1 Understanding the basic principles. 2 Direct investments in German property

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1 Preface Property investment has undergone a considerable evolution in the last decades. Most investors and developers have extended their goals from a national to an international level. As a result, they increasingly require the assistance of international property services. Among those services, tax consulting is of significant importance in the real estate business. In fact, maybe more than in any other sector of the economy, the taxation aspects of the transactions performed have an impact on the investor s net return. The present guide has been prepared by the PricewaterhouseCoopers Real Estate Team to provide an introduction to the German tax regime that applies to real estate investors. After a general overview on the German taxation regime, the various steps of the investment process are successively considered: acquisition and construction, financing structure, management and, finally, disposal of the asset. For each step, the direct and indirect tax regime is examined within the appropriate legal framework. The brochure focuses on real estate investments in Germany performed by both foreign corporations, as the most relevant cross border investors, and foreign individuals. Although the brochure aims to cover the most important tax issues, obviously, this guide is not intended to be a comprehensive study on the subject. The guide is based on existing German tax law. In early 2003 the Tax Concessions Pruning Act (Steuervergünstigungsabbaugesetz) - hereinafter referred to as Tax Reform was passed by both the upper and lower chambers of Parliament. Most of its changes entered into force as of 1 January Presently the German cabinet has approved a number of other tax law changes, which are to be submitted to the upper and lower chambers of Parliament for legislative approval. These changes are incorporated in the so-called Second Basket of further measures agreed between the parties at the time of the Tax Concessions Pruning Act (Korb II: Gesetz zur Umsetzung der Protokollerklärung der Bundesregierung zur Vermittlungsempfehlung zum Steuervergünstigungsabbaugesetz), hereinafter referred to as Second Basket. Further measures are contained in the Trade Tax Reform 2004 (Gemeindewirtschaftssteuergesetz), the 2004 Budget Support Bill (Haushaltbegleitgesetz 2004) and the Investment Modernisation Act (Investmentmodernisierungsgesetz), which will supersede the Capital Investment Companies Act (Kapitalanlagegesellschaftsgesetz) and the Foreign Investment Act (Auslandsinvestmentgesetz). At the time of 1

2 preparation of this guide, it is unclear whether all of the provisions, which are planned to come into effect from 1 January 2004 onwards will survive the legislative process in their present form (a number of changes have already been made during the past few weeks). For this reason, the advice of qualified professionals should be sought before any decision is taken on a specific project. November

3 Contents 1 Understanding the basic principles 1.1 The scope of German taxation 1.2 Income tax 1.3 Trade tax 1.4 Real estate transfer tax 1.5 Value added tax (VAT) 1.6 Land tax 1.7 Investment grants/special depreciation rates in the new federal states 1.8 Investment subsidies 1.9 Special depreciation 1.10 Recent and proposed changes 2 Direct investments in German property 2.1 Direct purchase of assets Legal aspects Tax aspects 2.2 Acquisition of a German property company Legal aspects Tax aspects Income tax Real estate transfer tax VAT 2.3 Buildings Legal aspects Tax aspects VAT 2.4 Financial investments in German real estate Closed-end real estate investment funds (Geschlossene Immobilienfonds) Open-end real estate investment funds (Offene Immobilienfonds) Special funds (Spezialfonds) Typical silent partnership Non-typical silent partnership Profit participating loans Participation rights (Genußrechte) 3

4 3 Financing the acquisition of German real property 3.1 Capital contribution Legal aspects Contribution (stamp) duties Tax aspects 3.2 Debentures 3.3 Tax aspects 3.4 Thin capitalisation rules 4 Managing German real estate 4.1 Renting Legal aspects Tax aspects 4.2 Hereditary building right and usufruct Legal aspects Tax aspects 4.3 Real estate financial leasing General issues Taxation issues Lessor as economic owner Lessee as economic owner 5 Selling real estate 5.1 Legal aspects 5.2 Tax aspects 6 Conclusion Structuring German real estate investments 4

5 1 Understanding the basic principles 1.1 The scope of German taxation The taxable income derived from real property transactions in Germany is determined in accordance with the provisions of German tax law, irrespective of whether the owner is a private individual or corporate body, resident or non-resident. According to the German Income Tax Act (EStG), non-resident taxpayers are, in general, liable to German tax only on their German source income, including the income from real property in Germany. (For this reason, they are referred to as having a limited tax liability.) The international tax treaties concluded by Germany give the right to tax income derived from such real property to Germany (see also article 6 of the OECD Model Convention). Indirect tax regimes, such as the value added tax (VAT) and the real estate transfer tax (Grunderwerbsteuer), apply to transactions involving or related to German real property. 1.2 Income tax Resident companies German income taxation depends mainly on the status of the taxpayer as well as on the category of income derived from an activity. Partnerships do not constitute a taxable entity for income tax purposes; their income is attributed directly to the individual partners and taxed under the Income Tax Act. However, a partnership is a taxable entity for trade tax purposes. Legal entities, in particular corporations, which have their seat or place of management in Germany, are referred to as having an unlimited tax liability in Germany, i.e., on their worldwide income, under the German Corporate Income Tax Act. German income tax law differentiates between seven categories of taxable income. For real estate transactions, the differentiation between business income (Einkünfte aus Gewerbebetrieb) and rental income (Einkünfte aus 5

