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German Tax Reform - The Never-Ending Story |
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 The German tax system continues to change, both as part of the formal
‘tax reform' process and a more wide ranging debate, with substantial
implications for private equity in each case.
It is clear that this will remain an area that is of key interest, with
opportunities as well as risks for the German private equity industry,
say Uwe Schimmelschmidt and Christopher Kellett of Clifford Chance
Pünder.
In the last few months, most private equity practitioners in Germany
have come to terms with the likely effects of the German tax reform,
largely encapsulated in the Tax Reform Act of October 23, 2000. The two
most talked about changes - tax free disposal of shares by corporations
and abolition of the depreciation ‘step up' - both of which, broadly,
take effect in January 2002, have been subject to much discussion and
various models have already been developed for transaction structures
this year, to optimise the parties' positions.
Just as the dust was settling and investors, vendors and professional
advisors were working through the detailed implications of the changes,
the issue of further reform of the German tax system has been brought
back on to the industry's agenda.
Act on the further development of tax law on businesses (Unternehmenssteuerfortentwicklungsgesetz)
The German tax system continues to change, both as part of the formal
‘tax reform' process and a more wide ranging debate, with substantial
implications for private equity in each case. It is clear that this
will remain an area that is of key interest, with opportunities as well
as risks for the German private equity industry, say Uwe
Schimmelschmidt and Christopher Kellett of Clifford Chance Pünder.
On August 15, 2001 the German government decided on a bill making
further changes to the Tax Reform Act (the Bill). It is to be expected
that most parts of the Bill will be passed without further material
changes. The Bill seeks to deal not only with issues that have become
apparent since the initial Tax Reform Act was passed, but also
introduces further tax changes. For example:
Sale by individuals of partnership interest
The sale of a partnership interest by an individual may at present
benefit from privileged tax treatment (tax-free allowance, application
of 50 per cent of the effective income tax rate). Under the Bill, the
sale of a part of a partnership interest will in future be excluded
from privileged tax treatment. Therefore, from 2002 only individuals
who sell their entire interest in a partnership may benefit from such
privileged tax treatment.
Trade tax on the sale by a corporation of a partnership interest
Under
the Bill the sale of a partnership interest by a corporation
will, in principle, be subject to trade tax. It is to be expected that
the German tax authorities will also levy trade tax on the sale of only
a part of a partnership interest by an individual. It should be noted
that the trade tax in this case is levied at the level of the
partnership itself and not at the level of the seller. This potential
‘tax trap' needs to be monitored carefully on acquisition of KG's. If
the partnership holds shares in corporations, it is currently
unclear whether, and if so to what extent, the part of the capital gain
attributable to those shares will be exempt from trade tax. The Bill
does not address this, but it is hoped that this issue will be
clarified by a tax law amendment before the end of the year.
Trade tax on sale by a partnership of shares in a corporation
When a partnership sells shares in a corporation, it is currently
unclear whether the capital gains on disposal are exempt from trade
tax. The Bill does not include any clarification in this respect;
however, a full exemption of such capital gains from trade tax at the
partnership level is currently being considered
Roll-over relief for individuals on sale of shares in corporations
Individuals or (to the extent partners are individuals, partnerships)
will be able to roll over capital gains realised upon the sale of
shares in corporation into shares in corporations acquired in the same
fiscal year or in the two subsequent fiscal years. The shares sold must
have been held by the individual or partnership for the 6 years
preceding the sale. This may enhance individuals' willingness to sell.
Anti-abuse provision on capital gains exemptions (tax-free sale by individuals)
At present, individuals cannot sell their shares in corporations
tax-free, but only benefit from a 50 per cent capital gains exemption.
To achieve a tax-free disposal, individuals may consider a tax-neutral
share exchange to a (new) holding company, which subsequently benefits
from the capital gains exemption when selling the contributed shares.
To prevent this ‘abuse', the Bill provides for a seven-year lock-up
period during which the interposed holding company cannot sell the
contributed shares tax-free.
