Moving abroad - Tax risks and avoidance strategies

Part 1: Practical case study on how tax burdens can arise that pose existential threats

Basic principles of exit tax

Application in the case of family enterprises
Exit taxation is a tax regime that ensures that increases in the value of shareholdings in corporations held as private assets will be taxed in Germany even if the shareholders move abroad and Germany’s right to tax ceases.

In practice, the exit tax issue arises particularly in the case of family enterprises that are organised in the form of a corporation, for example, a GmbH and have several shareholders. If these enterprises are profitable and the enterprise value is significantly above the original acquisition costs, then considerable tax consequences could ensue for the shareholders concerned that could even pose existential threats.

Gains from the sale of shares in the focus of the fiscal administration 
The focus of the exit tax is on the gains from the sale of shares in corporations which are held as private assets, or as the business assets of an asset management partnership. Most double taxation agreements (DTAs) allocate the right to tax these gains to the country where the shareholder concerned is residing on the date of the sale (Art. 13(5) of the OECD MTC). If the shareholder were to sell his equity interest prior to his move, thus while having unlimited tax liability status in Germany, then the capital gain would be taxable in Germany.

The aim of exit taxation is to tax hidden reserves. The intention is to tax the difference between the acquisition costs for equity participations and their market value while Germany still has the right to tax. The objective of the regulation is to avoid revenue losses for the German tax authorities that can arise as a result of private assets being moved abroad.

Legal basis for the assumption of a notional sale
The exit tax is regulated in Section 6 of the Foreign Transactions Tax Act (Außensteuergesetz, AStG). Those affected are natural persons who 

• directly or indirectly hold at least 1% of the shares in a (German) domestic or foreign corporation in their private assets (Section 17 of the German Income Tax Act) and
• permanently relocate their tax residence or habitual residence abroad and
• terminate their unlimited tax liability status.

All natural persons who reside or are habitually resident in Germany have unlimited tax liability.

If Germany is going to lose the right to tax because, in the future, another country will have the right to tax the capital gain then a notional sale of the shares in the corporation would be simulated. The difference between the fair value of the shares on the date of the relocation and the  original acquisition costs would then be taxed.

The capital gain would be subject to the partial income method, whereby 60% of the capital gain would be taxable. The shareholder’s personal income tax rate of up to 45% would be applicable plus the solidarity surcharge and church tax.

Calculation of the tax implications in the practical case study

For the business owner A - without any arrangements in place for avoiding the exit tax -, the following tax consequences, based on a highly simplified calculation, could ensue. Here, for reasons of simplicity, additional church tax that might possibly be incurred has not been taken into account.

Calculation of the tax amount 
The value of the stake held by A is €25m (25% of the enterprise value of €100m). The pro rata acquisition costs are 25% of the share capital or €1m.  This would result in a notional capital gain of €24m. The gain would be subject to the partial income method, whereby 60%, or €14.4m would be taxable.

Since A is unmarried and his regular income is more than €250k, in this respect the top rate of tax at 45% would be applicable plus the solidarity surcharge. 

Outcome - Multiplying the amount of the notional capital gain by the applicable tax rate results in an exit tax in the amount of €6.8m for A:

Notional capital gain €14.4m  x 47.475% =  €6.8m.

Request for deferral
The tax charge arising from the exit taxation has to be paid, although for A, who wishes to emigrate, there is no inflow of liquidity from the proceeds of a sale. Upon request, the tax that has been assessed can be paid in seven equal annual instalments  (Section 6(4) AStG). The taxpayer will, admittedly, be asked for a security; in the example, A would thus have to pay almost €1m per year. While A had always earned good money, nevertheless he had also cultivated an extravagant lifestyle and, thus, would not be able to afford to make these tax payments without profit distributions from ABC GmbH. 

Need for high level of profit distributions 
Since ABC GmbH had routinely retained its profits, it would thus be possible to distribute these so that A can pay his annual instalments. The profit distributions would normally be made on a pro rata basis (please see Section 1 above), 60% of the amount would be taxable and the personal tax rate would have to be applied.

Sample calculation: In order for A to have €1m after tax per year at his disposal, to pay the instalments, he will need a gross dividend of approx. €1.4m per year. For a stake of 25%, ABC GmbH would have to distribute €5.6m annually to all three shareholders on a pro rata basis. Over seven years, this would correspond to a drain on the liquidity of ABC GmbH in the amount of €40m. The €40m of revenue reserves of ABC GmbH would thus be completely used up for the profit distributions.

Even though the company has adequate revenue reserves at its disposal, the question that arises is whether or not, from a liquidity perspective, the profit distributions could likewise be financed.