Check-the-Box and Corporate Tax Policy

9 October 2024

Nicolas Traut (Oxford University Centre for Business Taxation)

Germany recently introduced entity classification election rules which brought about the possibility for certain pass-through entities to opt for a taxation under the corporate tax regime.¹  More than 25 years after the US introduced the “check-the-box” regulations, which are the prominent example of entity classification election rules but are also infamous for fostering international tax avoidance, this raises the question of whether Germany is following a similar path.²  

Based on more comprehensive reflections and references, which can be found in a recent article, the following remarks outline some fundamental considerations regarding the German design of “check-the-box”. They show how the German entity classification election fosters fairness, efficiency, and simplicity in business taxation, which can provide lessons for other jurisdictions on the use of “check-the-box” as a policy tool.

Dualism of Business Taxation and Check-the-Box

The context for the introduction of entity classification election rules is the “dualism” of business taxation. It is characterized by the differentiation of tax systems between pass-through income taxation of transparent entities and corporate income taxation of opaque entities. 

In Germany partnerships are taxed on a pass-through basis, meaning that the partnership itself is not subject to (corporate) income tax and that the partners pay personal (individual partners) or corporate (corporations as partners) income tax on the business profits. In contrast, corporations are opaque for tax purposes, they are subject to corporate income tax and the shareholders are subject to income taxation when profits are distributed.³ Rules exist to align the two business tax regimes with respect to the overall tax considering the different levels of taxation. In this context the German tax system aims to compensate for the economic double taxation in the corporate tax regime by applying specific taxes for dividends (lower flat tax or partial taxation) in addition to a corporate tax rate, which is relatively low compared to personal income tax rates. Furthermore, specific accumulation rules aim to account for the immediate attribution of profits to partners, which can be disadvantageous compared to the treatment of accumulated profits in the corporate tax regime.⁴  

Despite these existing attempts to align the business tax regimes, the legislator recognised the need to establish a way for taxpayers to overcome the dividing line between the business tax regimes, particularly to account for remaining disadvantages for partnerships with regard to accumulated profits. Against this background the new German entity classification election rules allow certain partnerships to opt to be taxed under the corporate tax regime. Under the election rules, a change of legal form from a partnership to a corporation is assumed (in the income tax context), which results in the partnership being treated as a corporation for income tax purposes and the partners being taxed as shareholders.⁵ 

Neutrality of Legal Form and Robustness to Avoidance

Two perspectives are relevant in answering the question of whether the election is a good policy choice: On the one hand, the German legislator (echoing a long-standing discussion in scholarship and practice) invoked neutrality of legal form as a reason for the introduction of the election. On the other hand, the US “check-the-box” regulations were discussed particularly with regard to the resulting tax avoidance opportunities relating to the emergence of hybrid entities.

Neutrality of legal form is an important theme in discussions on business taxation in Germany. It relates to tax differences based on legal form. In light of the dualism of business taxation, achieving a real neutrality of legal form by introducing the entity classification election is the stated objective of the German legislator.⁶ The concept of neutrality of legal form can be linked to established fundamental principles of good tax design (fairness, efficiency, and simplicity),⁷ and the entity classification election can indeed overcome shortcomings of a taxation based on legal form. The details are more complex, but conceptually the election can be understood as a measure in between a comprehensive reform aiming to eliminate the dualism of business taxation on one side, and specific adjustments of the rules on income, tax rate, and payable tax to account for the different tax treatment of businesses on the other side. The election has advantages insofar as it can indeed achieve a full neutrality in certain comparative pairs. By allowing a switch of the tax regime, it fosters a taxation according to the ability to pay for businesses in the same situation, and it avoids distortions such as the pressure to adopt the corporate form. Since it does not require a fundamental reform, it also has a certain advantage of simplicity. Of course, there are limitations. Under the German rules only certain businesses can make the election (sole proprietors for example cannot elect), and the election therefore is only effective in equalising differences in specific comparative pairs but does not lead to a comprehensive neutrality of legal form and does not aim for a broader neutrality in the income tax system. Instead, the German rules are an example of how the election can help to overcome specific problems of a business tax system that focuses on legal form.

Robustness to avoidance is another criterion for good tax design,⁸ and international tax arbitrage through hybrid entities (which are inconsistently characterized in different jurisdictions) as a result of the election is a concern in this context that has been discussed intensively regarding the US “check-the-box” regulations.⁹ This can again be linked to fairness, efficiency, and simplicity. While the details are again more complex, the exploitation of different qualifications of companies following from entity classification election rules can lead to concerns over fairness between taxpayers and countries, potential distortions in investment decisions, and a complication of the international tax system due to the need to react to avoidance tactics. The German entity classification election rules (in addition to already existing rules at the international level to tackle hybrid mismatches)¹⁰ entail rules to prevent tax planning and avoidance through entity classification election on two levels. On the one hand, the rules disallow an election for foreign entities which qualify as partnerships from a German perspective but would not be subject to corporate taxation in their country of management after the election. On the other hand, for domestic companies not the emergence of hybrid entities as such but only the effects can be addressed. Germany in this context relies on treaty overrides, which is problematic in light of international law and may not be a model for other jurisdictions.¹¹  

Overall, although the German treaty override approach is not a model of international cooperation, the German rules show that entity classification election rules can address issues of neutrality of legal form in a dualist business tax system and are not inevitably a tool for avoidance.

This blog is based on the following article:

Nicolas Traut, “Entity Classification Election Rules in Germany and Beyond: Necessary Tools to Achieve Neutrality of Legal Form or Invitation to Engage in Tax Avoidance?” British Tax Review 2024, 133–163.

References

¹See German Corporate Income Tax Law s. 1a. See also Law to Modernise the Corporate Tax Law, BGBl I 2021, 2050.
²See Code of Federal Regulations Title 26 ss. 301.7701-1, 301.7701-2, 301.7701-3. See also 61 Fed.Reg. 66,584 (18 December 1996).
³For relevant provisions, see German Income Tax Law ss. 1, 15, 20; German Corporate Income Tax Law ss. 1, 8.
⁴For relevant provisions, see German Income Tax Law ss. 3, 3c, 32a, 32d, 34a, 43; German Corporate Income Tax Law ss. 8b, 23; German Trade Tax Law ss. 7, 11, 14, 16.
⁵See German Corporate Income Tax Law s. 1a.
⁶See Bundestagsdrucksache 19/28656 (2021), 15.
⁷For a fundamental account of principles of a good tax, see Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Vol. 2, 423–426.
⁸See Michael P. Devereux et al, Taxing Profit in a Global Economy (2021), 50–53.
⁹In this context, see, e.g., Senate Hearing 112-781 (2012); Senate Hearing 113-90 (2013).
¹⁰See OECD, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (2015); Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market [2016] OJ L193/1; Council Directive (EU) 2017/952 of 29 May 2017 amending Directive (EU) 2016/1164 as regards hybrid mismatches with third countries [2017] OJ L144/1.
¹¹For relevant provisions, see German Income Tax Law s. 50d(14); German Corporate Income Tax Law s. 1a(1)(6)(No.2). For the broader context of treaty overrides in Germany, see Nicolas Traut, Tax Treaty Overrides and Friendliness Towards International Law: A Comparative Approach to Put the Later-in-Time-Rule to the Test, Capital University Law Review 48 (2020), 403.