Introduction of an option for corporate income tax (Art. 1a KStG-E)
In order to better ensure tax neutrality, partnerships shall now have the opportunity to opt for corporate income taxation. However, the option does not require a mandatory change to non-transparent taxation for (all) partnerships, but rather offers the possibility of a conscious decision against transparent taxation and in favor of procedural and substantive equality with corporations. Partnerships will still have the option of adhering to transparent taxation in future. Due to the advantages resulting from a transparent taxation regime, it is expected that in particular many small and medium-sized enterprises will probably opt for transparent taxation.
Overview of the planned changes
Change at the company’s level
Scope of application: commercial partnerships
According to Section 1 of the planned Art. 1a KStG-E, commercial partnerships – i.e. German limited partnerships (KG), general partnerships (OHG) and comparable foreign entities – as well as registered partnerships (PartGG) shall in future be able to opt for a taxation as corporation; the partners will then also be treated as a corporation’s non-personally liable shareholders. This requires an irrevocable application to the competent tax office prior to the start of the fiscal year from which the non-transparent taxation regime shall apply.
Exercising the option is deemed as change of legal form pursuant to German reorganization tax law
Pursuant to Art. 1a Sec. 2 KStG-E, such transfer to corporate taxation shall be deemed as change of legal form pursuant to Art. 1 Sec. 3 No. 3 UmwStG (German Reorganization Tax Act); therefore, Art. 1 and Art. 25 UmwStG (as well as the applicable income tax provisions providing for certain legal consequences of a change of legal form pursuant to Art. 25 UmwStG) will apply accordingly. The end of the fiscal year directly preceding the fiscal year from which a non-transparent taxation shall apply is mandatorily deemed as date of contribution; Art. 20 Sec. 6 UmwStG (retroactive effect for tax purposes) and, consequently, Art. 20 Sec. 5 sentence 2 and 3 UmwStG (withdrawals and contributions in the tax retroactivity period) shall not apply.
Art. 1a Sec. 4 KStG-E provides for the possibility of a re-option, i.e. a return to the transparent taxation regime. A commitment period for exercising the option is not intended. If the re-option is exercised, this is deemed to be a change of legal form pursuant to Art. 1 Sec. 1 Sentence 1 No. 2, 9 Sentence 1 and 2 UmwStG in conjunction with Art. 18 UmwStG; however, an application of Art. 9 sentence 3 UmwStG – i.e. a tax retroactivity – is expressly excluded. The consequences of a re-option also arise by operation of law if the requirements pursuant to Art. 1a Sec. 1 KStG-E cease to apply (cf. Art. 1a Sec. 4 Sentence 4 KStG-E).
This is the case, in particular, if a commercial partnership is transformed into a partnership under civil law or if there is no longer any corporate income tax liability in the country of the opting company’s management. The latter may be the case, for example, if the company (re)opts for transparent taxation in the country of management or relocates its management to another country in which it is treated as transparent for tax purposes.
If the penultimate shareholder withdraws from a company which has exercised the option, the opting company shall be deemed to have been dissolved immediately thereafter and – provided the remaining shareholder fulfills the personal requirements of an acquiring legal entity pursuant to Art. 1 Sec. 1 Sentence 1 No. 1, 3 or 4 UmwStG – to have accrued to such entity; Art. 2 UmwStG shall, however, not apply in this constellation (cf. Art. 1a Sec. 4 Sentence 5 KStG-E). If, on the other hand, the remaining shareholder does not meet the personal requirements of an acquiring legal entity, the opting company shall be deemed to have been dissolved and its assets distributed to the shareholders; Art. 11 KStG shall then be applied mutatis mutandis with the proviso that the assets to be distributed shall be replaced by the existing assets’ fair market value (cf. Art. 1a Sec. 4 Sentence 6 KStG-E).
If the opting partnership also changes its form into a corporation under civil law, this is deemed to be a conversion of a corporation into a corporate entity pursuant to UmwStG (cf. Art. 1a Sec. 4 Sentence 7 KStG-E).
