I. Objective of the new provision

The “option for corporate taxation” pursuant to § 1a German Corporation Tax Act (Körperschaftsteuergesetz – KStG) was incorporated into the law with effect from 1 July 2021. The background is to open up the generally higher taxation of current profits of a partnership to the lower taxation of a corporation, without a complex conversion process under company or reorganization law. The objective of bringing the tax burden on retained earnings closer to that of corporations and thereby improving the equity base and the investment opportunities of the company is also pursued by § 34a para. 1 German Income Tax Act (Einkommensteuergesetz – EStG), which leads to a special income tax rate of 28.25 %, but has hardly been used in practice due to further restrictions.
The commercial partnership wishing to be treated as a corporation (so-called opting company) must submit an irrevocable application to the tax office. The application must be submitted no later than one month before the beginning of the fiscal year from which taxation as a corporation is to apply. Applications can already be submitted now, but for the first time for fiscal years beginning after 31 December 2021 (§ 34 para. 1a KStG). Only commercial partnerships (Personenhandelsgesellschaft) and partnerships under partnership law (Partnerschaft) are eligible to apply, i.e., the option is not opened up to a partnership under civil law (Gesellschaft bürgerlichen Rechts).
In direct connection with this, the law regulates the way in which the opting company can revert to “conventional” taxation in accordance with the provisions of income tax law. In this respect, too, the law provides for an application obligation. This is referred to as the “reoption (Rückoption)” (§ 1a para. 4 KStG).

II. Legal consequence: separate taxation

If the application is effectively exercised, the company is taxable under corporate income tax law. As a result, the profits of the company are subject to a tax rate of 15 % (§ 22 para. 1 KStG) plus solidarity surcharge. If a distribution is made to the shareholders, this results in income from capital assets (§ 20 para. 1 no. 1 EStG). This clearly differentiates between the taxation of the company per se and the partners and eliminates the conventional form of taxation of a partnership in which the profits are allocated to the partners on a pro rata basis transparently.
An adjustment corresponding to the German Corporate Income Tax Act (KStG) is also made in trade tax law when the option is exercised. The option for corporate income taxation pursuant to § 1a KStG should in principle only have income tax effects. From a tax perspective, this creates a type of “hybrid company” which is to be regarded as a corporation for income tax purposes, but is otherwise to be treated as a partnership. In the other areas of tax law, the company continues to be treated as a partnership; only in land transfer tax law there are certain restrictions (§§ 5 and 6 German Real Estate Transfer Tax Act (Grunderwerbsteuergesetz – GrEStG)).

III. Effects under Reorganization Tax Law (Umwandlungssteuergesetz – UmwStG)

§ 1a para. 2 sentence 1 KStG provides that when the option is exercised, a change of legal form is to be assumed in accordance with the provisions of the German Reorganization Tax Act (UmwStG). Thus, for the aforementioned tax law areas, it is assumed that the partnership transforms into a corporation (§ 25 UmwStG). The Reorganization Tax Act manifests the principle that all reorganizations lead to the disclosure of hidden reserves, except for those in which the requirements of the Reorganization Tax Act are met, including that subsequent taxation is ensured (§ 20 para. 2 sentence 2 no. 1 Reorganization Tax Act). The continuation of these values, so-called book value continuation (Buchwertfortführung), must furthermore be applied for by the company.
The taxation benefit shall cease to apply (pro rata temporis, if applicable) if the aforementioned shares are resold within a seven-year period from the exercise of the option (§ 22 para. 2 UmwStG). The company must prove annually that this is not the case.

IV. Obligations of the opting company

The fact that a different taxation system is applied and the consequences under reorganization tax law explained above result in new legal obligations for the Company.
For a partnership that previously determined its profit within the framework of an income statement, the preparation of a balance sheet is now also mandatory (§ 1a para. 3 sentence 6 KStG). In the same way, the partnership is obliged to deduct capital gains tax in the case of distributions, as income from capital assets accrues to the partner (§ 44 para. 1 EStG).
Furthermore, the administrative effort increases. In addition to the application for the exercise of the option as well as the application for the book value continuation (Buchwertfortführung) in the framework, the annual proofs according to which the shares have not been further transferred (§ 22 para. 3 UmwStG) must be remembered.

V. Advantages for the option company

In addition to the enumeration of burdens for the opting company, there are various advantages that come with the option.
Commercial partnerships can achieve a lower overall tax rate by applying the corporate income tax system. This applies in particular if profits are not distributed, as the total tax burden with corporate income tax plus solidarity surcharge and trade tax of a partnership with warrants is up to around 33 %, depending on the trade tax multiplier, while the profits of a partnership can have a tax burden of up to around 52 %.
In all other respects, the company remains similar to a partnership, e.g. for the corporate law applicable to it. There are no provisions to be observed with regard to share capital and capital contribution, no formal requirements for articles of association or for the appointment of managing directors.
Despite the “fiscal” conversion, the provisions of the reorganization law do not have to be observed (with the exception of the resolution on the option, to which § 217 UmwG is declared to be applicable mutatis mutandis). The exercise of the option therefore avoids obligations under reorganization law (requirements for a transformation report and the registration of the transformation etc., §§ 190 et seq. UmwG).

VI. Necessity of precise planning

In principle, the option regime can be seen as an interesting possibility for companies to adjust taxation to their economic situation, while avoiding further restructuring measures, which not infrequently require a fundamental impact on the shareholders’ rights or at least considerable discussions about necessary changes to the contracts. An important aspect in the considerations is whether the shareholder structure will be changed in the foreseeable future. If the penultimate partner leaves, this is tantamount to a reoption (§ 1a para. 4 sentence 5 KStG), which can additionally trigger negative taxation consequences, since a partnership with only one partner does not exist.
In addition, the option enables a completely new concept, which has never existed before in German tax law, as it leads to a divergence between tax and civil law. Ultimately, it is a question of the individual case whether the option is advantageous for a company, because there are many individual questions to be considered, such as the ability to form a tax group, accounting, loss utilization regulations, inheritance tax benefits. It will take some time for practice and case law to clarify all the consequences.