6 Vermietung und Verpachtung) is of particular relevance (the taxation aspects of rental income are discussed below). Income is classified as business income either by statutory definition or by business activity. Corporations which, under civil law, have to comply with the accounting requirements contained in the commercial code (Handelsgesetzbuch), in particular the limited liability company (Gesellschaft mit beschränkter Haftung, GmbH) or public incorporated company (Aktiengesellschaft, AG), derive business income by statutory definition regardless of whether their actual activities can be characterised as a business activity. Partnerships such as the general partnership (Offene Handelsgesellschaft, OHG), limited partnership (Kommanditgesellschaft, KG) or civil law partnerships (Gesellschaft bürgerlichen Rechts, GbR) generate rental income as long as their activities are restricted to the mere holding and administration of real property. However, if any of the partnership s activities are viewed as business in nature, all of the income will be deemed to be business income. Limited partnerships in which limited partners are not authorised to manage the partnership and whose general partners consist exclusively of corporations are deemed to generate business income even if they do not pursue business activities. Business income is generally determined on an accruals basis. Income is, therefore, attributed to the year to which it economically belongs. Accounting records must be kept and financial statements must be prepared. In general, all expenses connected with income derived from the real estate are deductible, such as maintenance and repairs, depreciation allowances and financing costs. For corporations, the starting point to determine taxable income is the income reported in the company s annual accounts. Basically, all payments relating to the business can be deducted, unless they constitute acquisition or construction costs. Some adjustments are nevertheless made in order to bring the figures into line with the tax accounting rules. The company s income basis can thus be reduced by deductible expenses connected with real estate, such as depreciation of buildings, repair, maintenance and similar costs, interest expenses on loans taken up to finance the acquisition of real estate, etc. With the exception of land, most tangible and intangible fixed assets are depreciable. Please note that the depreciation rules as described below do not apply to property held as current assets. 6

7 The depreciation methods generally permitted for tax purposes are the straight-line and, under certain conditions, the declining balance method. The basis for depreciation is acquisition or construction cost. The standard depreciation rates for buildings range from 2% to 4%, assuming a useful life of 25 to 50 years. For buildings erected by the taxpayer or acquired in the year of their completion, higher depreciation rates are granted under certain conditions. Under Tax Reform 2001, the depreciation regime became less favourable, the deemed useful life being extended. Capital gains derived from the sale of real estate are, in general, taxable at the standard tax rates if they are classified as ordinary business income, trading in real estate or gains which are non-recurring in nature. For income tax purposes, selling an interest in a real estate partnership is considered a sale of the real property. By creating a so-called "replacement or reinvestment reserve", taxation of capital gains realised on the sale of German land or buildings may be deferred and the tax burden effectively reduced. The capital gains may be offset against the cost of assets which qualify as reinvestment objects (basically real property) acquired in the year of sale or during the course of the following four years. Gains realised by a partner on the sale of an asset which he holds as a sole proprietor or as a special business asset may be offset against the cost of reinvestment objects acquired by the partnership. In addition, rollover relief is permitted from 2002 onwards for capital gains realised by sole proprietors or partnerships on the sale of shares in a corporation (limited to capital gains of EURO 500,000 if a reinvestment is made in corporate shareholdings or tangible assets within a period of two years or in real property within a period of four years). As a result of Tax Reform 2001, the former imputation tax system was abolished and replaced by a classical system of separately taxing corporations and their shareholders. The split rates of corporation tax (30% on distributed profits/40% on retained profits) under the old system were replaced by a uniform corporate income tax rate of 25%. During a transitional period, if the corporation distributes to its shareholders income which initially was retained (and subjected to the higher 40% rate under the imputation system), it could claim a tax refund, the refund being limited to one-sixth of the dividend distribution. The pace at which the refund potential can be obtained was reduced under Tax Reform While dividends declared and paid before 12 April 2003 and those paid on or after 12 April 2003 but declared before 21 November 2002 continue to trigger a refund of one-sixth of the dividend, a so-called "corporate income tax refund moratorium" applies to dividends declared and paid between 12 April 2003 and 1 January 2006; no refund of the 10% tax differential under the old system will be made in respect of such dividends. For dividends paid in 2006 and later years, the level of the 7

