Reform of the German tax system will have a profound effect on the country's property/casualty (re)insurers. Dieter Lüer explains how the situation has arisen and its implications for the future.

It is common knowledge that the corporate tax burden for German businesses is far too high for them to be competitive in a globalised world. A tax rate which may effectively exceed 60% appears to be extremely high compared to other jurisdictions.

Many people were, therefore, surprised when the board of Mercedes-Chrysler decided to incorporate the newly established, post-merger operation in Germany, and not in the United States or elsewhere, because of an optimising tax effect. Even Germans were recently astonished to hear lobbyists complain that a corporate tax of 35% would create too heavy a burden for German retailers, who are used to paying much less tax.The German tax system, once the most modern and equitably linked to taxpayers' economic strength, has for many years now been an extremely complicated area, fraught with contradictions and giving rise to numerous controversies. During recent years, the amount contributed by the German workforce to the government's finances has constantly risen, whereas the share of corporate tax (representing only 5% of the total amount of the national tax budget) has remained stagnant, despite a considerable increase in corporate income. One of the reasons for this development is said to be the know-how that corporate Germany uses to take advantage of loopholes in the tax system.

For years, there have been calls for a radical reform of the German tax system to achieve a more equitable and less complicated structure. After an unsuccessful attempt by the Conservative government to restructure the tax system, the Socialists embarked on a new initiative when they came to power.In many respects the new government made use of the material prepared by its predecessor, but its main goal was to reduce the tax burden on mass incomes and increase that on high incomes and corporate taxpayers and it encountered extremely strong opposition from representatives of industry, trade and commerce

.The court intervenes

One special feature of Germany is the strong influence that the law and the Constitutional Court have on tax law, with very important practical consequences. In 1998, the court ruled that taxes should not generally exceed half the income a taxpayer produces, spurring reform, but in April 1999, the government's reform project suffered a heavy blow, as the Federal Fiscal Court asked the Constitutional Court to decide whether a split tax rate for corporations and private individuals (getting wealthier individuals to pay for a reduction in corporation tax) would be compatible with the German Constitution.

As the government's need for money remains unchanged, this action has placed the administration in a dilemma: with the government's expenses unchanged, there is little room for any reduction in taxes. Reducing public spending, for example, by reducing public subsidies, meets resistance from those favoured. The government's aim, therefore, was to keep the total income from taxes more or less the same by broadening the definition of taxable income while reducing the rate.

This leaves the German government with the open question as to whether the Constitutional Court will be prepared to accept the government's freedom to determine the net income for tax purposes. Traditionally, it is an accepted basic rule that taxes follow the financial strength of those subject to them. Consequently, the taxes due from corporate taxpayers are derived from the balance sheet which the Commercial Code requires all businesses to prepare. With very few well-defined exceptions, the taxman had to follow these balance sheets. Abandoning this link between the commercial balance sheet and the tax balance sheet could result in the tax bill for corporations no longer corresponding to their real financial strength.

Without a proper analysis of the complex reasons for the disparity between the tax burden on the private and the corporate sector, the then Minister of Finance Oskar Lafontaine decided that the tax burden on private households should fall, and that the amount to be paid by trade and industry should increase correspondingly.

Following broadening of the definition of the taxable income of corporations, the rate for corporate income tax for the years 1999 to 2001 was to be fixed at 40%, plus local taxes, which meant an effective rate of some 60%.

Effect on (re)insurance
When the rules on how to broaden the definition of corporate taxable income were laid down, not all industries were equally affected. The insurance industry (and particularly property/casualty insurers and reinsurers) was more drastically affected than others. The reason for this lies with the taxation of technical reserves like loss reserves.

With the 1999 tax reform it seems that the new government wanted the longstanding disputes between the taxman and the insurance industry over the technical reserves of p/c insurers and reinsurers to be solved once and for all. In very simple terms, the new tax law says that loss reserves have to be reduced to a reasonable level (which means to a level which avoids bonuses on the run-off of reserves as far as possible) and that all loss reserves are to be capitalised based on a interest rate of 5.5%.

