Thomas Sauter, KPMG Frankfurt

For editorial cut-off date, disclaimer, and notice of copyright see end of this article.

1. New loss utilisation decision

The lead article of German News no. 3/1998 (sec. 2.2 of article no. 148) reported on the Federal Tax Court (FTC) judgement of 13 August 1997 construing the term "new business assets" (neues Betriebsvermögen) in § 8 (4) KStG, a statute designed to prevent the loss carryforwards of corporate shells from being used for tax avoidance purposes. In August 2001, the Federal Tax Court rendered its second major decision on § 8 (4) KStG (judgement of 08 August 2001 – I R 29/00 – DStR 2001, 1974). This decision likewise focuses on the injection of new assets.

The manner in which an injection of new assets is defined for purposes of § 8 (4) sent. 2 KStG has considerable impact on the practical consequences of the statute. This issue takes on even greater significance when one considers that it is a likely focus of pending and future tax audits.

The Federal Tax Court's comments on the term "new business assets" will have considerable impact on the method by which newly injected assets are counted and hence on the extent to which new assets are found to have been injected. The Federal Tax Court abandons the approach previously supported by the majority opinion under which only net asset increases with reference to a specific balance sheet date were relevant. Furthermore, the Federal Tax Court treats transactions as constituting injections of new assets within the meaning of § 8 (4) KStG which even the tax authorities had not previously regarded as such.

The Court does not address the potential unconstitutionality on formal grounds of the present § 8 (4) KStG. This issue is accordingly still open (See Dieterlen/Schaden, DStR 2001, 253 and the FTC ruling of 29 November 2000, DStR 2001, S. 253).

2. Text the statute

§ 8 (4) KStG reads as follows:

Loss deduction under § 10d of the Income Tax Act on the part of a corporate entity is contingent upon its being not just legally, but also economically identical to the corporate entity which suffered the loss. Economic identity is not present in particular when more than half of the shares in a corporation are transferred and the corporation continues or recommences its business (Geschäftsbetrieb) with predominantly new business assets (Betriebsvermögen). The injection (Zuführung) of new business assets is not damaging if the sole purpose served thereby is the rehabilitation (Sanierung) of the business which caused the remaining deductible loss within the meaning of § 10d (3) sentence 2 of the Income Tax Act and the corporate entity continues to operate the business on a comparable scale, in light of the overall economic circumstances, during the following five years. The same shall apply mutatis mutandis with respect to the offsetting of loss [incurred] from the beginning of the fiscal year to the time of share transfer.1

For more background on § 8 (4) KStG, see KPMG German News nos. 3/1998 p. 2, 2/1999 p. 9, and 2/2001 p. 20 (articles nos. 148, 176, and 228 respectively).

3. Previous method for determining injections of new assets under § 8 (4) KStG

There are many unanswered questions with regard to injection of new fixed or current assets under § 8 (4) KStG. To date, neither the courts nor the tax authorities have resolved the controversial issues. With regard to fixed assets, the tax authorities have up till now applied the so-called "addition method" (see e.g. Dötsch marginal no. 545 on § 8 KStG). With regard to current assets, the prevailing view in the literature – shared even by high-ranking officials in the tax administration – has been that one must compare net current assets at the time of the relevant change in the corporation's ownership with subsequent net current assets.

The prevailing view in the literature furthermore accorded with the position taken by the tax authorities (cf. Federal Ministry of Finance directive of 16 April 1999, BStBl I 1999, p. 455, sec. 9). They treated injections of new assets as damaging for purposes of § 8 (4) KStG only to the extent they resulted from fresh debt or from shareholder contributions, as opposed to being self-financed, for instance, out of profits or by means of asset swaps.

4. FTC judgement of 8 August 2001 – impact on the determination of asset injections within the meaning of § 8 (4) KStG

4.1 Rejection of net balance sheet approach to determining asset injections

In its judgement of 8 August 2001, the Federal Tax Court takes the position that newly injected assets predominate within the meaning of § 8 (4) KStG not just when the net value of assets acquired less assets disposed of exceeds that of the original assets, but also when the gross value of newly injected assets exceeds that of the pre-existing assets.

The court takes a specific-asset approach in determining when newly injected assets predominate. Accordingly, the court rejects the position that the net value of the various balance sheet items is controlling. Under the Court's view, asset disposals are irrelevant, whereas under the net balance sheet approach, which looks to the difference between balance sheet items at the end and at the beginning of a fiscal year, disposals would reduce the value of the newly injected assets. If one follows the Court's approach, the value of newly injected assets would have to be determined by totalling all additions to current or fixed asset accounts as recorded on the relevant accounts (before transfers and reclassifications). In spite of all the arguments that can be raised against such an approach, including the practical difficulties of implementation, there presently exists a strong possibility that the tax authorities will adopt this procedure and apply it accordingly on all audits still open or that have yet to commence.

