Exit taxation Germany: Requirements and structuring options

Anyone wishing to emigrate should deal with the issue of exit taxation as early as possible. The German legislator recently tightened the regulations on this again. Fortunately, taxpayers have numerous legal options at their disposal to avoid or at least significantly reduce the burden of exit tax.

“Wegzugssteuer” AS Exit Tax

The exit tax is not a separate type of tax. It is part of income tax and is linked, among other things, to the departure from Germany. The increase in value of shares in corporations is taxed at the time of departure. From this perspective, income tax is levied on a fictitious capital gain. The taxpayer is treated as if he had sold his shares on departure. The exit tax serves as a kind of “final tax”. The tax authorities use it to secure their share of the capital gains before the right of taxation is generally transferred to another state upon departure. Conversely, this means that as long as the tax authorities continue to have access, the reason for the exit tax no longer applies. This connection can be used in individual arrangements to avoid taxation.

The requirements for exit taxation

If a natural person moves abroad with privately held shares in a corporation (such as a GmbH or AG), exit taxation applies in many cases. The following conditions trigger the exit tax liability: The person moving abroad has been subject to unlimited tax liability in Germany for at least seven years within the last twelve years, has held at least 1% of the shares in a company in the last five years and is permanently giving up their residence in Germany.

Nationality is therefore irrelevant. Simultaneous residence abroad also does not prevent tax liability. Interruptions in tax liability in Germany – for example due to temporary stays abroad – also do not prevent the exit tax. The periods in which the person moving away was subject to German tax liability are simply added together.

There are also cases in which the exit tax can apply even if the taxpayer does not move away from Germany. These include the following constellations:

• The taxpayer makes a gift or bequeaths shares to a person who is not subject to unlimited tax liability in Germany
• The taxpayer remains resident in Germany, but is deemed to be resident in another country under a double taxation agreement (DTA)
• The taxpayer contributes its shares to a foreign business or a foreign permanent establishment

Even this brief overview shows: The exit tax applies in far more cases than it appears at first glance.

What is taxed

All shares in corporations such as an AG, GmbH or KGaA are subject to taxation. Shares in foreign corporations – for example an English Ltd. – are also subject to taxation. It is sufficient for the taxpayer to have held at least a 1% stake in the company within the last five years before moving away. Following the most recent tightening of the law at the beginning of this year, capital gains from certain investment funds are now also subject to exit taxation. In particular, this now also includes the widely used exchange-traded funds (ETFs). Shares in special funds are now also subject to exit taxation. The extension of exit taxation is surprising in that the law already provided for instruments such as the advance lump sum, which allowed for the ongoing taxation of (notional) previously unrealised capital gains. The tightening momentum this has created could indicate that the German legislator is unlikely to shy away from subjecting further assets to exit taxation in the future.

The starting point for calculating the exit tax is generally the market value of the company shares. The acquisition costs are deducted from this. In turn, 60% of this is taxed at the personal income tax rate including the solidarity surcharge. The remaining 40% of the increase in value remains tax-free.

In other words, it is pretended that the shares have been sold with the departure. In this way, the tax authorities want to participate in the profits, even if they have not yet been realised. The fictitious sale leads to the usually undesirable effect that hidden reserves are subject to income tax. This can lead to considerable liquidity losses for those affected. Here is an example:

Mr Meier lives in Germany. Ten years ago, he acquired 100% of the shares in a GmbH for € 100,000 (book value) because he recognised the great opportunities of the business model. Due to the economic success of the company, these shares are now worth €500,000 (market value). The hidden reserves – i.e. the difference between book value and market value – therefore amount to €400,000.

If Mr Meier now moves abroad and also fulfils the other requirements for exit taxation, a fictitious sale of his GmbH shares is assumed. The hidden reserves of € 400,000 are “disclosed” and taxed at 60% (i.e. € 240,000). This amount is taxed at Mr Meier’s personal income tax rate. Assuming a top tax rate of 45% plus solidarity surcharge, this would mean that Mr Meier would have to pay around € 115,000 in taxes even though he has not sold his shares.

The “realisation of hidden reserves” means that previously untaxed increases in value are taxed on the occasion of relocation.

Design options

There are various approaches to avoid exit taxation.