8 annual potential refund is restricted, the amount thereof in any one year not to exceed one-fifteenth of the remaining potential refund at the end of 2005 (one-sixteenth if the taxpayer's business year is not the calendar year). To finance German unification costs, an additional 5.5% solidarity surcharge based on the assessed corporate/income tax payable is levied. For the year 2003 only, the corporate income tax rate is 26.5%, a revenueincreasing measure to finance the costs of the flood disaster in Germany in August Tax prepayments are required to be made at quarterly intervals throughout the business year. Tax returns have to be filed annually, generally not later than five months after the accounting year-end or within an extended period upon application. The tax will then be assessed by the authorities based on the information provided in the return and will become payable at the latest one month after the assessment is issued. The statute of limitations period is four years, and it commences to run from the end of the calendar year in which the tax return has been filed with the tax authorities. This period may however be extended to five or ten years, notably in the case of fraud. After expiry of the limitation period, the tax assessed cannot be altered, rectified or rescinded. For income tax purposes, losses suffered by companies (also through participations in transparent partnerships) may either be carried back for one year (maximum limit of Euro 511,500), or carried forward without time or amount limitation. According to the Second Basket draft bill, the relief claimable in respect of losses carried forward will be restricted to Euro 100,000 plus one-half of the excess of the positive income for the year over such amount. Furthermore, a corporation will only be able to offset losses from a silent partnership participation against profits from the same silent partnership in the preceding, or a following, year. In either case, the offset will be subject to the limitations detailed in the previous paragraph (see Section 1.10, Recent and proposed changes). Anti-avoidance rules were introduced in 1988 to prevent trading in the shares of companies with tax loss carry forwards and these were tightened under the 1998 Tax Reform. The anti-avoidance rules required that the company claiming tax relief for tax loss carry forwards is economically identical to the company which incurred the losses. The amendments introduced by the 1998 Tax Reform provided that economic identity would be denied if more than 50% of the shares of the loss company have changed hands, and the company continues, or takes up again, its business 8

9 activities with mainly new business assets. Loss of economic identity was only deemed to have occurred if both conditions were fulfilled. The introduction of new business assets was only accepted as a harmless financial rehabilitation if it occurred solely to rehabilitate the business which incurred the loss and the loss-making operations were continued in a comparable form during the following five years. Further restrictions, planned in the draft Tax Reform 2003, were not implemented. In case of a merger or the transfer of all of the assets in a company, a remaining tax loss of the company taken over was forfeited unless the acquiring company still pursues the business activities in a comparable form and to a comparable extent during the following five years. This applied in general also to losses for trade tax purposes if the purchasing company is a corporation. According to a provision introduced in Tax Reform 1999, losses incurred from one income source, e.g., income for rentals (Einkünfte aus Vermietung und Verpachtung) can only be offset against taxable income from other sources, e.g., business income (Einkünfte aus Gewerbebetrieb) within certain limits. However, this provision does not affect resident corporations, because all of their income is regarded as business income. Additionally, the government has introduced a provision prohibiting the deduction of losses generated from participations in entities established only to generate tax losses to be allocated to their investors (so-called Verlustzuweisungsgesellschaften). Losses for trade tax purposes can also be carried forward but not carried back. According to the Second Basket draft bill, the relief for loss carry-forwards is to follow the income tax rules (proposed - see above) is a restriction in the maximum loss which may be offset in any one year. If the taxable income of the year is Euro 100,000 or less, this may be reduced to zero by an offset of tax loss carryforwards. If the taxable income exceeds Euro 100,000, the loss offset is restricted to Euro 100,000 plus 50% of the excess of taxable income over Euro 100,000.) A subsidiary will no longer be able to offset any pre-fiscal unity losses against the current taxable income surrendered to its parent. German tax regulations require that intercompany transactions comply with arm s length principles in order to be accepted for tax purposes. Otherwise, adverse tax consequences can result. For instance, where the compensation paid by a German subsidiary to its foreign parent company is in excess of the amount which it would have paid to an independent third party, the excess amount is considered to be a hidden profit distribution, which is non-deductible in determining the subsidiary s taxable income. In addition to the additional corporation tax and trade tax payable by the subsidiary, dividend withholding tax (standard rate 20%) may be assessed on the shareholder. With Tax Reform 2003, detailed documentation requirements have been introduced which will have to be observed to avoid 9

10 hidden profit distributions being assumed. If these requirements are not met, the taxable basis will be estimated and a penalty will be assessed. Non-resident companies Income derived by non-resident corporations from German real estate transactions is generally subject to taxation under the German Income Tax Act. Basically, the same income determination rules apply as for resident companies. Unlike German legal entities, foreign corporations are not automatically deemed to generate business income as a result of their legal form. For tax purposes, only the nature of the German activities is taken into consideration. Among the types of income subject to tax and of relevance for real estate transactions are business and rental income, as well as capital gain income realised on a sale. A non-resident company generates rental income if it is engaged in the mere letting and administration of property, even if a large number of properties is held or the property let is of considerable size and the letting requires substantial administrative effort. Whether the property is let for housing or business purposes is irrelevant. However, it should be noted that the provision of certain additional services by the lessor to the tenants could lead to the income being classified as income from a business activity (see below). Rental income is determined on a cash basis, and accordingly income and expense must be reported in the calendar year in which it is received or paid. Business income from real estate transactions is derived if a nonresident company pursues business activities via a permanent establishment or permanent representative in Germany. For income tax purposes, a business activity is defined as an independent ongoing activity on the market with the aim to derive profits. It is, for example, assumed if the investor, besides the letting and administration, provides additional services to the lessee (e.g., cleaning the office space), or if a property is let under short-term contracts with high tenant turnover. Thus, for example, the operation of a hotel, the letting of exhibition space and stands and parking sites or the short-term letting of convention halls is considered a business activity. Capital gains derived from the disposal of real estate within ten years of the date of acquisition of the property are normally classified as income from capital gains. A general imposition of tax on all capital gains 10

