SMP
March 26, 2021 Briefing

SMP Briefing: "Check-the-box" in German tax law at last? Draft Law on an Option Model for the Taxation of Partnerships as Corporations

With the government draft of a "Law on the Modernization of Corporate Income Tax Law" published on the 21st of March 2021, the insertion of a "major tax policy project" into the legislative process is imminent. In addition to several selective adjustments to reorganization tax law and to the corporate tax group, the draft provides for significant amendments to the German Corporate Income Tax Act: In the future, partnerships are to be given the option of being treated like a corporation for income tax purposes (in principle, comparable with the "check-the-box" option known from US tax law).

The declared aim of the proposed legislation is to improve the tax environment, particularly for medium-sized partnerships and family businesses. Nevertheless, the planned regulation has implications for all corporate tax law and may in certain cases become relevant in the broader context of venture capital (VC) and private equity (PE) funds.

 

I. Design of the planned new regulation

Overview

An essential component of the new regulation is the introduction of a new Sec. 1a of the German Corporate Income Tax Act (Körperschaftsteuergesetz) "Option to Corporate Income Taxation". Under certain conditions, this will enable so-called opting (partnership) companies to be treated equal to corporations in terms of tax procedure and substantive law for the purposes of income taxation (including the corresponding consequences at the level of shareholders). For the legal implementation, the proven instruments of the German Reorganisation Tax Act (Umwandlungssteuergesetz) are used and existing provisions of the German Corporate Income Tax Act or the German Income Tax Act (Einkommensteuergesetz) are declared applicable (or not applicable) in a possibly modified form. The provision is complemented by further, but altogether straightforward, consequential amendments in the respective individual tax laws. The effect of exercising the option is limited to the area of income taxation. It is only relevant for other types of taxation if explicitly stipulated. The exercise of the option should therefore remain irrelevant, for example, in VAT and real estate transfer tax law.
Scope of application and requirements

The following partnerships are to be eligible for the option

  • commercial partnerships established under German law (limited partnerships and general partnerships, but not civil law partnerships) and partnership companies as well as
  • comparable commercial partnerships formed under foreign law.
However, in the latter case, sufficient domestic reference points are required (e.g. at least two partners with unlimited tax liability in Germany, domestic [management] permanent establishment). In addition, if the company has its place of management abroad, it must be subject to a tax liability in the other country that is comparable to the German unlimited corporate income tax liability (avoidance of hybrid companies).

The requirement for the effective exercise of the option is an irrevocable application, which must be submitted to the tax office responsible for the separate and uniform determination (Sec. 180 (1) Sentence 1 No. 2 (a) of the General Fiscal Code [Abgabenordnung]). The application must be made before the beginning of the fiscal year during which the taxation as a corporation is to apply. In addition, the application requires a shareholders' resolution, which must generally be approved by all shareholders. The partnership agreement of the partnership can also provide for a majority decision, which, however, must be adopted with at least ¾ of the votes cast.

Tax consequences of the transition to corporate taxation

The transition to taxation under the Corporate Income Tax Act is solved in legal terms by the fiction of a (purely fiscal) change of legal form and the corresponding application of the relevant provisions of the Reorganisation Tax Act (Sec. 1 and 25 of the Reorganisation Tax Act). The reference to these articles of the Reorganisation Tax Act is to be understood comprehensively: in principle, all prerequisites as well as all commonly associated legal consequences that apply during a change of legal form are to apply, without, however, such a change of legal form being executed under civil law. This should mean that

  • only trade or business partnerships (i.e. not purely asset-managing partnerships) can opt;
  • the option can only be exercised in an income tax-neutral manner if no functionally significant business assets of the opting company are retained - this also includes assets owned by the partners under civil law, which are to be regarded as so-called special business assets (Sonderbetriebsvermögen) for income tax purposes - and an (additional) application for book value continuation is filed;
  • an exercise of the option is to be regarded as a transaction for income tax purposes - at least according to the view generally held by the tax authorities to date (fictitious sale of assets from the transferring partnership and acquisition of assets at the acquiring opting company);
  • the shares in the company are to be regarded as shares subject to a lock-up period (Sec. 22 (1) of the Reorganisation Act) for seven years.

