German tax rates are competitive in comparison with other countries. The tax system has been reformed recently, and income tax rates were reduced in three steps. The peak tax rate for personal income was reduced from 53 % to 42 % in 2005. The corporation tax applicable to corporations was also considerably reduced from 45 %, and currently stands at 25 %. Tax law has been further simplified and rates reduced. In comparative statistics, Germany has average nominal tax rates for companies, but international investors quickly discover that the actual tax burden in Germany is much lower, because companies can take advantage of numerous exception and depreciation rulings.

 
The most important taxes for investors

The German tax system is very balanced. The most important taxes are the income tax levied on every citizen’s income, and the company taxes based on corporations’ revenues. There are also other taxes such as excise taxes on mineral oil or tobacco, for example, as well as sales tax, real estate transfer tax, and the trade tax charged directly by the municipalities.

 
Income tax (Einkommensteuer)

Who is liable for taxation?

Every citizen who has a main place of residence in Germany or lives primarily in Germany is liable to pay income tax. If an individual spends more than six months of the year in Germany, Germany is regarded as the main place of residence. In this case, the individual is obliged to pay tax on all income earned around the world, regardless of whether this comes from wages or salary, interest, or dividend payments. Citizens who live abroad all or most of the time have limited tax obligations. In these cases, only domestic income and investment income must be taxed.

Which earnings are liable to tax?

All earnings from the following are subject to tax:

• Non-self-employed work (dependent work)
• Self-employed work
• Business operations
• Capital assets
• Rents and leases
• Income from agricultural and forestry work
• Other earnings (for example from speculative profit).

The sum of all earnings minus deductions that vary from person to person, for example for costs for a private pension, is the amount to be taxed.

 
Company taxation

Companies in Germany are usually taxed on two levels. Corporations such as the stock corporation (AG) and limited liability company (GmbH) are subject to corporation tax, which is levied by the federal government. In additions, cities and communities impose a municipality charge, the trade tax.

Corporation tax (Körperschaftsteuer)

There is a standard corporation tax rate of currently 25 % for both a company’s retained (undistributed) profit and its distributed profits. However, if profits are distributed to shareholders, the shareholders must in turn pay income tax on these profits. The “half-income system” is used to reduce this double taxation burden. In this procedure, the shareholder only has to pay further taxation on 50 % of the dividends and profit payouts. As a result, after payout to the shareholder, only this 50% is subject to income tax, whereas the other half remains taxfree.

Example: For a dividend payout of 100,000 € the corporation tax is 25 % = 25,000 €. Of the remaining 75,000 €, the company transfers withholding tax of 20 % – i.e. a further 15,000 € to the tax authority before the payout is made to the shareholder. However, this withholding tax counts as an advance payment for the shareholder’s income tax once the dividend has been paid out, and therefore added again when the shareholder’s income tax is calculated. Of the remaining 75,000 € to be assessed after the dividend payment, only 50 % = 37,500 € are subject to income tax, the other 37,500 € are tax-free. Supposing the income tax rate to be 35 %, this would lead to income tax of 13,125 € on the taxable half. This is then offset against the withholding tax of 15,000 € deducted before the dividend payment, resulting in a tax rebate of 1,875 € from the tax authority. Ultimately, therefore, the shareholder receives an amount of 61,875 € after tax has been deducted. The solidarity surcharge is also levied on corporation tax.

Trade tax (Gewerbesteuer)

All business operations acting in Germany are subject to trade tax. Business operations include independent activities that aim to achieve profits over the long term, and thus also include corporations, in particular. Independent freelancers such as doctors, architects, lawyers, or artists are exempt from the charge. A tax-free allowance of 24,500 € applies for trade tax for natural persons running a business and for partnerships. For profit generated above this level, the tax burden is graduated from between one and five percent. A tax rate of five percent applies for all corporations. The tax is calculated on the basis of the operating profit, which is determined based on the company’s profit using a legally specified calculation method.

However, the actual level of trade tax depends significantly on the municipality in which the business operations are located. Each municipality must define a municipal multiplier (Hebesatz), by which the trade tax determined according to the statutory tax rate is multiplied. This multiplier is at least 200 % by law, and in conurbations in particular, can rise to more than 400 %.

Example: For a corporation with a trade tax burden of five percent and an annual profit of 100,000 €, the tax burden – or base amount – is therefore 5,000 €. The municipal multiplier is then applied to the base amount. If this is 300 % for example, the corporation’s trade tax burden is therefore 15,000 €. The entrepreneur can offset around half the trade tax against the personal income tax due of the entrepreneur. The tax itself is also regarded as an operating expense and is therefore profit-reducing and tax-reducing.

 
Real estate tax (Grundsteuer)

Anyone who owns land in Germany must pay real estate tax. The amount of tax depends on the value of the land and the buildings erected on it. However, the amount is often calculated not on the basis of the market value of the real estate but on a value that is usually much lower. Real estate tax is defined by the municipalities and is usually between one and two percent of the defined real property value. The tax is paid every quarter, and the landowner can also request to make a total payment on June 1. This charge can also be set off against tax.

 
Real estate transfer tax (Grunderwerbsteuer)

When real estate is sold or changes owner, a real estate tax of 3.5 % of the purchase price is levied as of a consideration of over 2,500 €. This tax is usually paid by the buyer.

 
Value added tax (Umsatzsteuer)

Value added tax (VAT) is not a tax on companies, because it is only paid by the end user of a product or service. The current rate of VAT of 16 % is clearly below the European average, and even after the increase to 19 % in 2007, it will still be below the EU average. A lower rate of seven percent is charged for goods and services needed on a day-to-day basis, such as food or newspapers. Some services such as banking services or non-profit making work are VAT-exempt. The official German name for VAT is Umsatzsteuer, but it was originally called Mehrwertsteuer and is still often referred to by this name. Companies must add VAT to their prices. Assuming the net sales price of a car is 15,000 €, the car dealer must demand an extra 16 %, or 2,400 €, from the buyer. The gross price for the customer is therefore 17,400 €. The dealer transfers the VAT received to the tax authority. This is done on a monthly, quarterly, or annual basis. The period depends on the level of company turnover. Companies themselves also pay VAT when they purchase goods or services. The tax receivables and expenses can be offset against each other in the VAT return (Vorsteuerabzug).

Example: In one month, the car dealer has sold ten vehicles, each at a gross sales price of 17,400 €. For each sale, the dealer receives 2,400 € VAT from the customer. At the end of the month, the dealer therefore owes the tax authority 24,000 €. However, in the same period, the owner of the car business also bought ten cars. The net cost of each car was 10,000 €. The car manufacturer added 16 % VAT to this amount. The dealer therefore transferred 116,000 € (including 16,000 € in VAT) to the manufacturer. In numerous other invoices, from the rental of salesrooms to office equipment or a new computer, the dealer pays another 3,000 € VAT to the landlord and other suppliers. At the end of the month, the business has received 24,000 € in VAT and itself paid out 19,000 €. These totals are transferred to the tax authority, and only the difference of 5,000 € must then be collected.

In practice, companies also occasionally pay out more VAT than they receive. This is often the case in the start-up phase, for example, when expenditure is high, but income is still low. In these cases, the tax authority quickly refunds the excess tax paid.