Germany - Berlin tax boffins set the agenda

Germany's corporate bosses expect the government to listen to them. They have wanted a tax change for years, and in December they were finally promised one. But it wasn't what they had asked for: it was more.

How could a Social Democrat/Green coalition give the captains of industry and finance more than the Christian Democrats had ever dared to do while in office? The tax change was logical; it was long overdue. German companies had clearly lost competitiveness with Europe and the rest of the world. After the change in landscape forced by the euro, something was urgently needed to loosen up the corporate structures in Germany, and to end the cosy system of tax credits for German investors who kept investing in their own country.

German citizens thought Hans Eichel their finance minister had given them a moderately nice Christmas present. On December 21 Eichel, a modest teacher of Latin and German before he became mayor of Kassel, and then prime minister of Hessen, unveiled a tax reform package to cut the basic rate of income tax from 26% to 15%, and basic corporate tax from 40% to 25%.

Moreover, private shareholders would pay tax on only half of their dividend earnings, and at 25% instead of 30%.This was going to cost the federal budget only about Dm40 billion in foregone revenue.

Global investors suspected it was yet another attempt to streamline Germany's punitive tax regime, which on a bad day can take more than half of corporate or individual profits.

But the readers of the small print had overlooked something. In fact the English version of Eichel's speech didn't mention it at all. The German text had a paragraph saying that profits which a company makes by selling a corporate participation on to another company are tax free.

The implication of this is enormous. It means that holdings in German industrial companies, which have been stuck for years on the books of German banks and insurance companies, accruing value, can be sold without even the hint of a tax penalty. Under the existing regime the tax on the profit can be up to 56%, making such sales all but prohibitive.

For corporate Germany it could be a watershed. It should allow banks and insurance companies to shed passive shareholdings in irrelevant sectors and concentrate on core businesses in Germany and across Europe, even globally. Suddenly, those hidden reserves built up over decades look like a rich hunting-ground for corporate finance and restructuring teams. And German companies should have the means and incentive to invest again in their own domestic operations (they have tended to set up cheaper operations such as assembly-plants abroad).

It took two days for some bright spark at Goldman Sachs to spot this quiet bombshell, and to check with the finance ministry in Berlin that it wasn't a mistake. Then it took about two seconds for the stock price of the obvious winners - Allianz, Deutsche Bank, Dresdner Bank - to roar upwards.

Even the tax boffins at the ministry hadn't expected that kind of reaction. In fact cynics unkindly suggest they really had made a mistake. They didn't quite realize the implications of the changes they plan to bring to the entire corporate taxation system.

"The ministry tax experts never mentioned this zero taxation in their discussions with me," says opposition politician and tax specialist Hansgeorg Hauser of the CSU (Christian Socialist Union).

The euphoria about the new tax exemption continued into January and even February. But the conservative Christian Democrat opposition, despite being under attack over party funding, and even though this is a measure more liberal than anything they had dared to do while in power, have complained that it is unfair, because it favours big corporations over those that are family-owned. Even friends of the government, and some social democrats themselves, are saying that total tax exemption may be too generous and discriminating against the Mittelstand - the medium-sized companies which are the backbone of the German economy.

Big German companies have for years wanted a reform along these lines. But they never dared asked for exemption. They tended to asked for a rate reduction to 20% or 30%, perhaps for five years, to allow them to restructure. The tax boffins have now offered them exemption, forever.

But the euphoria died somewhat in February. Zero taxation, as people began to work out, also means zero tax credits against which to book losses: one can't assume a bull market forever. And what about the treatment of hedges, if the economic effect of some of these hidden reserves has already been hedged with derivatives? Perhaps on balance these companies would be happier under the existing regime, especially since it will be at least January 2002 before they can benefit from the change.

With these sobering thoughts the share price of the aforementioned companies dipped again in February.

