In the case under consideration, two spouses each held more than 25% of the shares of two German public limited companies (Aktiengesellschaft or AG). In 1998, the couple moved from Germany to Belgium thereby ending their unlimited liability to German taxation. In 2001 the couple moved from Belgium to Switzerland.

In 2000, during the course of a tax audit, the local tax authority became aware of the holdings and, applying Sec. 6 AStG, assessed income tax on the value of the shares minus their initial acquisition costs. The couple took legal action against the tax assessment but the local finance court decided (in 2007) in favour of the tax authority. Upon the couple’s appeal, the Federal Finance Court (in its November 2009 ruling) upheld the lower court’s decision.

Sec. 6 AStG imposes an exit tax on persons who had been subject to unlimited German tax liability for a minimum of ten years prior to leaving Germany, thereby ending their unlimited German tax liability. The exit tax applies to participations in a limited liability company but only if the shareholder held a minimum participation during the 5 years prior to ending the unlimited German tax liability. The application of Sec. 6 AStG results in the assessment of income tax at the time of emigration irrespective of whether or not income is generated (e.g. through sale of the participation). This exit tax is based solely on the discontinuance of unlimited German tax liability. When the plaintiffs emigrated from Germany, the minimum participation which led to imposition of exit tax was 25% (it is currently 1%).

In a decision from November 2004, the European Court of Justice (ECJ), struck down a French regulation, which was similar to the original wording of Sec. 6 AStG, as incompatible with EU law since it discriminated against persons moving to EU member states as compared to those remaining in their original country of residence. In response to this ruling, the German legislature amended Sec. 6 AStG in December 2006 to include an interest-free suspension of taxation for taxpayers who emigrate to EU member states. Suspension ends when the taxpayer ends the participation in the German company or when he/she emigrates to a country outside of the EU. The amendment, which entered into force in 2006 and became effective as of 1 January 2007, enacted the suspension provision with unlimited retroactive effect.

The taxpayers in the case under consideration argued that at the time they emigrated from Germany to Belgium the previous version of Sec. 6 AStG had been in effect which, however, was contrary to EU law (applying the decision regarding the similar French regulation) and therefore could not have been used as the basis of a tax assessment. Since, however, Sec. 6 AStG was subsequently amended to remove the conflict with EU law, the taxpayers also challenged the lawfulness and the retroactive effect of the amended provision.

The Federal Finance Court held that the present Sec. 6 AStG is in line with European law since no obstruction of movement to other EU-member-states exists and that the retroactive effect is in line with the German Constitution since the amendment was in favour of taxpayers and beneficial amendments may be made with retroactive effect. Furthermore, the Court held that the plaintiffs could not rely on the assumption that the non-compatibility of the AStG provision with EU law would not be cured by the German legislature.

Since this decision is binding on the lower tax courts and it is unlikely that the Federal Fiscal Court will overrule its decision in the near future, any person looking to challenge the lawfulness of Sec. 6 AStG based on a breach of European law will have to be prepared to go before the European Court of Justice.

• The tax rates for siblings and their descendants is to be decreased with rates ranging from 15% to 43%. Under current law, siblings and their descendants are taxed at rates of 30% to 50%.

• Business successions would be facilitated by shortening the time period during which the business must be continued as well as by reducing the employee-retention requirements which must be met at the end of the respective time period. Furthermore, the definition of a small business, which is exempt from the employee-retention requirements, would be widened to a business with up to 20 employees rather than the currently applicable 10-employee threshold and the aggregate wage amount as well as the period of time during which such amount must be sustained would be decreased. The governing coalition will enter into negotiations with the German federal states regarding the regionalization of both tax rates and tax exempt amounts which could lead to tax competition between the various federal states.
For example, prior to the federal elections Bavarian Finance Minister Georg Fahrenschon announced that if the CDU, CSU and FDP formed the governing coalition, Bavaria would decrease its inheritance and gift tax rates radically to make Bavaria more attractive for businesses as well as wealthy individuals from Germany and abroad. By making Bavaria an inheritance and gift-tax haven, he plans to stimulate the growth of jobs, add economic value to the state and increase business tax revenues.
We will keep you posted on the other federal states´ decisions regarding inheritance and gift tax rates.

