The new tax option model for partnerships

The majority of German companies – also many large family-run corporate groups and world market leaders – are organised as partnerships. Due to flow-through regulations, they must face significant competitive disadvantages arising from German tax compared to competitors often being capital market-oriented and foreign companies, most of which are structured as corporate groups.

An entrepreneur seeking to optimise the tax burden of their partnership has so far been compelled to go to great lengths of changing the legal structure of their business into a corporation to enjoy the more favourable corporate income tax regulations. From the point of view of civil law, this is not always possible or reasonable. This is because partnership agreements, civil law requirements and disadvantages not related to taxation often make it impossible to successfully change the legal structure of the business so the enterprise finds itself caught in a “cul-de-sac” of the fiscally not desired legal structure.

With the option model, such enterprises will now be enabled to reap the advantages of taxation as a corporation without having to change their legal structure under civil law. Article 1a of the German Corporate Income Tax Act (KStG) makes it possible to change the tax structure in a single step only consisting of filing an application to the tax authorities.

The option model in a nutshell

In the USA, since 1997, certain local and offshore legal structures have been able to elect under the check-the-box regulations to change their tax classification as partnerships or corporations at federal level in deviation from the default rules.

Similarly, the German option model will now offer general and limited partnerships the possibility of electing to be taxed as a corporation upon request.  The option is not available to investment funds and certain foreign companies. Pursuant to Article 1a KStG, the exercise of the option is deemed to mean a change of the tax structure within the meaning of the German Reorganisation Tax Act (Umwandlungssteuergesetz) and is generally possible in a tax-neutral manner.

As the Reorganisation Tax Act applies, foreign partners in German partnerships, for example, do not enjoy this tax neutrality. For them, the fictitious change of the tax structure usually results in taxable profit realisation, which must be taken into account when assessing whether the option model is advantageous for the group of partners.

The tax consequences should also be thoroughly examined, for example, if the partnership holds any valuable special business assets (Sonderbetriebsvermögen). This can be, for example, real properties that are owned by the partners and used as business premises.  This is because, as a result of exercising the option, the enterprise electing to exercise this option and its partners are treated separately for income tax purposes, i.e. like a corporation and its shareholders. Special business assets no longer exist in corporations, so that this tax relationship must be dissolved in advance – as tax-neutrally as possible.

The law does not provide for any minimum period for which the enterprise is required to stick to the exercised option. The exercising of the fall-back option under Article 1a KStG is also deemed to mean a change of the tax structure within the meaning of the German Reorganisation Tax Act (UmwStG) so it is necessary to observe the seven-year lock-up period due to the fact that the option has been exercised.

Comparison of tax burdens

Alone or together with the check-the-box option, the German option model offers tax structuring opportunities for cross-border shareholding structures with a U.S. nexus. By choosing the appropriate option, the current total tax burden can be reduced at the level of the company/shareholders, if necessary.

Below we present selected tax structuring options that (would) arise in an outbound case due to the check-the-box option in the USA and the option model in Germany.

The initial case (Case 1) involves a U.S. partnership (LP), in which a natural person based in Germany participates through a German GmbH & Co. KG (limited partnership with a GmbH as general partner). In this case, the tax burden is approximately 40 per cent (U.S. income tax level). By exercising the check-the-box option for the LP (Case 2), the total burden can already be reduced. If, however, the check-the-box option is exercised for the GmbH & Co. KG (Case 3), then the current tax burden will be further reduced to approximately 30 per cent (U.S. corporate income tax level). In addition, unlike in Case 1, the exercise of the check-the-box option makes it possible to avoid the U.S. estate tax in Case 2 and 3. If, in the USA, the LP is replaced with a corporation (Corp, Case 4), the burden can be reduced at the level of the corporation in the USA. But the total tax burden is however overall higher than in Case 2 because of the existence of the flow-through entity – the GmbH & Co. KG. As long as any distributions made by Corp are invested at the level of GmbH & Co. KG and not passed to the owners, it is recommendable to file a request for GmbH & Co. KG to be taxed for corporate income tax purposes and exercise the check-the-box option (Case 5). This can reduce the total tax burden on retained profits at the level of the Corp to less than 30 per cent (U.S. corporate income tax level).

Impact on transactions

The sale of ownership interests in partnerships is – apart from special situations – generally treated for tax purposes in the same way as an asset deal. In contrast, the sale of shares in a corporation is usually taxed at a preferential rate; the so-called partial income procedure or the so-called affiliation privilege apply.

Conversely, the acquisition of a company in the form of an asset deal can be more attractive to the buyer than the acquisition of shares in a corporation as the former enables a reduction in taxes related to depreciation. The different tax treatment on the buyer's and seller's side usually makes it necessary for the parties to conclude an understanding.

The acquisition or sale of a partnership electing to be taxed as a corporation is based on the principles applicable to the acquisition or sale of a corporation, at least for income tax purposes. However, this does not apply to other types of tax, in particular the real estate transfer tax.

In transactions, partnerships electing to be taxed as a corporation will be a reality in the future and one will have to adapt to it. On the one hand, as  the process of exercising this structuring option is fraught with pitfalls, it will become the subject of tax due diligence. On the other hand, it will also be necessary to consider the impact on the transaction as such in terms of the contractual implementation and structuring.