Withholding Tax

What is withholding tax?

Withholding tax (German: Quellensteuer) is a tax that the payer withholds on payment and remits to the tax office, instead of the recipient paying it themselves. It is not a separate type of tax but a form of collection of the recipient's income tax or corporate income tax. The best-known example is wage tax (Lohnsteuer): the employer deducts it from the salary before the money reaches the employee.

In German law, the most important withholding taxes are wage tax, capital income tax (Kapitalertragsteuer) on dividends and interest and the tax deduction under Section 50a of the German Income Tax Act (Einkommensteuergesetz, EStG). Subject to withholding tax are therefore above all salaries, capital income and certain payments to recipients abroad. The deduction under Section 50a EStG concerns persons with limited tax liability (beschränkt Steuerpflichtige), that is, individuals and companies without residence or registered office in Germany, who are taxed here only on their German income. A GmbH (German limited liability company) is affected in several roles: as an employer, as a company that distributes profits to its shareholders and as a payer of licence fees or remuneration to recipients abroad. Because the payer is liable for the correct deduction, withholding tax is a fixed review point in tax due diligence.

How withholding tax works and liability

The debtor of the payment determines the tax, withholds it from the payout, declares it and remits it. For the recipient, the deduction works in one of two ways depending on the case. It can settle the tax finally (Abgeltung), for example with private capital income. Or it is credited later in the recipient's tax assessment (Veranlagung), for example with wage tax or with capital income of a corporation.

If the deduction is omitted or too low, the tax office holds the payer liable. For the GmbH, the management acts; if it breaches tax duties intentionally or through gross negligence, it can be personally liable under Sections 34 and 69 of the German Fiscal Code (Abgabenordnung, AO). The duty to deduct exists regardless of whether the recipient owes any tax in the end.

Capital income tax on profit distributions

When a GmbH distributes profits, it withholds capital income tax of 25% plus 5.5% solidarity surcharge on it, together 26.375% of the gross dividend. The tax must be declared and remitted by the tenth day of the month following the inflow.

Even where a domestic holding GmbH is the shareholder, the deduction is made first. The holding company credits the tax withheld against its corporate income tax or has it refunded; until then, liquidity is tied up (holding structure). Foreign shareholders can apply for relief under the respective double taxation treaty. These are agreements between two states that determine which state may tax which income. Parent companies in other EU states may be entitled to full relief under the EU Parent-Subsidiary Directive. The prerequisite is a shareholding of at least 10% that has existed for at least twelve months, and compliance with the rules against abusive arrangements.

Withholding tax on licences and payments abroad

If a domestic company pays certain remuneration to persons with limited tax liability, it must make a tax deduction under Section 50a EStG. Three groups are mainly covered:

• Remuneration for granting rights of use, such as licences for trademarks, patents, know-how or works protected by copyright
• Remuneration for artistic and sporting performances in Germany
• Remuneration to members of a supervisory board or of an advisory board that supervises the management

The deduction is 15% of the total remuneration without deduction of costs, 30% for supervisory board remuneration, in each case plus solidarity surcharge. It is declared for each calendar quarter to the Federal Central Tax Office (Bundeszentralamt für Steuern). For software, the scope of the rights granted matters. Mere use as intended, for example of purchased standard software, generally triggers no deduction. It is different where rights to reproduce, adapt or redistribute are granted.

Relief under double taxation treaties

Double taxation treaties limit the right of the source state to tax dividends and licence fees, for licences often down to zero. The deduction in Germany, however, does not lapse or reduce automatically. If an exemption certificate (Freistellungsbescheinigung) of the Federal Central Tax Office is available at the time of payment, the payer may apply the lower rate. If it is missing, the full amount must be withheld; the recipient can then apply for a refund.

Conversely, foreign customers often withhold tax in turn on licence payments to German companies. The foreign tax can in principle be credited in Germany only up to the amount of the German tax on this income. In loss years the credit therefore comes to nothing; on application, the tax can then be deducted as an expense, which compensates for the burden only partly.

Worked example: withholding tax on a licence fee abroad

Simplified example without VAT: a German software GmbH pays a company abroad an annual licence fee of EUR 120,000 for the use of a trademark. The double taxation treaty with the state of residence excludes German tax on licence fees.

