Partnerships – check-the-box
26 August 2022
Tax burden on German partnership income?
The taxation of German partnership income effectively depends on the tax burden of the partners because partnerships are regularly treated as transparent for German income tax purposes. This results in an allocation of the partnership’s taxable income to its partners. Consequently, partnership income is subject to tax at the level of its partners, i.e. either with personal income tax in case the partner is an individual or corporate income tax if the partner is a corporation. While corporations are taxed at a uniform corporate income tax rate of 15.825 % (including solidarity surcharge), the tax burden of individuals depend on the amount of income and the applicable progressive personal income tax rate ranging from 0 % up to 45 % (plus solidarity surcharge and church tax). Therefore, the legal form of a German company is crucial to determine the effective tax burden.
In addition, partnerships carrying out commercial business in Germany are – similar to corporations – usually subject to German trade tax at a rate between 7 % and 17 % (depending on the multiplier rate of the municipality where the business is carried out).
More favourable tax burden of corporations?
At first glance, the aforementioned lower tax burden of corporations may appear to be more favourable compared to individuals, provided the average personal income tax rate of individuals exceeds 16 %. Individuals might therefore decide to no longer hold their partnership interests directly, but rather through interposed corporations. Alternatively, they might directly change the legal form of the partnership into a corporation and benefit from a lower tax burden.
However, this is only half of the equation since the aforementioned more favourable tax burden is only “temporary”. This is based on the fact that a later distribution of the profits from the corporation to its shareholders qualifies as an additional taxable event for the shareholders. Considering this taxable event, the supposedly more favourable tax treatment of corporations is eliminated. Thus, corporations only have a more favourable tax burden to the extent they retain their profits and do not distribute them to their shareholders.
General mechanisms of check-the-box elections?
Check-the-box elections allow partnerships to choose – by checking the box in a particular tax return – to opt for switching from their regular tax transparent status to a non-transparent status. The consequence of the procedure is that the electing partnership will itself become subject to corporate income tax and as a result qualify as a taxpayer. Such elections are known from other jurisdictions such as the US or France.
The new German check-the-box election
The German legislator introduced with the Act on Modernisation of Corporate Income Tax Law a check-the-box election for partnerships to get treated as corporations for German income tax purposes for financial years 2022 onwards. The transition from the transparent tax regime to a stand-alone taxation of corporations takes place through a fictitious change of the legal form only for income tax purposes, i.e. there is no change of the legal form of the partnership under company law. This deemed tax treatment also applies to the partners of the electing partnership who are then fictitiously taxed like shareholders of a corporation.
In addition, the new check-the-box election provides for a re-election back to the transparent tax regime without any commitment period. Corresponding to the election, the re-election is treated as a deemed change of the legal form for income tax purposes.
Which partnerships can benefit from check-the-box election?
Commercial partnerships in the legal form of a general partnership (Offene Handelsgesellschaft) and limited partnership (Kommanditgesellschaft), partnership companies (under the Partnerschaftsgesellschaftsgesellschaftsgesetz) as well as comparable foreign partnerships are eligible to apply for the check-the-box procedure. However, the election should only provide a more favourable effective tax position if the underlying partnership generates profits that will be retained and not repatriated to the partners.
What needs to be considered before an election?
Partnerships and their partners who would like to benefit from the election should consider the following during the lifetime of the check-the-box procedure with due care before applying for the election:
- The ongoing income tax burden on the partnership income: the reason why the election might be attractive for the partnership and its partners
→ Partnerships should be prepared to provide forecasts of their taxable income and profit distribution volumes in future financial years to identify their expected future tax burden
→ An election could generally be attractive if, inter alia,
- the partners of the partnership are individuals with an average personal income tax rate of more than 16 %
- the partnership also qualifies as a corporation for tax treaty purposes
- The transition to a stand-alone taxation: in order to mitigate any potential tax pitfalls from the fictitious change of the legal form for income tax purposes
→ It needs to be determined whether the transition can be carried out tax neutral or alternatively existing tax losses can be utilised through the disclosure of built-in gains
→ Typical tax pitfalls could be, inter alia,
- the transfer of all functionally essential business assets, including business assets of the partnership legally owned by one of its partners (so-called Sonderbetriebsvermögen)
- forfeiture of existing tax losses
- investing period of up to 7 years
- The re-election back to the transparent tax regime: to ensure that the election is not a one-way trip and there is a possibility for a return without any (major) tax show-stoppers
→ Similar to the transition it should be reviewed whether the re-election can be carried out without triggering a significant amount of taxes
Additional non-tax considerations?
It might be also possible for some partnerships to get with the election the best out of two worlds: a reduced tax burden combined with a non-tax advantage. This is because there is a continuation of the corporate and commercial law regulations for partnerships, e.g. for co-determination of supervisory boards or a release from the obligation to disclose the annual financial statements.