With respect to fixed assets, the specific-asset approach was advocated by certain commentators even prior to announcement of the Federal Tax Court's decision of 8 August 2001. In its statement of grounds (sec. B (4) (b) (aa) thereof), the Court states the following:

"Accordingly, the economic identity [of the corporation that incurred the losses with the corporation that is seeking to deduct them] must be affirmed as long as the business is operated using predominantly assets (fixed assets) that were present prior to the change in ownership."

Other aspects of the court's reasoning and the fact that, in our opinion, the newly injected asset in question was a debt claim properly classified as a current asset, create doubt whether the parenthetical use of the words "fixed assets" in the above sentence can be taken to mean that the specific-asset approach is limited to fixed assets and does not extend to current assets.

4.2 Injection of new assets through asset swap

In the case decided by the Federal Tax Court, the corporation (GmbH) that the court found to have forfeited its economic identity under § 8 (4) KStG held a debt claim against its former parent company (due to losses assumed by the parent). In conjunction with the change of ownership, the GmbH assigned its claim against its former parent company to its new parent company and took a claim against its new parent in return. The Federal Tax Court regarded this as an injection of new assets.

The Federal Tax Court is thus of the opinion that even a straight asset swap constitutes an injection of new assets. The position adopted by the Federal Tax Court goes well beyond the definition of newly injected assets previously applied by the tax authorities. The tax authorities only treated assets as newly injected if they were acquired using outside debt financing and/or through shareholder contributions.

After the decision of the Federal Tax Court, it must be assumed that asset injections will be evaluated solely on the basis of the specific-asset approach, and that this will mean the inclusion of assets acquired by the corporation through asset swaps or otherwise self-financed.

4.3 Guarantees and pledges of security for bank loans as transactions equivalent to injection of new assets

Subsequent to the change of ownership, the new parent company posted security to finance the purchase of merchandise by the corporation and made guarantees for its benefit. In the view of the Federal Tax Court, the extension of guarantees and pledges of security for bank loans can constitute transactions equivalent to the injection of new assets. By basing this holding on the general clause found in § 8 (4) sentence 1 KStG, as opposed to the narrower wording of this provision's sentence 2 ("... economic identity is in particular not present when ...."), the Court opens up the possibility of treating other situations previously thought to be outside the statute as "equivalent transactions".

Under the specific-asset approach adopted by the Court, merchandise purchased using the proceeds of a bank loan would appear to lead to a double injection of new assets. On the one hand, the disbursement of the loan would increase liquid funds. On the other, the use of these funds to purchase merchandise would increase inventories and constitute a second injection of new assets. To the extent the bank loan was covered by guarantees or other securities, these would seem to constitute yet another injection of new assets under the view espoused by the Federal Tax Court.

Even under this view, account would still have to be taken of loan collateral existing prior to the change of ownership for purposes of calculating the so-called "Comparison Figure I" (Vergleichsgröße I).

5. Summary

The Federal Tax Court judgement of 8 August 2001 considerably expands the concept of "injection of new business assets" compared with the previously prevailing views. The new decision neither provides a comprehensive definition of the injection of new business assets nor prescribes a detailed method by which to determine when such injections occur. Still, the decision shows that the net balance sheet item approach formerly advocated by a majority of commentators at least with regards to current assets is incompatible with the Court's reading of the law.

It is not presently possible to know whether and to what extent the tax authorities will adopt the approach to newly injected assets laid down by the Federal Tax Court, nor can one say what precise effect this would have on the rules by which the tax authorities determine injections of new business assets in specific circumstances. There is, however, reason to apprehend that the tax authorities will adopt the legal positions taken by the Court, which would lead to considerably higher valuations of newly injected current assets compared with the net balance sheet item approach.

Whether the Federal Tax Court is prepared to apply in an explicit manner the treatment of current assets that is implicit in its present decision is an interesting question, the resolution of which will have to wait until a appropriate case comes before the Court. Were the Court to do so, this would mean that, whenever more than half of an active corporation's shares change hands within a five year period, it would only be a matter of time before newly injected assets predominated and the corporation forfeited its loss carryforwards. Normal business operations would result in a steady accumulation of newly injected current assets such as inventories, merchandise, bank deposits, and debt claims.

While this would contravene the legislative purpose of § 8(4) KStG, the Federal Tax Court decision here reported on points in this direction. The judgement will thus result in further uncertainty in the area of loss utilisation planning and necessitate a critical review of existing strategies.

Editorial cut-off date: 20 March 2002

Disclaimer and notice of copyright

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1 Unofficial translation.