The German insurance industry came to the conclusion that this would lead to an additional tax bill of between DM 15 billion and DM 20 billion, whereas the government calculated the amount at around DM 8.75 billion. Based on the calculations of the insurers' association, the Gesamtverband der Deutschen Versicherungswirtschaft (GDV), 30% of the industry's total loss reserves of DM 140 billion would, thus, not be admitted by the tax authorities. It, therefore, looked as if the p/c insurance and reinsurance industry (together with the energy industry, though for different reasons) was going to finance a sizeable chunk of the tax reform.

Redefining loss reserves

Redefining loss reserves for tax purposes has several effects: loss reserves built up under the previous system exceed those admitted under the new rules, thus increasing the taxable profit. Insurers will, consequently, be faced with a considerable cash draw, which will make it difficult to show a reasonable result in the forthcoming commercial balance sheets.

The long-term consequence of this will be general financial stress and a fall in investment income. On several occasions during the legislative process, the supervisory authorities pointed to the increased risk this posed for the financial strength of the German insurance industry.

To comply with EU law, the reserves insurance companies have to show in their (commercial) balance sheets are considerably higher than those admitted under the new tax law. In other words, (re)insurers will in future have to finance some of their reserves by using taxed profits.

The Supervisory Authorities were alarmed at the prospect of technical reserves under the new tax laws tending to be at the lowest level still admitted under commercial law. Pre-tax profits will, therefore, have to increase. Wherever possible, existing latent reserves are to be sacrificed, or companies will have to try to increase overall profitability. Increased earnings will be necessary in order to maintain the level of reserves required and pay taxes.

A first indication that insurers have learned their lesson is provided by the fact that, for the first time since 1994, motor rates have stopped falling and the market is looking at the possibilities for rate increases.

Whatever the precise financial outcome of this method of taxing loss reserves, the extra burden on the industry will be huge. Reinsurers in particular, with their more volatile results, will face problems not always easy to overcome.

The 1999 Tax Reform Act has been approved as proposed by the government, without any major changes, at least as far as insurers are concerned. But the government has softened its position, conceding that the additional burden for the insurance industry should not exceed the figure of DM 8.75 billion. It also promised that the taxation of existing reserves under the new formula will be extended over several years, in order to reduce the cash-flow effect.

However, neither proposal is likely to avoid lasting negative effects, and once the new rules have been applied, it will be difficult to reverse the damage done to the German insurance industry's financial situation.

The government recently decided to set up a kind of working party with the aim of determining more precisely how the new legislation would be applied, given that it does not clearly define what is meant by a “realistic” approach for establishing reserves and what type of reserves are to be capitalised.

The 1999 Tax Reform Act has met with much justified criticism. Nevertheless, it is only the first step towards a more radical reform. In the future, a much lower corporate tax rate is to be applied to the newly-defined taxable income. A sensible reduction in the rate (35% including local business tax is the figure generally cited) should follow very soon, otherwise the 1999 Tax Reform Act will have very negative effects. However, as a paper presented recently by a study group asked by the government for its views pointed out, the obstacles to completion of the reform are tremendous.

We can only hope that lower tax rates are introduced without delay, thus causing the effects of the reform of the German tax system to become much less dramatic than initially feared.

Whatever the final outcome, the debate about the reform of corporate taxes in Germany has caused much concern within the insurance industry. The government has shown that it is prepared to use methods which may have tremendously harmful effects on the industry's financial stability. This explains why industry leaders and decision-makers reacted so strongly.

It remains to be seen what the effect will be on future investments in a globalised environment. The possibility that German and foreign investors will avoid spending their money in such an environment cannot be excluded. Some may even be tempted to relocate their business outside Germany, where possible, if the climate for investment does not improve. The German tax reform will then have proved to be counterproductive. The least that can be said today is that the credibility of Germany as a place with hard but stable conditions for investors has suffered.

Another consequence that may arise in a perhaps more distant future relates to German accounting standards, which differ considerably from British and American accounting principles. More and more German businesses are preparing their balance sheets on a German and IAS or GAAP basis as they address investors from the global markets. The new tax law encourages those who advocate abandoning traditional German accounting standards, even if the regulation of insurance companies' accounting is and will remain a very special issue.

Dieter Lüer is a partner in the Munich law firm of Heuking Kühn Lüer Heussen Wojtek. He is also a former director of Frankona Reinsurance. Tel: +49 89 29 09 70; fax: + 49 89 29 09 72 00; e-mail: heuking_kuehn_muenchen@compuserve. Com