Author: itsupport

Transferring money abroad became a tradition for Germans after World War II. Political instability forced many to divert their assets toward more secure holdings. The post-war revival that followed saw Germany climb the ranks of the world’s strongest economies, but it failed to stem the outflow of cash altogether. The reason: tax rates – among the highest in Europe. But things have just got better for Germany.

Large-scale tax reforms came into force on January 1, 2008. The German Parliament’s decision – criticised in many quarters as not going far enough to enhance economic development – could have a major impact. Domestic businesses and foreign investment should benefit, but there are doubts over whether the reforms have gone far enough.

The 2008 Company Tax Reform Act was essential for many reasons – not least to make Germany more internationally competitive. In the broadest sense, most believe this is where the government has succeeded. The decision to reduce the corporate tax rate from 25 percent to 15 percent is the key. RP RICHTER&PARTNER – one of Germany’s leading tax, audit, accounting and legal service consultants – provides tailor-made solutions to clients with an international approach.

Managing partner Wolfgang Richter, a former senior partner in and head of the tax department at Ernst&Young Munich, welcomes the positive change, but has mixed feelings about other aspects of the reform. “In our opinion the Company Tax Reform Act 2008 is an important step towards a more internationally competitive tax environment in Germany,” he says.

“However, a simplification of the German tax system, which had been planned, did not become reality.”

Complex legal system
If reducing the corporate tax burden was seen as crucial to Germany’s competitiveness, tackling the complex legal system was one of the several requirements that failed to materialise. But it was not all bad. Some simplification was realised following many months of consultation and talks between experts on all sides.

The non-deductibility of the trade tax as business expense, from the trade tax basis and the corporate-income tax basis, was one such benefit. This non-deductibility had no significant impact on the trade tax burden, because the general multiplier to calculate the taxable amount was decreased from 5 to 3.5 (the abolishment of the progressive tariff of the general multiplier for partnerships and sole proprietorships could have an impact on the trade tax burden, but this change will only affect small businesses).

The improvement of this method was that deductibility of the trade tax was such a complex calculation issue. But German tax reform 2008 has been as much about missed opportunities as improvements.

The failure to abolish trade tax – seen as major step towards simplification – is generally perceived as a serious flaw. There is little doubt the predominance of the municipalities, and the anticipated loss of local tax revenue, forced legislators to think again. Numerous transition rules between the old and new also conspired to undermine the anticipated move from old to new, according to experts such as Richter.

His firm operates fully integrated tax, audit, accounting and legal services.

Recognised as one of the leading consultancies in Germany, especially in the tax business (see rankings of JUVE, Legal 500, Tax Directors Handbook and World Tax by International Tax Review), the company has a unique insight of the challenges facing the business sector.

“After much deliberation, the German tax authorities, including the Ministry of Finance, became anxious because they could not calculate the impact of tax revenue loss from the transition rules,” he explains. “Fearing significant losses could have resulted in tax base, simplification failed to materialise.”

Draft publication
Many had feared the worse during the long months leading up to publication of a final draft and the Act being formally adopted by the Bundestag and Bundesrat. Concerns were not just limited to matters of trade tax. Worries surrounded the thin capitalisation rules (so called interest-barrier rule,) which apply not only to shareholder loans but also to any bank loan. The new rules are seen as a significant limitation for high leverage buy outs/investments.

“The tax legislators listened, but made only few changes,” says Frank Schönherr, tax law expert and another founding partner of RP RICHTER&PARTNER. “New rules for shifting of functions and transfer pricing brought quite some disturbances, especially the question of whether the doubling of functions is a taxable shifting of functions.” But while changes to the final draft were small, some amendments were a surprise.

One example was the interest barrier rule. Many businesses successfully raised concerns about the rule, leading to a change. The draft had been tied to the EBIT, but by the latter stages of the legislation process it was aligned to the EBITDA. This led to a higher amount of deductible interest expenses (30 percent of EBITDA is deductible interest expense).

