In Germany, the breakthrough for genuine tax reform has at last occurred. The modest tax reform proposals that were enacted for 1999-2000 have now been followed by fundamental reforms that will be implemented over the next five years. Not only has the corporation income tax been reduced to 25% (from 40%/30%), but the top individual income tax rates will be reduced from 51% to 42% (in 2005).
Most surprising to the business and tax communities was the government.s initiative to exempt corporations from taxation on capital gains from the sale of subsidiaries. This provision becomes effective in 2002 and applies to all corporations selling shares in subsidiaries held for at least for one year. The government hopes to encourage the restructuring of German industry through this measure, resulting in increased investment and employment.
SUMMARY OF MAJOR CHANGES
Income Tax
The lowest income tax rate will be reduced on January 1, 2001 from 22.9% to 19.9%. The maximum tax rate will be reduced from 51% to 48.5%. These tax rates will fall as of January 1, 2003 to 17% and 47% respectively; and as of January 1, 2005, to 15% and 42% respectively. When the maximum tax rate becomes effective in 2005, it will apply beginning at a taxable income of DM 102,000 for single individuals.
The basic exemption will be increased from DM 13,499 to DM 14,093 on January 1, 2001; and further to DM 14,500 on January 1, 2003; and on January 1, 2005 to DM 15,000.
For spouses filing jointly, the above taxable income level at which the maximum tax rate applies and the basic exemption are doubled.
Corporation Income Tax
Currently the corporation income tax has a split rate. A tax of 40% is imposed on retained earnings and 30% on distributed earnings. Both of these rates will be reduced to 25%. If the trade income tax and the solidarity surcharge are included, most corporations will bear an effective tax rate of some 38%.
.Solidarity. Income Tax Surcharge
The Solidarity Surcharge of 5.5% has been retained for both corporation and individual income tax purposes.
Dividends
The current German imputation tax system (in which domestic German taxpayers credit the underlying corporation tax on dividends against their own income tax liability) will be abolished as of January 1, 2001. In its place, shareholders (natural persons) will include 50% of the dividends received into their income. The change brings Germany more in line with the tax rules of other EU member states. The new rules are slightly more favorable for taxpayers. For corporations, the receipt of dividends will be tax free.
Capital Gains, Individuals
If securities are held for a period of at least one year, there is no tax on the resulting capital gains. Capital gains on securities held for less than one year are only included to 50% in taxable income. There is also a de minimis exclusion of DM 1,000 on such short-term capital gains.
Beginning January 1, 2002, the above treatment for tax free capital gains will only apply if the selling shareholder holds less than 1% of the outstanding capital of the company. (Currently a shareholder can hold 10% of the company.s capital before taxation of the capital gain would occur.) This latter provision is bitterly opposed by the venture capital industry as being inimical to entrepreneurial companies.
Capital Gains for Corporations on the Sale of Shares in a Subsidiary
The capital gains from the sale of shares of domestic and foreign subsidiaries of a German corporation are not subject to tax if the shares have been held for longer than one year. This provision comes into effect in 2002.
Partnerships
In order to reduce the tax burden of partnerships compared to that of corporations, the trade income tax will continue to be deductible and now also can be credited on a formula basis (1.8 times the basic tax rate of 5%) against the partner.s income tax. In practical terms, most partnerships will thereby be exempted from the trade income tax.
The one-time tax exemption of DM 60,000 on the sale of a partnership or of a sole proprietorship (because of age) has been raised to DM 100,000. A half tax rate will apply to the balance of the gains from such a sale beginning in 2002.
TAX ENHANCEMENT MEASURES
The tax reform measures will be financed to some extent through lower depreciation rates. For example, the accelerated depreciation rates on movable goods will be reduced from a maximum of 30% to 20%. As to other goods, the useful life for purposes of calculating depreciation shall be further extended. Finally, the depreciation rates for commercial real property will be reduced from a maximum of 4% annually to 3%.
Debt equity rules will also be more restrictive. On shareholder financing, the maximum permissible debt-equity ratio will be reduced from 3:1 to 1.5:1 for regular corporations. For holding companies, the permissible ratio will be reduced from 9:1 to only 3:1. These new ratios should be achieved as of December 31, 2000, or as of the end of the fiscal year ending thereafter for non-calendar year corporate taxpayers.