Proposed reforms to the German tax system will boost capital markets and clear the way for extensive pension reform, according to a report by Morgan Stanley Dean Witter’s Peter Koenig, in Frankfurt. In January the government announced from 2001 German corporations will be capital gains exempt when selling assets in foreign and domestic companies; corporate tax for retained earnings and distributed profits will be 25% opposed to 40% and 30% respectively; and German dividend income will also be tax free.
MSDW anticipates lower corporate tax and stronger GDP growth will boost EPS by 2% per annum and the reforms will create incentive for buybacks. The company’s economists forecast buybacks of E20bn in 2002, particularly among chemical, insurance and utility companies. It also predicts more M&As and an increase in the free float of the German stock exchange from about 65% to 90%.
These changes in the capital markets will also feed through to pension funds. Germany’s second pillar system is very complex but now looks like changing. Direktzusagen, or the book-reserve approach, dominates the system. Pension fund liabilities are funded internally, simple but not necessarily cost-efficient. Under the book-reserve system, assets appear on a company’s balance sheet at the book value as of the acquisition date.
After a while a fund gathers substantial hidden reserves. “Taxation of capital gains resulting from an externalisation of was unanimously regarded as the highest hurdle on the way to pension funds reform…now that the tax impediment is bound to disappear, the pension fund segregation option becomes really valid” says Koenig.
Externalisation brings other advantages. It allows the match of asset allocation with the structure of liabilities in a dedicated pension fund. Larger asset pools enable different risk levels for employees. Externalisation will shorten the balance sheet leading to improved key figures, like profitability and price-to-book values as well as improving transparency when comparing corporations nationally and internationally- something analysts and ratings agencies will welcome.
German pension funds have tried to externalise pension funds by transferring assets and liabilities to trusts. Under US-GAAP this is an externalisation if the trust pledges assets to the pension beneficiaries. But German tax rules mean assets remain the corporation’s property to avoid capital gains after the transfer. “While this structure is built on a very clever combination of different accounting rules, it cannot be regarded as a true externalisation of pensions…after the implementation of the tax reform, taxation of capital gains on hidden returns can be avoided,” says the report. “We believe the door to comprehensive pension reform has been pushed wide open,” says the report boldly. Dickon Reid

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