Definition of a holding company
There is no statutory definition of a holding company pursuant to German tax law but there are several special tax regulations that determine the requirements for a qualified holding company. For example, a "qualified holding company" under Germany's thin capitalization rules is any company, whose primary business is to hold or finance equity interests in corporations, or any company, in which more than 75% of the owned assets are holdings in corporations.
For the purposes of this guide, a holding company is any company with subsidiaries and no other fixed assets. Furthermore, for the purposes of this guide, the word "subsidiary" is only used to describe an investment in a corporation.
Company law regarding holding companies
Under German company law, a company can qualify as a holding company in the legal form of a corporation (for example, a limited liability company [Gesellschaft mit beschränkter Haftung-GmBH], stock corporation [Aktiengesellschaft-AG]) and a partnership (for example, a general partnership offene Handelsgesellschaft or a limited partnership Kommanditgesellschaft), respectively.
Taxation aspects of the formation and restructuring of holding companies
The reorganization and restructuring of business entities in Germany is mainly governed by the German Reorganization Act (Umwandlungsgesetz) and the German Reorganization Tax Act (Umwandlungssteuergesetz). Basically, all economically sensible forms of domestic reorganizations are legally possible, and, in most cases, can be achieved without recognition of a realized gain.
The EU Merger Directive addresses a limited number of specific transactions between EU-resident corporations. The objective of the EU Merger Directive, in broad terms, is to allow specific types of reorganizations to take place without an adverse tax effect.
On February 17 2005, the EU Council adopted a proposal for amending the EU Merger Directive. As a consequence, the Directive has been extended with respect to the types of transactions and legal company forms covered. Furthermore, the applicability of the Directive to certain operations was clarified.
Taxation of holding companies
Dividends
Withholding taxes on incoming dividends distributed to holding companies by the subsidiaries (subsidiary's jurisdiction)
Under the EU Parent-Subsidiary Directive (Mutter-Tochter-Richtlinie) any dividend payment made by an EU subsidiary to a German holding company is not subject to any dividend withholding tax: provided that the German holding company owns directly a 20% share capital investment (for the calendar years 2007/2008: 15%; as of 2009: 10%) in the shares in the EU subsidiary for a minimum period of 12 months.
Withholding taxes on outgoing dividends distributed to the parent company by holding companies (holding company's jurisdiction)
Generally, profit distributions made by a German resident corporation are in general subject to German dividend withholding tax (Kapitalertragsteuer) of 20% plus 5.5% solidarity surcharge (21.1% in total).
In Germany, the provisions of the EU Parent-Subsidiary Directive an are applicable. According to the Directive, any incoming dividends remitted by a German company to an EU parent company are free of withholding taxes, if the EU parent company controlled at least 20% (for the calendar years 2007/2008: 15%; as of 2009: 10%) of the shares (directly) in the German holding company for a minimum period of 12 months (see above). However, it has to be considered that withholding tax will be levied if there is no substance and no business reason for involving the foreign company and the shareholders of such a foreign company are ineligible for the withholding tax exemption.
Distributions paid by a German subsidiary to a non-German permanent establishment (PE) in the EU which is maintained by a qualifying EU parent company are also free of withholding taxes. The same applies if such a PE is maintained by a German parent company, provided that the relevant shares are effectively connected with the EU PE.
Furthermore, the current minimum interest of 20% is reduced to 10%, if a German holding company distributes a dividend to a EU parent company and such dividend is not subject to tax in the parent company's jurisdiction and, correspondingly, a dividend distributed from this state to Germany is also tax-free; provided that the same minimum equity interest is required as in Germany (reciprocity principle - Gegenseitigkeitsklausel).
Corporate income tax on dividend income received by holding companies (holding company's jurisdiction)
Profit distributions by foreign and domestic corporations to a holding company in Germany are generally tax-free; however an amount equivalent to 5% of the dividend income is to be treated as a non-deductible business expense that may not reduce the income of the recipient holding company. Thus, only 95% of the dividend income received by the German holding company is tax-free. In contrast, all costs incurred with respect to the investment in a subsidiary company may be deducted for tax purposes. The taxable amount is subject to a corporate tax rate of 25% plus 5.5% solidarity surcharge (26.38% in total) at the level of the German holding company.