11 realised without regard to the period of holding, as planned in the draft Tax Reform 2003, was not implemented. Capital gains realised on the sale of German real estate by non-resident companies and by partnerships which, under the provisions of German commercial law, would be obliged to maintain bookkeeping records, are taxable as deemed business income, irrespective of whether a permanent establishment or permanent representative is maintained in Germany. This applies in particular to foreign investors who adopt a corporate structure for business activities and may also be applicable to the cross-border split of a unitary enterprise (so-called Betriebsaufspaltung). In conclusion, for foreign business entities and individuals, a tax-free capital gain can only be achieved under certain limited circumstances. Non-resident taxpayers are subject to certain restrictions with regard to the determination of the tax base: expenses are only tax deductible if they are economically connected with taxable German income, specifically income which is not tax free. Concerning the possibility to carry tax losses back or forward, the provisions mentioned above for resident companies are also applicable for non-resident companies if the losses arise in connection with what would have constituted German income. The losses can be offset against both operating income and capital gains realised on the sale of German property. Income subject to withholding tax, however, cannot be offset against losses from other categories of income, and losses arising under the heading "income from capital" can neither be carried forward nor back. The corporate income tax rate applicable to non-resident corporate investors no longer differs from the rate which is applicable to resident corporations. The tax rate is 25% (formerly 40%). Including solidarity surcharge the corporate income tax rate is % (before Tax Reform %). As mentioned above, the corporate tax rate for 2003 was increased to 26.5%. Resident individuals Under the German Income Tax Act, individuals who have their residence in Germany or are physically present in Germany for more than 183 days in the tax (calendar) year are subject to so-called unlimited tax liability, i.e., they are taxable on their world-wide income. A German resident individual who receives income from real property is deemed to generate rental income unless he carries out a business activity and the real property is attributable to his business undertaking. The net rental income derived from the property is subject to German income tax. The German Income Tax Act provides for a rate scale which is proportional at lower and higher income levels, but progressive for middle income levels. 11

12 The depreciation rules described above also apply to real property owned by individuals. The taxation of gains realised on the sale of real property depends on the tax classification of the income derived. If the property does not form part of a business, gains on its sale are subject to income tax at normal tax rates if the sale is made before it has been acquired or within ten years after the date of acquisition. If the sale is not concluded within the aforementioned timeframe, capital gains are tax-free unless the real property forms part of a business. Non-resident individuals Individuals who are not resident in Germany are subject to so-called limited tax liability, i.e., they are taxable only on their German source income. The determination of the tax base itself does not differ in principle from that in the case of non-resident companies described above. 1.3 Trade tax Every corporation or taxpayer with business activities and a permanent establishment located in Germany is subject to trade tax (Gewerbesteuer), a tax payable to the municipalities. According to the draft of a Trade Tax Reform Act 2004, the tax will be renamed "community business tax" (Gemeindewirtschaftssteuer) and is to be collected from all taxpayers who earn business, professional or trading income and from the self-employed. Rental income as defined above is therefore not typically subject to trade tax, unless generated by a corporation or another entity subject to the community business tax (see Section 1.10, Recent and proposed changes). The character of the trade tax is that of an additional income tax giving rise to an effective tax burden in most cases of between 9% and 20% depending on local tax rates. Trade tax is deductible for corporate income tax purposes. Because a simplified computation of the tax burden is planned under the draft Trade Tax Reform 2004, the effective future community business tax rate is expected to range from 6.4% to 15.7%. However, according to the draft Trade Tax Reform 2004, the community business tax will not be deductible for corporate income tax purposes. Taxable income is based on the taxable income calculated for (corporate) income tax purposes, adjusted by certain add-backs and deductions. Some of the most important of these are described below. When computing the tax base for trade tax, only 50% of the interest paid on long-term loans can be deducted, thereby affecting the leveraging of investments. Nevertheless, under the draft Trade Tax Reform 2004 proposals, the 12

