Adjustments to the corporate income tax option under Section 1a Corporation Tax Act (“KStG”) as a result of the Growth Opportunities Act – Genuine relief or smoke and mirrors?

With the Growth Opportunities Act of 27 March 2024, the legislator introduced a number of tax changes. Among other things, it made a total of four adjustments to the option for corporate taxation of partnerships in accordance with Section 1a KStG, which came into force retroactive-ly for the 2024 assessment period (“VZ”). 

It cannot be denied that Section 1a KStG has so far led a shadowy existence despite its funda-mentally positive effect for taxpayers. The number of corresponding applications since the standard was introduced in 2021 is still estimated to be in the three-digit range. The legislator is now attempting to increase the attractiveness of Section 1a KStG by making it easier (see German Parliament Printed Paper (“BT-D”) 20/8628, p. 2 (in German)).

This raises the question of whether the legislator has succeeded in making the option under Section 1a KStG more attractive in future. This question will be examined in this article.

Why is there an option under Section 1a KStG?

Section 1a KStG was introduced with effect from 1 July 2021. According to the explanatory memorandum (BT-D 19/28656, p. 21), the aim was to give taxpayers more tax structuring options and to make German tax law more international. 

Previously, corporations had a significantly lower tax rate compared to partnerships when retaining profits due to their tax burden of around 30%. Due to the transparent taxation of partnerships, a tax burden of up to 47.48% (plus corporation tax where applicable) was possible at shareholder level if the shareholder was a natural person. The retention tax relief introduced in 2008 within the meaning of Section 34a of the German Income Tax Act (EStG) was intended to provide relief, but the standard is difficult to manage. A further obstacle was that the tax liability of 28.25% resulting from the reinvestment previously had to be paid from non-favoured funds. This was changed by the Growth Opportunities Act.

Furthermore, the German transparent taxation of partnerships does not exist in many jurisdictions and therefore sometimes leads to undesirable qualification conflicts.

Which problems of the old legal situation are addressed?

• According to Section 1a (1) KStG (old version), only commercial partnerships and partner-ships were authorised to submit the irrevocable application to the competent tax office (problem 1). Furthermore, the application originally had to be submitted no later than one month before the start of the financial year from which the option was to apply (problem 2).
  
• The change of taxation type leads to a fictitious change of legal form within the meaning of Section 25 in conjunction with Sections 20 et seq. Transformation Tax Act (“UmwStG“), which generally results in the realisation of hidden reserves. However, according to Section 20 (2) UmwStG, an application for book or interim value continuation is possible, which results in the blocking period liability of Section 22 UmwStG.
  For Section 20 (2) UmwStG, the transfer of all functionally essential business assets is mandatory. In the case of a GmbH & Co. KG, for example, the retention of the share in the general partner German limited liability company (“GmbH”) by the limited partner was therefore detrimental (problem 3). Section 1a (2) KStG (old version) did not previously provide for a restriction.
• In the context of current taxation, all income that was previously special business income no longer falls under Section 15 EStG, but under the respective type of income (Section 19 EStG for an activity for the company, Section 20 EStG for loans, Sections 21 and 22 EStG for the transfer of assets). Payments made by the company to the shareholders are treated as dividends within the meaning of Section 20 (1) no. 1 EStG. In this respect, Section 1a (3) KStG (old version) previously stipulated that income was deemed to have been distributed if its distribution could be demanded (problem 4).
• Section 1a (4) KStG, which regulates the possibility of a reverse option, which in turn triggers a transaction in accordance with Sections 3 et seq. UmwStG remained unchanged.

Note: However, according to the statutory regulations, Section 1a KStG does not change the civil law nature of the respective company. In this regard, the provisions of the German Civil Code (“BGB”) / German Commercial Code (“HGB”) / partnership company (“PartG”) and the deviating rules in the articles of association are still decisive.

Advantages of the amendments to Section 1a KStG through the Growth Opportunities Act

Extension of the group of persons entitled to apply (problem 1)

So-called registered civil law associations (“eGbRs”) are now also included in the group of persons entitled to apply (Section 1a (1) sentences 1 - 4 KStG new version). These are all GbRs that are entered in the company register (see Section 707a (2) BGB). Registration is generally voluntary, even if it is required for some legal transactions (in particular for transfers of real estate pursuant to Section 47 (2) Land Registry Act (“GBO”). However, this means that the law falls short of the original draft of the Growth Opportunities Act to give all GbRs, and not just those registered, the option to register.

