In the last year the Federal Constitutional Court (Bundesverfassungsgericht), the Federal Fiscal Court (Bundesfinanzhof) and other fiscal courts (Finanzgericht) commented on several trade tax related questions in their decisions. Some considerable rulings will be outlined in the following.
a. Constitutionality of minimum multiple for trade tax purposes
With its ruling dated 27 January 2010 (2 BvR 2185/04) the Federal Constitutional Court confirmed the constitutionality of Sec. 16 (4) s. 2 Trade Tax Act (TTA) according to which the multiple for trade tax purposes shall amount at least 200 percent. This provision, which was applicable for the first time in 2004, limits the right of the municipalities to determine the multiple for trade tax purposes. The reason for the introduction of this provision was that municipalities which could not, due to their unfavorable location, anticipate operating businesses increasingly enticed such operations to relocate by completely waiving trade taxes (by determining a trade tax multiple of zero). Small countryside municipalities without any infrastructure became proper locations for companies which did not need such infrastructure. Municipalities, respectively their inhabitants, did not benefit from increased tax payments but from increasing leases for office spaces and office equipment. The existence of such trade tax havens shall be avoided by the introduction of Sec. 16 (4) s. 2 TTA.
Two municipalities located in Brandenburg appealed against this provision.
According to the decision of the Federal Constitutional Court, Sec. 16 (4) s. 2 TTA is formally in line with the German constitution. Against the background of the described locational advantage of municipalities waiving the trade taxes and with view to the existence of trade tax havens resulting there from, the Federal Constitutional Court held that there is the need of a unitary provision for Germany. In addition, with regard to the substantive law, the court held that the provision does not violate the right of self administration of the municipalities and pointed out that the guarantee of such self administration also in respect of taxes does not mean that a municipality may determine the multiple for trade tax purposes without any legal restriction.
In practice, the provision of Sec. 16 (4) s. 2 TTA resulted in the desired effect. The excessive settlement of companies in the respective municipalities decreased.
Even though the provision of Sec. 16 (4) s. 2 TTA has been introduced, there are still substantial differences within the trade tax multiples. In particular, in the countryside the trade tax multiples are in general lower and therefore, the trade tax burden is furthermore of importance for the decision about the location of companies which do not need a special infrastructure.
b. Constitutionality of trade tax on capital gains pursuant to Sec. 7 s. 2 Trade Tax Act (TTA)
According to the ruling of the Federal Fiscal Court dated 22 July 2010 (IV R 29/07) Sec. 7 s. 2 TTA is in line with the German constitution.
According to Sec. 7 s. 2 TTA, a capital gain resulting from the sale or winding up of a operation or parts of an operation of an entrepreneurship or of a participation of a general partner in a partnership limited by shares is subject to trade tax to the extent such capital gain is not attributable to a directly participating individual. This means in a nutshell that capital gains realized by selling a share in a partnership is in general subject to trade tax if such sale is made by a corporate entity or a partnership. Only the (direct) sale by an individual is not subject to trade tax. Prior to the introduction of this provision which was applicable for the first time in 2002, capital gains had not been subject to trade tax due to its special character as an impersonal tax.
Sec. 7 s. 2 TTA is supposed to avoid abusive structuring where in a first step assets are contributed to the partnership in a tax neutral manner and where in a second step such partnership is sold without triggering any trade taxes.
Despite of the general critique that not the selling partner itself but the company is burdened with trade tax, the underlying law suit focused on the different treatment of individuals on the one hand and partnerships and corporations on the other hand.
The Federal Fiscal Court, however, held that the aim of the law sufficiently justifies this differentiation between companies and individuals. With respect to the restriction that only directly participating individuals may benefit, the Federal Fiscal Court refers to the provision of Sec. 35 Income Tax Act according to which in case of an indirect participation of an individual in a partnership a tax relief may be achieved by crediting the trade tax against the personal income tax.
Consequently, Sec. 7 s. 2 TTA remains with its broad scope which exceeds its actual purpose. In addition, there is still the need to reflect the consequences resulting from a sale of or a withdrawal from a partnership in the partnership agreement. It remains to be seen whether the Federal Constitutional Court shares the Federal Fiscal Court’s view.