13 interest expense on borrowings from a related party will be added-back in full to taxable income, but, to compensate for this, the recipient of the income is entitled to exclude the corresponding interest income amount from his trade tax base. On the other hand, 1.2% of the unitary tax value of real property belonging to the business assets can be deducted in arriving at the income for trade tax purposes (the "simple" trade tax deduction, in contrast to the extended trade tax deduction, see below). The unitary tax value is calculated on a valuation basis as per 1 January 1964 and is considerably lower than the fair market value. The deductions therefore usually cannot compensate the add-backs, which may lead to a significant tax burden. Even if a taxpayer s activities are viewed, in principle, as subject to trade tax, tax may be avoided on the basis of a year-by-year application. Taxpayers engaged only in the mere administration of real estate may apply for a so-called extended trade tax deduction, which permits a deduction from the tax base for trade tax purposes of income derived from these passive rental activities, thus reducing the tax base for such activities to nil and affording exemption from tax (see Section 1.10, Recent and proposed changes). A number of restrictions have to be considered in order to benefit from this exemption. However, in practice, this rule provides a tax saving strategy for high-yield investments and also avoids the imposition of trade tax on capital gains. According to the draft Trade Tax Reform 2004, from 2004 onwards, the extended trade tax deduction will only be granted to companies with rental income from property exclusively used for residential purposes (see, however, Section 1.10, Recent and proposed changes). In general, the sale of a partnership interest constitutes a termination of business and as such is not subject to trade tax. However, from the year 2002 onwards, gains realised on the disposal of a partnership interest have been treated differently. Capital gains realised by a corporate partner or by another partner who is not an individual on the sale of a partnership interest (or part of a partnership interest) are subject to trade tax. Furthermore, trade tax will be levied on dividends received by shareholders on holdings of less than 10%. As a part of the changes in taxation introduced by Tax Reform 2001, individuals who are partners in partnerships may claim a relief for trade tax paid by the partnership in arriving at the amount of their income tax payable. The deductible amount may be slightly raised according to the draft Trade Tax Reform

14 1.4 Real estate transfer tax Real estate transfer tax is an important cost factor not only in direct acquisitions of property but is also in share deals or corporate reorganisations and restructurings. The object of taxation for real estate transfer tax purposes is the real property. So-called business fixtures (Betriebsvorrichtungen) are not viewed as real property. Hereditary building rights (Erbbaurechte, for details see Section 4, "Managing German real estate") and buildings erected on land owned by a third party are also deemed to be real property for purposes of this tax. In purchase agreements, the tax burden will typically be assumed by the purchaser. However, both parties are liable for tax. General tax exemptions exist, for example, for transactions between related persons or transfers by way of inheritance. Other exemptions will rarely be of practical relevance. Real estate transfer tax is levied on a number of other transactions, such as purchase agreements, barter agreements or making the highest bid at an auction. In addition, an agreement to transfer one of these claims, as well as the transfer of the legal title of ownership without any underlying agreement, is subject to tax. Furthermore, where the aforementioned conditions are not met, but a party has de facto attained a similar position to the legally entitled owner, tax may be imposed. This is the case where the recipient is able to benefit from all substantial proceeds from the use or disposal of the real property. The conditions differ slightly from the economic ownership concept for income tax purposes. Whether this also applies to cases of financial leasing under German tax law depends on the individual circumstances. Although, generally speaking, the transfer of shares in a corporation or an interest in a partnership is not taxable, there are some important exceptions. For example, the direct or indirect unification of 95% of the shares in a company or partnership which owns real property in the hand of one individual, partnership or corporation, and the transfer of 95% or more (before 1 January 2000, 100%) of the shares in such a company or partnership, are all subject to real estate transfer tax under present law. Furthermore, a direct or indirect change of the partners in a partnership owning domestic real estate will also give rise to real estate transfer tax if the change is effected within a period of five years (for details, see Section 2.2, "Acquisition of a German property company"). Due to these complex rules, for example in a group structure, tax may, under certain circumstances, be triggered twice, or even more often, in connection with the acquisition of one item of real estate (see also Section 2.2.2, Tax aspects of an acquisition of a German property-owning company). 14

15 On the other hand, a tax credit is possible where one taxable transaction follows another which was already subject to tax. It should be noted that, upon application, the tax will not be imposed in certain cases, for example, if the transaction is reversed or the original transaction is rescinded within two years. Further, the transfer of property to or by a partnership which from a tax viewpoint is transparent is privileged by a partial tax exemption if a partner participates directly or through another partnership in the transaction on both sides. The extent of the exemption depends on the proportion of interest in the partnership held by the participant. Although some legal restrictions apply in special cases and the anti-abuse case law has to be taken into account, the privileges for partnerships can often be used to minimize tax costs. Proper tax planning of group and partnership structures is required in conversion and reorganisation situations. The mere change of legal form of a corporation into a partnership and vice versa will, however, not trigger real estate transfer tax. The applicable tax rate is 3.5% of the agreed consideration. The consideration includes VAT at the normal rate of 16%, if applicable. In most cases, the agreed consideration is the purchase price. A separate real property value (Grundbesitzwert) for tax purposes applies to a number of special transactions. In detail, the value basically applies to transactions where no consideration can be determined, such as group reorganisations, contributions in exchange for shares, unification of shares and other transactions based on statutory agreements. For the transfer of a hereditary building right, the tax base is the capitalised value of the ground rent. The regulations of real estate transfer tax apply irrespective of whether the transaction itself is also subject to VAT. 1.5 VAT (Value Added Tax) The basic concepts of the German VAT regime, such as taxable persons, nature of the goods, delivery of goods and supply of services, have been brought in line with the 6th EC Directive. Thus, the German basic regulations are comparable to those applicable in the other EU Member States. The German VAT system can be summarised as follows. * A taxable person (entrepreneur) under the German VAT Code is a person who independently carries out an economic activity which, under the German VAT Code, is viewed as a supply of goods or services. * Therefore, a company may be considered to be an entrepreneur for VAT purposes even though it only performs tax-exempt transactions (in such a case, however, the company will generally not be permitted to recover input VAT). 15

