Germany: Back Taxes Payable By German Banks Due To Taxation Of Option Premiums On Cash Basis?

Originally published in September 2001

The issue is due to a mismatch of a long standing accounting treatment under German GAAP of option premiums received by banks and of taxation rules proposed by the fiscal authorities first time in 1996 based on the "Dual Contract Theorem" applied by the Federal Fiscal Court to private option transactions. The comments below first outline the German GAAP applicable to option premiums and thereafter the taxation rules.

Option premiums received by banks when writing options are considered under German GAAP as other liabilities in their balance sheet. There is no upfront recognition of income. The liability set up for the option premium received is only released to income at expiry, exercise or closing out of the option transaction. There is also no pro rata recognition as income of the option payments received.

If expected losses out of the option transaction (e.g. in an unhedged situation) exceed the amount of the premiums received, an accrual for pending losses must be set up (§ 249 sec 1 Commercial Code).

It should be noted, that option premiums paid for the purchase of options are taken up in the balance sheet as an asset and are valued according to the lower of cost or market. They cannot be expensed immediately.

A balance sheet drawn up in conformity to German GAAP also forms the basis for taxation, unless specific tax provisions apply (§ 5 sec 1 Income Tax Act).

Until 1996, there was no doubt, that for German tax purposes the taxation of option premiums received adopted the same principles as for German GAAP. Consequently, income recognition for tax purposes followed German GAAP treatment, i.e. income recognition at expiry, exercise or closing out of the option transaction. In 1996, the German fiscal authorities reconsidered the taxation of option premiums received. They maintained, that the so-called Dual Contract Theorem developed by the jurisdiction of the Federal Fiscal Court should be applicable for tax purposes and decisive for the income recognition out of option transactions.

The Dual Contract Theorem of the Federal Fiscal Court is based on an older jurisdiction of the Federal Court. In a case concerning the question whether or not private investors could be held liable by the bank involved for stock option transactions regarding shares and ending in a loss, the Federal Court ruled, that an option transaction (e.g. call option) could be split in two distinct legal transactions or contracts:

1. The purchase contract regarding the acquisition of the option and, independent thereof,
2. the exercise of the option by purchase of the underlying stock.

In the professional literature, this jurisdiction is known as the so-called Dual Contract Jurisdiction. When considering the appropriate tax treatment of options written by private investors, the Federal Fiscal Court adopted in two decisions the Dual Contract Theorem of the Federal Court (decision of 28.11.1984, BStBl 1985 II p 264; decision of 28.11.1990, BStBl 1991 II p 300). The Federal Fiscal Court ruled in these decisions, that a private investor is taxed on premiums for written options as other taxable income (§ 22 sec 3 Income Tax Act) when received, i.e. on a cash basis.

Although these two decisions are in the first instance only relevant for private investors and only define the applicable taxable source of income, the fiscal authorities nevertheless held these decisions also relevant for option transactions entered into in the conduct of a trade or business. This attitude is hard to understand and lacks substance. In three decrees, the fiscal authorities pointed out, that option transactions in a trade or business also need to be considered according to the Dual Contract Theorem of the Federal Fiscal Court (Decree of the Finance Ministry of Hesse of 17 September 1996, Circular Letter of the Supreme Finance Directorate of Cologne of 11 March 1997, Decree of the Supreme Finance Directorate of Frankfurt/Main of 5 June 1997). Based on the understanding, that under the Dual Contract Theorem the option premium is received simply for the willingness to enter into the option purchase contract, the fiscal authorities maintained, that the banks have already fulfilled all their obligations under the option transaction when writing the option. Consequently, as the compensation for writing the option is the option premium received, the fiscal authorities insisted on a taxation of the option premiums on a cash basis, i.e. upfront.

The above rulings of the fiscal authorities do not deal with the issue of accounting for the obligation of the writer of an option e.g. to deliver the underlying asset or to effect cash settlement. For German GAAP, this obligation is considered by setting up for accounting purposes other liabilities in the amount of the option premium received. Any exceeding loss out of the option transactions due to delivery or settlement is considered by setting up an accrual for pending losses (see above). This accrual was also recognised for taxation. However, there is a change in the tax law effective 1997 in respect of the tax recognition of this obligation, which makes the position of the fiscal authorities overall unacceptable to banks.