The court granted the injunction due to serious doubts as to whether the audit’s time limitation, based on company size alone, was lawful.
Under German tax law, audits are allowed in regard to taxpayers who conduct commercial or freelance work or other taxpayers whose annual income exceeds EUR 500,000.
In general, the local tax authorities are competent in regard to tax audits and are given discretion as to the taxpayers, the type of tax, the circumstances and the time frames to be audited. However, the Ministry of Finance, in the Tax Audit Regulations (Betriebsprüfungsordnung or BpO) has issued administrative regulations as to how such discretion must be exercised.

Sec. 4 II of the Tax Audit Regulations defines that large firms are to be audited regularly without disregarding any fiscal years. The practice in this regard over the last few decades has been to audit large firms over a three-year term.

In June 2008, the Ministry of Finance of the German federal state of Northrine-Westfalia issued a decree that allowed the conduct of single-year audits – so-called “prompt tax audits” (zeitnahe Betriebsprüfung) in order to generate additional taxes as well as to create legal certainty for taxpayers.

In the case under review, the Finance Court of Cologne held that the discretion of the tax authorities regarding the term to be audited can be exercised only to the extent to which it does not infringe the principle that the administration is bound by its own practices with the result that if a tax authority generally audits over a three-year period, it cannot generally conduct shorter-term audits. The Court further noted that since tax audits are a limitation of taxpayers’ rights – particularly for large firms for which tax audits are costly and time-consuming – a reduction of the audit term, with the corresponding increase in effort and expense for the taxpayer, must be supported by valid reasons. The Finance Court of Cologne further held that the categorization of a company as a “large firm” is not, in itself, sufficient to justify a one-year audit term.
Since the case under consideration only involved the granting of a preliminary injunction for the conduct of the audit, the tax authority must still decide whether to allow the appeal and thereby accepting the decision or to provide further justification for the shortened term.

Furthermore, since the rule of precedence is not a part of the German justice system, other courts and tax authorities are not bound by the decision of the Finance Court of Cologne. However, this decision could be cited in other cases as argumentation against a shortened audit term.

• Definition of function: Throughout the legislative process it was decided that Sec. 1(3) AStG should only cover functions as a whole, not partial functions. Through its definition of “function” in the draft decree, however, the BMF would also apply the new rules to partial transfers, which would be an overstepping of its legal boundaries.

• Transfer package: Under German tax law, a business function must be priced as a transfer package, which means that a reasonable price not only contains the sum of the prices for the transferred assets but also must take into account the profit expectations on the transfer. Since this price estimation is not in line with OECD standards — the OECD Discussion Draft on the Transfer Pricing Aspects of Business Restructurings focuses on the price determination of individual assets – the German rule could lead to double taxation.

• Burden of proof: Under general German tax law, the tax authorities must prove that a transfer price determined by the taxpayer does not meet transfer pricing principles. A tax office can estimate transfer prices only upon reasonable doubt regarding the prices determined by the taxpayer. As drafted, however, the draft decree would seem to shift this burden of proof to taxpayers while, at the same time, making this burden difficult to achieve.

• EU law: Two of the main tenets of EU law are freedom of establishment and freedom to provide services. Any taxation measures taken by an individual EU member state which are seen as limiting or blocking these freedoms are considered contrary to EU law. Given the draft decree’s increased obligations on function transfers as well as the potential higher taxation created by its profit-potential considerations, it is likely that the decree is contrary to EU law.

• Length and complexity of the draft: The draft consists of 72 pages, discussing several issues repeatedly without summarizing them.
We will keep you posted on the Ministry of Finance’s reaction to the various points of criticism.

The ECJ noted that while such a tax treatment is a restriction on the freedom of establishment, since the company would be allowed to deduct the losses of a permanent establishment located in the same Member State as the company itself, it can, however, be justified in light of the need to safeguard the allocation of the taxation power between the Member States and the need to prevent a double use of the losses. The ECJ therefore concluded that these interests, taken together, pursue legitimate objectives compatible with the Treaty and thus constitute overriding reasons in the public interest which justify the restriction of the freedom of establishment, provided that the tax treatment is proportionate to these objectives.