c. Doubts on constitutionality of the minimum taxation rule
The Hessian Fiscal Court dealt in two rulings with the constitutionality of the so-called minimum taxation rule (Sec. 10a (2) Trade Tax Act (TTA)) which provides for a limited use of trade tax loss carry forwards within one taxable period (fully up to one million EUR and exceeding this amount up to 60 percent of the trade tax income). The Hessian Fiscal Court insofar followed a ruling of the Federal Fiscal Court dated 27 January 2006 (VIII B 179/05) according to which the general aim of the minimum taxation to strengthen and perpetuate the financing of municipalities justifies the deviation from the so-called net principle and from the rule of equality provided by Art. 3 (1) of the German Constitution. Correspondingly, the Hessian Fiscal Court held in its ruling dated 20 September 2010 (8 K 2285/09) that, to the extent the trade tax loss carry forwards may be used in future taxable periods, there are no concerns regarding the constitutionality. The case the ruling of the Hessian Fiscal Court based upon did not provide for any evidence that a use of tax loss carry forwards in the future was impossible. In its ruling dated 26 July 2010 (8 V 938/10) however, also based on the ruling of the Federal Fiscal Court dated 27 January 2006, the Hessian Fiscal Court held that there were considerable doubts on the constitutionality of Sec. 10a (2) TTA to the extent that due to factual or legal reasons, trade tax loss carry forwards may not be carried forward. In this case the ruling was based upon a company that was in liquidation and thus not able to use the trade tax loss carry forwards in future periods.
The jurisprudence (e.g. Fiscal Court Munich dated 31 July 2008 (8 V 1588/08)) increasingly deals with the critique on the minimum taxation raised by the literature. In its rulings, the Hessian Fiscal Court admitted the appeal and one could expect that the Federal Fiscal Court will deal once more with the constitutionality of the minimum taxation rule.
d. No crediting of trade tax in connection with Sec. 18 Reorganization Tax Act (RTA)
With ruling of 15 April 2010 (IV R 5/08), the Federal Fiscal Court held that capital gains, which are subject to trade tax pursuant to Sec. 18 (4) RTA 2001, may not be taken into account for purposes of the tax relief of Sec. 35 Income Tax Act (ITA). Furthermore, the Federal Fiscal Court states that the provision of Sec. 18 (3) s. 3 RTA, which was introduced to the RTA in 2001 and explicitly regulates that Sec. 35 ITA shall not apply, has only declaratory character.
Pursuant to Sec 18 (3) (former (4)) RTA, capital gains are in principle subject to trade tax within five years following the conversion from a corporation into a partnership or a sole proprietorship. Sec. 35 ITA allows for a flat crediting of trade tax against the personal income tax.
The Federal Fiscal Court bases its decision on the spirit and purpose of Sec. 18 RTA and an interpretation of Sec. 35 ITA conformant to the system of the ITA. Sec. 18 (3) RTA deems capital gains to be subject to trade tax in order to prevent that capital gains stemming from the sale of the business of a corporation will be eluded from trade tax by converting the corporation into a partnership and selling the partnership subsequently. Accordingly, the crediting of the trade tax resulting from the application of Sec. 18 (3) RTA would factually dispense the trade tax on capital gains explicitly stipulated and would thereby circumvent the anti-abuse rule of Sec. 18 (3) RTA.
Against this background, the Federal Fiscal Court views the provision added to Sec. 18 RTA according to which Sec. 35 ITA shall insofar not be applicable, as a mere clarification.
e. Treaty participation exemptions and add back for trade tax purposes
In its ruling of 23 June 2010 (I R 71/09), the Federal Fiscal Court dealt with the relationship between national and treaty participation exemptions and their relevancy with regard to the add back for trade tax purposes. From the Federal Fiscal Court’s point of view, the national participation exemption regime of Sec. 8b (1) Corporation Tax Act (CTA) and the treaty participation exemption provisions, which are part of many double taxation treaties, are basically independent from each other and are not mutually exclusive. Nonetheless, the treaty participation exemption rules have only small relevance because in contrast to Sec. 8b CTA they usually provide for restricting requirements and are therefore seldom applied compared to the national participation exemption rule. This shall be different, though, with regard to the trade tax respectively the add back for trade tax purposes. According to Sec. 8 No. 5 Trade Tax Act (TTA), those shares of profit which have not been taken into account pursuant to Sec. 8b (1) CTA have to be added on to the trade income as far as Sec. 9 No. 2a or No. 7 TTA do not apply. Due to the fact that such add back would factually neutralize the tax exemption of dividends and their inclusion in the trade income would lead to — according to double taxation treaties — inadmissible taxation of the dividends, the Federal Fiscal Court held that the treaty participation regime shall be granted preference to the national add back of the trade tax regime. Only such primacy allows for the effectiveness of the treaty exemption.
Albeit this ruling refers to the double taxation treaty between Germany and Poland, which meanwhile has been amended, the Federal Fiscal Court’s decision should be relevant for all double taxation treaties, whose scope includes trade tax.
f. Trade tax exemption at transition to asset management
With ruling dated 17 March 2010 (IV R 41/07), the Federal Fiscal Court commented on the requirements for a trade tax exemption of capital gains.
