In the context of cases of consolidated tax groups for income tax purposes, there are routinely differences between the accounting profit, which is transferred to the parent entity within the scope of a profit transfer agreement, and the taxable profit. If the accounting profit that was transferred exceeds the tax-relevant result then this is referred to as an overpayment and, the other way round, as an underpayment. There may be various reasons for such differences between the accounting earnings and taxable earnings. Some possible ones are, for example:
- differences in the useful lives on which depreciation is based in the financial accounts and the tax accounts,
- capitalisation of different acquisition and production cost components, or else
- the fact that it is not possible to include a provision in the tax accounts at the same level that it was created in the financial accounts.
Please note: The new contribution solution pursuant to KöMoG is targeted exclusively at overpayments and underpayments of profit transfers between members of a consolidated tax group. The new rules however have no implications for overpayments and underpayments of profit transfers during the period prior to tax consolidation.
Previous provision on overpayments and underpayments of profit transfers between members of a consolidated tax group
According to the regulations up to now, if there has been an underpayment between members of the tax group then the parent entity has to create a deferred tax asset balancing item in its tax accounts and in the case of an overpayment a deferred tax liability balancing item. At the parent entity – over time and commensurately with the amounts reported by the subsidiary – these balancing items are built up and reduced. At the level of the subsidiary, these overpayments and underpayments of profit transfers, in the context of a consolidated tax group, result in withdrawals and additions to contribution accounts for tax purposes pursuant to Section 27(6) of the Corporation Tax Act (Körperschaftsteuergesetz, KStG).
New regulations under KöMoG (contribution solution)
The so-called contribution solution will apply to the overpayment and underpayment of profit transfers between members of a consolidated tax group that take place after 31.12.2021. This means that underpayment of profit transfers in the context of a tax group will result in a contribution by the parent entity to the subsidiary and overpayment of profit transfers will result in a repayment of a capital contribution. Overpayments and underpayments of profit transfers will increase and reduce, respectively, the carrying amount of the equity investment for the subsidiary in the parent entity’s tax accounts and, correspondingly, the contribution account for tax purposes at the level of the subsidiary.
Please note: Contrary to the previous approach, the carrying amount of the equity investment in the parent entity’s accounts has to be fully adjusted (thus not in proportion to the size of the equity investment). In the case of overpayments of profit transfers, the subsidiary’s contribution account for tax purposes would be directly reduced, although this would not give rise to income from investments. Furthermore, overpayments of profit transfers in the context of a consolidated tax group would primarily reduce the contribution account for tax purposes in priority to other payments.
As of 1.1.2022, no more tax balancing items may be created in the parent entity’s tax accounts for the overpayment and underpayment of profit transfers. Existing balancing items will have to be reversed in the first financial year that ends after 31.12.2021.
In the tax accounts, a balancing item on the assets side has to be reversed against the carrying amount of the equity investment in a profit-neutral way (accounting asset swap). However, there would generally be a risk of an immediate effect on the profit if the amount of the balancing item on the liabilities side was greater than the sum of the carrying amount of the equity investment and the balancing item on the assets side. The partial income method or Section 8b KStG would then apply. With respect to the excess amount, legislators have however granted taxpayers the option of creating a provision that has to be reversed and the reversal evenly recognised in the income statement in the year in which it was created and the nine subsequent financial years (one tenth in each case). If the equity investment is sold or if an event similar to a disposal occurs (e.g. a reorganisation, or a constructive equity contribution) then this would result in the recognition in the income statement of the complete reversal of the amount of the provision still existing at that time. In the case of the reversal of the provision, the partial income method or Section 8b KStG would likewise come into effect.
Please note: With respect to the amount of the provision that is created, taxpayers will be able to exercise the option on an individual basis up to the level of the excess amount.
Conclusion and Outlook
Legislators wanted to simplify the complex system of balancing items that was giving rise to various issues. However, the transition to the contribution solution has prompted fresh discussions. For example, critics believe that the new regulations, among other things, disregard the income realisation principle because income is realised by the reversal of balancing items on the liabilities side even though no sale or an event similar to a disposal has occurred.
Furthermore, there is compulsory taxation of hidden reserves although it is unclear if they even still exist at the time that the tax is imposed. In this way, taxpayers are deprived of the possibility, at least, of using tax deferral structures for hidden reserves realised in the past. There is likewise still no consensus on how indirectly consolidated tax groups should be treated under the new regulations of the KöMoG. From the wording of the law it is possible to derive the question as to whether the overpayment and underpayment of profit transfers in the context of a consolidated tax group results in a direct contribution or a repayment of capital contributions between the parent entity and subsidiary or across the entire shareholding chain.
Please note: Overall, it remains to be seen how these discussions will develop and what response, if any, they will elicit from the German legislature - we will keep you updated accordingly.