A relatively simple approach is to consider how the emigration itself should be organised. For example, you can start by considering whether a limited stay abroad is an option instead of a permanent departure. This is because the exit tax can be cancelled retroactively if the taxpayer returns to Germany within seven years and becomes subject to unlimited tax liability in this country again. This period can be extended by a further five years (totalling twelve years) on application. In the event of a return within this period, a refund of the exit tax paid is possible. However, the company shares in question may not be sold during the period of residence abroad. In addition, the intention to return must be convincingly demonstrated for the extension of the deadline. The liquidity problem at the moment of departure also remains unresolved. However, the person moving away can at least apply for payment in seven equal annual instalments.

It is also conceivable to convert the corporation into a partnership or to contribute the company shares to the partnership as business assets. However, there are also pitfalls to consider here, for example in the form of unbundling taxation. If a taxpayer with income from business operations gives up their domestic residence and is no longer resident in Germany, thereby restricting or excluding the German right to tax assets in their business assets for tax purposes, these assets are deemed to have been removed from the business assets at fair market value. The same applies to taxpayers with income from self-employment. As in the case of exit taxation, the fictitious withdrawal results in the realisation of capital gains and an end to the tax deferral effect. The standard case is the transfer of assets to a foreign permanent establishment. A key element in avoiding exit taxation is that the business continues to be managed from Germany.

If there are plans to transfer assets to others free of charge anyway – for example by way of anticipated inheritance – the shares in question could be used for this purpose, the increase in value of which would otherwise be subject to exit tax. By transferring shares to relatives free of charge, gift tax allowances can also be utilised prior to departure. Caution is advised if the person receiving the gift lives abroad.

Contribution of shares to a Liechtenstein family foundation

Transferring the shares to a Liechtenstein family foundation can be an attractive option. Not only can tax advantages be realised, but the assets can also be effectively protected. A key feature of the foundation is that it has its own permanently independent assets. It is independent of the founder’s assets. Investments in a foundation are not possible. With early planning, the Liechtenstein foundation can also be used to avoid exit taxation. To this end, the Liechtenstein foundation can set up German companies, for example as the parent company in a holding structure. Alternatively, the company shares can be transferred to the foundation as early as possible before any significant increase in value.

The transfer of the founder’s assets to the Liechtenstein family foundation is also possible free of inheritance and gift tax in some constellations. One reason for this is the exemption regulations for favoured company assets. This institute is applicable if

1. the foundation can freely dispose of its assets under civil law

2. the founder does not have comprehensive powers of control over the foundation’s assets

3. the foundation is non-transparent and structured like a German family foundation, i.e. according to its articles of association, the founder and his relatives and their descendants are entitled to more than half of the benefits or accruals.

The favoured company assets include in particular

• Domestic business assets
• Domestic agricultural and forestry assets
• Shares in corporations domiciled in the EU or the EEA if there is a shareholding of more than 25 per cent

The acquirer of the favoured assets is granted a tax relief discount of 85% if the business is continued for at least 5 years and the payroll reaches at least 400% of the average payroll of the last 5 years before the transfer of the business. The administrative assets of the company may not account for more than 50 per cent of its value. This exemption option can be extended to a 100 per cent exemption from inheritance tax in the event of a transfer to a family foundation. The prerequisite is that the payroll over seven years amounts to 700 per cent of the average wages of the last five years prior to the valuation date and the administrative assets amount to a maximum of 10% of the company value.

There are also other possible advantages of the Liechtenstein family foundation. While German family foundations, for example, are subject to corporation tax of 15% and a solidarity surcharge, capital gains from a Liechtenstein family foundation are only subject to a minimum annual income tax of CHF 1,800 if structured correctly. Foundations in Liechtenstein are also not subject to inheritance tax as is the case in Germany. It is also possible to structure the transfer of business assets to a Liechtenstein family foundation free of withholding tax. For example, by structuring the transfer in return for payment by utilising income tax exemptions or by first converting a corporation into a partnership.

The recent extension of exit taxation has shown that legislators are prepared to make further cuts for wealthy emigrants or founders of foreign foundations. With a forward-looking relocation of assets to other jurisdictions with stable political and economic conditions, those affected should at least be able to mitigate further encroachments on their freedom of movement.

Internationally, however, it can be seen that more and more EU countries are following the German regulations.