16 * The supply of goods means the transfer of the right to dispose over tangible property as an owner. Goods are notably tangible property, and some rights in rem giving the holder thereof the right of a user over the immovable property (e.g., hereditary building right). Land and buildings are viewed as "goods" for the German VAT legislation and thus taxable. However, a tax exemption exists for all transactions subject to real estate transfer tax, in particular the sale of real estate. * Supply of services means any transaction not constituting a supply of goods. In principle, supplied services in connection with real properties fall within the scope of VAT. Most of these transactions are, however, exempt under German VAT law. This is, for instance, generally the case if real properties are merely rented or leased. Included herein are lease financing activities in which the lessor is economic owner. Although transactions subject to real estate transfer tax (hereditary building rights excluded), especially the sale of real estate, are tax exempt, they may voluntarily be subjected to VAT. Under the draft 2004 Budget Support Bill transactions subject to real estate transfer tax will be subject to VAT. These transactions, as well as construction work and the cleaning of buildings or part of a building, will be taxed under the reverse charge procedures. This applies if a sale is effected to another enterprise for purposes of the latter s business regardless of whether the purchaser is entitled to recover input VAT (VAT option). The vendor may, under certain circumstances, opt to subject the sale to VAT either wholly or in part. Details are contained in "Acquiring German real estate - Direct purchase of assets" (see also Section 1.10, Recent and proposed changes). Under certain circumstances, the VAT option applies to the letting of real estate, the transfer of hereditary building rights and other rights in rem (see Section 4.1, Renting"). When letting buildings partly for nonbusiness purposes (i.e., letting for housing or to public entities) and partly for business purposes, the VAT option is only applicable on the portion serving business transactions. If the VAT option is exercised, the purchaser or lessor may recover input VAT paid on his supplies and services and thus considerably reduce acquisition or construction costs. However, if the lessor waives the option to pay VAT on the rental income within ten years after acquisition or sells the property without charging VAT on the purchase price within that time-frame, a portion of the purchase VAT initially recovered will have to be paid back. If applied, VAT also forms part of the consideration for real estate transfer tax. The application of the VAT option thus increases the real estate transfer tax burden and the notarial and land register fees. There is an important general exception. The sale of a whole business or an independent part of a business to an entrepreneur is, in general, not 16

17 taxable. Even the disposal of one piece of real estate can fall into this category, if it represents the main business asset. Consequently, the purchaser "succeeds" the seller in his VAT position. The general VAT rate currently is 16%. 1.6 Land tax German municipalities levy a land tax (Grundsteuer) on properties situated in their district on a yearly basis independent of the status of the owner and his income tax position. The tax base is the assessed unitary value, to which the municipalities apply their local multiplier. As the resultant tax is relatively low, deductible for income taxation, and typically passed on as an agreed part of rentals to the lessee, no further details are given here. 1.7 Investment grants/special depreciation rates in the new federal states Investment in the new federal states (East Berlin, Brandenburg, Mecklenburg-Vorpommern, Sachsen, Sachsen-Anhalt, Thüringen), including West Berlin, has been promoted through German governmental incentives ever since German reunification. The tax subsidies may only be applied for by the economic owner (who is generally identical with the legal owner) of the subsidised assets. 1.8 Investment subsidies For domestic and foreign investors, the German "Investitionszulagengesetz 1996" provided, under certain conditions, tax-free investment subsidies for the acquisition or construction of movable new business assets (thus not being applicable to real property). If acquisition/construction was made before 1 January 1999, subsidies of 5%, or in certain cases of up to 10%, of the acquisition/construction costs were granted. In order to avoid repayment of the subsidy, the assets must remain in the former GDR for a minimum of three years. 1.9 Special depreciation Furthermore, under the "Fördergebietsgesetz" under certain conditions, special depreciation on the acquisition or construction of movable and immovable assets in the area of the former GDR or West Berlin could be claimed. The special depreciation rates were allowed in addition to straight-line depreciation and, from 1997, ranged from 20% to 40% of the acquisition/construction or renovation costs, depending on the kind of 17

