Expansion of tax loss utilisation: Act on the further development of the tax loss carry forward for corporations
The “Act on the further development of the tax loss carry forward for corporations” enacted on 20 December 2016 revisits an old controversy. Under the heading of “shell purchase”, the strict limitation of tax loss utilisation to loss-bearing companies has long been a topic of discussion. Essentially, the goal is to prevent companies from disposing of losses by transferring the “formal corporate structure”, i.e. the shares in the legal entity representing the loss-bearing company (“loss trafficking”). The pertinent existing provision in Sec. 8c Corporate Tax Act (KStG) makes the restriction on loss deduction solely dependent on changes to the circle of shareholders (at the level of the legal entity). For example, share transfers and certain capital-related measures may lead to the prorated (for transfers of more than 25%) or total (for transfers of more than 50%) forfeiture of the carried forward tax losses. The only exception relates to specific intra-group restructuring measures (“group clause”). Moreover, companies can save carried forward losses that have not been fully utilised if they have built-in gains (“built-in gains clause”).
This regulation has been criticised as too restrictive because the denial of loss carry forward also applies to companies whose (loss-bearing) business operations are not affected by any changes to the shareholders’ circle. In its recent decision (published on 12 May 2017), the German Federal Constitutional Court declared major parts of the provision in Sec. 8c KStG unconstitutional. For fiscal periods between 2008 and 2015, the German legislature is obliged to adjust the current provision, however, the new regulation, entering into force retroactively as from 1 January 2016, is not covered by the decision and will also take structural changes to the business activities (i.e. at the corporate level) into account.
Key features of the law
The central part of the new law is the introduction of the new Sec. 8d KStG, which ‘saves’ any unused losses, upon request, despite a qualified harmful shareholder change (“continuity-bound loss carry forward”).
- Application and legal consequencesIn future, companies can determine whether or not, following a qualified harmful shareholder change, carried forward losses are lost pursuant to Sec. 8c KStG. If a written application is filed together with the tax return for the fiscal year in which the qualified harmful shareholder change occurs, the continuity-bound loss carry forward will be assessed separately as per Sec. 10d (4) Income Tax Act (EStG), allowing future profits to be offset.
- Prerequisite: Continuation of consistent business operationsSec. 8d KStG needs a company to continuously operate one and the same business establishment in the three fiscal years prior to filing of the application or – if the company was established less than three fiscal years ago - since its formation, including after any change of shareholders. A business operation meeting this definition must be continued without limitation (Sec. 8 (2) KStG). Otherwise the continuity-bound loss carry forward will be forfeited.
Start-ups or companies subject to major restructuring, in particular, can now benefit from the fact that carried forward losses are no longer lost per se in the course of capital-related transactions. Many sellers of enterprises will appreciate that the acquirer can use carried forward losses even after the transaction and this enables them to charge a markup on the purchase price.
Nevertheless, the new regulations need detailed analysis of whether the prerequisites are satisfied and, therefore, whether a markup on the purchase price is justified. Furthermore, opting to save the carried forward losses is not without risks because the continuity-bound loss carry forward is subject to the continuation of the business in the future. Hence, it might be preferable to accept the prorated loss demise in order to avoid a total loss demise in the near future. We would be happy to support you in choosing the best option for your company.
German cabinet approves royalty restrictions to combat tax planning by international corporations
On 25 January 2017, the German government approved a Bill to combat harmful tax practices in connection with the assignment of rights. The aim is to stop multinational companies from using royalty payments to shift their profits to countries with special preferential regimes (known as patent box or IP box regimes), and the Bill thus serves to implement Action 5 of the OECD and G20 Base Erosion and Profit Shifting (“BEPS”) project. The BEPS project targets preventing tax competition among countries and stopping aggressive tax planning by international corporations.
Key features of the Bill
The centrepiece of the Bill is the introduction of a new government draft in the form of Sec. 4j Income Tax Act (EStG RegE) governing the tax deductibility of royalty payments and of other expenditure on the assignment of rights.
- Preferential regime (low taxation of recipient)Sec. 4j (1) EStG RegE assumes taxation at a low rate, by the jurisdiction where the recipient resides, of the income resulting from the assignment of rights (“preferential regime”). Such taxation at a low rate shall be deemed to exist if the proceeds of an obligee from the assignment of rights are taxed at a rate of less than 25%. Hence, the royalty restrictions are to cover any payments to companies residing in countries that have generally low tax rates or special tax rates and benefits for royalty income in place.
- Related party as obligeeThe scope of application of the proposed legislation is limited to payments between “related parties” within the meaning of Sec. 1 (2) Foreign Taxation Act (AStG). Such a related party relationship shall be deemed to exist if a company, on account of a shareholding under corporate law, may exert material influence on (foreign) companies (especially where a stake of at least 25% is involved). Royalty payments to unrelated third parties are not affected by Sec. 4j EStG RegE and will remain deductible without any restrictions. The focus of the Bill is thus, in particular, on international groups of companies.
- No substantial business activity of obligeeThe royalty restrictions will not apply where the obligee developed his rights via substantial business activities. However, the Bill does not include any positive definition of the scope and quality of such substantial business activities. Rather, the Bill merely provides for a negative delimitation according to which a substantial business activity does not exist where the relevant rights have not been self-developed, but acquired. It is unclear whether or not the construction of the concept of “own research or development work”, as laid down in Sec. 8 (1) No. 6 lit. a) AStG, may additionally be referred to for a concretisation of a substantial business activity.
- Legal consequencesIf, due to a preferential regime, income from royalties paid to a related party by the user of the rights is taxed at a low rate or not at all, then the corresponding expenditure of the obligee is not to be deductible as operating expenses (or only on a pro rata basis).
Linking low taxation to an income tax load of less than 25% is problematic since this would affect not only tax havens. In a number of EU member states, the rate is less than 25%. It still needs to be discussed whether or not this constitutes a breach of the freedom of establishment guaranteed under EU law.
Moreover, the vague concept of “substantial business activity” tends to create uncertainty as to what degree of “substance” will suffice. Such a broad definition of an exception, leaving the requisite interpretation and delimitation to the authorities and courts, is flawed and will lead to unnecessary legal uncertainty.
The Bill clearly focuses on the configuration of “foreign group company and domestic operating profit company”. Whether it may cover any deviating configurations is doubtful, nevertheless the unclear scope needs to be taken into account for any tax planning and structuring concerning royalties in the future. It is intended that Sec. 4j EStG-E is to be followed after the 31st of December 2017. Companies should check their established licence models within affected countries (e.g. Cyprus and Liechtenstein).