Despite the confusion, however, the tax move has reinforced the message that Germany is changing. Out goes Deutschland AG and the consensus social market economy; in comes the new market-based, foreigner-friendly if-not-exactly Anglo-Saxon environment. The proposed tax regime no longer favours Germans with tax credits on dividend payments - everyone pays the same (that should put an end to the dividend-stripping done mainly out of Luxembourg, in which foreigners do sell-and-buyback deals with Germans over the dividend period - although dividend stripping deprives the taxman of only about Dm400 million in revenue). It also means German citizens have less incentive to invest just in German companies.

One of the main aims of the reform was to bring German taxation more into line with the rest of Europe, says Alfons Kühn, head of taxation at the German Industry and Trade Association (DIHT).

Kühn headed the so-called Brühler Commission on tax reform which was set up in November 1998 and was given three months to come up with a new tax model for Germany. "It was the chance of a lifetime," says Heiko Medert of the GDV (Association of German insurers), "but they were in a Zwickmühle [Catch-22]. They were damned to produce a reform or lose their reputation."

The commission drew up an outline of reforms by early March last year. During that time there was increasing tension between chancellor Gerhard Schröder and his finance minister Oskar Lafontaine (former SPD party leader and at one time a rival candidate for the chancellorship). The finance ministry was finding itself cut out of more and more important decisions, and often learning of them through the press. When Lafontaine resigned and Eichel took over, that gave a lot more clout to the Brühler Commission. Lafontaine had his own ideas on tax reform based on rate reduction and job creation. Eichel was open to more radical solutions.

This was the year in which Schröder upset the international financial community by bullying the German banks into bailing out construction giant Philipp Holzmann, and by, initially, publicly opposing the hostile takeover of Mannesmann by Vodafone AirTouch. Although Schröder backed down on Mannesmann, it was more difficult to undo the damage to the image of Germany as an open capital market. It was also hard to explain to foreigners why saving Holzmann was a pragmatic move to save not only Holzmann but also its suppliers and subcontractors, jobs throughout Germany, and Schröder's own party conference.

The tax reformers saw their task as an opportunity to redress the balance and they became more radical as the year progressed. Although Germany's tax law isn't EU-compliant, it has been in existence long enough to be grandfathered. But there is a case against Germany in the European Court of Justice for tax-discrimination against foreigners. The tax experts were keen to go that extra kilometre and make the system Europe and globally friendly.

The basis of the new code is to treat the joint-stock or limited liability company (AG and GmbH) differently from the personally-owned company and partnership (KG and OHG). The AG and GmbH get preferential tax treatment, but their shareholders don't. The moment there's a dividend, the shareholders must pay their 25% tax.

The new twist is that shareholders need to pay the 25% on only half of their dividend. It's a concept already used in Austria, although in the Austrian case - fine point - the taxpayer pays half the tax rate on the whole amount (in the German proposal he pays the full tax rate on half the amount).

When an AG and GmbH retain profits (on which they pay corporate tax), and reinvest that profit in the shares of other companies abroad, they don't have to pay more tax if they sell such a stake - or if they spin off one of their own overseas divisions. So it's logical that the sale of participations built up at home over decades should also be tax free, following this model. It had already been freed of tax in the case of investments outside Germany. So, when the draft reform was published on December 21, with its quiet announcement that inland sales would be tax free too "we were simply harmonizing the domestic situation with the rule for stakes abroad", says Eichel's parliamentary secretary Barbara Hendricks.

This may have been a logical consequence but members of the Brühler Commission don't remember discussing it until late November last year. And then the reason was the anomaly with the rule for stakes abroad. Should they both carry tax or should they both be tax free? Kühn at the DIHT recalls the reasoning: "Such sales are already free in Holland, Belgium and Luxembourg. Companies indicated to us that if we re-imposed a tax they would simply move their headquarters to Holland."

On December 10 there was a final discussion with a small group of tax and finance ministry experts. The group included finance ministry secretary Heribert Zitzelsberger, one of the few tax experts with corporate and public sector experience (he was head of tax at Bayer AG for 12 years). Zitzelsberger is regarded by some as the driving force behind the reforms. Others cite Kühn as the man who finally won the argument for zero taxation.

But even Kühn was surprised by the announcement on December 21 - "I talked to Zitzelsberger about it but I never talked to Eichel". It was as if the ministry had sleepwalked into a tornado.

