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Disclaimer: this article should not be taken or considered as legal advice. Our aim is only to give you an overview and introduction so that you can better find your path of growth and investment in an optimized legal organization form.
OK, that’s the legal stuff out of the way – on to the juicy part.
For non-EU based investors, navigating the tax system in a foreign country can be a whole new level of headache. That goes double when the tax system is complex and nuanced, which is true for Germany. But put away the Aspirin®, because, with the right knowledge and planning, non-EU based VCs and angels can still successfully invest in German startups while minimizing their tax liabilities.
Here are some key things non-EU based investors looking to invest in German startups should keep in mind:
Know Your Tax Residency Status
The first question you need to ask is: what is my current tax residency status? This will decide whether or not you’re entitled to certain tax exemptions or treaty benefits under Germany’s Double Taxation Agreements (DTA).
For example, under the DTA, USA/Germany withholding taxes on dividends can be reduced to 0% if the shareholder holds 80% in the company or 5% if the shareholder holds 10%.
However, benefits like this are increasingly becoming subject to strict anti-avoidance principles. For example, the respective US person has to demonstrate “substance” from a tax perspective. On top of that, as a matter of control, the tax authorities are required to exchange information regarding tax payers and relevant tax information.
The tax residency status is not always easy to determine, in particular, if the legal owner is for tax purposes a transparent or tax exempt entity. In that respect several anti-abuse regulations exist under national law but also under DTAs. What’s more, even if you’ve determined your tax residency status, you may still have a presence in Germany through a permanent establishment so at least you have limited tax liability in Germany.
Know Your Investment Vehicle
When it comes to the investment vehicle, there are two things that will decide how you’re taxed. First of all, whether you invest directly or indirectly into the German startup; secondly, how the investment vehicle is treated under German tax law.
Let’s dig a little deeper.
Since 2018 funds are required to determine whether they qualify as “Investment Funds” or a partnership. Investment funds are subject to a specific tax treatment. Partnerships can qualify as Investment Funds but only under limited circumstances – that VCs are generally not subject to. On the other hand, all funds (regulated or not) in the form of a corporation are generally classed as Investment Funds.
Sound complicated? We’re only just getting started.
The real complexity here is that certain vehicles, in particular the US-LLC, may be considered as corporation or as partnership according to an official ruling-test published by the German tax authorities and compliant with the German Fiscal Supreme Court.
If the investment vehicle is considered to be an Investment Fund the vehicle is generally entitled to DTA benefits and is treated to be tax opaque.
German VC-funds currently still have the legal form of a partnership – so that they don’t qualify for the tax treatment applicable to Investment Funds. These VC-funds are subject to the standard income tax principles.
In that respect there is another level to be considered: the classification of the partnership as an ‘asset management partnership’ or a regular ‘trading partnership’.
Why does this matter?
Because it could mean huge tax leakage. The asset management partnership is fully tax transparent, while the trading partnership is subject to German trade tax (a municipal tax with a tax rate between 7% and 17%). We’ll talk more about German trade tax shortly. In the meantime, let’s answer the question that’s no doubt on your mind:
What’s the difference between the two types of partnership?
Well, an ‘asset management partnership’ is limited in its activities – holding of the shares in the portfolio companies and the sale after a certain period of time (meaning there’s no trading of the startups).
However, according to an official ruling published by the German Tax Authorities there are certain other restrictions. In particular, that no management functions may be performed in the startup company or the kind of leverage and financing of the fund itself.
Further, from a structuring perspective, the General Partner is generally a corporation to limit its liability. From a German tax perspective such a structure is considered to be a trading partnership even if the corporation only performs asset management.
Luckily, German tax law provides an exception to this kind of tax treatment: when a Limited Partner is entitled to the management of the partnership. Please note, if a Limited Partner performs the day-to-day management function, a permanent establishment of the partnership is created abroad.
This demonstrates just one of the many complexities under German tax law. So hopefully, you can see why getting external advice on the documentation and structuring is essential to avoid paying more taxes than absolutely necessary.
Trade Tax (Gewerbesteuer)
Trade tax (Gewerbesteuer) is a tax that is levied on the profits of businesses and self-employed individuals in Germany. Trade tax is unique to Germany but it’s a municipal tax similar to federal, state, and local income taxes on business profits in the US.
As a municipal tax, the local governments have the right to determine the specific tax rate which varies between 7% and 17%.
This leads to a combined tax rate (income and trade tax) for a corporation of around 30% and tax leakage for trading partnerships that aren’t fully tax transparent.
For example, if you as an US person invest through a German trading partnership into a German startup company you are subject to the German trade tax which may be credited under the DTA USA/Germany. But, if you are a tax exempt person, your tax base is too low, or you cannot otherwise make use of such a foreign tax credit – German Trade Tax will be a definitive cost factor.
So you see how important structuring is when it comes to taxation.
The corporate income tax rate in Germany is 15% plus a “Solidarity Surcharge” of 5.5% (in total 15.825%).
German Partnerships are tax transparent, meaning the partners pay their taxes in the jurisdiction they are tax resident. It’s important to note that a partner can create a permanent establishment in Germany or the partnership interest can be attributed to a German entity so that German income taxes are triggered.
In a case like this, it’s the respective principles under the DTA that matter most. For example under the DTA USA/Germany taxes in Germany can be credited as a foreign tax credit against the US tax liability.
Personal income tax rates vary between 24% and 48%.
Another thing to note: as a result of international agreements, several tax structures such as hybrids (intended to reduce or optimize the tax basis/rate) have been abolished – and Germany fully complies through an interest barrier rule, anti-hybrid/double deduction rules, and strong CFC legislation.
Capital Gains Tax
Under German Tax law as well as under the DTA the right to tax capital gains from the sale of shares lie with the jurisdiction the shareholder is tax resident. Under German Tax law the sale of a share in a corporation by a German corporation is effectively subject to 1.5% German taxes.
German Withholding Taxes
German dividends are subject to a withholding tax rate of 25% plus 5.5% Solidarity Surcharge (in total 26.375%).
This withholding tax can be reduced under the DTA to 15% or even lower if certain circumstances apply. But, reducing withholding tax in this way is subject to strict anti abuse principles – effectively the recipient of the dividend has to demonstrate sufficient substance from a tax point of view.
By contrast, capital gains are not subject to German withholding taxes.
Consequently, as a matter of tax efficiency, structuring is highly important. Especially if the withholding tax cannot be credited under national law or reduced to 0%.
We hope this article has helped you to navigate through some of the complexities and nuances of the German tax system – and the thick veil of mist surrounding the subject has started to clear (at least a little). At the very least, we hope this will guide you to ask the right questions when you seek out legal advice.
This Article was written as a part of the Skytrain Network – a community of LPs, GPs, family offices, angels, syndicate leads, serial entrepreneurs, emerging fund managers and operators who are passionate about Berlin. Backed by Silicon Allee and the Berlin Business Office, USA, our goal is to build a bridge across the Atlantic and help US investors to leverage our network and facilitate investment into the lucrative VC scene here in Berlin, Germany.
While we’re passionate about venture capital, we are not financial, legal, or investment advisors so please don’t take any of the information in this article as advice. Always consult legal professionals and do your due diligence before undertaking any kind of investment. Luckily, this article was written with the support of our friends at Schalast and they are more than qualified to help you.
Article written by Andrew Wilkinson