Winners and losers
So who were the major winners and losers from reform? There are two groups of taxpayers that are expected to benefit most:

The first, benefits most from the reduction of corporate tax rate, which was lowered from 25 percent to 15 percent. Taking the trade tax burden into account, the average corporate tax rate was reduced from about 40 percent to 30 percent varying from 23 percent to 33 percent depending on the municipal rate fixed by the municipality (´Hebesatz der Gemeinde´).

Foreign corporations could do even better. Non-resident corporations for example, holding German real estate (PropCos), could under some circumstances be free of trade tax. They will have to calculate with an aggregate tax burden of 15 percent instead of 25 percent. And the losers: highly debt financed companies with low income. This is primarily due to the interest-barrier rule.

“The so called German ‘Mittelstand’ could also be loser of the reform if they do not adjust their structure to the new rules,” says Schönherr. “The Mittelstand is organised generally as the partnerships. “The partnership is liable to trade tax, the individuals holding an interest in the partnerships are liable to income tax. The progressive tax tariff had been increased from 42 percent to 45 percent (so called Rich Tax).” No compensation has been introduced for this increase despite earlier reassurances by the government. To equalise the tax burden of partnerships and corporations, the tax reform introduced a special tax rate for retained earnings of partnerships.

However, if these monies are distributed, the aggregate tax rate on the income derived from the partnership is higher than the taxation of income derived from the partnership at the new top tax rate of 45 percent (plus solidarity surcharge, plus church tax, if any).
Estimates over whether the reforms will result in an aggregate rise in total tax revenues remain in the balance.

“It cannot be excluded that the counter financing of the tax rate reduction through broadening the tax base (new thin capitalisation rules, new add-backs for trade tax purposes) could lead to a higher aggregate tax revenues in total,” explains Schönherr. “But the government is of the (official) opinion that the broadening of the tax base equals the lowering of the tax revenue, resulting from the reduction of the corporate tax rate finally.”

Although Schönherr agrees the impact of reform is likely to be positive, he warns it is impossible to rule out the possibility that broadening might have a negative impact on key sectors of the economy. Real estate investors and real estate leasing companies in particular could suffer from the new interest-barrier rule and the new add-backs for trade tax purposes, he says. Highly leveraged investments are likely to be affected negatively too.

Thin capitalisation rules
There is less doubt about the ‘negative impact’ of the new thin capitalisation rules. When European courts issued a ruling in 2002 declaring German thin capitalisation rules contrary to law, change became inevitable. The first solution of the tax legislators after the Lankhorst-Hohorst case in 2002 was to broaden the scope of application by including loans from domestic shareholders. Due to problems with these early amendments, the Company Tax Reform Act 2008 introduced additional changes to thin capitalisation rules.

The new system applies to any loan irrespective of the status of the lender, as a shareholder or not, and irrespective of whether the lender is a domestic or a foreign one. The effect is that general loans could lead to the non deductibility of interest expenses, according to Claus Lemaitre, international tax partner at RP RICHTER&PARTNER.

“In our opinion many of the unsolved application problems of the old thin capitalisation rules will still arise by the application of the new thin capitalisation rules,” says Lemaitre. “The new rules have a negative impact on the economy in Germany in our opinion because a tax burden could arise even in cases where no positive income is earned by the company.”

The application of the new thin capitalisation rules, flawed or otherwise, meant the legislators did make a significant step towards preventing a shift of interest to foreign countries. But alongside the changes of the add-backs on trade tax, thin cap’ rules will have the most affect on how companies operate in future.

Worrying changes
Changes of the rules regarding the loss of loss carry-forwards have proven a worry too. “This new rule will lead to many unexpected tax issues in the M&A and restructuring context,” Mr Lemaitre says. The write-offs of shareholder loans were ruled by changes of the Tax Act 2008 ‘Jahressteuergesetz 2008’.

In many cases shareholder loans can no longer be written-off. The German tax authorities’ description of this ‘change’ as a ‘clarification’ has not been universally accepted.