Cross-border share exchange
If shares in a German corporation (German Shares) have been exchanged
on a tax neutral basis for shares in an EU resident corporation
(EU-Shares), the EU-Shares are ‘tainted' shares (einbringungsgeborene
Anteile). The tainted EU-Shares are currently subject to a seven-year lock-up
period if the original holder of the German Shares is a corporation. A
sale within this period triggers full capital gains taxation. If the
original holder of the German Shares is an individual, the tainted
EU-Shares do not benefit from the general 50 per cent capital gains
exemption irrespective of any holding period. The Bill provides that, regardless of any lock-up period, the sale of
tainted EU-Shares is tax-free (corporate sellers) or half-exempt
(individual sellers), if the German Shares could have been sold
(partially) tax-free had the share exchange not occurred. This should
remove a hurdle to some deal structures. The requirements to be met in order to achieve a tax-neutral
cross-border share exchange will not be changed (including the seven
year lock-up period).
Transfer of real estate within a group of companies
Under the Bill, the transfer of real estate within a group of
companies, or the transfer of shares in companies owning real estate
within the group, will be exempt from real estate transfer tax. This
will remove the current real estate transfer tax constraints on group
reorganizations. The exemption for the intra-group transfer of real
estate or shares is conditional upon the relevant real estate remaining
in the group for the following five years. The real estate transfer tax
exemption is, however, currently subject to controversial discussions.
The overall effect of these changes cannot be assessed with certainty
yet. While the roll-over relief appears to be beneficial, other changes
may give vendors pause for thought.
Re-introduction of trade tax on capital gains?
Recently, a proposal has been mooted to impose trade tax on all
disposals of shares by entities which are subject to trade tax on their
business operations. This would negate much of the benefit under the
Tax Reform Act (which provided for tax-free disposals of shares). This
issue has been debated for some time and it is unclear how it will be
resolved. From a private equity perspective, it is hoped that this
suggestion will not be adopted.
New developments in fund taxation
Private equity funds are typically constituted in the form of a
partnership to ensure tax transparency, i.e. investors should be
treated as if they were direct shareholders of the investee companies.
There should be no tax charge at the fund level (nor at investor level
just because investors are shareholders of the fund, rather than direct
shareholders in the investee company). From a German tax point of view,
this means that the fund must qualify as a non-business income
generating partnership (passive income). It is here (and with regard to
taxation of the carried interest of investment professionals) that the
tax authorities' most recent plans have alarmed the private equity
industry, as well as investors.
A resolution of the tax authorities proposed (the Proposal) that a
private equity fund will be deemed to generate business income if the
fund holds participations of more than 25 per cent. If a fund is
treated as generating business income, this would mean:
* capital gains for German private investors would
no longer be fully tax exempt (under certain conditions), but would be
subject to the half taxation principle;
* if an overseas fund had a permanent establishment
in Germany, the half taxation principle would apply not only to German
but also to foreign private investors in the fund.
In addition, there might be a trade tax charge at the fund level.
The Proposal also envisages taxing disproportionate gains on the
carried interest as income (not capital gains), i.e. subjecting such
gains to income tax and related charges at a top rate of over 50 per
cent. The private equity industry in Germany is actively engaged in
discussions with the relevant authorities highlighting the problems the
Proposal would cause and the disadvantages for the German marketplace.
At present, it seems that the intention of the tax authorities to tax
funds on the basis described above may be dropped. The treatment of
carried interest gains is less clear. The final outcome of the
discussions in both areas is uncertain. It is to be hoped that a
solution can be reached which does not give rise to additional risks or
a structural disadvantage for the German private equity market.
Moving forward
The German tax system continues to change, both as part of the formal
‘tax reform' process and a more wide ranging debate, with substantial
implications for private equity in each case. It is clear that this
will remain an area which is of key interest, with opportunities as
well as risks, for the German private equity industry.
© Clifford Chance. All rights reserved.
 Main area of work is M&A, in particular private equity
and leveraged acquisitions in Germany. Regularly handles
multi-jurisdictional acquisitions for financial and private equity
investors as well as industrial groups. Also advises lenders to private
equity transactions with regard to structuring and equity-related
issues. For more information please contact +49 69 7199 3432,
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