The Act on the Modernisation of Corporation Tax Law (Gesetz zur Modernisierung der Körperschaftsteuer, KöMoG) is likely to become applicable as of 1.1.2022. An overview of the main features of the new statutory provisions on the option model was included in this article; in this edition, we start a short series of reports with detailed explanations. The current report - Part I - includes a comparison of the different systems of taxation for partnerships and corporations and provides an initial insight into the basic tax consequences of the option model.
The background to the option model
Since 2000, in the course of the reform efforts aimed at harmonising business taxation, there has been an extensive convergence in the overall tax burden of corporations and their shareholders, on the one hand, as well as partnership organisations and their partner members, on the other hand. Nevertheless, there are still considerable differences in the taxation schemes and systems. The aim of the option model for partnerships is, in particular, to strengthen the competitiveness of small and medium-sized family enterprises with the legal form of the Kommanditgesellschaft (KG) [limited partnership] or the offene Handelsgesellschaft (OHG) [ordinary partnership]. As a result of the KöMoG (at present, not yet published in the BGBl [Bundesgesetzblatt, or the Federal Law Gazette]; approved by the upper house of parliament [Bundesrat] on 25.6.2021), professional partnerships and partnership organisations will be given the option of using the same tax regulations as corporations.
Transparency principle for partnerships
Partnerships are subject to the principle of transparent taxation. Under tax law, they do not constitute autonomous legal entities because you effectively look straight through the companies. Consequently, taxes on the earnings generated by the partnership are not levied at the company level. Instead, for tax purposes, the profits - irrespective of whether they were withdrawn or left in the company - are attributed to the partners and are taxed at the personal rate of income tax of each partner or, in the case of legal persons, of corporation tax. One exception to this is trade tax, which is levied on a business regardless of personal circumstances (a so-called Objektsteuer). The principle that applies is that the supply relationships between the company and the partners are regarded as non-existent for tax purposes. Under German commercial law, remuneration paid to partners (such as, in particular, payments for work that has been performed, rents for assets that have been provided for use, or interest on loans that have been granted to the company) has to be included at the level of the partnership as profit-reducing operating costs. However, to determine the taxable profit, all special payments are then added back once again at the level of the partnership as advance dividend payments. This rule for special payments causes all the income to be recharacterized as the partners’ commercial income. Furthermore, for tax purposes, assets that have been provided for use are not deemed to belong to the partners’ private assets but, instead, constitute special business assets at the company.
Separation principle for corporations
By contrast, corporations are taxed in accordance with the separation principle. In this case, under tax law, the corporation and the shareholders are regarded as two legal entities that are independent of each other. The income of a corporation is first subject to corporation tax as well as trade tax at the level of the corporation. A tax burden only arises for the shareholders when there is a dividend pay-out. Dividend pay-outs are assigned to income from capital assets and generally taxed at a separate withholding tax rate of 25% of the gross dividend if the partial income method for material holdings does not have to be applied. In this respect, supply relationships governed by the law of obligations (such as agreements between the company and the shareholders with respect to employment, loans or rent) are recognised for tax purposes. The amounts in these agreements have to be appropriate in order not to be deemed to be hidden profit distributions. As long as the payments resulting from these agreements do not constitute hidden profit distributions then, at the level of the corporation, they have to be classified as operating costs - just like comparable payments to third parties - and they will also reduce taxable profit. Practical effects: For the shareholder, the salary paid within the scope of an employment relationship constitutes income from employment (Section 19 of the German Income Tax Act [Einkommenssteuergesetz, EStG]) and is subject to payroll tax. Loan interest received is classed as a capital gain (Section 20 EStG) and is subject to withholding tax, and rental payments received are classed as income from letting and leasing (Section 21 EStG) and are taxable at the personal rate of income tax.
Far-reaching consequences of exercising the option
Exercising the option would result in a change in the system of taxation - from one according to the transparency principle to taxation according to the separation principle. Far-reaching consequences would ensue from this, notably, the complex concept of special business assets would cease to apply along with the accounting particularities via special partner balance sheets and supplementary partner tax accounts. There would be continuing recognition for tax purposes of the supply relationships between the partners and the partnership that has exercised the option. The expenses resulting from these would then also constitute operating costs for tax purposes at the level of the company and this would lead to a reduction in taxable profit. At the level of the partners, this income would no longer be recharacterized for tax purposes as income from commercial operations.
Application to exercise the option
According to the new provision in the Corporation Tax Act [Körperschaftsteuergesetz, KStG] (Section 1a(1) KStG, as amended), it is possible to file an application to exercise the option to be treated as a corporation for tax purposes. However, the application to exercise the option can only be made for the partnership as a whole. It would affect all the partners. A hybrid structure where partnership taxation would continue for some of the partners would not be possible. The approval of all the partners would be required for the application. If majority voting has been stipulated in a partnership agreement, then a 3/4 majority would be sufficient. Companies whose partnership agreements contain a majority clause applicable to resolutions on this matter would be exempt from this principle. The irrevocable application, using an officially prescribed set of data, would have to be filed with the tax office that is responsible for the partnership. The application would have to be filed, at the very latest, one month prior to the start of the financial year when taxation in accordance with the KStG option is supposed to be activated for the first time and this filing will directly bring about the change to the taxation regime from the start of the following financial year. Nevertheless, the company will have an opportunity to return to transparent taxation.
Please note: There is no legal minimum term for the option model so that, after the end of one single financial year, it would already be possible to revert back again to being taxed as a partnership via a return option. For the option where book values are rolled over, you should however be mindful of the blocking periods under the Reorganisation Tax Act.
competitiveness of the partnerships that exercise the option. This will be realised through the new possibilities that will arise for retaining profits for the long-term in a tax optimised way and the fact that the overall profit will not be directly attributed to the partners. The liquidity that will thus be gained can then be used for making investments. Under civil law, the partnership will still continue to be treated as such.