August 15, 2017 News

Taxation of dividends for corporate investors

Tax exemption on dividends for corporate investors: corporate income tax ("CIT")

Portfolio companies usually keep their proceeds and profits in the company to invest for further growth and development. Still, it sometimes seems that dividends are distributed by the portfolio companies to their investors or – even more likely – from a subsidiary to the portfolio company.

Dividends distributed by one corporation to another (e.g. the portfolio company to the corporate investor; directly or indirectly via a fund structured as a partnership) are generally (exception rules could apply) exempted from CIT if the recipient of the dividend, i.e. the shareholder, holds a minimum stake in the distributing company of at least 10%. For the purpose of the tax exemption it doesn't matter whether the distributing corporation is a domestic or foreign company (on special rules for municipal trade tax, see below). However, 5% of the (gross) dividend is deemed to be non-deductible business expenses. As a result, 95% of the capital gains are not taxable in Germany. In addition, the actual business expenses connected with the shares in the portfolio company are in principle deductible.

The remaining (not tax exempted) 5% of the dividend is subject to CIT at a rate of 15% (plus solidarity surcharge of 5.5% on the CIT, adding up to an effective tax rate of 15.83%). In relation to the full dividend, only about 0.75% CIT is imposed on the (gross) amount.

Distinction: If the distribution is not an actual dividend but a repayment of former contributions (which is determined on the basis of a special provision in German tax law in a fictitious manner), the distributions would be treated as a mere – tax neutral – repayment of contributions, which only reduces the book value of the shares in the portfolio company of the corporate investor without triggering the above '5% taxation'.

Tax exemption on dividends for corporate investors: municipal trade tax ("MTT")

The dividend tax exemption scheme for CIT is in principle also applicable to MTT in Germany (if the dividend is subject to MTT due to a domestic permanent establishment). But the corporate investor needs to meet a minimum participation rate of at least 15% instead of 10%.

Other requirements for foreign distributing corporations have to be met. In particular, these foreign companies have to generate their income mainly by carrying out what is called 'active' business activities (simply speaking e.g. classic trading of goods, rendering services, etc.) and not only 'passive' activities (by generating income through mere asset holding activities, e.g. interest income). The details of these requirements tend to be pretty complex and need to be documented by the corporation to benefit from the tax exemption.

If the tax exemption scheme applies for MTT purposes, 5% of the dividend is also deemed to be non-deductible business expenses and is therefore subject to MTT. The MTT rate depends on the specific assessment rate determined by the municipality where the relevant domestic permanent establishment (to which the dividend is allocated) is based. This can vary, but in an average case the effective MTT rate is roughly 15%. In relation to the (gross) dividend, MTT on tax exempted dividends amounts to approx. 0.75% (roughly calculated as described above).

Distinction: Other income like interest income or exit proceeds

Other income derived from the investment in a portfolio company is regularly subject to tax without special benefits (e.g. interest income resulting from granting a loan to the portfolio company). This income, obtained by a corporate investor, is subject to CIT and MTT of approx. 30% (in an average case; the specific rate can vary from case to case).

But there is also a tax exemption scheme for corporate investors on capital gains derived from an exit (e.g. sale of shares) in a portfolio company (assuming it's a corporation). If this tax exemption applies, only 5% of the capital gains are liable to CIT and MTT, typically resulting in a tax burden of only 1.5% (in an average case). On top of that, the corporate investor doesn't need to meet any minimum participation rate to benefit from this tax exemption, which is a big advantage over the tax exemption for dividends described above.