German stock dividends result in German tax refunds.

Germany subjects undistributed earnings of German resident corporations to a tax rate of 50% (56% before 1990). On payment of a dividend, the German tax authorities refund the difference between the undistributed rate (50%/56%) and the distributed earnings rate of 36%. Tax legislation is currently being discussed in Germany that would lower the tax rate on undistributed earnings to 44% and the rate on distributed earnings to 30%, effective Jan. 1, 1994.

Many U.S. multinationals have profitable German subsidiaries. Due to the need to reinvest earnings in the business, dividends paid to the U.S. corporations rarely equal total German resident corporations' earnings. Therefore, U.S. multinational groups are effectively forced to pay the higher German undistributed tax rate on their German earnings.

Through the use of a "stock dividend," a GmbH (a type of German business entity taxed as a corporation) can obtain a full German tax refund (of the differential between the undistributed and distributed tax rates) without the need to pay any cash. The stock dividend is essentially a dividend declaration followed by an increase in the German subsidiary's capital.

Generally, two shareholder resolutions (approved by the U.S. parent's Board of Directors) are required. The first resolution declares a dividend payable from the German subsidiary's earnings, with use of the payment restricted to the purchase of additional shares of the GmbH. The second resolution would establish the issuance of the additional shares and share premium reserve (i.e., paid-in capital). The new shares would participate in the profits earned by the German subsidiary starting with the current business year. No cash is actually paid to the United States, but a 5% withholding tax on dividends must be paid to the German government.

Example: A U.S.-owned GmbH, a calendar-year corporation, has been operating profitably since 1990. The GmbH has paid some cash dividends to its U.S. parent but has reinvested a significant amount of its earnings in the German business. The GmbH does not have cash in excess of working capital needs. The GmbH's retained earnings as of Dec. 31, 1992 are DM 10,000,000 (approximately $6,000,000). If the GmbH were to declare a stock dividend equal to its accumulated retained earnings, a German tax refund of approximately DM 2,800,000 ($1,700,000) could be obtained.

For U.S. and German GAAP purposes, it should be possible to accrue the German tax benefit as soon as the shareholder resolutions are passed. A German tax ruling is not required; however, to be completely free from doubt, a ruling on the German tax consequences should be obtained.

A second German tax benefit results because the stock dividend earnings are characterized as share premium reserves or capital contributions. This characterization provides a cushion against German tax that could be assessed on a "hidden distribution" of profits. A hidden distribution of profits can be asserted by the German tax authority for shareholder payments such as management charges and technical assistance fees. A hidden distribution of profits without share premium will result in a German tax assessment greater than a hidden distribution of profit with share premium reserve.

Many U.S. multinationals are currently in an excess foreign tax credit (FTC) position. Generally, these companies would want to avoid U.S. taxation of the German stock dividend because additional excess FTCs would be generated. However, Sec. 305(a) provides that, generally, a stock dividend is not includible in gross income. One major exception to this rule is a distribution payable at the election of the shareholders, either in stock or property.

Rev. Rul. 80-154 stated that a "resolution declaring a cash dividend raises the presumption that a cash dividend is intended. However, this presumption is rebutted when the corporate resolution ties up the |cash' dividend so effectively that the shareholders never receive it, never exercise any control with respect to it, and the dividend is used to pay for additional stock." Under the terms of the stock dividend resolutions, the U.S. company never has an option of receiving cash. Therefore, if the shareholder resolutions are properly drafted, the stock dividend should be nontaxable for U.S. tax purposes.

Finally, if the German withholding tax is paid by the GmbH, the U.S. parent will have dividend income equal to the amount of the withholding tax paid on its behalf. If the withholding tax is borne by the U.S. parent, there is no income inclusion. In both cases, the tax may be available as an FTC subject to the FTC limitation.

A German stock dividend is a relatively easy way to obtain a German cash refund and corresponding reduction in a multinational group's effective German tax rate. The technique is commonly used in Germany, does not require any cash to be paid by the German subsidiary, and is generally nontaxable for U.S. tax purposes. The technique will become even more valuable (assuming a GmbH has retained earnings that were originally taxed at 50% or 56%) if the lower German distribution tax rate is reduced to 30%.