Germany: Germany - Still a Good Place from a Tax Perspective for the Option Business of Banks?

By decision of 18 December 2002, the German Supreme Tax Court held that the option premium received by the writer of an option (call or put) should be recorded as a liability in his books and only taken to income when realised. Under the date of January 12, 2004 the Ministry of Finance issued a decree recognising the Supreme Tax Court decision in principle but disallowing a tax deduction for risks from the option transaction exceeding the amount of the option premium. This article discusses the tax implications for banks of the decision and the decree in view of the limitation of tax loss utilization effective 1 January 2004. From Hans-Jürgen Hennig of PricewaterhouseCoopers.

The Supreme Tax Court Decision of 18 December 2002

On 18 December 2002 the Supreme Tax Court decided that the option premium received by the writer of an option should not be taken to taxable income until realised. Realisation in this sense is the exercise or expiry of the option, as only then the writer has no longer obligations under the option contract.

This decision put an end to six years of controversial discussion and defeated the position of the German tax authorities maintaining since 1996 that the option premium constitutes taxable income for the writer of an option already when received (upfront taxation).

The Supreme Tax Court dealt mainly with the old style option transactions, i.e. options actually exercised. However, in practice, options in the financial services business are rarely exercised but terminated by cash settlement or by closing out prior to the maturity of the option.

Another important feature of the decision is the question of the recognition of the expected risk of the writer of an option exceeding the amount of the option premium. The risk could be an actual risk, if e.g. there is no or only a partial hedge. Such risk could derive from the financial statements when e.g. options and the underlying are valued separately under German GAAP.

The Supreme Tax Court did not decide by sentence how such expected exceeding risk needs to be recognised for tax purposes. In the reasons to the decision the Court left open whether such exceeding risk should be reflected by setting up a non tax deductible accrual for anticipated losses out of pending transactions (Drohverlustrückstellung) or as a tax deductible liability accrual (Verbindlichkeitsrückstellung) in the writer's books.

Basis of the decision of the Supreme Tax Court regarding the recognition of the option premium as a liability was the accounting treatment of option business under German GAAP. A fundamental principle of German GAAP is that unrealised gains are disregarded when valuing assets or liabilities whereas unrealised losses must be considered. With certain exceptions enumerated in Sec 5 and 6 of the Income Tax Act these accounting principles also apply for tax purposes.

However, one of the exceptions for tax purposes relevant here is that accruals for anticipated losses out of pending transactions cannot be considered for tax purposes. Therefore, such accruals included in the German GAAP balance sheet for option risks have to be released to taxable income. Only if such losses actually occur, e.g. by closing out of the underlying option transaction, such losses then realised can be considered for German tax purposes as deductions.

This tax treatment of unrealised risks exceeding the amount of the option premium therefore results in a tax disadvantage for the option business of banks.

Following the above decision of the Supreme Tax Court, the German Tax Administration refrained from further pursuing that option premiums have to be taken to income already when received.

They accepted the Supreme Tax Court decision for the recognition of the received option premium as a liability until exercise or expiry of the underlying option transaction (or close out by offsetting transaction etc).

However, they confirmed in the Decree of 12 January 2004 that any expected loss over and above the amount of the received option premium should be treated as an anticipated loss from pending transactions which is not deductible for German tax purposes although accrued for German GAAP (see above).

As outlined above, the decision of the Supreme Tax Court did not form a final view on the appropriate treatment of such expected exceeding losses for tax accounting purposes. The position of the Ministry of Finance is therefore a one-sided view which can only be explained by fiscal reasons.

A taxation of option transactions according to their economic substance must consider the risk of the writer of an option over and above the premium received in a tax deductible manner, i.e. by recognising a tax deductible liability accrual for the complete risk that results from the option transaction.

The view of the Ministry of Finance in the decree of 12 January 2004 is a threat to the volatile option business of banks leading to substantial tax disadvantages depending on the volume, the structure and the duration of the individual option business.

This is demonstrated by the following table. There, the expected loss exceeding the option premium received is not recognised for tax purposes in year 1 because of being an anticipated loss from pending transactions. This loss is realised and therefore considered as a deduction for tax purposes only in year 2 where a close out is made by the writer of the option.

The above example demonstrates that in year 1 the tax charge results in a net loss which runs against equity unless this is restored e.g. by a sufficient shareholder contribution in year 1.

The result becomes even worse if different tax rates in the individual years are applicable. In addition, there is a further severe disadvantage arising from the tightened loss carry forward rules effective 1 January 2004 (see below).

In view of the above detrimental result for tax purposes, it should be noted that for tax recognition of the option writer's risk the argument can be made that the Ministry of Finance Decree does not refer to the modern type of option transactions and their economic substance as a margin business. In practice, the overwhelming majority of option transactions is settled by cash settlement without delivering of the underlying or by entering into a closing out transaction prior to maturity. Therefore, there is sufficient ground for the argument that any risk of the writer of an option over and above the option premium received by him needs to be considered by a tax-deductible liability accrual.

Under the new rules for tax loss utilisation only 60% of profits can be set off against loss carry forwards.

If there is a relevant option business of the individual financial institution, there could be significant tax disadvantages. Even in the best case scenario of subsequent profits exceeding the loss, an unacceptable tax rate arises due to the limitation of loss utilisation effective 1 January 2004 as outlined in the table below:

The above example assumes a realised 2004 loss e.g. out of the option business.

In 2005 the bank achieves profits of 100 (case a), 119 (case b), 140 (case c) or 167 (case d).

The above loss carry forward limitation to 60% of subsequent profits results in case a) in a loss of 16 due to tax payment. Only 60% of the 2005 profit, i.e. 60, will be eliminated from the tax base 2005 due to the loss carry forward from 2004. As a result, a taxable income of 40 and a tax of 16 arises, which constitutes an unlimited tax rate and reduces the equity.

In case b) a tax rate of 100% results, in other words, the economic profit is fully wiped out by the tax arising due to limited loss utilisation.

Case c) and case d) present a better picture regarding the tax rate effect in 2005. However, only when the profit 2005 substantially exceeds the loss carry forward (see case d), the statutory German tax rate of 40% can be achieved.

The above table clearly demonstrates the real tax cost due to the tightened loss utilisation rules effective 1 January 2004. A profit of 167 needs to be earned for full loss carry forward absorption.

In the decision of 18 December 2002, the Supreme Tax Court referring to old style option transactions decided that the option premium received by the writer of an option should be recorded as a liability. This clarifies a controversial issue.

The Ministry of Finance in the Decree of 12 January 2004 maintains that the expected risk of the writer of an option over and above the option premium received can only be reflected by a non tax deductible accrual for anticipated losses out of pending transactions. This view is detrimental to the banks.

Such treatment, together with the tightened loss utilisation rules effective 1 January 2004 results in a severe tax disadvantage.

A potential solution against the detrimental treatment of unrealised losses for tax purposes could be to realise losses by closing out or by transferring the option position within the group. But even in this case, the above discussed 60% limitation regarding the utilisation of loss carry forwards could result in unacceptable tax rates.