Effective 1997, accruals for pending losses are no longer tax deductible (§ 5 sec 4a Income Tax Act). When taxing option premiums received on a cash basis, the underlying liability also needs to be considered for tax purposes to achieve equitable treatment based on the economic substance of option transactions.

As financial institutions need to apply risk limitation rules for banking supervisory purposes, they will normally be placed in or enter into a micro- or macro hedge situation when writing options. However, this may not apply or not fully apply to non-regulated business when writing options.

There is a controversial discussion whether or not the liability out of an option transaction to e.g. deliver or to settle needs to be considered for tax accounting purposes either by way of an accrual for pending losses or by an accrual for uncertain liabilities. The difference is, that an accrual for pending losses is not deductible for German tax purposes (see above). On the other hand, an accrual for uncertain liabilities was and is deductible also for tax purposes. However, the fiscal authorities maintain, that the liability in case of an uncovered option transaction needs to be considered as an accrual for pending losses with the effect, that such accrual would not be tax deductible. Such result is unacceptable and does not reflect the economic substance of option transactions.

Accordingly, the option premium would then be recognised as taxable income on a cash basis, whereby the underlying liability in an unhedged situation would not be tax deductible. This would result in a full upfront tax recognition of option premiums received. As such tax treatment is incomprehensible, banks have appealed against tax assessments issued on this basis. The comments below deal with the present stage of jurisdiction in the subject matter and conclusions out of this jurisdiction.

Up to now there exists only one fiscal court decision in respect of the tax treatment of option premiums received by a bank for written options. This is the decision of the Lower Fiscal Court of Munich of 28 November 2000. This decision fully supports on an unreflected basis the view of the fiscal authorities, that option premiums have to be taxed on a cash basis. The tax payer has filed an appeal against this decision with the Federal Fiscal Court in mid 2001.

In its decision, the Lower Fiscal Court points out, that the fiscal authorities have rightly considered the received option premiums as fully taxable when received. The court further outlines, that the plaintiff cannot set up an accrual for uncertain liabilities (which would be tax deductible) in respect of the received option premiums (put/call-options) nor recognise option premiums received for swap-options as deferred income. However, the plaintiff can set up an accrual for pending losses out of these transactions (please note, that such accruals are no longer tax deductible effective 1997 - see above).

The case at issue relates to options received in 1993. The bank involved in this case had written options for stock and debentures and received premiums. In addition, the bank has received premiums for interest swap-options in connection with certain loans.

The bank argued in the case as follows:

• According to German GAAP, the premiums received had to be considered as liabilities as the writer of the option did not yet satisfy his obligation at the time of the conclusion of the option contract. The same consideration should undoubtedly also apply for tax purposes, i.e. treatment of the option premium as a liability.
• The option contract is a pending contract which has only been satisfied by the purchaser of the option (when paying the premium) but not yet by the writer of the option, as he has an ongoing obligation to settle. Only when the option is exercised or expires, the premium received can be released to taxable income of the option writer. There is no room for earlier income recognition.
• According to the jurisdiction of the Federal Court, an option transaction needs to be considered as a uniform transaction. The Dual Contract Theorem of the Federal Fiscal Court does not apply to option transactions in a business or trade, as the Federal Fiscal Court only deals in the respective decision with the taxation of private individuals, where different income recognition rules apply under tax law.
• Even if the Dual Contract Theorem is considered, this does not result in an upfront taxation of the premiums received. The option contract is a pending transaction, where the writer of the option has an ongoing obligation during the life of the option contract, justifying income recognition only at expiry, settlement or closing out.

The fiscal office as defendant maintained as follows:

• The sale of an option is a two-sided contract, which from a legal point of view is already completed by both sides when granting the option right against payment of the premium. Therefore, there is no possibility to set up an accrual for uncertain liabilities.
• The option contract and the subsequent exercise of the option, if any, are not so closely linked that they need to be considered as a uniform transaction. The option premium is earned simply due to entering into the option contract. This view would also be supported by the fact, that the premium paid cannot be reclaimed by the purchaser of the option.

After consideration of both submissions, the Lower Fiscal Court decided that option premiums received are to be recognised upfront as taxable income. The Lower Fiscal Court fully supported the Dual Contract Theorem. The court further referred to the fact, that the plaintiff can set up an accrual for pending losses in respect of his ongoing liability under the option contract. All this is incomprehensible in respect of the substance of option transactions. Another peculiarity of the case is, that although the plaintiff has proposed an oral hearing before a decision, the Lower Court has disregarded this and decided without oral hearing.