Generally, the same exemption applies for local trade tax purposes. However, the full amount of the dividend is subject to local trade tax if, at the beginning of the taxable year, the holding company does not hold at least a 10% ownership interest in the subsidiary company. There is an additional active participation requirement applicable to equity interests in foreign subsidiaries, which however, does not apply to investments in a subsidiary domiciled in an EU member state. Moreover, if a double tax treaty applies, the dividend payments could be tax-exempt for trade tax purposes pursuant to the double tax treaty. The local trade tax is a tax on a business enterprise and is levied by German municipalities, based on a company's "trade income" (Gewerbeertrag). Trade income is computed based on federal corporate income tax with certain modifications. The local trade tax rate depends on the local trade tax multiplier (Hebesatz), which is determined by a municipality. It has to be considered that the local trade tax is a deductible business expense for federal corporate income tax purposes and, thus, is deductible from its own assessment basis. Therefore, the effective rate of local trade tax ranges from 12% to 20% (for example, Frankfurt am Main with 19.68%) depending on where the taxpayer carries out its business and what apportionment factors apply if the business is operated in more than one local tax jurisdiction.
If a holding company is a partnership, for federal income tax purposes the dividends are taxed at the partners' level (for the taxation of the partners see below). However, the partnership is a taxpayer for local trade tax purposes, if it has an active trade or business as defined under the German Trade Tax Act or if it is deemed to have an active trade or business.
Double tax treaty protection
Pursuant to the double taxation treaties between Germany and other countries, it is often possible to reduce withholding tax rates on dividends received or distributed by a German holding company.
Capital gains
Capital gains tax on the sale of subsidiary shares by holding company (holding company's jurisdiction)
If a holding company is a corporation that sells an equity interest in another domestic and/or foreign corporation, any capital gain realized on such sale will be tax-exempt for German federal corporate and local trade tax purposes. However, since 5% of the capital gain is treated as a non-deductible expense, effectively only 95% of a capital gain, if any, is tax-exempt.
If the holding company that sells its equity interest is a partnership with individual partners, then - at the level of the partners - the gain realized on the sale is subject to the "half-taxed income rule", pursuant to which only 50% of the gain is subject to federal income tax and additional solidarity surcharge. At the level of the partnership half of the gain is subject to local trade tax.
If the holding company that sells its equity interest is a partnership with corporate partners, then - at the level of the partners - 95% of the gain on the sale is tax-free for federal corporate income tax purposes. At the level of the partnership 95% of the capital gain is also tax-free for local trade tax purposes.
Capital losses
Deductibility of unrealized capital losses
Unrealized capital losses are not deductible.
Deductibility of realized capital losses
Due to the tax exemption (as described above), capital losses associated with the disposed shares may not be deducted for tax purposes (for example, losses resulting from the sale, from write-offs, from reductions in capital, from the liquidation of the corporation).
Deductibility/amortization of underlying goodwill
For tax purposes goodwill acquired for a consideration can be generally amortized on a straight-line basis over 15 years. However, goodwill related to acquired shares cannot be amortized.
Costs
Deductibility of interest costs
Generally, interest costs are tax deductible; however, there are several limitations (for example, constructive dividend, if the interest does not meet the arm's-length test, German thin capitalization rules). Furthermore, any costs that are directly and economically related to tax-exempt income are not deductible. However, all costs incurred at the level of a corporation with respect to the investment in a subsidiary company may be deducted for tax purposes - although the dividend income is generally tax-free - since 5% of the dividend income is treated as a non-deductible business expense.
For trade tax purposes there are some additional limitations. For instance, only 50% of interest payments on long-term loans are deductible.
Deductibility of acquisition costs
For German tax purposes acquisition costs cannot be deducted as expenses, but have to be capitalized.
Deductibility of costs on disposal
Disposal costs are effectively not deductible since, for purposes of calculating the tax-free capital gain realized upon the sale of shares, the sale proceeds are reduced by the amount of disposal costs. Thus, the disposal costs reduce the assessment basis for the 5% non-deductible business expenses. An overall loss on disposal is disregarded for tax purposes.
Interest
Withholding tax on interests
In general, Germany does not impose a withholding tax on interest payments. However, for example, if interest is paid by a German domestic bank the withholding tax generally is 30% (Zinsabschlagsteuer) plus 5.5% solidarity surcharge (combined rate of 31.65%). Furthermore, the interest payments would also be subject to withholding tax if the respective loan is secured by German real estate.