In the case the Federal Fiscal Court based its decision upon, a GmbH & Co. KG (a limited partnership with a limited liability company as general partner) sold all fixed assets except for the factory premises to a limited liability company. The factory premises were let to the acquiring company. In the following, the GmbH & Co. KG limited the scope of its activities to the leasing and management of its real estate.
The Federal Fiscal Court’s held that the capital gain is no tax-privileged capital gain but rather current trade income. Next to the fact that the factory premises as a fundamental operational asset have not been sold, the BFH draws the trade tax liability upon the continuity of the business and therefore an ongoing personal tax liability of the GmbH & Co. KG. Although the leasing qualifies as mere asset management, the business imprint of Sec. 15 (3) No. 2 Income Tax Act (ITA) results in the continuity of the business. Sec. 15 (3) No. 2 ITA provides for a legal fiction, deeming the activity of a limited partnership with only a limited liability company as general partner with sole management authority always as a business activity irrespective of the actual activities of the partnership. Therefore, it is irrelevant that the GmbH & Co. KG in the case at hand does not generate original business income as this is symptomatic for the deemed business partnership.
g. Cancelation of trade tax loss carry forwards with regard to partnerships
In its ruling of 3 February 2010 (IV R 59/07), the Federal Fiscal Court dealt with trade tax loss carry forwards pursuant to Sec. 10a Trade Tax Act (TTA). The claimant — a limited partnership — was held at 40 percent by another limited partnership as controlling company. The partners of the controlling company (two limited liability companies) were merged with the consequence that the controlling company ceased to exist and its assets were taken over by the receiving limited liability company. The Federal Fiscal Court assessed such scenario constitutes a harmful change in ownership at the level of the claimant, so that the trade tax loss carry forward was partially cancelled pursuant to Sec. 10a TTA.
The use of trade tax loss carry forwards requires the identity of both the business and the entrepreneur carrying out the business. In the context of a partnership, the partners are regarded as co-entrepreneurs realizing trade income individually and are considered — from a trade tax perspective — as bearer of the tax loss carry forward. The same applies to a partnership where at least one of the partners itself is a partnership (two-tier partnership) in the case that the controlling company is regarded as a co-entrepreneur, i.e. bears sufficient entrepreneurial risk and is entitled to adequate entrepreneurial initiative. Due to the fact that these requirements were fulfilled in the case at hand and that the controlling company therefore was regarded as co-entrepreneur of the claimant, the merger of the partners of the controlling company and therewith the termination of the controlling company led to a harmful change in ownership at the level of the claimant. Henceforth, not the controlling company held 40 percent of the claimant, but rather the receiving limited liability company.
Furthermore, the Federal Fiscal Court clarified that the retroactive effect pursuant to Sec. 2 (1) s. 1, 2 TTA also applies to the trade tax loss carry forward
h. Trade tax exemption and fiscal unity
The Federal Fiscal Court held in its decision dated 10 March 2010 (I R 41/09) that a limited liability company which is exempt from trade tax might be a controlling company in a trade tax fiscal unity insofar as the tax exemption of the parent company is an objective exemption. According to the Federal Fiscal Court, the catalogue of tax exemptions of Sec. 3 Trade Tax Act (TTA) does not constitute personal or subjective exemptions, but in most cases only objective tax exemptions (in the case at hand e.g. Sec. 3 No. 20 TTA).
This means that the trade income which is due to the fiscal unity attributed to the controlling company is not concerned by the objective tax exemption at the level of the controlling company and is therefore subject to trade tax at its level.
This perception is based upon the fact that the controlling company and the controlled company do not constitute a uniform enterprise although Sec. 2 (2) s. 2 TTA deems the controlled company as a permanent establishment of the controlling company. Moreover, the companies continue to be independent businesses whose income has to be determined separately for tax purposes. Therefore, in order to obtain a tax exemption, objective tax exemptions would need to exist both at the level of the controlling and of the controlled company. During the implementation of the fiscal unity, only the general trade tax liability of the controlled company is attributed to the controlling company.
If it is intended, as in the case of the ruling, that one part of a trade tax exempt company should be spun off and should the subsidiary not be tax exempt with the income stemming from the spun-off part, one should consider instead of spinning off the business to a limited liability company and the subsequent establishment of a fiscal unity to use a partnership as controlled company and to establish a so-called trust model (Treuhandstruktur). According to the Federal Fiscal Court ruling dated 3 February 2010 (IV R 26/07; cp. TaxInfo No. 011, September 2010), the contractual agreements between parent company and its subsidiary would be deemed non-existent for tax purposes due to the lack of two business assets.