Eichel (left) and Schröder plan tax revolution. But whose hand, if any, is on the tiller?

The government would like to have the new bill passed by June. It goes to the parliamentary finance committee at the end of March and must then pass through the Bundestag (lower house) and the Bundesrat (senate). The Bundesrat includes representatives of the 16 Länder and since elections last year the coalition parties no longer enjoy the majority there.

Politicians don't expect too much opposition. Almost everyone agrees the need for tax reform. And the debate is esoteric - too complex for the man in the street. But it is about exchanging one concept of taxation for another. Zitzelsberger (sadly too ill to take part in the fight) and Kühn are passionate for the new concept which is designed to encourage re-investment in corporate Germany and corporate Europe. Others say there was nothing basically wrong with the old system, apart from the rate being too high. But Zitzelsberger, Kühn and others were faced with the challenge of making Germany visibly more competitive with the rest of Europe.

For around a decade, foreign companies have been failing to reinvest in Germany, often almost entirely for tax reasons. German companies themselves have sought refuge in lower-cost countries such as Hungary, Poland, the Czech Republic.

There is considerable confidence that Eichel is the finance minister Germany has been waiting for to change the climate. But cynics can be forgiven for fearing that yet again, when it comes to the fine-tuning, the end-effect of German tax reform won't be much different. Germans will be paying their solidarity supplement for the 1990 unification for years to come. In order to balance the federal budget by 2006, which is Eichel's declared goal, he can't afford to give too much away. And there are no detailed revenue projections which take into account the systemic change. The tax boffins have taken a leap in the dark, hoping to join other countries at forefront of the tax-friendly nations. But history is against the change. "[Former chancellor Helmut] Kohl and Schröder are not another Margaret Thatcher and Tony Blair," laments a German admirer of the reforms which have transformed Britain since 1979.

The government's move to Berlin has changed the relationship between German industry and its lawmakers. No longer can Germany's corporate giants pop into Bonn, the Bundesdorf on the Rhine, and tell papa Kohl and Theo Waigel what to do.

Now the big companies, their associations and lobby groups, must come cap in hand to what is fast becoming a world-class capital. The sense of a resurging and more powerful Germany is palpable, and awesome.

Most of the centre of Berlin is still a building-site. Around the four-square Reichstag, with its Norman Foster glass dome, the cranes and hoardings continue to frame vast construction work. Coloured plastic pipes pump away the groundwater. There are still years of building ahead. But the hulks of future ministries and government offices rise in all directions above the dust and builders' rubble. From the Brandenburg Gate the broad avenue Unter den Linden is lined with buildings that are mostly complete: the hotel Adlon, the French embassy, Bundestag offices for parliamentarians, the huge Russian embassy which occupies almost an entire block, Humboldt University, the tomb of the unknown warrior, all this in erstwhile East Berlin.

Beside the river Spree, the Pergamon Museum and Berlin Cathedral are unchanged but farther downstream are the Volkspalast, (former Palace of the People) riddled with asbestos and ripe for demolition, and the forbidding portico of the Marstall where Kaiser Bill kept his horses, now a library. West of them is Gerhard Schröder's palace, the Bundeskanzleramt a functional office complex. And to the south one of the most extravagant buildings in Berlin, an office block with a huge atrium dwarfing those crossing its floor. This is the home of the trade associations such as the Deutsche Industrie und Handelstag (DIHT), the Bundesverband der deutschen Industrie (BDI) - suitably imposing. The smart Mercedes outside was apparently so eager to disgorge its industrialist burden that it dozed into a pillar, slightly denting its number-plate.

In five years this will be a coherent capital as impressive as Washington. The Vorstände of Frankfurt and Düsseldorf will come here with as much respect and discomfort as the moguls of Manhattan and Chicago visiting DC.

Siemens is two years into its divestment programme. The fact that the German government has promised changes, which would allow companies to keep their windfall profits on divestments, is welcome, but it hardly calls for a change of strategy.