Exemptions on withholding tax on interests
In case there is withholding tax levied on interest payments, it is possible to reduce withholding tax rates pursuant to the double taxation treaties between Germany and other countries. The European Community Mutual Assistance Amendment Act transforms, among other things, the provisions of the EU Interest and Royalties Directive into German law. The Directive requires EU member states to eliminate withholding taxes on payments of interest and royalties between associated enterprises within the EU. However, the Directive is only applicable, if either the creditor or the debtor directly holds at least 25% of the shares in the other party or if a common parent holds at least 25% of the shares in both companies.
Thin capitalization rules
For federal corporate income tax and local trade tax purposes, Germany's thin capitalization rules provide for certain limitations on the tax deductibility of interest expense incurred concerning long-term debt provided by a substantial shareholder and/or related party to the substantial shareholder.
In reaction to the European Court of Justice's (ECJ) decision in Lankhorst-Hohorst (C-324/90) new German thin capitalization legislation has been introduced, effective for taxable years beginning after December 31 2003.
A shareholder is a "substantial shareholder" if, among other things, the shareholder's equity interest in the corporation is, directly or indirectly, at any time during the taxable year more than 25%, or if the shareholder is a member of a group of shareholders (Personenvereinigung) which altogether have a greater than 25% equity interest in the corporation, or the shareholder with a stake of less than 25% has - alone or together with others - a controlling influence on the corporation at any time during the taxable year. This rule also applies irrespective of whether the shareholder who grants the loan, is a resident taxpayer in Germany. The same applies if the loan is granted by an unrelated third party, who has recourse against the shareholder or a person related to the shareholder.
Generally, interest payments on loans between a corporation and its substantial shareholder are reclassified as non-deductible constructive dividends only if the entire interest expense deduction is more than the €250,000 ($333,830)-a-year exemption threshold. In the case of a fixed rate interest-bearing loan, the safe harbour debt-to-equity ratio is 1.5:1. Interest expenses incurred, in excess of the safe harbour, are not deductible and therefore, are treated as a constructive dividend, unless the unrelated third-party comparison test is met. The safe harbour of 1.5:1 also applies to qualified holding companies (formerly this rate was 3:1). A qualified holding company is any company whose main business is to hold or finance equity interests in corporations, or any company, in which more than 75% of the owned assets consist of holdings in corporations. Under the terms of a ruling by the German Federal Ministry of Finance only a company that has at least one substantial shareholder can qualify as a holding company and a foreign corporation may only qualify as a holding company if it is subject to taxation in Germany. According to unofficial statements from the tax authorities, the receipt of dividends and interest that are only subject to limited German taxation do not qualify. There is no safe harbour available if consideration paid under the loan is not determined as a fixed interest amount (for example, if the consideration is, at least in part, based on the borrower's profitability).
Furthermore, there is no safe harbour and no unrelated third-party test available for loans that are taken up to finance intra-group share acquisitions (so-called tainted intra-group loans).
If the debtor is a partnership, the loan is attributed to its material corporate shareholder for German thin capitalization purposes.
For German thin capitalization purposes it is crucial to fulfil the requirements of a qualified holding company. Otherwise, for German thin capitalization purposes the proportionate equity interest of the related-party borrower has to be reduced by the German generally accepted accounting principles (GAAP) value of the investments in other subsidiaries, leaving many non-qualified holding companies with no equity under Germany's thin capitalization rules. Furthermore, if the German holding qualifies as a subordinated company (that is, direct or indirect subsidiary of a qualified holding company), it can, generally, be debt-financed only by the qualified holding company, and not by any other group company under Germany's thin capitalization rules.
Controlled foreign corporations rules
Generally, a German holding company is deemed to have received a dividend from a non-resident company, if
more than 50% of the non-resident company's share capital or voting rights are directly and/or indirectly owned by German companies and/or German individuals, alone or together with related persons;
the non-resident company is subject to foreign tax at a effective tax rate lower than 25%; and
the non-resident company generates income from activities not listed as active in the German controlled foreign corporations (CFC) rules.
The minimum investment requirement is reduced to 1%, if the foreign entity generates passive income with investment character (Zwischeneinkünfte mit Kapitalanlagecharakter) (for example, interest income), which is more than 10% of its total gross revenue or is more than €62,000 ($82,796) of the income attributable to the German company. If more than 90% of the foreign company's income is passive income with investment character, even the requirement for a minimum investment of 1% does not apply.
As a consequence, the passive income is attributed to the German company on a proportionate basis and, thus, subject to taxation in Germany, that is, federal corporate income tax/income tax, local trade tax and solidarity surcharge. However the amount attributed in this way may be offset with German losses.