However, in deviation from the general reorganisation tax regulations regarding a change of legal form, the exercise of the option shall not be subject to a retroactive effect. And so, the date of contribution is to be the end of the fiscal year preceding the fiscal year for which taxation under the Corporate Income Tax Act is to take place for the first time. Whether the exercise of the option is to be regarded as a reason for the formation of a short fiscal year appears to be undecided.

Since the wording of the provision of Sec. 27 of the Corporate Income Tax Act on the so-called tax contribution account does not permit direct application in the event of an opting company - the partnership, which under civil law remains unchanged, does not dispose of any necessary "nominal capital" - Sec. 1a (2) Sentence 4 of the Corporate Income Tax Act Draft provides that the equity to be reported in the tax balance sheet of the partnership is to be recorded in the tax contribution account as a whole. Partner accounts that are to be regarded as debt and not as equity for tax purposes are not included.

Taxation after exercise of the option

After exercising the option, the partnership is to become a corporate tax subject and the partners of the (civil law) partnership are to be treated as shareholders of a corporation for tax purposes. The law assumes that from the shareholder's perspective, the participation in the opting company is to be treated as a participation in a corporation for income taxation purposes, both substantively and procedurally. This has consequences for the type of income that the shareholder generates through his share as well as for determining the point in time at which his income is recognized for tax purposes.

Regarding the type of income, the draft regulation provides that "income caused by the corporate relationship" is to be recognized by the shareholder as income from capital assets. This primarily describes income that would be regarded as a share in profits within the meaning of Sec. 15 (1) Sentence 1 No. 2 Sentence 1 first clause of the Income Tax Act if the option had not been exercised. Therefore, this income is accessible to the tax exemptions pursuant to Sec. 3 No. 40 of the Income Tax Act or Sec. 8b of the Corporate Income Tax Act at the level of the shareholders and is generally subject to the capital income tax withholding at the level of the opting company. In the context of Sec. 8b (4) of the Corporate Income Tax (fully taxable dividends from widely held stock participations < 10%), the question of determining the amount of the participation arises - since there is no "share capital", the focus would probably lie on the "participation in the assets" in the case of an opting company.

With the aim of implementing the principle of separation and thus the tax-recognized retention of profits, the time of taxation is generally based on the inflow of income to the shareholder. Profit shares should therefore only be considered as distributed when they are withdrawn – or when their payment can be "demanded" by the shareholder. The latter criterion is to be understood as a restriction of the principle of retention, which also corresponds to the legal situation for controlling limited liability company shareholders: if a shareholder can already dispose of the (non-withdrawn) amounts economically, these are deemed to have accrued and thus are to be taxed by him.

Re-option

In principle, an opting company is free to return to a taxation according to partnership principles. There is no time limit for the option exercised pursuant to Sec. 1a (1) of the Corporate Income Tax Act. Nevertheless, at least in the first seven years after exercising the option, there are obstacles to re-option due to the lock-up period for conversion tax purposes triggered by the fictitious change of legal form.

Analog to the exercise of the option, the application for the re-option must be made before the start of the fiscal year during which taxation is to be (re)applied in accordance with the transparency principle. Retroactivity is not intended either. In deviation from the option, the application for the re-option does not require a shareholders' resolution. Furthermore, in certain cases, the re-option can also be triggered without a request (and possibly unintentionally by the shareholders).

II. General assessment and practical advice

Even if numerous questions of detail are still open, the draft law is to be welcomed. The different needs and requirements of taxpayers are accommodated by the optional structure chosen. Particularly in a cross-border context, the option model appears to be a pragmatic solution to the challenges often arising from the special features of German partnership taxation (e.g. special business assets).

The pragmatic approach to the legal implementation of the option model is also convincing. By reverting to the established system of reorganisation tax law, many questions can be answered with the established application principles of Sec. 20 and 25 of the Reorganisation Tax Act. Due to the equality of opting companies with corporations, the consequential changes which are necessary in the other individual tax laws are also manageable. However, at the shareholder level this is accompanied by the arrangement of the taxation consequences in the current draft law, which does not appear to be fully systematic at first glance. It should be pointed out that in the further course of the legislative process, the insertion of (possibly clarifying) equalizations in the laws will become necessary (e.g. in the case of limited corporate income tax liability, Sec. 2 No. 1 of the Corporate Income Tax Act). The question whether an opting company can be a controlled company (Organgesellschaft) within the meaning of Sec. 17 of the Corporate Income Tax Act should also be clarified.