18 investment, provided the assets remained in East Germany for a period of at least three (movable assets) or five years (immovable assets). Due to changes in the law, after the boom in the building industry for newly erected buildings in the subsidised area, the highest special depreciation rates were granted for renovation and modernisation of buildings, resulting in some cases in full amortisation of renovation and modernisation costs within ten years. These special depreciation rates can, in principle, only be applied to investments made before the end of In practice, an investor can still claim these rates under certain circumstances. After subsidies in the form of attractive depreciation rates were terminated, parliament changed to direct subsidies. In the "Investitionszulagengesetz 1999" effective as of 1 January 1999, a number of investments (focusing on housing investments) were subsidised through cash payments of 10% to 15% (for the years 2002 to 2004, the maximum rate has been increased to 22%) of the investment volume depending on the type of real estate investment in the former GDR. In principle, those payments are tax exempt and do not affect the level of depreciation and renovation costs for income tax purposes. The rules of this new law apply to investments made after 31 December Recent and proposed changes In early 2003 the Tax Concessions Pruning Act (Steuervergünstigungsabbaugesetz or Tax Reform 2003 ) passed by both chambers of Parliament. Most of its changes entered into force as of 1 January The resultant changes to the other individual items of tax legislation are described below. Income Tax Act The level of foreign tax credit which may be claimed is to be restricted by ignoring the income which is tax-free in a foreign State when calculating the foreign effective tax rate. (The German corporate tax against which foreign tax credit may be claimed is, at 25%, low.) Losses incurred from a silent partnership participation may only be offset against income from the same silent partnership. Trade tax credit against income tax payable is forfeited if the local rate of trade tax is usually less than 9.1% (local multiplier less than 200%). Corporation Tax Act Foreign tax credit restricted in a similar manner as that under the Income Tax Act. Partnerships must be actively involved in trading to qualify as a fiscal unity parent. The "multi-parent" fiscal unity has been abolished. 18

19 The parent in a fiscal unity must itself qualify for concessions and credits claimed through its subsidiary. A profit pooling agreement must be registered by the end of the first year for which it shall apply. The pace at which the corporation tax refund potential (which has its origin in the retained earnings which were taxed at the higher [40%] rate under the former imputation tax system) can be realized has been reduced (see Section 1.2 above) Trade Tax Act The trade tax base for companies in low tax rural or urban districts (with a local multiplier of less than 200%, equivalent to an effective tax rate of 9.1% for a company) is to be added to that of its parent. Low tax districts will be excluded from the allocation of the tax base over the locations where a company or fiscal unity maintains branch operations. General Tax Code (Abgabenordnung) Enhanced transfer pricing documentation obligations with penalties for failure to comply. In addition to Tax Reform 2003, the German cabinet has recently approved a number of tax law bills, which are to be submitted to the upper and/or lower chambers of Parliament for legislative approval. These bills will be the subject of further negotiations. Draft "Second Basket: further measures agreed between the political parties at the time of the TAX Concessions Pruning Act" (Korb II: Gesetz zur Umsetzung der Protokollerklärung der Bundesregierung zur Vermittlungsempfehlung zum Steuervergünstigungsabbaugesetz) Thin capitalisation regulations The present version of the Corporate Income Tax Act requires the add-back of interest expense on loans from a shareholder or related party as a hidden distribution of profits to the extent certain specified debt/equity ratios were exceeded at any time during the year. The ratios were 1.5:1 for operating companies and 3:1 for holding companies. The holding company s ratio was in any case enhanced over that of an operating company by a provision exempting the former from the requirement to deduct the book value of its investments in arriving at its equity base. As a quid pro quo, sub-subsidiaries enjoyed no debt/equity safe haven whatsoever, and were therefore obliged to route their inter-company borrowings through their immediate parent, the German holding company. The 3:1 holding company ratio has now been withdrawn, but the other special rules which permit the safe haven to be concentrated at the level of the parent of a German sub-group remain in place. Of even greater impact for many of the German holding company structures which are based on the concept of a "country holding" acting as the parent 19

