As proposed, the lowest tax rate will be reduced from 22.9% to 19.9% and the top tax rate will be reduced from 51% to 48.5%. As of January 1, 2003, these rates will be further reduced to 17% and 47% respectively; and as of January 1, 2005, to 15% and 45% respectively. The basic exemption will be increased from the current DM 13,499 to DM 14,093 (2001); to DM 14,500 (2003); and to DM 15,000 (2005).
Corporation Income Tax
The corporation income tax shall no longer have the split rates of 40% for retained earnings and 30% for distributed earnings, but rather a unified rate of 25%. Including the trade income tax and the solidarity surcharge, the overall corporate tax burden will be some 39% as of January 1, 2001.
Dividends
The former rules as to dividends that allowed German residents to take a tax credit for the underlying German corporation income tax have been abolished. In its place, the tax reform proposals provide that the shareholders will only need to tax one-half of the net dividends that they receive.
Capital Gains
Short-term capital gains on the sale of corporate shares (with a holding period of less than one year) shall be treated as though they were a prepayment of dividends, i.e. one-half of the amount received will be taxed at ordinary income tax rates. There is, however, an exemption of DM 1,000 on such short-term capital gains. Should, however, the holding period exceed one year, such capital gains shall be tax free.
Progression Clause
Dividends and capital gains which are only to be included to one-half for tax purposes shall further be subject to the .progression clause. as to the untaxed portion of those dividends and capital gains. The progression clause means that in the determination of the actual tax liability, the individual.s entire dividend and capital gain income will be included for purposes of determining a putative tax on that entire income. From that putative tax, the taxpayer.s average tax rate will be determined. This average tax rate would then be applied only to the individual.s actual taxable income. The philosophical basis for this treatment is that progressive tax rates are politically justified on the basis of a greater ability to pay, the higher the income. If a taxpayer has tax free income, i.e. the untaxed portion of the dividends and capital gains, the taxpayer has a greater ability to pay tax and thus the applicable average tax rate should be higher.
Capital Gains of Corporations
The most radical reform proposal is the exemption from tax of sales by German corporations of an investment in the shares of German and foreign corporations. The proposed effective date is January 1, 2001.
Investment Funds
The original tax reform proposals allowed investment funds to be subject to the same taxation rules applicable to corporations. This proposal has been deleted from the submitted legislation because of the lost tax revenues that would arise.
Partnerships
Partnerships will receive the option to be taxed as though they are corporations. They could thus be subject to the corporation tax rate of 25%, rather than to the progressive individual income tax rates of their partners. Partnerships which do not chose this option will receive a credit against their income tax liability for approximately one half of the trade income tax. This will have as a practical effect that most partnerships will no longer pay trade income tax.
Financing of the Tax Cuts
In order to offset a portion of the revenues that would be lost through the implementation of the above tax reform proposals, several measures shall be undertaken. Accelerated depreciation for movable property shall be reduced from 30% to 20%. Straight-line depreciation for buildings which are business assets shall be reduced from 4% to 3% annually. Finally, the participation exemption whereby capital gains on the sale of shares in corporations escape taxation, will be reduced from holdings of at most 10% to only 1%. Finally, the official depreciation tables will reflect a longer useful life for most assets.
Estimated Tax Savings
The net tax savings attributable to the foregoing tax reform proposals as of 2005 should amount to DM 44.2 billion annually of which private individuals should realize DM 21 billion thereof, DM 15.6 billion for family-owned and middle-sized companies and DM 7.6 billion for large corporations. The effect of implementing the tax reductions for individuals and companies from 2002 to an effective date of January 1, 2001 is estimated to result in annual savings of DM 27.6 billion.
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