Germany: 226. FTC Expands Corporate Capital Gains Exemption

The Federal Tax Court has handed down an important ruling on the interpretation of a key capital gains exemption in German corporate tax law (ruling of 6 July 2000 - I B 34/00 - DB 2000, 1940).

§ 8b (2) KStG creates an exemption for the capital gain realised by a corporation on the disposition of shares in another corporation. Under old corporation tax law, the exemption was limited to dispositions of shares in foreign corporations. To qualify for the exemption, the selling corporation had to be entitled, with respect to the shares sold or otherwise disposed of, to a dividends received exemption under a tax treaty or to an indirect foreign tax credit under § 26 (2) or (3) KStG. Under new corporation tax law, the capital gain exemption applies to dispositions of shares in all corporations, domestic and foreign, and is no longer contingent, with respect to foreign shares, on the existence of a tax treaty or qualification for the indirect foreign tax credit.

As explained in article no. 120, the tax authorities have long taken the position that the capital gains exemption of § 8b (2) KStG does not apply to capital gain realised by means of a constructive dividend or a constructive contribution (sec. 41 (5) KStR = corporation tax guidelines). A constructive dividend occurs when a German subsidiary sells shares in another corporation to its parent or affiliate at less than fair market value. A constructive contribution occurs where a German parent sells shares to its subsidiary at less than fair market value. Constructive dividends and contributions are in practice hard to avoid in related party transactions, if only because of the difficulties in determining fair market value.

The wording of § 8b (2) KStG under old corporation law makes no mention of constructive dividends or constructive contributions. The new version of § 8b (2) KStG, on the other hand, states that it applies to gains resulting from constructive contributions, but is still silent as to constructive dividends. The new corporation tax law applies to sales of shares in calendar year corporations from 2002 onwards and (generally) to sales of shares in non-calendar year corporations occurring after the end of the fiscal year ending in 2002 (e.g. from 1 July 2002 onwards for a corporation with a fiscal year ending on July 30th).

The case involved the 1995 sale of a 100 % stake in a Polish corporation by a German subsidiary to its U.S. parent company, and was of course subject to the old corporation tax law. The sale took place at book value (DM 38,388). The tax authorities took the position that expenses totalling DM 129,035, which the subsidiary had incurred to build up the Polish corporation, should have been capitalised (added to the subsidiary's basis in the shareholding), hence that the book value should have been DM 167,423. The tax authorities also considered this figure to be the fair market value.

Hence, the tax authorities treated the amount of the underpayment (DM 129,035) as a constructive dividend, increased the subsidiary's earnings for the year by this amount, and assessed tax accordingly.

The German subsidiary appealed the adverse assessment and also filed a motion to stay collection of tax. Under German tax procedure law (§ 361 AO, § 69 FGO), taxpayers are entitled to have collection of tax stayed or, if already collected, to have tax refunded, pending the outcome of an appeal, where "serious doubt" exists as to the legality of the assessment. The determination as to the existence of "serious doubt" is made on a summary basis. Both the tax authorities and the Tax Court denied the motion to stay. The taxpayer appealed the denial to the Federal Tax Court, which handed down the ruling here reported on in an interlocutory proceeding.

The taxpayer (the subsidiary) did not contest the tax authorities' estimation of the fair market value of the shareholding and appears likewise to have accepted the finding that the expenses incurred in connection therewith should have been capitalised. However, the taxpayer argued that no constructive dividend was paid because the excess of fair market value over the selling price constituted a capital gain that was exempt from taxation under § 8b (2) KStG. The tax authorities reiterated the position taken in the corporation tax guidelines (sec. 41 (5) KStR) that the statute did not apply to capital gains resulting from constructive dividends or constructive contributions.

The Federal Tax Court held that the taxpayer was not entitled to a stay of collection because, no matter who was right on the issue of § 8b (2) KStG, no capital gain was realised. By conceding the issues of fair market value and capitalisation of costs, the taxpayer in fact admitted that the book value of the shareholding in question should have been DM 167,423 at the time of sale. Since, after addback of the constructive distribution, the sales proceeds likewise totalled DM 167,423, there was no net gain or loss. Whether § 8b (2) KStG applies to gains realised by addback of constructive dividends was moot, because the addback did not lead to any gain in this case.

While the court could have stopped here, it instead delved into the underlying issue of the proper interpretation of § 8b (2) KStG. After examining the statutes involved, the court concluded that the logic of these statutes indicated that § 8b (2) KStG should apply "not just to the [contractually] agreed capital gain, but also to the capital gain as adjusted for tax reasons" (loc. cit. p. 1941). The court thus indicates that capital gains resulting from both constructive dividends and constructive contributions should be tax exempt where the other requirements of § 8b (2) KStG are fulfilled.

The July 2000 ruling of the Federal Tax Court indicates that the court is prepared to decide against the tax authorities and hold that § 8b (2) KStG also applies to capital gains realised by reason of constructive dividends and constructive contributions triggered by sales or other dispositions of qualifying corporate shares. Where cases posing this issue are pending, the ruling here reported on establishes the existence of the "serious doubt" required by German tax procedure law to obtain a stay of collection of tax (or a refund of tax already collected) until the case is finally decided.

The July 2000 ruling thus diminishes the risks run by corporations relying on § 8b (2) KStG in related party transactions. However, as the facts of the case in question indicate, sales of shares at book value are not entirely shielded from adverse tax consequences by § 8b (2) KStG even when the statute is construed to cover constructive dividends and constructive contributions. Where the correct book value of the shares disposed of is understated, the book value will be adjusted upwards under standard balance sheet correction principles. Only the gain on sale in excess of the true book value enjoys the projection of § 8b (2) KStG as construed by the Federal Tax Court.

Certain caveats are necessary, however. We are reporting here on a summary interlocutory ruling. It is conceivable that the Federal Tax Court would reach another result when ruling on the merits. This appears unlikely, however, given the care with which the present ruling was drafted.

Furthermore, the wording of § 8b (2) KStG has been revised under the new corporation tax law to include constructive contributions (see sec. 1 above). By negative inference from the failure of the legislature to mention constructive dividends in spite of the well-publicised controversy surrounding this issue at the time of enactment of the relevant legislation in 2000, one may argue that constructive contributions are excluded from the exemption under the new corporation tax law. However, we again consider it unlikely that the tax courts would follow this argument, since it would cause the new version of the statute to be more restrictive than the old statute in this one limited respect, whereas overall the new statute is obviously intended to be broader.