Siemens spun off Epcos, its passive components joint venture with Matsushita, last year and its shares are now listed in Frankfurt and New York. It also sold its Siemens-Nixdorf retail and banking systems division to Goldman and KKR for around Dm1.4 billion in October last year. This month it will float off semiconductor business Infineon for around e5 billion.

That is hardly the behaviour of a company petrified by antiquated tax laws. Yet for years German companies and banks have complained that corporate restructuring in Germany is hampered by taxes on the sale of hidden reserves. Commerzbank was crucified in the early 1980s when, as a result of an interest-rate mismatch, it had to realize some of its hidden reserves to pay the bill. Deutsche Bank last year lamented that it couldn't pay for its $9 billion purchase of Bankers Trust by selling a chunk of its holding in DaimlerChrysler or Philipp Holzmann (before it crashed - now that would have been smart).

The fact is that German companies, even banks and insurance groups, have learned to live with this sclerotic tax code. Bayerische Vereinsbank was able to get round it in 1997 when it exchanged Allianz shares for stock in Bayerische Hypobank and the two banks merged. But that was before the Federal tax authorities stepped in and closed the loophole.

There are two major institutions which stand to gain directly and then perhaps indirectly from the proposed tax reform. The first is Allianz, with its Dm40 billion portfolio of non-core German industrial participations, and Deutsche Bank, with a non-core portfolio of Dm23 billion.

Allianz has already begun to tinker with this area, perhaps anticipating that something would loosen on the taxation front.

In 1998 it issued Dm2 billion ($1.1 billion) of bonds exchangeable into the stock of Deutsche Bank, and this January it issued e1.7 billion ($1.7 billion) of bonds exchangeable into Siemens stock. The Deutsche Bank bond matures in March 2003, and the Siemens bond in March 2005. If a favourable tax change comes before then, Allianz will not only have enjoyed cheap funding, it will have realized some of its petrified portfolio in a tax-efficient way.

Deutsche Bank did a similar $1.3 billion zero-coupon issue in January 1997 convertible into the stock of Daimler-Benz, and another of e1.8 billion ($2.1 billion) convertible into the shares of Allianz in December 1998.

"These issues are currently an ideal way to liquidate certain holdings tax-efficiently," says Stefan Theissing, director of corporate finance at Allianz. "Whatever happens, we've sold an option and have cashed in a premium. We have the benefit of cheap funding." The latest offering convertible into Siemens stock anticipates an appreciation of the share price of about 6% a year.

The new tax reforms are likely to have a knock-on effect through all German corporate finance activity. "Companies can't assume any more that they have a long-term investor," says Stefan Schuster, managing director for capital markets policy at Deutsche Bank. "There are better chances now for spin-offs and smaller initial public offerings (IPOs) of company divisions."

Shareholder value is the buzzword which in some parts of Germany sends shivers down the spine. Surely there is a value in building up hidden reserves for a rainy day. Won't this change make stocks more volatile and tempt companies into short-termism? All these well-rehearsed arguments have protected German companies for years from the searching wind of competition, until the "made in Germany" concept lost its edge. Now paradoxically it is the Social Democrats who are opening corporate Germany to competition.

With a new takeover law expected to be passed this year - 60 clauses have been written already - and the successful bid for Mannesmann by Vodafone AirTouch, there's the sense of a new climate of corporate governance in the air. Even the contrarian Volkswagen, which along with BMW is against having a takeover law, has announced a switch to US-style GAAP accounting, in order to boost its share price and stave off a potential hostile bid.

The German accounting profession is also under attack, for having signed off on the accounts of such firms as Bayerische Hypobank, Philipp Holzmann and Flowtex Technologie just before major losses were uncovered.

The cosy supervisory board system, as a sinecure for senior bankers and industrialists, is coming to an end - with a reduction in the number of mandates given to one person, and a demand for more vigilance, accountability and professionalism. Stock ownership plans are increasingly used to motivate senior management.

But it will take years before this culture penetrates the powerhouse of corporate Germany, the medium-size companies known as the Mittelstand. It will take some courage for any government to interfere with them.