On March 24, 2021, the German government passed a draft bill for the modernization of corporate tax law. The legislative process is intended to be completed already in the current legislative period. Somewhat surprisingly, the draft of the German Act on the Modernization of Corporate Tax Law contains, among other regulations, a right for trading partnerships to opt for corporate income taxation. This is planned to come into effect from the 2022 assessment period, but the application must be submitted to the tax authority before the start of the fiscal year. Since applications will be possible after the law has come into force at the earliest, it is likely that action will have to be taken within a short timeframe if the option is intended to be exercised already for a fiscal year beginning on January 1, 2022. Therefore, partnerships and their partners should, irrespective of the still ongoing legislative process, consider timely whether they wish the option to be exercised. In this regard, a number of points need to be taken into account.
So far, partnerships have been subject to trade tax on their profits, but not to corporate income tax. Instead, the partners have been subject, depending on the legal form, to personal income tax or corporate income tax on their share of profits (so-called “transparent taxation”). This applies irrespective of whether their share of profits has been paid out or retained to strengthen equity in the partnership. Corporations (e. g. German limited liability companies and joint-stock companies), on the other hand, are subject to trade tax and corporate tax income tax on their profits, but their shareholders are only taxed once dividends are paid out. Although the corporate income tax rate is significantly lower at 15% than the personal income tax rate (up to 45%), the aggregate tax rate for paid out profits is similar for partnerships and corporations. This is achieved by crediting trade tax against personal income tax for partners of partnerships on the one hand and the reduced tax rate for dividends (final withholding tax) on the other hand. But things are different for retained profits: As long as a corporation retains profits, the aggregate tax rate is lower than that of a partnership, because the shareholders are only taxed once dividends are distributed. Thus, corporations enjoy a cash flow advantage as long as profits are retained.
To eliminate this disadvantage of partnerships, the so-called Brühl Recommendations already included an option model 20 years ago. Instead of this, the legislator had only included an optional beneficial tax rate for profits that are retained in the partnership (Article 34a German Income Tax Act) in the law, which is comparatively complex and partially has disadvantages. Even if the timing is surprising, the German government now obviously intends to implement into the law, additionally, the possibility to achieve comprehensively equal taxation for partnerships and corporations.
For Which Partnerships is an Option Interesting?
The option model is interesting for all partnerships whose investment and cash flow planning is based on internal funding through retained profits. For joint partnerships that pay out their profits to partners on a regular basis, it usually makes more sense to maintain transparent taxation. If it is intended to partially retain and partially distribute profits, it is worthwhile to make a model calculation that is as accurate as possible.
Additionally, partnerships that plan to retain profits should also examine the advantages and disadvantages of exercising the option in detail and make any necessary preparations. The following points may be decisive:
- Does the structure of the partners accounts fit? Profits that are credited to shareholder loan accounts and can be withdrawn at any time are to be considered distributed under the draft bill. If necessary, the partnership agreement will need to be amended.
- Does exercising the option result in the taxation of unrealized capital gains? Exercising the option is to be regarded as a change of legal form within the meaning of the German Conversion Tax Act. Such a change of legal form generally can be made on a no gain and no loss basis. However, this is not always the case. It is possible that business assets owned by the partners, but connected to the partnership (so-called Sonderbetriebsvermögen), needs to be restructured first.
- Are there participations in foreign corporations? It is possible that withholding taxes on dividends from foreign corporations can no longer be credited against German tax after the option has been exercised.
- Are there any trade tax losses carried forward? Their fate when the option is exercised is unclear so far.
Important: Exercising the option is not intended to have any impact on the inheritance and gift tax classification of the partnership. This is important because the inheritance and gift tax benefits for business assets are connected to stricter requirements for corporations than they are for partnerships. Furthermore, after an option has been exercised, it is possible to opt back to transparent taxation with effect for the future, whereby this is deemed to be another change of legal form for purposes of taxation.