In the following, we would like to look at some examples of constellations for which an option can now be considered:

• The GbR is a popular legal form in the field of private property management. While new foundations in this regard have been eGbRs since 1 January 2024 anyway, it is also not too much effort for existing GbRs to be entered in the company register. In this case, it may be attractive to initially offset any losses from the use of the property (e.g. due to financing expenses or major maintenance expenses that cannot be capitalised as production or acquisition costs) against other positive income through transparent taxation. 
  
  With a long-term holding strategy, a subsequent option can then trigger a real tax advantage. While a tax burden of up to 47.48% is possible for the GbR (from a current taxable income of EUR 277,826), undistributed income of the opted eGbR is only taxed at 15.825%. Even with a distribution, the effective tax rate is only 38.03%. Provided that the requirements of the extended trade tax reduction are met, cf. Section 9 no. 1 Trade Tax Law (“GewStG”).
  
  It should be noted that the option pursuant to Sections 5 and 6 Land Transfer Tax Law (“GrEStG“) may have unfavourable consequences in the case of property transfers. Therefore, the examination of the advantageousness of an option for corporation tax is always re-served to the individual case.
  
  
• The option can be interesting for the many existing freelance GbRs if they distribute little and do not wish to change their legal form to a partnership company for reasons of name continuity, for example. However, this option is subject to trade tax, which leads to a comparatively higher tax burden when distributing profits. Furthermore, remuneration for services and transfers of use by the partners are then subject to the rules on hidden profit distribution. This step should therefore be carefully considered.
  
• Finally, due to its cost-effective establishment – provided that the liability-limiting effect can be waived – an opting eGbR could be useful as a holding company in order to bundle investments and benefit from the privileges of Section 8b KStG and Section 9 no. 2a GewStG (intercompany privilege). This means that dividends to the eGbR are 95% tax-free for shareholdings of at least 10% or 15%. Advantages can also arise from the fact that an eGbR (in contrast to most corporations and commercial partnerships) is not subject to the accounting obligation under the HGB, meaning that such an obligation can only arise from Section 141 of the German Fiscal Code (“AO”). This means that, subject to certain limits, profits can be determined in accordance with Section 4 (3) EStG (so-called revenue surplus calculation), which is significantly more cost-effective than accounting.

Retroactive application (problem 2)

According to the new Section 1a (1) sentence 7 KStG, the application can now be submitted in cases of new formation up to one month after the conclusion of the partnership agreement with (back ) effect for the current financial year. The same applies to the change of legal form from a corporation to a partnership, whereby the one-month period begins with the registration of the change of legal form with the relevant register of the corporation or partnership. 

According to the explanatory memorandum, it should therefore be possible in these cases to ensure consistent treatment as a corporation tax subject (see BT-D 20/8628, p. 191). This is to be welcomed, as the old legal situation was extremely unsatisfactory in this respect.

Harmlessness of the retention of GmbH shares (problem 3)

A new second half-sentence has been added to Section 1a (2) sentence 2 KStG, according to which the retention of the share in the general partner GmbH held as special business assets II is not detrimental to the book or interim value application within the scope of Sections 20 (2), 25 UmwStG under the new legal situation. This means that the previously required notarised transfer of the GmbH shares to the KG (resulting in the creation of a single KG) will no longer be necessary in future.

The background to the amendment is that no hidden reserves are to be retained in the event of a tax-neutral transfer in accordance with Sections 20 (2) and (25) UmwStG. In the case of a GmbH & Co. KG, the general partner's interest in the KG is typically 0%. The only income of the general partner GmbH is a small liability fee. Even if the shareholding is to be allocated to the necessary special business assets II (see H 4.2 (2) "Shares in corporations" Income Tax Manuel (“EStH”)), there is therefore usually no retention of hidden reserves, as these do not usually exist in practice. 

Taxation only on actual withdrawal (problem 4)

Most recently, Section 1a (3) sentence 5 KStG was shortened so that only the actual withdrawal at shareholder level leads to a deemed dividend within the meaning of Section 20 (1) no. 1 EStG. In future, a notional dividend will no longer be triggered if only the payment can be demanded. The legislator clarifies in the explanatory memorandum (see BT-D 20/8628, p. 192) that a withdrawal is any process as a result of which the profits no longer represent equity of the opting company and are no longer available for offsetting against losses of the company. For example, posting to a debt capital account or offsetting against a claim against the shareholder is sufficient for this. On the other hand, company law does not provide for a separate distribution resolution for partnerships - in contrast to corporations. This fundamental difference could justify different treatment in some respects.

The deletion of the previous addition ("or their payment can be demanded") and the sole focus on the actual withdrawal date brings advantages that should not be underestimated. The old version of the standard has so far meant that – unless the partnership agreement provided otherwise – a claim for payment could generally be demanded at the end of the calendar year or deviating financial year and this was subject to taxation without an inflow of liquidity to the shareholder. Until now, this almost mandatory consequence could only be avoided de facto through a distribution block regulated in the articles of association.

