Tax arbitrage - real life examples from Germany

I recently had to look something up in my BA final year project (written 1995-96) on the differences in the taxation of and subsidies for housing in the UK and Germany. I worked for a tax advisor in Germany for four years, this was our bread-and-butter business. The facts and figures are of course historic, but the basic principles still stand. You can test your understanding by attempting the questions at the end.

Example One - the split purchase

One unusual thing (from a UK perspective) about buying a new house/flat in Germany is that it is normal to buy the land as one transaction and then to pay for the construction entirely separately.

Why might this be?

i. In the UK, new housing is zero-rated for VAT, in other words, not only does the builder not have to charge VAT on the selling price, he can reclaim most of the input VAT. Stamp Duty was a flat 1% of the price paid for the house if above £60,000.

ii. In Germany, construction of new housing is liable to VAT like anything else, the rate was 14% at the time. This does not apply to subsequent sales by a private owner. Their Stamp Duty ('Grunderwerbsteuer') was much higher, call it 3% of the price paid for land or for land and buildings.

iii. So let's take an example where the land costs £50,000 and the construction costs another £50,000 (or their Deutschmark equivalent). A UK purchaser buys the finished house for £100,000, pays £1,000 Stamp Duty and that was the end of that. He could have saved himself the £1,000 by buying the land for £50,000 (below the £60,000 threshold) and then paying a builder £50,000 for the construction, but this would involve a lot of hassle and faff and would be barely worth it.

iv. For the German purchaser, the decision is much easier. He can either:

a) Buy the finished house for £100,000 and pay £14,000 VAT and then pay £3,420 Stamp Duty on top, total tax cost £17,420.

b) He can buy the land for £50,000 and pay £1,500 Stamp Duty. He then orders himself an off-the-shelf house from a local builder for £50,000. The builder charges £7,000 on the price, total tax cost £8,500.

Example Two - privatised tax collection

Another unusual thing is that in Germany, landlords who bought newly built homes were given very generous capital allowances on the cost of construction, allowable against income tax.

i. To simplify things a bit, under §7(5) EStG, for the first six years, the landlord could claim capital allowances of 10% of the construction cost against his total taxable income (not just rental income), and the top rate of income tax was over 50%. So the landlord was refunded about 30% of the amount paid for construction. These allowances were of course not clawed back if and when the home was later sold.

ii. In these cases, the purchase price would be carefully split so that lowest reasonable value was ascribed to the land and the highest reasonable value to the construction (the seller of the land and the building company were often connected or they colluded).

iii. According to the German building societies association, the average price paid for second hand homes was DM 300,000 and the average price paid for new ones was DM 433,000. So the potential landlord was indifferent between paying DM 300,000 and paying DM 433,000 and getting DM 133,000 back in tax breaks. (Sure, the maths is trickier than this because the land element of the DM 433,000 did not qualify for capital allowances, but let's assume that's balanced out by the fact that new builds commanded higher rents).

iv. Look at it now from the point of view of somebody who owns an undeveloped site, suitable for one home. The second hand home next door just sold for DM 300,000 and the costs of building a new one is DM 150,000, so the implied land value is also DM 150,000 (sticking with the £50,000/£50,000 split, the exchange rate was about 3),

v. So this lucky landowner can have a house built for DM 150,000 and sell it for DM 433,000. The transaction has to be [artificially] split up between the land and the construction as explained above (let's say a fifth for the land and four-fifths for the construction) and the landowner has to take the VAT of 14/114 of the construction element on the chin, which works out at about DM 42,000.

vi. So the landowner pockets DM 433,000 minus DM 150,000 minus DM 42,000 = DM 240,000, which is DM 90,000 over and above what the plot was really worth.

Question

a) Let's assume that the top rate of income tax is increased from 50% to 60% but that everything else remains constant. Would the price which the owner of an undeveloped plot go up or go down?

b) Any guesses by how much the price would go up or down?

Click and highlight to reveal answers:

a) The value of the tax break was 30% of the price paid for the construction, calculated as income tax rate 50% x capital allowances of 60% in total. Two-thirds of the tax break - DM 90,000 out of DM 133,000 - fed into a higher land price. If the income tax rate is increased to 60%, the value of the tax break is now 36%. So the bulk of that extra 6% would also feed into a higher land price.

b) As things stood, the gross value of the tax break to the purchaser was DM 133,000, which is 30/70 x the second hand price of DM 300,000. The new gross value of the tax break is 36/64 x DM 300,000 = DM 169,000, an increase of DM 36,000, two-thirds of which would go into a higher land price = DM 24,000.