German Tax Law Fundamentals: PE, Income Methods, and Key Definitions
Permanent Establishment (PE) under German Law (Section 12 General Fiscal Code)
Permanent establishment shall mean any fixed place of business or facility serving the business of an enterprise. In particular, the following shall be considered permanent establishments:
- The place of business management;
- Branches;
- Offices;
- Factories or workshops;
- Warehouses;
- Purchasing offices or sales outlets;
- Mines, quarries, or other stationary, moving, or floating facilities for the exploitation of natural resources;
- Building sites or constructions or installation projects, including those moving or floating, where:
- An individual building site or construction or installation project, or
- One of several coexistent building sites or constructions or installation projects, or
- A number of immediately successive building sites or constructions or installation projects last less than six months.
Note: Permanent establishments, and thus taxable presences, can be created inadvertently.
Permanent Representative under German Law (Section 13 General Tax Code)
A permanent representative shall mean any person who conducts the business of an enterprise in a sustained manner and, in so doing, is subject to its instructions. In particular, a permanent representative shall mean any person who, in a sustained manner, on behalf of an enterprise:
- Concludes or brokers contracts or solicits orders, or
- Maintains a stock of goods or merchandise and makes deliveries from this stock.
Note: Agents can create taxable presences of a principal inadvertently.
Key German Tax Terminology
- Tax Assessment
- An administrative act by a tax office where a tax is assessed (e.g., income tax assessment, corporate income tax assessment), typically based upon a tax return submitted by or on behalf of the taxpayer. The tax is paid by the taxpayer.
- Self-Assessment
- A tax return submitted by or on behalf of a taxpayer which is treated like a tax assessment (e.g., value-added tax returns, payroll tax returns, withholding tax returns). The tax is paid by the taxpayer.
- Withholding Tax
- A flat-rate tax deducted at source by the debtor of a taxable payment on behalf of the taxpayer. The tax is not based upon net taxable income, but upon gross receipts.
- Hidden Reserves
- The difference between the fair market value of an asset and the tax book value of an asset.
- White Income
- Income that is taxed in no country.
- Dry Taxation
- Tax that is due on unrealized income.
- Total Period
- The time from the inception of an enterprise until its final liquidation.
3. Methods of Determining Taxable Income
3.1 Cash Method
Income is determined as the difference between cash receipts less expenses paid, less amortization or depreciation charges.
- The method is typically used for income other than business income.
- Income can be easily manipulated (e.g., the Goldfinger model).
Key Concepts in Cash Accounting:
- Depreciation: Deduction of the acquisition cost of a tangible asset over its useful life.
- Amortization: Deduction of the acquisition cost of an intangible asset over its useful life.
- Straight-Line Method: Annual deduction equals a fixed percentage of the acquisition cost, resulting in a constant amount.
- Declining Balance Method: Annual deduction equals a percentage of the book value as of the last year-end, meaning the deduction decreases each year.
3.2 Accrual Method
Income is determined on the basis of a balance sheet and calculated as the net increase (or net decrease) of the equity, minus contributions and less withdrawals.
- Based on the statutory balance sheet.
- This is the typical method for business income.
3.3 Book-to-Tax Adjustments
Definition: A book-to-tax adjustment reflects a difference in the valuation of an asset or a liability for statutory purposes (valuation under IFRS, US-GAAP, or German GAAP) and for tax purposes.
Typical Examples of Adjustments:
- Differences between Fair Market Value and Going Concern Value:
- Fair Market Value: The value of an asset on the market.
- Going Concern Value: The value of an asset as part of a going concern (an active enterprise).
Example 1: If an enterprise owns shares and the fair market value has dropped below the acquisition cost as of the balance sheet date, what is the going concern value?
Example 2: If an enterprise owns bonds and the fair market value has dropped below the acquisition costs as of the balance sheet date, what is the concern value?
- Legally Defined Differences for Purely Fiscal Reasons, such as:
- Liabilities that have to be repaid from future profits or income.
- Accruals for patent infringements.
- Jubilee accruals.
- Accruals for impending losses.
- Assets that exist only for statutory purposes but not for tax purposes (such as interest in a partnership).
- Pension accruals.
3.4 Non-Deductible Business Expenses
Note: Non-deductible business expenses are expenses that meet the definition of business expenses, but the law specifically defines them as non-deductible. Possible reasons for disallowance include:
- Removing Unwanted Tax Structuring Alternatives:
Example: Interest deduction at the partnership level, general interest deduction, or debt push-down structures.
- Disallowing Tax Deduction for Private Consumption:
Examples: Gifts, entertainment expenses, hunting, and fishing.
- Disallowing Tax Deduction for Criminal Activities:
Example: Bribery.
- Consistency:
Examples: Tax charges, incidental charges.
3.5 Excursus: The Constructive Dividend
Definition: A constructive dividend is characterized by:
- A decrease in net equity or a lost increase in net equity;
- Caused by a transaction;
- Disguised as a transaction under the law of obligations;
- Which is actually a transaction under company law.
Reasons for Constructive Dividend Classification:
- Formal Reason
- The failure to define the rights and obligations between a company and a shareholder prior to the transaction.
- Material Reason
- The compensation is not commensurate (i.e., not at arm’s length).