Assignment of losses in case of acquisitions during a fiscal year; firsttime comments regarding group-clause and hidden reserves-clause.
On 15 April 2014, the Federal Ministry of Finance (Bundesfinanzministerium, BMF) published a draft of a circular regarding Sec. 8c Corporate Income Tax Act (CTA), which is supposed to replace the existing circular dated 4 July 2008. Pursuant to the draft circular, the BMF has changed its view with regard to the assignment of profits and losses in the case of an acquisition of shares during a fiscal year and comments for the first time on the scope of the so-called group-clause in Sec. 8c (1) s. 6 CTA and the so-called hidden reserves-clause in Sec. 8c (1) s. 7-9 CTA. The draft circular provides legal certainty for a series of issues. However, in many cases the views expressed by the tax authorities have a detrimental effect for the taxpayer.
With respect to an acquisition of shares of a loss-making company, so far, the taxpayer could choose how to allocate the taxable income obtained in the tax assessment period. The overall profit or loss could either be assigned proportionally on a monthly basis or on the basis of economic cause. From now on, profits and losses can only be assigned based on economic criteria according to the draft circular. The simplifying time-proportionate assignment is no longer possible. Accordingly, the taxpayer is now either required to prepare interim financial statements as of the transfer date or has to assign the respective profits or losses based on an economic estimate.
One positive aspect of the draft circular is that the BMF for the first time acknowledges, in line with the corresponding jurisprudence of the Federal Fiscal Court (Bundesfinanzhof, BFH), that profits resulting from the time period prior to the transfer date can in principle be offset with tax loss carry forwards provided that the overall result of the fiscal year, in which the harmful transfer takes place, is positive. This means that even if tax loss carry forwards are forfeited due to a transfer of shares, the tax loss carry forwards can be utilized at least partially. However, the BMF plans to prioritize the set-off with losses incurred subsequent to the transfer date and to apply the provisions of the so-called minimum taxation rule in Sec. 10d (2) Income Tax Act (ITA) with respect to the set-off with profits generated prior to the transfer date.
The so-called group-clause provides that an acquisition of shares is not harmful in terms of Sec. 8c CTA if the “same person” holds a 100% direct or indirect participation in both the transferring and the acquiring legal entity. Therefore, the group-clause addresses legal entities at three levels of the group: the same person holding the participation in the transferring and the acquiring legal entity at the shareholder’s level, the transferring and the acquiring legal entity at the level of the acquisition and the loss-incurring company as transferred entity beneath the level of the acquisition. Pursuant to the BMF, the group-clause only applies in case that at the shareholder’s level only one individual or a single legal entity holds a 100% direct or indirect participation in both the transferring and the acquiring legal entity. Also in case of a partnership holding the participation at shareholder’s level, the exemption clause is not to be applied in the view of the Federal Ministry. Furthermore, the draft circular provides that the group-clause is not applicable if individuals, trusts or territorial entities are involved as transferring or acquiring entities at the level of the acquisition as a participation in such entities is not possible. This understanding of the BMF leads to a rather strict interpretation of the group-clause. It predominantly remains to be applicable in connection with groups consisting of corporations only. It is doubtful whether such strict interpretation of the group-clause is compatible with the ratio legis. However, it is likely that a different tax treatment can only be fought for in fiscal court proceedings.
The interpretation of the so-called hidden reserves-clause by the BMF is similarly strict. Hidden reserves stemming from shares in companies or from shares subject to the retention period of Sec. 22 Reorganization Tax Act held by the loss-incurring company shall not be taken into account although their realization may at least partially lead to taxable income. Furthermore and contrary to the prevailing view in literature, the draft circular stipulates that hidden reserves at the level of the controlled entity shall not be taken into account at the level of the controlling entity. Such interpretation raises doubts as tax losses of the controlled entity, which are assigned to the controlling entity due to a fiscal unity, are forfeited in the case of a transfer of shares in the controlling entity. In addition, the income of the controlling entity resulting from a realization of hidden reserves at the level of the controlled entity are taxed at the level of the controlling company. The fact that the losses incurred by the controlled entity should be seen alongside the taxable hidden reserves is – contrary to the ratio legis of the hidden reserves-clause – not taken into account in the case of a transfer of shares in the controlling entity. The strict interpretation of the fiscal authorities triggers the actual realization of hidden reserves at the level of the controlled entity for the set-off with existing tax losses of the controlling entity prior to the application of Sec. 8c CTA, although the hidden reserves-clause is supposed to avoid such effect.
The draft circular provides only for one simplification rule beneficial for the taxpayer insofar as generally, no business valuation has to be conducted in order to determine the fair market value of the transferred shares. Moreover, the fair market value can be determined on the basis of the purchase price paid for the transferred shares should such purchase price be reasonable, i.e. calculated at arms’ length. However, the appropriate geographic allocation of hidden reserves of an international group might still prove to be a complex issue in practice.
From a taxpayer’s point of view, it is to be hoped that the circular will be amended in favour of the taxpayer prior to the publication of its final version. Such amendments could result from the expert’s opinions invited to comment on the draft circular. Should the circular be published without further amendments, it can be expected that several issues will be fought for in fiscal court proceedings resulting in a shortfall of the legal certainty originally intended. Nevertheless, the draft circular contains some important clarifications and provides legal certainty regarding the tax authorities’ interpretation of the law. Such legal certainty can be used in the case of acquisitions of shares and restructurings. Furthermore, it should again be possible to obtain binding rulings from the tax authorities (verbindliche Auskunft) with regard to the group-clause or the hidden reserves-clause.