Changes at shareholder level
At the level of the (former) partners, an exercise of the option for income tax purposes will result in the fact that the respective participation is treated in the same way as a corporation’s non-personally liable partner’ participation (cf. Art. 1a Sec. 3 KStG-E). At shareholder level, this has the particular consequence that all payments made by the company to its shareholders due to the corporate relationship now generally result in income pursuant to Art. 20 Sec. 1 No. 1 EStG or are attributed to income pursuant to Art. 19 EStG, Art. 20 Sec. 1 No. 7 or Sec. 2 Sentence 1 No. 7 EStG or Sections 21, 22 EStG and no longer qualify as income from trade or business pursuant to Art. 15 Sec. 1 Sentence 1 No. 2 EStG.
The partners’ liability under civil law for corporate income and trade tax owed by the commercial partnership or registered partnership under the option remains unaffected. If the partners have unlimited liability under civil law, this also applies to the commercial partnership’s or registered partnership’s corporate income and trade tax liabilities. Liability pursuant to Art. 71 or Art. 74 AO (German General Tax Code) may also be possible.
Further effects of the option’s introduction
As a consequence of the planned insertion of a new Art. 2 Sec. 8 GewStG, opting partnerships and registered partnerships will also be equated with corporations for trade tax purposes. Furthermore, all provisions pursuant to KStG (German Corporate Income Tax Act), EStG (German Income Tax Act), UmwStG, InvStG (German Investment Tax Act), AStG (German Foreign Transaction Tax Act) or ZerlG (German Act on the Distribution of the Federal Tax Revenue) that refer to corporations or to corporate entities are to apply; this follows from the extension of Art. 1 Sec. 1 No. 1 KStG to include the opting companies. Only those regulations which only apply to certain, expressly designated corporations and those whose criteria can only be met by a genuine corporation (e.g., Art. 28 KStG) are not to apply accordingly. Consequently, an opting company cannot become a controlled company pursuant to Art. 14 KStG.
Finally, in the context of international tax law, it must be taken into account that, according to Art. 1a Sec. 1 Sentence 3 No. 2 KStG-E, the option is not available to companies which, after exercising the option, are not subject to any tax comparable to German unlimited corporate income tax liability in the country where their place of management is located. On the one hand, this means that the option is not limited to partnerships with their place of management in Germany; on the other hand, however, the requirement that the company must be subject to a comparable corporate income tax liability abroad is intended to avoid potential qualification conflicts in case of hybrid legal forms.
Evaluation of the planned changes
Promotion of tax neutrality
The introduction of the long-discussed option model for a partnership’s taxation as corporation is very welcome, as it represents a significant step towards ensuring the neutrality in company taxation. It is true that a change of legal form to a corporation under Art. 25 UmwStG is already possible for companies covered by the personal scope of Art. 1a KStG-E. However, the significant difference to the current legal situation is that the opting partnerships will continue to be partnerships under civil law and the treatment as a corporation will only extend to tax law, i.e. there is no conversion under civil law. In practice, this will result in a significant simplification compared to the status quo if the partnership form is selected and continued for non-tax reasons.
Implications under Reorganization Tax Law from the ordered change of legal form
From a consultant's point of view, however, with regard to the discrepancy between civil law and tax law, it must be noted that, in the absence of a conversion pursuant to civil law, generally no (company law) regulation is made with regard to the transfer of individual assets to the "acquiring" corporation’s assets. From an (original) tax point of view, this may therefore require side agreements with regard to functionally important business assets in a shareholder’s special business assets in order to ensure the possibility of a contribution at book or interim values pursuant to Art. 20 Sec. 2 Sentence 2 UmwStG.
Due to the fact that the exercise of the option is equivalent to a change of legal form pursuant to Art. 25 UmwStG, it must also be taken into account that the shares received are subject to a blocking period pursuant to Art. 22 Sec. 1 UmwStG due to the reference of Art. 25 UmwStG to Art. 20 to Art. 23 UmwStG. Consequently, there are no advantages in this respect compared to the change of legal form pursuant to Art. 25 in conjunction with Art. 20 UmwStG, which is already possible.