The deemed dividend is treated as if it had in fact been distributed, however, the tax exemption for dividend as described above is not applicable. Even if a tax treaty is in place that provides for an exemption, under Germany's CFC regime, it is not possible to pay tax-exempt dividends. Withholding taxes imposed if dividends are distributed through the ownership chain may generally not be credited. However, in case of a German individual taxpayer the withholding taxes can be credited against the German tax or be used to reduce the attributed passive income in accordance with the general German foreign tax credit rules.
There is a case pending at the ECJ regarding whether the UK CFC rules comply with EU law (Cadbury Schweppes - C-196/04). The outcome of this court proceeding may have a direct effect on the existing rules.
Tax consolidation
Generally, under Germany's tax consolidation regime (Organschaft) for federal income tax and local trade tax purposes the income or loss of a controlled company (Organgesellschaft) is attributed to the controlling company (Organträger - organschaft parent company).
To qualify as an organschaft, the following requirements have to be met:
the organschaft parent company owns the majority of the voting rights (Mehrheit der Stimmrechte) in the controlled company (regardless whether directly and/or indirectly owned);
the investment in the controlled company has been held for the entire taxable year of the controlled company;
the place of management (Ort der Geschäftsleitung) of both, the organschaft parent company and the controlled company has to be in Germany, that is, the day-to-day business decisions have to be made in Germany;
if the organschaft parent company is a partnership, the partnership has to conduct an active trade or business pursuant to section 15 paragraph. 1 No1 Income Tax Act;
a profit-and-loss absorption agreement (Ergebnisabführungsvertrag) for a minimum term of five years (60 months) has been concluded between the organschaft parent company and the controlled company; and
the profit-and-loss absorption agreement has to be registered with the competent local court's commercial register by the end of the controlled company's taxable year for which the organschaft rules shall apply.
Under the organschaft regime, the organschaft parent company can be a German resident corporation, a branch of a foreign corporation registered in Germany or a company with its legal seat abroad and its place of management in Germany. A German resident partnership may also be the organschaft parent company, provided that it carries on commercial activities. The controlled company, however, must be a corporation with its statutory seat and effective place of management in Germany.
The limitations on the organschaft with respect to the limitation on the offset of profits and losses to German subsidiaries may not be in compliance with EU law. In March 2005, the ECJ heard a case (Marks and Spencer C-324/03) referred to it by the UK High Court dealing with the British consolidated tax return rules, which likewise limit losses to those incurred domestically. The Advocate General's opinion is due on April 7 2005. The outcome of this legal process may have a direct affect on the applicability of the German organschaft rules.
Taxation of shareholders in holding companies
Taxation of resident shareholder
Corporation
Corporations resident in Germany are subject to tax on their worldwide income. A corporation is considered to be resident in Germany, if it maintains either its registered office (as determined by the articles of incorporation) or its central place of management in Germany. Otherwise, a corporation is considered to be non-resident.
Profits are subject to a federal corporate income tax rate of 25% plus 5.5% solidarity surcharge (26.38%) at the level of the corporation.
For German tax purposes a corporation is treated as having an active trade or business (Gewerbebetriebe) by virtue of its legal form under civil law, and therefore, does only generate active trade or business income (gewerbliche Einkünfte), irrespective of its general classification of such income for German tax purposes. Thus, a corporate entity is always subject to local trade tax. The local trade tax is a business expense for federal corporate income tax purposes and, thus, deductible from its own assessment basis. Therefore, the effective rate of local trade tax ranges from 12% to 20% depending on where the taxpayer carries out its business and what apportionment factors apply if the business is operated in more than one local tax jurisdiction.
If a shareholder in a German holding company is a corporation, the dividend income is exempt from taxation. In this situation, however, an amount equivalent to 5% of the dividend income must be treated as a non-deductible business expense. Thus, only 95% of the dividend income received is tax exempt. Expenses related to the equity investment that are actually incurred are fully deductible. This rule applies to dividends, which are received from domestic and foreign corporations. The tax withheld by the distributing German holding company is fully creditable against the shareholder's federal corporate income tax liability.
Partnership
A partnership is not subject to income or federal corporate income tax, since it does not qualify as a person or corporate body in law. For tax purposes the profits of a partnership are attributed to the partners in proportion to their interest in the business. The partner's income from the partnership is subject to federal income tax (in the case of an individual) or federal corporate income tax (in the case of a corporation).