However, the ECJ also stated that it is contrary to the freedom of establishment to disallow a company located in one Member State from deducting the losses incurred by its non-resident permanent establishment if the permanent establishment has exhausted the possibilities for deducting the losses incurred in the Member State where it is situated in the accounting period concerned and in previous accounting periods and there is “no possibility for that subsidiary’s losses to be taken into account in that State” in future periods.

Following this ECJ decision, the German Federal Fiscal Court stated in a decision of 17 July 2008 that, by way of exception, a company can deduct losses relating to a permanent establishment belonging to it and situated in another Member State if and to the extent that the company can prove that the losses can under no circumstances be utilized in the Member State in which the permanent establishment is located. The deduction must, however, be made from the company’s income generated in the same fiscal year in which the permanent establishment’s losses were incurred.

On 13 July 2009 the German Federal Ministry of Finance published a decree in which it declared that the Federal Fiscal Court’s decision will not apply to cases other than the one decided. While, in general, there is no rule that Federal Fiscal Court decisions are binding on the German tax authorities, it is nevertheless necessary to the principle of the separation of powers that the tax authorities may not ignore the Court’s decisions without reason. In this regard, the Ministry of Finance named the following reasons for its decree.

- the ECJ’s “no possibility for that subsidiary’s losses to be taken into account in that State” wording includes only legal possibilities for loss deduction regardless of whether the deduction is actually taken or not.

- In the Lidl Belgium case, the loss actually could be deducted from income generated by the permanent establishment in subsequent years and, therefore, the Federal Fiscal Court’s decision was not a decision on the merits of the case and its statement regarding the loss deduction can only be regarded as dictum.

Given these considerations, it will now be up to taxpayers to bring another case to court which will cause the German Federal Fiscal Court or the ECJ to clearly state the preconditions for inter-European deduction of permanent establishment losses.

The federal government has now published the draft of a regulation which sets forth these duties. The regulation does not, however, name the states which will be considered tax havens; rather it empowers the Federal Ministry of Finance to publish the list as a decree. This approach was reportedly chosen in order to allow monitoring of further developments in the field of international information exchange which can then be reflected in the tax haven list on a regular basis.

The problem with this approach, however, is that it shifts accountability for the legislative enactment procedure from parliament to the executive branch. Since the German constitution specifies that the law-making process is the responsibility of the German parliament (Bundestag and Bundesrat) and can only be transferred to the executive branch by a law which defines the content, purpose and scope of the decree to be created by the executive branch, the question arises as to whether the law-making method chosen in regard to tax havens is in accordance with the German constitution.

Therefore, it can be assumed that the constitutionality of the Federal Ministry of Finance decree will be challenged as soon as the tax haven list is published with the issue potentially passing to the Federal Constitutional Court for decision.

On 10 July 2009, the German Bundesrat held its last meeting before the summer break. Since Germany is facing federal elections in late September, this session potentially represented the current government’s last chance to pass the draft laws which it has submitted in the past few months. Therefore, the meeting held on 10 July 2009 was a marathon session involving voting on 62 different laws.

Among these draft laws were the German Act on the Combat of Tax Fraud, which increases a taxpayer’s duty to provide information in regard to transactions involving tax havens or the placing of funds in such countries. If certain requirements are not met, the taxpayer may face the disallowance of tax deductions related to such transactions or investments. For further details of this draft act please see our blog entries of 19 March and 28 April.

Another act which passed the Bundesrat on Friday is the Citizen Relief Act which, as initially formulated, would merely have governed the tax deductibility of social insurance contributions. The amended act also governs the temporary suspension of the so-called “Zinsschranke” and “Mantelkauf” regulations, both of which were introduced by the German Business Tax Reform of 2008. The Citizen Relief Act includes a temporary revision of these regulations in order to ease the negative impacts which they would create in the current economic crisis. For details please see our blog entries of 29 May, 5 June and 24 June.

With the Bundesrat´s consent, the draft acts completed passage through the legislative process and will enter into force once they have been published in the Federal Law Gazette (Bundesgesetzblatt).

Side note:

The legislative process in Germany is divided between the Bundestag and Bundesrat, of which the former is the central body where all federal legislation is adopted. The Bundesrat subsequently addresses the draft bills approved by the Bundestag. The scope of the Bundesrat’s right to participate in the legislative process varies depending on whether the bill is a consent bill or a bill which does not require Bundesrat consent.