In the first article, we started our series of detailed explanations of the German Act on the Modernisation of Corporation Tax Law, which was promulgated on 30.6.2021, with a comparison of the various systems of taxation for partnerships and corporations as well as a look at the process of exercising the option; in Part II, in this newsletter, we discuss the consequences of exercising the option through a notional change of legal form with particular reference to the special business assets.
The background to the change in taxation
As of 1.1.2022, partnership organisations and professional partnerships (Personenhandelsgesellschaften, a German type of professional corporation) will have the possibility, by way of the option, of using the same tax regulations as corporations. This should eliminate the differences that exist within the framework of German business taxation for the partnerships that exercise the option.
Please note: The Act on the Modernisation of Corporation Tax Law (Gesetz zur Modernisierung der Körperschaftsteuer, KöMoG) was promulgated in the Federal Law Gazette (Part I No. 37, p. 2050) on 30.6.2021, although the Act will, for the most part, come into force on 1.1.2022 it also partially came into force immediately after it was promulgated.
While a transition to corporation tax sounds simple at first, nevertheless, it can indeed entail pitfalls in view of the particularities that apply to the taxation of partnerships under German tax law. In this regard, the special business assets of co-entrepreneurships assume particular importance.
Transitioning to taxation in accordance with the German Corporation Tax Act
Exercising the option to be treated as a corporation for tax purposes is handled like a notional change of legal form of a commercial partnership into a corporation, although the Reorganisation Tax Act is directly applicable. For a tax neutral transfer, the change of legal form would have to take place at book value. However, in order to be able to file an application for the book values to be rolled over (or for recognition at intermediate values) all the assets that form part of the business assets that are essential for operations have to be transferred to the enterprise making the acquisition. This rule also applies to assets held as special business assets by individual partners.
Business assets that are essential for operations held as special business assets
Special business assets comprise assets owned by the co-entrepreneurs and not by the partnership. Nevertheless, the assets are used for the business operations or for the stake in the company. The special business assets are merely in the possession of the partnership. Such assets frequently include real estate, buildings, licences, patents, investments and possibly stakes in the general partner GmbH [a German limited liability company].
Business assets that are essential for operations but held as special business assets will have to be identified and transferred to the jointly owned assets at the same time as the option is exercised and be materially related to it; this is because merely continuing to make the assets available for use would prevent the roll-over of book values altogether. Consequently, economic ownership has to be transferred on the reference date of the notional change in the legal form.
However, as exercising the option does not involve a reorganisation act under civil law, there are no generally applicable rules for the transfer of economic assets to the assets of a notional corporation. Therefore, appropriate ancillary civil law agreements (such as contribution or transfer agreements) between the co-entrepreneur and the company will be necessary. For such a transfer, legal issues related not only to civil law but also company law will have to clarified thus, for example, how the respective transfer should be structured in relation to the co-share-holders since, normally, there are non-tax-related reasons for the existence of special business assets. Moreover, neither changes in the size of the shareholding nor a gratuitous contribution to the other co-shareholders would be desirable. Transferring special business assets in return for granting company shares without further provisions regarding the other shareholders would increase the fixed capital account of the transferring shareholder and, thus, the size of the shareholding in the partnership that has exercised the option to the detriment of the other co-shareholders. If no other company shares are granted then the contribution would lead to an increase in the joint specific-purpose reserve account, to which all shareholders are entitled and, thus, a gratuitous contribution.
If a transfer at the same time is not desirable then, alternatively, the special business assets that are essential for operations can be separated, in parallel, ‘sidewards’ in a (possibly new) sister GmbH & Co. KG [a German limited partnership with a limited liability company as a general partner] deemed to be of a commercial nature. We believe that the transfer can take place at same time as the option is exercised with the roll-over of book values. According to the current case law of the Federal Fiscal Court (Bundesfinanzhof, BFH), the requirement for a mandatory transfer beforehand no longer exists. A transfer where hidden reserves are not realised would give rise to a blocking period.
Recommendation: Since, in this case, the Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) - according to the current draft of a guidance letter of 30.9.2021 - provides for a review to determine if the conditions for the option to be exercised at book values are not present pursuant to Section 20 of the German Reorganisation Tax Act, consideration should be given beforehand to obtaining binding information in this regard. Nevertheless, the BFH and the BMF have accepted this method for comparable cases of gratuitous contribution.
Real estate transfer tax changes due to the KöMoG
When the option is exercised, the lack of change in the legal arrangements does indeed mean that this does not give rise to the elements required under the Real Estate Transfer Tax Act (Grunderwerbsteuergesetz, GrEStG) because the same principles apply to a notional change of legal form as do to an actual change of legal form. However, when real estate in special business assets is transferred then particular attention should be paid to the additional changes in the GrEStG due to the KöMoG.
The transfer of domestic (German) land and property in special business assets from a sole owner or from several co-owners to jointly owned assets - which according to Section 1 GrEStG is generally a taxable event - is tax-exempt according to Section 5 GrEStG insofar as the transferor/s hold/s a share of the assets that are jointly owned. A reduction in the size of the stake within 10 years (starting from 1.7.2021) would however result in subsequent taxation accordingly.
In order to clamp down on certain tax structures (creation of shelf companies) the lawmakers made additional changes to the GrEStG in the form of prior and subsequent holding periods for partnerships that exercise the option; these amendments made it into the final draft proposal for the KöMoG at the urging of the Finance Committee so that the concessions will not even apply. Through this, despite only partial amendments there will indeed be considerable restrictions as exercising the option will be viewed as a reduction in the shareholding. Therefore, exercising the option for co-entrepreneurships with land and properties that form a part of special business assets that are essential for operations is likely to become, at least, significantly more difficult.
Please note: It will be absolutely necessary to compare tax burdens on a case-by-case basis.
In the alternative solution, where land and properties that are held as special business assets are transferred to a sister GmbH & Co. KG deemed to be of a commercial nature, the tax concessions would still apply so that the real estate transfer tax would not have to be paid insofar as the transferor holds shares in the acquiring company. This would apply as long as, during the 10-year blocking period, this sister GmbH & Co. KG, on its part, does not opt for corporation tax or the transferring shareholder/s, do not reduce their shareholdings.
Conclusion and Outlook
In view of the strict conditions with respect to special business assets that are essential for operations in the case of a change of legal form, it will be significantly more difficult for businesses with special business assets that are essential to make use of the option. In the run-up to the draft legislation there was a discussion about keeping these as business assets, unfortunately, this was not included in the final version. It remains to be seen whether or not, in the new legislative period, lawmakers will improve this section of the legislation and thus make it easier for many companies to exercise the option.
In practice, many issues relating to the exercise of the option have generally already arisen. In order to provide advice and information on the disputed issues for the local tax offices that process enquiries as well as for taxpayers and their consultants, the BMF is working on a guidance letter on the application of the option pursuant to Section 1a KStG. The BMF published a draft on 30.9.2021 and asked for comments on this by 20.10.2021. The initial impression of the BMF guidance is that it confirms the numerous considerations of the tax consulting community that has already intensively addressed cases of uncertainty in connection with the option pursuant to Section 1a KStG. We will report back once the final version is available.
Recommendation: At any rate, the effects of the option need to be carefully thought through beforehand; in this case, the requisite preparatory steps will have to be completed by the reference date selected for the exercise of the option.