Moving abroad - Tax risks and avoidance strategies
Part II - Conditions for the application of alternative structuring options
Exit taxation can present considerable challenges for shareholders of corporations - without early planning there is a risk that tax burdens will arise that pose existential threats. In Part I we presented a specific practical case study and calculated the tax burdens for this. Below we discuss the following potential strategies to avoid this tax: clever residency management, conversion into a partnership, the setting up holding structures or a transfer to a foundation.
1. Clever residency management
Temporary absence
If the basic intention is to move abroad only temporarily then, potentially, the so-called return provision under Section 6(3) of the Foreign Transactions Tax Act (Außensteuergesetz, AStG) could be applicable. In this way, the tax claim would be cancelled if within seven years the taxpayer once again has unlimited tax liability and, during their absence, did not carry out a harmful supplemental tax event. The time period can be extended to twelve years provided that there is still an intention to return.
Not giving up unlimited tax liability status
Unlimited tax liability ends not just when residency in Germany is given up, but also when habitual residency in Germany has been terminated. In this case, anyone who stays longer than 183 days in another country would be considered not to have unlimited tax liability in Germany any more.
To permanently maintain unlimited tax liability status in Germany it therefore has to be possible to establish residency or habitual residency in Germany (Section 1(1) of the Income Tax Act [Einkommenssteuergesetz, EStG]). When relocating abroad it is necessary to check if, according to a relevant double taxation agreement (DTA), there is likewise residency.
2. Conversion of a corporation into a partnership
Structuring
According to Section 6 AStG, exit taxation only affects shares in corporations within the meaning of Section 17 EStG. That is why the conversion of a corporation into a partnership is a structuring option that could be considered. Through this a switch is made to a stake in a partnership.
Under nearly all DTAs, a country will have the right to tax income from an operating partnership provided that the latter has its registered office in the respective country. For the company to also be recognised by the foreign fiscal authority it has to have been operating commercially from the beginning.
If there is a wish to carry on the company form with limitation of liability, then the legal form of a GmbH & Co. KG [a German limited partnership with a limited liability company as a general partner] would be appropriate. The most common method for converting a corporation into a partnership is a change of legal form while preserving its identity (cf. Sections 190 ff. of the Transformation Act [Umwandlungsgesetz, UmwG]).
- First of all, a Komplementär-GmbH [general partner limited liability company] has to be formed here. This company should have the same shareholders as the existing GmbH [limited liability company].
- Subsequently, the legal form of the existing, operating GmbH will be changed into that of a Kommanditgesellschaft [limited partnership]. The shareholders of the GmbH will be the limited partners and the general partner will be the newly formed Komplementär-GmbH.
- The change of legal form requires a resolution in this respect (Section 193(1) sentence 1 UmwG) and it has to be adopted by a majority of at least three quarters at the shareholders’ meeting (Section 233(2) UmwG) and certified by a notary (Section 193(3) UmwG).
Implications at the level of the company
Under German commercial law, in the case of a change of legal form the identity of the legal entity as well as the financial situation and ownership structure are maintained. The only change is that of the legal form - from a GmbH to a GmbH & Co. KG. The book values as well as the acquisition and production costs of the assets are carried forward. By entering the change of legal form in the Commercial Register it becomes effective under civil law.
By contrast, under tax law a transfer of assets is simulated. In the final tax accounts of the transferring GmbH the assets generally have to be recorded at their fair market values. This results in the realisation of hidden reserves and a transfer gain for the transferring GmbH that is subject to corporate and trade taxes.
Implications at the level of the shareholders
As a consequence of the change of legal form, the mode of taxation would shift from the separation principle to the transparency principle. This means that, in the future, taxation would take place at the level of the shareholders of the GmbH & Co. KG.
For this system transition the retained profits of the GmbH would have to be fully distributed. Under Section 7 UmwStG, all open revenue reserves of the corporation would be deemed to have been distributed and would have to be taxed by the shareholders. At the level of the shareholders, 60% of the gain would be taxable and the personal tax rate would have to be applied.
Example: In our practical case study (please see Part I in the 2/2025 issue of the PKF Magazine) it was assumed that there were revenue reserves in the amount of €40m. This would result in a tax burden in the amount of €11.4m.
3. Holding with an additional GmbH & Co. KG
Structuring
For this structure a newly formed GmbH & Co. KG, which acts as a holding company, is placed between the shareholders and the GmbH. To this end, the shareholders contribute their shares in the GmbH to the business assets of a newly formed GmbH & Co. KG. The contributing shareholders become limited partners and consequently hold business assets. As the participations are no longer held as private assets by the shareholders, and Section 17 of the Income Tax Act (Einkommenssteuergesetz, EStG) does not apply to stakes in business assets, the shareholders are able to move abroad without the elements of exit taxation being fulfilled pursuant to Section 6(1) AStG.