The issue of so-called disproportional (also known as incongruent) distributions has not yet been publicly discussed in this context. In the case of partnerships, each partner can in principle determine under civil law at what point in time they withdraw their profit shares (Section 122 HGB). The profit distribution key under commercial law is not necessarily affected by this. Unlike in the case of a corporation, no (uniform) resolution on the appropriation of profits is required. As the differences under company law continue to exist despite the exercise of the option, a different actual withdrawal in accordance with Section 1a (3) sentence 5 KStG should not result in a disproportionate distribution by the opting company.

If the option under Section 1a KStG is exercised, care should be taken to ensure that withdraw-able profits and shareholder loans are recognised separately. The method of accounting should also be reflected in the articles of association. After all, the question of when a payout can be demanded will no longer play a role in future.

Are there still pitfalls with Section 1a KStG?

Anyone who now has the impression that the problems with an option in accordance with Section 1a KStG have been eliminated should realise that the standard still has weaknesses that should be addressed by the legislator. In addition, there are a number of peculiarities that depend on the individual case, meaning that it is almost impossible to implement a structure by using Section 1a KStG without expert help. The following are examples of some of the weaknesses and peculiarities: 

• Even if the legislator has improved the legal situation with regard to the GmbH & Co. KG, the need to transfer the functionally necessary special business assets to enable Section 20 (2) UmwStG often causes problems, as a transfer of ownership from the shareholder to the company is required under civil law, which is often undesirable for liability reasons. Even if the option itself does not trigger real estate transfer tax with regard to existing properties owned by the company due to the lack of a change of legal entity, the transfer of the shareholder properties to the company is subject to real estate transfer tax due to Section 5 (1) sentence 2 GrEStG. All in all, the breach of the blocking period triggered by the option in accordance with Section 5 (3) sentence 3 GrEStG must be observed for earlier property transfers to the company.
  
• The option in accordance with Section 1a KStG means that all amounts recognised in existing supplementary balance sheets are attributed to the company, which may result in equalisation claims under civil law between the shareholders. The company is therefore dependent on the solvency of its co-shareholders.
  
• If the company has previously made use of the retention exemption, subsequent taxation must be carried out with the option pursuant to Section 34a (6) no. 2 EStG.
  
• Any trade losses that can be carried forward within the meaning of Section 10a GewStG are cancelled out due to Section 23 (5) UmwStG.
  
• The company cannot (or can no longer) utilise the trade tax allowance of €24,500 in accordance with Section 11 (1) sentence 3 no. 1 GewStG.
  
• The company cannot be a controlled company within the meaning of Section 14 (1) sentence 1 KStG or Section 2 (2) sentence 2 GewStG (BMF letter dated 10 November 2021 - IV C 2 - S 2707/21/10001 :004, para. 56; hereinafter BMF letter 2021).
  
• Exercising the option under Section 1a KStG can lead to new qualification conflicts in an international context. While the 2021 BMF circular in para. 54 assumes treaty eligibility, it is likely that foreign states will come to a different conclusion based on the civil law criteria. As a result, this could even lead to an increase in planning costs for companies.
  
• In the event of the departure of a domestic shareholder after exercising an option, the exit taxation pursuant to Section 6 Foreign Tax Act (“AStG”) in conjunction with Section 17 (1) EStG generally applies. 
  
• The parent-subsidiary guideline (Section 43b EStG) does not apply (BMF letter 2021 pa-ra. 52).

Increased attractiveness of Section 1a KStG - pipe dream or reality?

It remains to be seen whether the standard will now make it out of the niche of tax structuring practice. The pitfalls that still exist, which do not make practical implementation easy, are likely to continue to deter many. 

Especially in loss-making start-up phases, the choice of a partnership can be advantageous from a tax perspective. This applies in particular to start-ups (for a comprehensive description, see Kleen, magazine Finanzrundschau, 2022, 1115). If the question arises at a later date as to whether the change from the income tax system to the corporation tax system should be completed after the loss-making phase by changing the legal form from a partnership to a corporation, an option in accordance with Section 1a KStG should at least be considered in future. 

The eGbR in particular, which is now included in the regulation, now offers a lean alternative to the existing corporations and other opting partnerships with its simple formation, low formation costs and the possibility of determining profits by means of a revenue surplus calculation. 

Due to the complexity, we believe that the decision in favour of an opting partnership should only be made after forward planning. 

This overview is for initial information purposes only and expressly does not constitute legal or tax advice.