If a partnership has an active trade or business its profits are subject to local trade tax with the same consequences as described above. To qualify as an active trade or business the entity has to operate autonomously on a lasting basis, generate profits and participate in general commercial business activities. Activities relating to agriculture and forestry and self-employed work are excluded. The scope of the activities must constitute more than the mere management of a private property investment. Furthermore, a GmbH & Co KG is generally considered as having an active trade or business because of its legal form as a commercial law limited partnership with a GmbH as unlimited partner.
If a German holding company's shareholder is a partnership, the dividends are taxed for federal income tax purposes at the partner's level. If the partner is an individual, 50% of the amount distributed (so-called half-taxed income rule) is subject to tax at the individual's level. The tax withheld by the distributing company is fully creditable against the partner's income tax liability.
If the partner is a German corporation, the principles described above apply.
At the level of the partnership 50% (in case of an individual) or 95% (in case of a corporation) of the dividend income is also tax-free for local trade tax purposes. However, the full amount of any dividend payments will be subject to local trade tax if the minimum ownership interest or the active participation requirement is not fulfilled (see above for further details).
Taxation of non-resident shareholder
German non-resident companies are subject to taxation on German source income only, which includes income derived from a PE or a permanent representative in Germany, gains from the sale of shares in an affiliated German corporation, income from agriculture and forestry, rental income and certain categories of income subject to withholding tax.
Depending on the type of income, the German source income of non-residents may be subject to tax either through withholding at source (see above) or by assessment upon the filing of an income tax return. Business expenses or other income-related expenses are only deductible to the extent that they are economically related to the relevant income. Losses from one category of income may only be offset against income from another if both categories are subject to tax through direct assessment rather than the withholding tax procedure. The tax withheld on investment income is deemed to fully settle the tax liability on that income unless it is derived through a PE in Germany, in which case the withholding tax is credited against the income tax payable upon direct assessment.
The federal corporate income tax rate for non-resident companies is the same as for resident companies. The income tax is the same tax rate as for single resident individuals, however, a minimum tax rate of at least 25% applies. The minimum tax rate of 25% only applies if the resulting tax burden is no higher than the tax burden that would result from a (notional) tax assessment based on the progressive tax rate. The federal income tax rate is imposed at progressive rates under complex tax tables and the maximum tax rate for the year 2005 is 42% plus 5.5% solidarity surcharge based on the federal income tax liability.
If a non-resident company has a PE in Germany, the company is subject to local trade tax with respect to the income derived from it.
Losses and minimum taxation rule
This so-called minimum taxation rule applies beginning with taxable years starting 2004. Losses may generally be fully set off against income arising in the same tax year.
Federal corporate income tax losses that cannot be offset in the current taxable year can be carried back one year up to an amount of €511,500 ($683,019). Local trade tax losses cannot be carried back.
A federal income and local trade tax loss carryforward can be offset against profits up to an amount of €1 million ($1.335 million). Any loss carried forward of more than that amount can only be offset in an amount of 60% of the remaining taxable income.
Transfer pricing
All transactions between related companies must be carried out in accordance with the arm's-length principle. Where transfer prices are not in line with market prices, either constructive dividends or constructive contributions will be assumed. In this case the tax administration is entitled to adjust the profits of the German corporation. The position of the tax administration is stated in a set of administrative principles. The Tax Preference Reduction Act introduced in 2003 implements for the first time a legal requirement to maintain a documentation of transfer-pricing arrangements. This is applicable for the tax year 2003 and thereafter. Therefore, in case of cross-border relationships between group entities, it is now mandatory to document the legal and commercial basis of the underlying transfer-price arrangements and any other business relationships subject to the arm's-length principle. At the request of the tax authorities, this documentation must be presented within 60 days. Normally, such a request will only be made in advance of a tax audit. Requests in other circumstances are, however, possible. If no documentation is presented, the tax authorities are authorized by law to assume that the profits of the German entity have been reduced because of inappropriate transfer prices and may make corresponding adjustments in the form of an estimate for the basis for taxation. Moreover, in the event that the documentation requirements are violated, the tax authorities have the option to levy penalties and reverse the burden of proof, placing it on the taxpayer.
For further information please contact:
Eckart Nuernberger
KPMG DTG AG
Tel: +1 212 954 7950
Email: eckartnuernberger@kpmg.com
Franz Prinz zu Hohenlohe
KPMG DTG AG, National Tax Germany, Frankfurt
Tel: +49 69 9587 3477
Email: franzhohenlohe@kpmg.com