The GmbH & Co. KG is the parent company and has the status of a holding company because it holds and manages the shareholding in the GmbH. The GmbH continues its operations unchanged.
Substance requirement when relocating to a DTA country
It should be noted that a GmbH & Co. KG as a holding company will need business substance. From a tax perspective, the conditions have to be created so that the shareholding in the GmbH subsidiary company is attributed to the permanent establishment of the GmbH & Co. KG holding company. A distinction generally has to be made here as to whether the move is to a DTA country or to a non-DTA country.
In order to maintain the German right to tax dividends from the contributed shareholding, or a capital gain from a subsequent sale of the shareholding, the shares have to be held in a GmbH & Co. KG that has been operating commercially from the beginning and it has to be possible to attribute the shareholding as well as the income that results from it to the domain that has been operating commercially from the beginning. A GmbH & Co. KG that is only deemed to be of a commercial nature is considered to be transparent for tax purposes, and from the perspective of another country a partner has income from capital assets.
The requisite business substance can be created by the holding company providing group services (e.g., in the areas of finance and accounting, IT, controlling, legal and HR) and invoiced as such. Substance can technically be brought into the holding company by the GmbH transferring its administration division - in accordance with Section 613a of the German Civil Code - to the holding company.
4. Transfer of a GmbH to a foundation
Structuring alternatives
A foundation is a separate legal entity that, unlike a corporation, has no shareholders. The shareholder would thus be able to move abroad without triggering an exit tax liability. When transferring to a foundation there are two options:
- transfer the GmbH to a private foundation in the form of a family foundation, or
- transfer the GmbH to a public benefit foundation.
Family foundation
This avoidance strategy is appropriate, in particular, for shareholders who are already married, or have a family. In this case, before relocating, a shareholder would set up a foundation to which they would contribute their shares in the GmbH as the foundation assets.
Establishing a foundation with legal capacity requires an act of formation (Stiftungsgeschäft) and recognition by the competent foundation authority of the respective German federal state where the foundation has its registered office. In the case of a family foundation, it would make sense to establish it for an indefinite period and to specify its purpose in such a way that it is geared towards the advancement and support of the family members who, according to the by-laws, are the beneficiaries. The beneficiary family members are referred to, in German, as Destinatäre [beneficiaries] and this would also include the former GmbH shareholder, so that the latter would still have an indirect interest in the GmbH. The foundation assets would consist of the shares in the GmbH. The foundation would thus be entitled to all the income from the participation in the GmbH. These amounts serve to fulfil the purpose of the foundation and will benefit the Destinatäre.
A tax exemption as tax-privileged business assets would only be possible if the shareholding in the GmbH was more than 25%. Under this condition, regular relief of 85% is granted up to a value of €26m, or upon request, optional relief of 100%. In the case of a gift above €26m, the exemption is reduced by one percentage point for each €750k and would be zero from a value of €90m.
Example: In the practical case study (please see Part I), Mr A holds exactly 25% and, thus, not more than 25% of the GmbH, therefore, no preferential treatment would be granted. For the donation of the 25% a gift tax in the amount of €6.7m would be payable. This tax cannot be reduced and the family foundation model is accordingly not a real option for A.
Variation on the family foundation
In the case of business owner C, who holds 50% in the GmbH and likewise has children, the value of the donation or the gift would have been €50m. This gift of more than 25% would have been tax-privileged. The relief would have been reduced by 32%, so that the regular relief would have been 53%. As a result, 47% of the €50m less the tax-free amount of €0.1m, thus, €23.5m would have been taxable.
The tax burden for a family foundation, in tax class I, would be €6.3m. For a foundation, as the ‘recipient of the gift’ this would not be feasible. In such cases, the so-called needs assessment in order to obtain a tax-exemption under Section 28a of the Inheritance Tax Act (Erbschaftssteuergesetz,ErbStG) could be interesting. According to this, a family foundation can submit an application for a (partial) waiver of gift tax insofar as this pertains to tax-privileged assets (within the meaning of Sections 13a, 13b ErbStG) and settling the tax liability would constitute an exceptional hardship for the foundation.
Public benefit foundation
The advantage of a public benefit foundation is that it is 100% exempt from inheritance and gift taxes. The question of the benefit to the public of a foundation is determined by the type of income generation and its use. Public benefit purposes include, for example, the promotion of education and learning, scholarship and research, nature protection and landscape conservation as well as arts and culture. In practical terms this means that the shareholders must consider which public benefit purposes they would like to pursue with their foundation. In principle, providing for the founder and their family is admittedly not completely excluded. However, because of the requirements, in practice providing support cannot really be achieved.
Summary
For shareholders of corporations moving abroad is associated with considerable tax challenges. To avoid the tax burdens that could arise and pose existential threats it is vital to plan early and to deploy appropriate strategies. The ones to be considered are:
- clever residency management,
- conversion into partnerships,
- setting up holding structures, or
- transfers to foundations.