“In our opinion and in the opinion of many other tax practitioners the change is not a clarification but the implementation of an unfavourable new rule,” Mr Lemaitre explains. The legislators will perhaps demur, arguing their reforms have certainly made Germany more attractive to overseas companies looking to invest. As for the domestic market – despite the reform set backs, 2008 could be the year that sees the Germany economy out perform some of its rivals.

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Although traditionally better known for its hot springs, fishing and whaling industries, Iceland has steadily transformed itself into a financial powerhouse in the last 20 years. Icelandic investment firms have continued to buy up, for example, significant tranches of the UK retail High Street. Icelandic investment firm Baugur and FL Group now own House of Fraser and MK One, for example and is now tipped to buy Debenhams.

Iceland’s business turn-around is reflected in the former state-run banks which have all been privatised. Prosperous, well-run Icelandic businesses have increasingly been forced to look overseas for M&A targets, given the lack of appropriate targets at home. Hence the slew of Icelandic companies and investment houses chasing cross-border deals.

The UK, unsurprisingly, has been a target for much of the cross-border interest: many Icelanders speak English and the UK economy is one of the most open and dynamic in the world. So Icelandic-Brit deals look unlikely to abate, especially if UK interest rates continue to slip, as looks likely. According to a recent survey by M&A intelligence and research service Mergermarket, more than half of senior Icelandic managers are considering a deal in the next 12 months.

Iceland’s economy though is one that’s increasingly highly leveraged with significant levels of external debt thanks to the large amounts of M&A and private equity activity. Which means the economy has, to say the least, sizeable imbalances and therefore remains vulnerable to economic crisis. The diminutive population means that the financial players generally are likely to know each other and there’s an abundance of cross-company ownership.

Iceland’s racy makeover
So, what is behind Iceland’s makeover from grey, dull fish exporter to hot tourist spot and international financial mover and shaker? At first glance, Iceland remains a country riddled with contradictions. It is not a low tax economy. Its aggregate tax burden is roughly 40 percent of GDP, significantly higher than the UK and the US, though lower than many other European countries. More revealingly however is Iceland’s corporate tax rates are low at 18 percent. Although this is not quite Ireland or Hungary territory (12.5 and 16 percent respectively), it’s still impressive.

Former Icelandic prime minister David Oddsson, who oversaw much of Icelandic’s key economic reforms in the 1990’s, has to take much of the credit for Iceland’s economic rejuvenation. Corporate rate reductions were slashed in order to promote a pro-growth economy; wealth taxes were abolished and a flat tax rate was also forced through. Widespread financial de-regulation followed.

Domestic investment firms have been astute in making the most of Iceland’s economic comeback, embracing cross-border opportunities. Despite high interest rates, many Icelandic investment companies in the 1990’s were able to borrow money from countries with lower interest rates before depositing this cash on home ground, allowing them to quickly build up reserves. Meanwhile, old state-run industries were also being privatised, with new property rights created.

Iceland’s re-vamp has also been helped by environmental issues and concerns. Blessed with a super-abundance of hydroelectricity and geothermal power sources, Iceland is now actively looking at ways it can export hydroelectric energy to mainland Europe. Icelanders themselves are early adopters of mobile technology and broadband penetration is amongst the highest within the OECD.

Still fiercely independent
Today, Iceland’s economy looks generally highly robust: unemployment rates are one of the lowest in the world. Oddities remain though: Iceland is not a member of the European Union, nor does it seem much interested in joining. This is premised on the concern that Iceland would have to give up control over much of its natural resources, including fishing grounds, were it to join. Given Iceland’s booming economy and high growth curve, there seems no pressing urgency – at least for the moment – for it to join, so say Iceland’s powerful anti-EU lobby.

On the other hand, pro-EU Icelanders point to Iceland’s formidably high cost of living, even by central London or Scandinavian standards. Rising Icelandic inflation continues to make imports expensive. However, Iceland is a member of the European Free Trade Association and in 1992 Iceland became a member of the European Economic Area, allowing Iceland – and other countries including Norway – to join in the EU single market without formally having to join the EU.