Accordingly, it should also be noted that the re-option as a structured change of legal form into a partnership should generally result in a violation of the blocking period pursuant to Art. 22 Sec. 1 Sentence 6 UmwStG and thus to a retroactive taxation of a gain from the contribution of shares.
Reclassification of remuneration to shareholders
Furthermore, the reclassification of, among other things, managing directors' salaries and interest on loans from special remuneration pursuant to Art. 15 Sec. 1 Sentence 1 No. 2 EStG to income pursuant to Art. 19 EStG or Art. 20 Sec. 1 No. 7 EStG results, if the arm's length principle has not been met, in the assumption of an undisclosed profit distribution pursuant to Art. 8 Sec. 3 Sentence 2 KStG.
Implications for the GbR and asset-managing commercial partnerships?
An exercise of the option for corporate income taxation for partnerships other than limited partnerships and general partnerships as well as corresponding foreign companies is (currently) not intended. This excludes in particular civil law partnerships from the option provided for in Art. 1a KStG-E; however, an option for corporate income tax will also be indirectly possible for these companies through an upstream change of the civil law partnership’s legal form into a limited partnership or general partnership. While this limitation of the personal scope of application of Art. 1a KStG-E seems to be absolutely appropriate on the basis of the current law due to the, to some extent, still existing uncertainties with regard to the scope of the civil-law partnership’s legal capacity, a corresponding need for adjustment may arise in future.
If, in the course of the planned Partnership Law Modernization Act (Personengesellschaftsrechtsmodernisierungsgesetz - MoPeG), registered partnerships under civil law are equated with commercial partnerships for German Transformation Law (UmwG) purposes and if this will be followed for reorganization tax law purposes by a corresponding adjustment of Art. 1 Sec. 3 No. 1 UmwStG, we believe that an extension of the personal scope of application of Sec. 1a Sec. 1 Sentence 1 KStG-E should also be considered.
However, the reference to Art. 25 UmwStG is likely to also exclude merely asset-managing partnerships and partnerships no longer classified as commercial partnerships from the scope of Art. 1a KStG-E.
Replacement of balancing items in case of transfers of excess and lower amounts within tax groups (Art. 14 Sec. 4 KStG) by a so-called contribution solution
Overview of planned new regulations
Art. 14 Sec. 4 KStG-E now stipulates that a controlled company's transfer of a lower amount (Minderabführung) is to be treated as a contribution by the controlling company to the controlled company. In future, transfers of an excess amount (Mehrabführung) within the tax group will be treated as a refund of contributions by the controlled company to the controlling company. This will result in a direct increase or decrease of the investment’s value in the controlling company’s tax balance sheet. Furthermore, according to the legislator’s intention, transfers of excess and lower amounts should now lead to a refund of contributions or a contribution in full and not only to the extent of the ratio of the controlling company’s participation in the controlled company.
Reversal of balancing items in the tax group
Pursuant to Art. 34 Sec. 6e KStG-E, any balancing items still existing at the controlling company in respect of the tax group's transfers of excess or lower amounts are to be reversed in the first fiscal year ending after December 31, 2021. Balancing items on the assets side are to increase the carrying amount of the controlling company's investment in the controlled company in the tax balance sheet, while balancing items on the liabilities side are to reduce it accordingly. To the extent a balancing item on the liabilities side exceeds the sum of the balancing item on the assets side and the carrying amount of the controlling company's investment in the controlled company in the tax balance sheet, such difference constitutes income from investment in the controlled company to which Art. 3 No. 40 EStG and Art. 3c Sec. 2 EStG or Art. 8b KStG are to apply. However, the taxpayer may form a reserve in an amount equal to such income from investments which reduces the taxable profit. The reserve is to be reversed in the year of formation and in each of the following nine years by one tenth, increasing the profit. The income resulting from the release of the reserve is in turn subject to Art. 3 No. 40 EStG and Art. 3c Sec. 2 EStG as well as Art. 8b KStG.