20 of a Fiscal Unity of the German operations (in order to obtain an offset at the level of the parent, where the financing costs are incurred, without having to flow the subsidiaries s profits to the parent as taxfree dividend income) will be the proposal to disallow all interest expense as a constructive dividend where the loan from a shareholder or related-party was taken out from the same or another related party to acquire shares in a corporate entity. This prohibition is absolute; there are no safe haven provisions and not even the theoretical possibility of showing that the funds could have been borrowed on otherwise equal terms from a third party. The thin capital provisions will also apply to the acquisition of shares from a German resident related company and for trade tax purposes. Changes to the thin capitalisation rules are as follows. The debt/equity ratio will be 1.5:1 in all cases including holding companies. Loans from third parties (e.g., local banks) also need to be added back if the lender has a right of recourse against the shareholder or a party related to the shareholder. (Therefore also bank loans are to be taken into consideration.) Related-party "finance" is to include rents and royalties. The "loan" is to be the market value of the item let or licensed. The "interest" is to be 75% of real estate rentals and 25% of the rent of movables or license fees. The rules will be extended to partnerships in which a corporation owns more than 25%. All interest paid on a related-party loan for the acquisition of shares from a related-party will be disallowed as a "hidden distribution". The thin capital rules will only apply if the total annual relatedparty interest charge exceeds Euro 50,000. Restrictions on loss utilisation The relief claimable for tax losses brought forward is restricted to Euro 100,000 plus one-half of the positive income for the year in excess of Euro 100,000. The Euro 100,000 figure has been brought in to protect small businesses by allowing the first Euro 100,000 of annual taxable income to be offset in full against tax losses brought forward. The loss carry-back option of up to Euro 511,500 for one year remains substantially unchanged, with the interesting consequence that the shelter from minimum taxation for the past is more than five times higher than that for the future. The opportunity has been taken to curb perceived abusive of the silent partnership structure. Under the proposal, a corporation will only be able to offset its silent partnership losses against taxable income from the same silent partnership in the preceding, or a following, year. In either case, the offset will be subject to the limitations detailed in the previous paragraph. Draft "Investment Modernisation Act" (Investmentmodernisierungsgesetz) 20

21 The Investment Modernisation Act consists of two chapters, the Investment Act (InvA) and the Investment Tax Act (InvTA). If the provisions of the InvA as well as those of the InvTA become effective on 1 January 2004 in the form and the content of the current draft this will materially change the possibilities for investment in German real estate. The draft tax rules bring about significant changes, many of which ease the taxation of German investment funds. The following changes can be mentioned. The admissible additional business activities which a capital investment company (KAG) may pursue have been expanded. The amendments permit the rendering of investment advice to third parties. This provision seems to include consulting services rendered to foreign funds and consumers. As well, the formation of so-called Master-KAGs - i.e., one management company managing different investment funds - will be allowed. Simplification of the tax provisions applicable to German and foreign fund investments. Equality between domestic and foreign funds in regard to the tax treatment. Increase in publication requirements. The taxation categories of "black"-, "grey"- and "white"-level funds are to be abolished even though the broad definition of a foreign fund is retained. Two types of foreign funds (transparent/non-transparent) are to be introduced but only with regard to their taxation, depending on whether or not the KAG fulfils certain information and publication requirements. If these requirements are not fulfilled (i.e., nontransparent funds), not only the distributions from the fund may be subject to tax, but additionally lump-sum taxation may apply. Dividends and capital gains distributed by real estate companies will be subject to tax at the level of the recipient on the "half income" basis. A further investment limitation under the current laws will be abolished, so that real property may be held by a subsidiary of a fund established and resident in another country. The principle of transparency is left unchanged, i.e., the fund itself will still not be subject to tax in Germany. The fund s income will be attributed to, and taxed on the level of, the investor. Draft "2004 Budget Support Bill" (Haushaltbegleitgesetz 2004) Under the draft 2004 Budget Support Bill, transactions subject to real estate transfer tax will be subject to VAT under the reverse charge procedures; the same applies to construction work and the cleaning of buildings or part of a building. 21

22 Furthermore, government subsidies for building and investment in property granted to individuals, so-called "Eigenheimzulage" and "Wohnungsbauprämie", will be abolished for new building projects. Draft "Trade Tax Reform Act 2004" The tax will be renamed "community business tax" (Gemeindewirtschaftssteuer) and is to be collected from all recipients of business, professional or trading income and from the self-employed. Related-party interest expense will be added-back to taxable income, but otherwise the only adjustments are to be those necessary to avoid double taxation within Germany or taxation in Germany of activities abroad. The "extended trade tax deduction" (which can lead to exemption of income from real estate for trade tax purposes) will only be granted to companies which receive rental income from property that is exclusively used for residential purposes from 2004 onwards (see, however, Section 1.3, Trade Tax). The relief for losses brought forward is to follow the income tax rules (proposed, see above, is a restriction of the maximum loss offset in any one year to Euro 100,000 plus 50% of the income in excess of Euro 100,000). A subsidiary will no longer be able to offset any pre-fiscal unity losses against the current income surrendered to its parent. Natural persons as sole proprietors or partners will have a "low income allowance" of Euro 25,000. This is to be progressively reduced as the level of income rises to Euro 50,000. It will not be claimable above this figure. The community business tax will not be a tax-deductible expense. The calculation will be simplified by applying a straight 3.2% of taxable income multiplied by the local rate (or factor) set by the town or rural council. This double-barrelled calculation is necessary where taxable income has to be allocated over more than one community. For Frankfurt and Munich, with local rates of 490% (the highest in Germany), this implies an overall burden of 15.7% of taxable income as opposed to the present 19.7%. The total overall tax burden for corporations or branches in one of these two cities would thus rise from 40.9% to 42.1% (community business tax, corporation tax, solidarity levy, but no dividend withholding tax). A local authority will not be permitted to set a local rate of less than 200%. The minimum effective rate is therefore 6.4%. 22