Another hot issue is the unwillingness by Icelanders to give up sovereignty to Brussels. It remains a fiercely independent nation as well as an increasingly wealthy one: according to the Organisation for Economic Cooperation and Development (OECD) and the International Monetary Fund, Iceland now ranks as the world’s fifth-richest nation.

FDI remains patchy
Iceland’s own internal FDI – most of it from Europe and the US – is rather muted in comparison with its strenuous investment efforts overseas. However, plenty of FDI has been channelled towards Iceland’s own IT and software industry. It’s estimated since 2003 around $800 million has been invested. Some significant FDI investment in Iceland’s aluminium industry has also taken place.

Supporters of Icelandic FDI point to its strong levels of efficiency and productivity (amongst the highest in the world) and one of the lowest corporate tax rates in the world (18 percent), as well as its strategic location as a bridge between the US and Europe. Tax benefits to overseas investors includes no net wealth tax, no legislation on thin capitalisation; there’s also no branch profits taxes on repatriated profits.

Iceland’s legal market remains small. There are no large international legal players based in the capital Reykjavik and most domestic law firms focus on dispute resolution and family law. However, specialty legal work is booming, helped by the buoyant corporate M&A market.

Tourism ramping up
Away from the business news headlines however, Iceland’s economy – an odd mixture of capitalistic market economy supporting an extensive welfare state – is still strongly dependent on the fishing industry. In recent years, Iceland though has cottoned on increasingly as a tourist destination, particularly with eco-tourists and whale-watching.

In 2006, Euromonitor estimated tourism accounted for more than six per cent of Iceland’s gross domestic product. The main attraction for tourists is the unspoilt nature of much of its glaciers, lakes and lava field.

Although whale watching has also proved popular, Iceland is increasingly popular with adventure tourist and farm holidays. However, extreme seasonality means the tourist industry has to be flexible and focused. There also remains concern about the possible resumption of commercial whaling – and the impact this could have on Iceland as a green or nature lovers holiday destination. There is also a question mark about just how successful Icelandair is likely to be in developing its network and also being able to maintain growth.

Real estate prospects remain positive
Icelandic real estate roughly doubled between 2001 and 2007. The average price of an apartment ballooned from almost ISK 15 million in 2001 to beyond ISK 30 million by the end of 2007. Recently, as in the US and in some parts of Europe, there has been concern about falling price inflation, however the Icelandic market appears, so far, robust.

House prices are forecast to stay more or less at a standstill in 2008, due to tighter access to loans and a cooling labour market, followed by an uplift in 2009 when interest rates are anticipated to fall again.

Iceland’s mortgage market, like its banking market, has become more liberalised over the years, resulting in wider access to credit and borrowing, stoking demand and prices.

Summing up
Perched at the top of the Atlantic, Iceland is a tricky country to summarise. There are some glaring contradictions: despite relatively high rates of personal taxation, corporate taxation is amongst the lowest anywhere. Despite close ties to Europe and Scandinavia, it is stubbornly independent of Brussels. Although Iceland has an abundance of cheap, green energy, it has few natural resources. And though Iceland can claim a high degree of IT and technological prowess, from biotechnology to financial services, it still relies heavily on its ages-old fishing industry to provide 40 percent of its total exports. It also belongs to NATO, but has no armed forces (it declared itself a nuclear-free zone in 1985).

Meanwhile Iceland’s centre-right government, led by Geir Haarde, head of the Conservative Independence Party, continues to steer a delicate path of avoiding overheating the economy while promoting a high standard of living. Per capita GDP is estimated at more than €25,000 and Iceland’s pension system is well capitalised.

Iceland fact-box
Population: 312,000 people

GDP total: $18.4bn

GDP growth (2007): 2.6 percent

Inflation rate (2007): 4 percent

Budget (2007) $6bn

Unemployment: two percent

Net public debt: 17 percent of GDP