SMP
September 01, 2017 News

Taxation of exit proceeds for corporate investors

Beneficial exit taxation scheme for corporate investors

Germany has a favorable tax regime for corporate investors such as VCs investing via a corporation. Capital gains derived from an exit of shares in a corporation are usually tax-exempted in Germany. Only 5% of the profits derived from this exit are deemed to be nondeductible business expenses. As a result, 95% of the capital gains are not liable to tax in Germany.

The remaining (taxable) 5% of the capital gains are subject to German corporate income tax ("CIT") at a rate of 15% (plus a solidarity surcharge of 5.5% on the CIT, adding up to an effective tax rate of 15.83%). In relation to the full amount of capital gains derived from the exit, only about 0.75% CIT is imposed on any profits.

If the profits can be allocated to a German permanent establishment, German municipal trade tax ("MTT") is also payable, but the above tax exemption mechanism also applies. Only 5% of the exit profits are then subject to MTT. The resulting effective tax burden depends on the assessment rate that is determined by the municipality where the permanent establishment is maintained. Moreover, the specific tax consequences can vary, depending on the level where MTT is imposed (e.g. on the level of the corporate investor or that of the VC fund if it is liable to MTT itself). In average cases, the MTT is about the same as CIT (0.75% of the profits).

In summary, corporate investors typically owe CIT and MTT in an amount equal to approx. 1.5% of the capital gains derived from the exit of shares in a corporation. This taxation scheme is very beneficial and makes investments in Germany attractive for corporate investors. Both German investors and foreign corporate investors that are (partially) liable to pay tax in Germany on their capital gains benefit from the tax exemption. The capital gains depend on the investment structure and the relevant double tax treaty between Germany and the foreign country.

Corresponding to the tax exemption for capital gains, capital losses resulting from a sale of shares in a corporation are, by contrast, not deductible for tax purposes at all (no portion of the loss is deductible, even if only 95% of the capital gains are effectively tax-exempt. The same applies for write-downs of the (book) value of shares in the corporations.

Exceptions

There are a few exceptions that this tax exemption scheme does not apply to. Possibly the most relevant one for VCs is the exception for short-term trade profits which – if applicable – means that the exit proceeds are taxed in full. This increases the CIT and MTT burden from approx. 1.5% (see above) to approx. 30% (in an average case – the specific rate can vary). For more information on this issue and new developments, see my article Taxation of exit proceeds – new developments for corporate investors

Distinction: Other income like interest income or dividends

In contrast to the tax exemption on capital gains, other income derived from an investment in a portfolio company (e.g. interest income resulting from granting a loan to the portfolio company) is usually subject to tax without any special benefits. A tax exemption scheme similar to the one above only applies to dividends received by a corporate investor, provided that such an investor holds at least 10% (for CIT) and 15% (for MTT) in the portfolio company, along with further requirements that have to be met if the dividend is paid by a foreign portfolio company. For a more detailed explanation of the taxation of dividends in Germany, see my article Taxation of dividends – tax exemption for corporate investors.