From the case of the Lower Fiscal Court of Munich, the following conclusions can be drawn in respect of premiums received by a bank for options written:

• The decision is the first court sentence in this case. However, the decision does not consider the facts and arguments presented by the bank.
• As the Lower Fiscal Court did not invite to an oral hearing, the bank could also not explore the possibility to explain in its case how option transactions are executed today at stock exchanges and the resulting tax consequences.
• Without further reflectiveness, the Lower Fiscal Court adopts the Dual Contract Theorem of the Federal Fiscal Court developed in a case concerning a private individual, whereas the plaintiff in his submission provided detailed arguments, why the Federal Fiscal Court decision does not apply to option transactions in a trade or business.
• In substance, the decision of the Lower Fiscal Court is not convincing at all as there is no detailed discussion how modern option business is executed and which tax impact results therefrom. In addition, the decision lacks an independent detailed discussion of the view of the fiscal authorities.

Based on this, it is therefore not surprising, that the plaintiff filed an appeal against the sentence with the Federal Fiscal Court. In addition, a similar case is now pending with the Lower Fiscal Court of Hamburg.

The point at issue is the taxation of option premiums received for the years 1991 to 1993. It can be expected, that an oral hearing will take place in this case, giving the bank the opportunity to detail its arguments. A sentence of the Lower Fiscal Court may be expected later this year or early next year. If the sentence supports the position of the bank, the fiscal authorities are going to appeal. On the other hand, if the decision supports the view of the fiscal authorities, the bank will no doubt appeal.

The case pending with the Lower Fiscal Court of Hamburg will give the bank the opportunity to underpin by the following course of action that a tax deductible liability needs to be set up for option premiums received:

• Sustain the position already described in a detailed submission of the Association of German Banks on 19 December 1997 to the Federal Finance Ministry. In this submission, the Association requested to continue with the present German GAAP treatment also for tax purposes and to set up either a tax deductible liability or a tax deductible accrual for uncertain liabilities. This submission is until today left unanswered by the Federal Finance Ministry, although there have been some discussions between both institutions.
• To maintain that the Dual Contract Theorem of the Federal Fiscal Court in the decision of 28 November 1990 issued in the case of private individuals engaged in option transactions cannot at all be considered as relevant for the accounting treatment or tax treatment of option transactions in a trade or business.
• To sustain, that in substance the liability of the writer of an option is his ongoing obligation to e.g. deliver the underlying (call-option) or to get the underlying delivered (put-option) over a defined period of time, which excludes upfront income recognition from an economic point of view.

In respect of the Dual Contract Theorem the following needs to be said and will no doubt be brought into the case:

• All cases dealing with option transactions by the Federal Court or the Federal Fiscal Court do not deal with the present type of option transactions with execution via the German Futures Exchange or Eurex. The Federal Fiscal Court decision of 28 November 1990, which forms the basis of the view of the fiscal authorities only concerns transactions in the older years 1976 to 1979 or in 1981, where option transactions relating to stock were executed in a traditional style. The German Futures Exchange did not exist at that time.
• The Federal Fiscal Court decision dealing with option transactions of a private individual only refers to options on quoted stock which had to be delivered or to be received and which was in fact delivered or received in the transaction. Modern type option transactions at the German Futures Exchange or Eurex do not only comprise option transactions with stock but also options concerning interest derivatives, indices etc on a standardised basis. For all these transactions, the exercise of an option with delivery of the underlying is a rare exception, the cash settlement by closing out of an option transaction a usual standard. Such closing out transactions were not possible for option transactions entered into in 1976 to 1981, which were considered as the basis of the above Federal Fiscal decision.
• In the option cases decided by the Federal Court or the Federal Fiscal Court the writer of the option and the purchaser were as a rule different persons. The contracting party for option transactions at the German Futures Exchange or Eurex is for the opening as well as for the closing transaction always the German Futures Exchange or Eurex, i.e. the same person.

The Dual Contract Theorem was developed by the Federal Fiscal Court in relation to transactions which since more than ten years are no longer the standard for the execution of option transactions at the German Futures Exchange or Eurex. Since then, option transactions are usually terminated by closing out against cash settlement. An artificial split of a uniform option transaction in two separate legal contracts is therefore not possible in the case of such standard option transactions, especially in view of their execution technique at the German Futures Exchange or Eurex.