For the (legal) practice, the foreseeable amendments to the articles of association of partnerships willing to apply for an option will be significant. On the one hand, the necessity of an adjustment of the tax clauses in the partnership agreement as well as the majority requirements regarding an option application must be examined. In addition, attention must be paid to the design of the capital account regulations to ensure an accurate recording in the tax contribution account when the option is exercised and to ensure a synchronization between the time of the tax recording of the profit shares recorded in the accounts and the actual inflow of funds to the shareholders.

The strict requirements regarding functionally essential business assets of the SBC (typically real estate, but possibly also shares in a general partner limited liability company in a German GmbH & Co. KG) could prove to be a problem. According to the explanatory memorandum, the retention of such assets shall always result in the option not being exercised in an income tax-neutral manner. With the exercise of the option corresponding assets would then, for example, be transferred additionally (and simultaneously) to the partnership's overall assets under civil law.

A further point of criticism arises regarding the lack of coordination with the existing regime of preferential treatment of non-withdrawn profits pursuant to Section 34a of the Income Tax Law. If the partners of the partnership have previously made use of this preferential treatment, exercising the option pursuant to Sec. 1 (1a) of the Corporate Income Tax Law would lead to subsequent taxation of the amount subject to subsequent taxation. Since the Federal Ministry of Finance does not consider the option model and the preferential tax treatment pursuant to Sec. 34a of the Income Tax Law to be in competition with one another, but sees the regulations as complementary to each other, an appropriate regulation for the transition between the regimes should be considered.

In summary, it can be said that the regulatory depth and complexity of the provision should not be underestimated despite its manageable scope. Taxpayers will have to consider the advantages or disadvantages of using the option on an individual basis. In doing so, interdependencies with other tax planning aspects (e.g. exit taxation) as well as any consequential effects in other types of taxation (e.g. with regard to inheritance/gift tax aspects) will have to be taken into account.

III. Relevance in the fund context?

In the context of VC and PE funds, the significance of the planned option model appears limited at first glance. Nevertheless, some aspects are worth mentioning:

Foreign holding or acquisition vehicles as well as blocker companies.

Especially in the international private equity context, (e.g. US) Limited Liability Companies (LLCs) are regularly used in acquisition structures. These companies are sometimes used as blocker companies by asset management funds, too, in order to avoid to be treated as a deemed trade or business partnership when holding an interest in another partnership which carries on a trade or business for tax purposes (so-called 'infection theory').

In both cases, these companies must be qualified as partnerships or corporations for German taxation purposes on a case-by-case basis. Depending on the respective structure, the result of this comparison is not always clear and thus subject to legal uncertainties. In cases where the qualification as a corporation is preferred for the purposes of German taxation, this uncertainty could be eliminated by a binding determination by way of an option application in the future. However, the practical significance is likely to remain limited to individual cases:

  • For one thing, the foreign company would also have to be taxed as a corporation in the other state. Often, however, transparent taxation in the other country is precisely what is desired.
  • On the other hand, it seems questionable whether the single-member LLCs (fund as sole shareholder) frequently used in this context are even covered by the personal scope of application of the option model (especially since sole proprietors are explicitly excluded).

If the qualification as a partnership from a German perspective would be useful, the planned model does not offer a solution: a "reverse" option for taxation as a partnership is not provided for.

Exercise of the option and investment tax law

Should a fund organized as a partnership (investment fund) make use of the option, this would not alone make it an investment fund within the meaning of the Investment Tax Act (Investmentsteuergesetz). It will therefore neither be possible to intentionally opt "into" the taxation regime of the Investment Tax Act, nor is there a risk of unintentionally triggering the application of the Investment Tax Act through an option.

 IV. Outlook

The option model will be applied for the first time in the 2022 assessment period. The next step will be the introduction of the Draft in the German Bundestag. It remains to be seen with interest whether and in what form this important tax legislative project can be implemented.