• With an exemption certificate at the time of payment: no deduction, payout EUR 120,000
• Without a certificate, gross agreement: tax deduction 120,000 × 15% = EUR 18,000, solidarity surcharge 18,000 × 5.5% = EUR 990, together EUR 18,990; payout 120,000 minus 18,990 = EUR 101,010; the licensor applies for the refund afterwards
• Without a certificate, net agreement of EUR 120,000: the tax assumed is itself part of the remuneration; gross amount 120,000 / (1 minus 0.15825) = around EUR 142,560; tax around 142,560 × 15.825% = around EUR 22,560, that is, around 18.8% of the net amount

In the third case, the licence costs the GmbH around EUR 22,560 more than agreed. A later refund belongs to the licensor, not to the GmbH; it reaches the GmbH only if the contract provides for passing it on. If the deduction is omitted entirely, the tax office holds the GmbH liable. The example shows why the exemption certificate should be available before the first payment and why the licence agreement should regulate who bears a withholding tax.

Distinctions: withholding tax, flat-rate withholding tax and wage tax

• Flat-rate withholding tax (Abgeltungsteuer): the special tax rate of 25% for private capital income. Capital income tax is the form in which it is collected at source.
• Wage tax: the withholding tax on salary, which the employer withholds and for which it is liable.
• Income tax on profits: umbrella term for the taxes on profit and income; withholding tax determines only the route by which part of it is collected (income tax).

Common mistakes

• Rights granted abroad not reviewed. Licence payments to foreign partners are made without the duty to deduct under Section 50a EStG having been reviewed.
• Net agreement without a tax clause. If a net amount is agreed, the payer bears the withholding tax on the grossed-up amount.
• Exemption applied for too late. The procedure at the Federal Central Tax Office takes time; until the certificate is available, the full amount must be withheld.
• Deduction at the holding company forgotten. Distributions to a domestic corporate shareholder are also in principle subject to capital income tax.
• Foreign withholding tax not planned for. Loss-making companies with licence customers abroad often cannot credit it and bear it as a cost.

Frequently asked questions

Is withholding tax an additional tax?

No. It is an advance collection of the tax that the recipient owes anyway and is credited against it or deemed settled. It becomes an additional burden only if a credit or refund is not possible.

Who is liable if the tax deduction is omitted?

The payer. The tax office can hold the GmbH liable by a liability notice and, in the case of grossly negligent or intentional breach of duty, the management personally.

What is an exemption certificate?

A certificate of the Federal Central Tax Office under which the payer may make no deduction or a lower one. It is applied for by the recipient and applies only to payments for which it is already available.

Must tax be withheld on payments to freelancers abroad?

For pure services performed abroad, as a rule not. A deduction can, however, come into consideration if the service involves granting rights of use, for example to software, texts or designs. The distinction depends on the contract and belongs in the tax review before the first payment.

Is withholding tax due on the purchase price when shares in a GmbH are sold?

As a rule, no. A capital gain on disposal, to the extent that Germany taxes it, is captured at the seller in the assessment procedure. Withholding tax can, however, arise on distributions made in connection with the sale.

How is withholding tax treated on foreign shares?

The company's state of residence usually withholds tax on dividends. In Germany it is credited against the flat-rate withholding tax, at most up to the rate that the double taxation treaty permits, often 15%. A higher deduction is refunded only by the source state on application. Switzerland, for example, withholds 35%, there called Verrechnungssteuer; 15% is credited, and the remaining 20% is reclaimed by the investor in Switzerland. What cannot yet be credited for lack of flat-rate withholding tax is carried by the bank in a withholding tax pot (Quellensteuertopf) during the year. In Switzerland itself, Quellensteuer refers mainly to the tax deducted from the wages of foreign employees without a settlement permit.

The Roemer Capital view

Before a funding round or a sale, Roemer Capital has all recurring payments abroad listed: licences, group allocations, remuneration of advisory board members and freelancers. Whether a tax deduction had to be made on them is assessed by the client's tax adviser; Roemer Capital makes sure the question is resolved before the data room.

An open deduction is rarely a large amount. In due diligence, however, it raises the question of how reliable the other tax processes are and often leads to an additional warranty or indemnity in the contract.