As the decision of the Lower Fiscal Court of Hamburg will be appealed by the bank or by the fiscal authorities, the Federal Fiscal Court will have an opportunity to decide on two option cases at the same time, namely the option case of the Lower Fiscal Court of Munich and of the Lower Fiscal Court of Hamburg. The Federal Fiscal Court should be fully aware of the importance and the impact of its decision for the banking industry. It is expected that the Federal Fiscal Court will give a very detailed consideration to the legal and economic substance of option transactions when ruling on the tax consequences.

The view of the fiscal authorities requiring a taxation of option premiums received on a cash basis results in a mismatch of the accounting and the tax treatment. For accounting purposes under existing German GAAP, there is no other choice than to recognise the option premiums received as other liabilities. For tax purposes, there will be an up-front taxation whereby in an unhedged situation in cases where losses exceed the option premium an accrual for pending losses can be set up. As pointed out above, under German tax law effective 1997, such accrual is no longer tax deductible. The combined result disregards the economic substance of option transactions and does not lead to an equitable tax treatment. Overall, a tax treatment of option premiums according to the above described view of the fiscal authorities will have the following impact:

• Upfront taxation of the option premiums at normal German income tax rates on a current basis.
• The fiscal authorities are trying to apply their view also to tax periods where no final tax assessment yet exists. They insist on the above discussed tax treatment for tax periods under tax audit review, which could comprise fairly old years, in individual cases years from 1993 onwards.
• For such periods back taxes have to be paid at the then (old) applicable high tax rates (aggregate income tax charge of deductible trade tax, non-deductible corporation profits tax and solidarity surcharge thereon) resulting a tax charge of 50% or more.
• For these back taxes, interest on tax is payable at a rate of 6% p.a. The interest period starts 15 months after the end of the respective tax year. Under the new interest on tax rules, there is no time limit when interest period ends and the interest is also no longer tax deductible.

As the accounting treatment of option premiums received as a liability continues, the upfront taxation results in the commercial statements in a deferred tax asset. However, this does not exclude the detrimental effect on the commercial profits or the commercial equity for the following reasons:

• Depending on the duration of the interest carrying period, the interest on tax charge could be significant.
• The upfront taxation is reversed, once the option transactions expire or if there is a closing out. However, such reversal may take place in long term option transactions in tax periods where lower tax rates apply (i.e. 2001).
• Assuming, the taxation relates to long term option transactions, tax would have been paid by the bank in the amount of 50% or more. If a transaction reverses or is closed out in years starting 2001, the applicable tax rate is only about 40%.

Depending on the amount of option premiums received - which will be some billion Euros in bigger cases - there could be a very high upfront tax charge which need to be financed, a significant interest amount on back taxes and a negative tax impact overall due to lower tax rates applicable at expiry of the option transaction.

Due to this serious financial impact, the German banking industry is up to now disregarding the view of the fiscal authorities and insists on a taxation treatment of option premiums received according to German GAAP.

It appears, that up to now all German banks have considered option premiums received as liabilities also for taxation purposes. Consequently, such option premiums are in practice only released to taxable income at expiry of the option transaction, at exercise or at closing out.

To the extent accruals need to be set up in an unhedged position, the German banks and the professional literature are with sound arguments of the view, that such accruals constitute tax deductible accruals for uncertain liabilities. This is contrary to the position of the fiscal authorities which insist, that such accruals are (non-deductible) accruals for pending losses. This unreflected position leads to a non acceptable level of taxation of option transactions.

In all option cases at hand until now, the question of how to treat option premiums paid in the balance sheet of the purchaser have not been considered an issue. Both for accounting and for tax purposes, option premiums paid are regarded as an asset to be valued at the lower of cost or market. In other words, there is no upfront deduction of the option premium paid possible.

Based on the development of two Lower Fiscal Court cases described above, it can reasonably be expected, that the Federal Fiscal Court will have on its table two cases early 2002. Due to the importance and the impact of the decision on the banking industry, it can further be expected, that the Federal Fiscal Court will speed up court proceedings. Whereas the normal term for a case with the Federal Fiscal Court is on average about three years, it can be expected, that there will be a much shorter period in the option case. In a best case scenario, a decision may well be available close to year end 2002 or early 2003 and be based on the economic substance of option transactions rather than artificial legal arguments.