The German Income Tax Modernization Act (Gesetz zur Modernisierung des Körperschaftsteuerrechts) introduced the corporate income tax option under Section 1a Corporate Income Tax Act. This option enables commercial partnerships and partnership companies to opt to be taxed as if they were corporations for business years beginning after 31 December 2021 without changing their structure under civil law.
The Federal Ministry of Finance comments in detail on the application of Section 1a Corporate Income Tax Act in a letter dated 10th November 2021 (BMF-letter Ref. IV C 2 - S 2707/21/10001 :004; only available in German language) and addresses the following aspects, among others:
Personal Scope of Application of the Corporate Income Tax Option
Trading partnerships and partnership companies (such as German OHG and KG) are eligible to exercise the option. According to the Federal Ministry of Finance, this also applies if a purely asset-managing activity is carried out.
The option is also open to companies of foreign legal form that correspond to a German partnership according to the comparison of legal types. The prerequisite for the option is that the foreign company is subject to a tax comparable to German corporate income tax (section 1a paragraph 1 sentence 6 Corporate Income Tax Act). Companies with their registered office and central administration abroad can also opt for corporation tax and are then subject to corporation tax on their domestic income.
The existence of the personal requirements for the option during the entire taxation period must be proven upon request of the tax authorities for each year within the scope of the corporate income tax return. If the proof is not provided, the tax authorities assume that the personal prerequisites for the option did not exist in the relevant financial year.
The exercise of the option is only possible upon application to the tax office locally responsible for the separate and uniform determination of the partnership's income. The application must be submitted in accordance with the officially prescribed data record. Proof must be provided that the required number of partners have agreed to the exercise of the option.
Please note: An application form and further details can be found on the Website of German Bundeszentralamt für Steuern (in English).
The application must be received by the tax authority at least one month before the beginning of the business year from which the option is to apply. In the case of a business year with the same calendar year, the application must therefore be submitted no later than 30th November of the preceding year. This also applies to newly established companies. It is not possible to file an application before the company is established, so that an option for the first business year of a company is excluded.
After the application has been filed, the tax authority summarily examines whether the legal requirements for the application are met. If the application is granted, the company is notified of a corporate tax number. In contrast to the notification of the corporate tax number, a negative decision is a contestable administrative act.
The application is irrevocable. No further application is required for subsequent business years. An application filed late is invalid and does not automatically count as an application for the next business year.
Transition to Corporate Taxation
The transition to corporate taxation is considered a change of legal form. Thus, for income tax purposes, an acquisition and disposal transaction is deemed to have taken place, which may be tax-neutral under the provisions of section 20 Reorganization Tax Act. The personal requirements for the application of the Conversion Tax Act must be fulfilled by the company and the individual shareholders on the tax transfer date at the latest. If this is not the case for individual partners, the built-in gains in the business assets of the partnership must be disclosed.
A tax-neutral (fictitious) change of legal form also requires the transfer of the (economic) ownership of all functionally essential business assets, which also include those in the special business assets of the individual partners.
The conversion date is the end of the financial year immediately preceding the financial year in which the option is exercised for the first time (section 1a paragraph 2 sentence 3 Corporate Income Tax Act). Therefore, in addition to an opening balance sheet, a closing balance sheet for tax purposes must be prepared for the opting company for the last legal second of the previous year and a corporation tax return and, if applicable, a trade tax return must be submitted.
Since the exercise of the option is deemed to be a fictitious change of legal form, a blocking period violation can be triggered with regard to various tax-related circumstances (e.g. in the case of a preceding transfer of a business, partial business or co-entrepreneurial share within a period of five years without disclosure of built-in gains.
Furthermore, it should be noted that trade tax losses that can be carried forward, losses carried forward by the partners as limited partners as well as interest and EBITDA carried forward for purposes of regulations regarding interest barriers are lost as a result of the option.
Tax Consequences for the Partnership
The opted company is treated like a corporation for income tax purposes. Therefore, the provisions of the Corporate Income Tax Act, Income Tax Act, Trade Tax Act, Solidarity Surcharge Act, Foreign Tax Act and Reorganization Tax Act apply in particular. For the purposes of the application of double taxation treaties, the opting company also fulfils the requirements of a corporation under treaty law.
The sale of the shares in the opting company or a transaction equivalent to a sale within seven years after the conversion date constitutes a lock-up period violation and retroactively triggers a taxation of built-in gains, insofar as the fictitious change of legal form took place at book or interim values.
Tax Consequences for Partners
At the shareholder level, profit shares are only considered distributed when they can be withdrawn or their payment can be demanded (section 1a paragraph 3 sentence 5 Corporate Income Tax Act). The decisive factor is therefore the possibility of profit withdrawal under company law, so that profit shares whose payment the shareholder can demand with the adoption of the annual financial statements are deemed to have been distributed at that time. If, for example, a separate resolution is required for payment or withdrawal, this is generally not yet a fictitious distribution. At the time of the distribution, the opting company must declare and pay capital gains tax.
Income received by the shareholder for his work in the service of the company, which is to be assessed as appropriate, leads to income from employment.
Termination of the Corporate Income Tax Option
A return of the company to transparent taxation is possible either by operation of law or at the request of the company. The application for reversion must be submitted at the latest one month before the beginning of the financial year in which the company is no longer to be taxed as a corporation. The option is terminated by operation of law if, among other things, the personal requirements for the option cease to apply.
A retroactive effect for conversion tax purposes is excluded in all cases of termination of the option. If the fictitious change of legal form has taken place at book or interim values when the option was exercised, the reversal option or other termination of the option within seven years leads to a blocking period violation and thus to retroactive taxation of built-in gains.