Amendments to the German Corporation Income Tax Act

Background

Until now, the choice of the legal form of an entity had a direct impact on the applicable tax regime, since partnerships are transparent and corporations opaque for German tax purposes.

In particular, since a partnership is transparent, the income of the partnership is attributed directly to the partners and may (only) be subject to German (corporate) income tax at their level.

On 25 June 2021, the act on modernising the corporate income tax laws (Gesetz zur Modernisierung des Körperschaftsteuerrechts) (the Amendment Law), amending, inter alia, several provisions of the German Corporate Income Tax Act (Körperschaftsteuergesetz –KStG) and the German Investment Tax Act (Investmentsteuergesetz – InvStG) was passed (cf. Federal Law Gazette I of 30 June 2021, page 2050 et seq.).

The key element of the Amendment Law is the implementation of a new paragraph 1a in Section 1 KStG, which grants, inter alia, German general partnerships (offene Handelsgesellschaft), limited partnerships (Kommanditgesellschaft) and comparable foreign partnerships (eg the Luxembourg société en commandite spéciale (S.C.Sp.)), the opportunity to opt for taxation as a corporation.

Since the Amendment Law will also amend provisions relevant for investment funds, the impact of these amendments on the taxation of investment funds and its investors is explained below.

Exercise of the option and revocation

As explained above, German partnerships and comparable foreign partnerships will have the right to opt for taxation as a corporation, by filing an application, and can, therefore, from both a (tax) procedural and substantive perspective, be treated as corporations.

However, the right to exercise this option does not apply to:

• investment funds within the meaning of the InvStG, and
• partnerships, which, after exercising the option, are not subject to a tax liability comparable to German unlimited corporate income tax liability (unbeschränkte Körperschaftsteuerpflicht) in the state in which their principal place of business (Geschäftsleitung) is located.

Pursuant to Section 1 para. 2 InvStG, investment funds are (foreign) investment estates (Investmentvermögen), as defined in Section 1 para. 1 of the German Capital Investment Code (Kapitalanlagegesetzbuch). However, according to Section 1 para. 3 no. 2 InvStG, investment estates organised as partnerships are, in general, not investment funds within the meaning of the InvStG, unless they qualify as UCITs. Therefore, investment funds organised as partnerships can in general exercise the option.

On this basis, a German Investment-KG, for example, can generally elect to be treated as a corporation. On the other hand, investment funds organised as a Luxembourg S.C.Sp. do not have this option since they are not subject to corporate income tax in Luxembourg (unless reverse hybrid rules apply).

Moreover, it should be noted that an Investment-KG, which has exercised the option does not qualify as an opaque investment fund within the meaning of chapter II of the InvStG (Chapter-II-Fund), but is treated as a normal (opaque) corporation.

The option is not irreversible, and on application, treatment as a corporation can be revoked by the partnership and the partnership will thereafter be treated as transparent for tax purposes again.

Taxation of the partners

As a result of the exercise of the option, the interest of the partners in the partnership will be deemed to be a share in a corporation for tax purposes.

The exercise of the option constitutes a transformation of legal form (Formwechsel) within the meaning of Section 1 para. 3 no. 3 of the German Conversion Tax Act (Umwandlungssteuergesetz – UmwStG). Sections 1 and 25 UmwStG, and therefore in particular Sections 20 et seq. UmwStG, are to be applied accordingly.

The transformation of the legal form generally gives rise to a disposal, since the acquiring company grants the new company shares as consideration for the transferred business assets to the partners.

However, the transferred business assets can be recognised at book value, so that the transfer can be made in a tax-neutral manner such that any off-balance sheet reserves (stille Reserven) will not be subject to tax. The prerequisite for this is, inter alia, that the essential business assets of the partnership are transferred, which may cause issues in particular with respect to functionally essential business assets of the partners qualifying as special business assets (Sonderbetriebsvermögen). However, this is generally not an issue for investment funds organised as partnerships as their partners usually have no special business assets.

It should be noted that income generated from the shareholdings will give rise to dividend income within the meaning of Section 20 para. 1 no. 1 German Income Tax Act (Einkommensteuergesetz – EStG), which is subject to withholding taxes, whereas distributions of partnerships are not subject to withholding taxes.

Impact of the election on income of an opaque investment fund

General background

If an investment fund, organised as a Luxembourg S.A. or S.C.A, for example, which qualifies as an opaque Chapter-II-Fund within the meaning of the InvStG, holds interests in a commercial partnership, which has a permanent establishment in Germany, the fund realises other domestic income (sonstige inländische Einkünfte) within the meaning of Section 6 para. 5 no. 1 InvStG in connection with Section 49 para. 1 no. 2a EStG and is therefore subject to German taxation on its German permanent establishment income. This includes capital gains resulting from the disposal of the partnership interests.

If a partnership held by the opaque Chapter-II-Fund opts to be taxed as a corporate , the distributions to the Chapter-II-Fund are from then on subject to taxation as so-called domestic participation income (inländische Beteiligungseinnahmen) pursuant to Section 6 para. 2, para. 3 no. 1 InvStG. However, only distributions will be taxable at the level of the Chapter-II-Fund, not capital gains from the disposal of the partnership interests.

Impacts of the option on the equity investment quota and partial exemption

Pursuant to Section 2 para. 6 InvStG, equity funds (Aktienfonds) are investment funds which, in accordance with their investment conditions (gemäß ihren Anlagebedingungen), continuously invest more than 50 % of their assets in certain qualifying equity investments (the so-called Equity Fund Equity Investment Quota (Aktienfonds-Kapitalbeteiligungsquote)).

According to Section 2 para. 7 InvStG, mixed funds are investment funds which, in accordance with their investment conditions (gemäß ihren Anlagebedingungen), continuously invest at least 25 % of their assets in certain qualifying equity investments (the so-called Mixed Fund Equity Investment Quota (Mischfonds-Kapitalbeteiligungsquote)).
Equity and mixed funds benefit from the partial exemptions (Teilfreistellung) pursuant to Section 20 InvStG. Pursuant to Section 20 InvStG, for example, income from equity funds which meet the Equity Fund Equity Investment Quota, is exempt from tax up to 80% for German corporate income tax purposes and 40% for German trade tax purposes, depending on the individual circumstances of each investor.

Amendments to Section 2 para 8 sentence 5 no. 1 InvStG have clarified that shares in a partnership are not deemed to be equity investments, even if the partnership has opted for corporate taxation.

Therefore, it is not possible to reach the Equity Fund Equity Investment Quota or Mixed Fund Equity Investment Quota by exercising the option for taxation as a corporation.

Entry into force and temporal scope of the application of the amendments

The amended rules of the KStG and the InvStG are in principle applicable with effect from 1 January 2022.
However, Section 1 para. 1a of the KStG has effect for the fiscal year 2021 with the provision that it can be applied for the first time for financial years beginning after 31 December 2021.

The implementation regulation ensures that an application for the option for taxation as a corporate can be submitted during 2021 so that the partnership can be taxed as a corporation with effect from the financial year 2022.