Evaluation of the planned changes
The abandonment of the previous concept of the formation of balancing items for tax group excess or short transfers in the tax balance sheet, which is based upon the controlling company’s participation in the controlled company’s nominal capital, in favor of a contribution solution is to be supported overall, as it will result in a considerable simplification in practice.
In our opinion, however, the mandatory reversal of any balancing items on the liabilities side to income from January 1, 2022 is too far-reaching. This is because it simulates a sale of the shareholding, resulting in compulsory taxation, albeit at a favorable rate. The formation of the reserve should mitigate the tax burden accordingly. However, the ten-year liquidation period assumes a gradual sale of 1/10 of the shareholding per year, which can result in unjustified tax burdens.
Globalization of the German Reorganization Tax Act with regard to the conversion of corporations (Art. 1 UmwStG, Art. 12 Sec. 2 and 3 KStG)
Overview of the planned changes
Modernization is also planned with regard to reorganization tax law. In order to take account of ongoing globalization, it is planned to remove the restriction of the UmwStG’s territorial scope to the EEA, so that tax-neutral reorganizations will in future also be possible in cases involving third countries.
This is to be achieved by repealing the current Art. 1 Sec. 2 UmwStG, which, in its current version, geographically limits the applicability of the UmwStG’s second to fifth parts (mergers, split-ups, spin-offs and asset transfers) to EU/EEA states, in order to effectuate a complete globalization of the reorganization tax law for corporations as transferred legal entities. This has the consequence that in future all conversions of corporations pursuant to Art. 1 Sec. 1 sentence 1 UmwStG, which are comparable to a domestic conversion pursuant to UmwStG, will fall within the scope of the UmwStG worldwide, to the extent the German right of taxation is not limited or excluded.
The planned integration of Art. 12 Sec. 2 KStG (spin-offs, split-ups and mergers of third-country corporations of the same state) into the UmwStG as well as the planned deletion of Art. 12 Sec. 3 KStG (order of mandatory liquidation taxation in case of a corporation’s relocation to third countries) contributes to a corporation’s uniform treatment for income tax purposes in transformation cases exclusively in the UmwStG and also aims to globalize the transformation tax law for corporations.
No extension to contributions pursuant to Art. 20 et seq. UmwStG
However, the present draft law expressly refrains from extending the provisions on contributions and exchanges of shares (Art. 20 et seq. UmwStG) to cases involving third countries as, in the legislator’s opinion, a revenue-neutral uniform provision (securing the right of taxation at the second level beyond Art. 22 UmwStG) would entail restrictions for contributors from EU/EEA countries compared to the current legal situation.
Evaluation of the planned changes
The globalization of reorganization tax law is generally very welcome, as it will now also allow mergers, split-ups, spin-offs and asset transfers in cases involving third countries and thus clearly meets the needs of globally operating companies, for example, with subsidiaries outside the EU or EEA. Unfortunately, however, even after the reorganization tax law’s planned extension to third-country cases, in particular the exchange of shares with third countries (e.g., participation in participation programs in US companies through the contribution of shares in a German company, for example, in the case of start-ups or venture capital projects) will still be excluded from the tax-neutral contribution pursuant to Art. 20 et seq. UmwStG.
Conclusion and outlook
The KöMoG is expected to come into effect on January 1, 2022. The amendments provided for in the draft law are to be welcomed to a large extent, although a further globalization of the reorganization tax law would be desirable, in particular with regard to the practice-relevant exchange of shares in third country constellations. However, due to the consequential problems that would result in connection with the blocking period pursuant to Art. 22 UmwStG, it is questionable whether this step could be implemented in a timely manner without making fundamental changes to the UmwStG’s basic concept.
In our opinion, the prescribed reversal of balancing items on the liabilities side for tax groups as of January 1, 2022 requires another critical assessment, even taking into account the formation of a profit-reducing reserve.
The implementation of this reform project in the remaining legislative period is ambitious, but should not be ruled out in view of the largely positive effects for taxpayers; this also applies in particular in view of the fact that the implementation of an option model for partnerships has already been discussed for many years. The first reading in the Bundestag is scheduled for mid-April.
Many thanks to my co-author Dr. Christiane Krüger, LL.M.