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1. New directive issued

In article no. 67 we reported on a directive issued by the Munich Regional Tax Office relating to a controversy which has existed for some time in Germany regarding the possible gift tax consequences of transfers by shareholders to corporations for less than full consideration. We noted at the end of the article that other German states may soon take a position on the issue as well.

In March 1997, a so-called coordinated all-state directive was issued by the tax authorities of all German states which deals comprehensively with gift tax issues raised by inter vivos transfers to corporations (directive of 15 March 1997 - DStR 1997, 540; hereinafter "the directive"). Since under German law gift tax (like inheritance tax) is triggered when either the donor (decedent) or the recipient is a German person (sec. 2 par. 1 ErbStG), the problems involved are not confined to transfers to German corporations or by German persons. They can be posed as well when a German person makes a transfer to a foreign corporation, or when foreign persons make transfers to German corporations (corporations either formed under German law, hence having their registered office in Germany, or corporations with their principal place of management in Germany).

The directive agrees with that of the Munich Regional Tax Office in that it would not treat a transfer by a sole shareholder to a corporation as a taxable gift to the corporation. In fact, the directive states categorically that a transfer by shareholders to the corporation in which they hold shares never constitute a taxable gift to the corporation because the transfer is motivated by the corporate relationship and hence lacks the required donative intent.

2. Treatment as gift taxable to the other shareholders

The main thrust of the directive is to treat transfers to corporations as taxable gifts to the shareholders of the corporation in a wide variety of circumstances. In as much, the directive contradicts the Federal Tax Court which held in its decision of 25 October 1996 (BStBl II 1996, 160; also reported on in article no. 67) that a transfer to a corporation is received by the corporation, not by its shareholders, and that respect for the separate legal identity of the corporation precluded treatment of such transfers as indirect gifts to the shareholders, even though they might be benefited thereby. In the court's view, the legal cause of any increase in the value of their shares in the corporations was their shareholder status, not receipt of a taxable gift.

Given the conflict between the directive and the case law, taxpayers would be well advised to appeal any assessments made on the basis of the new directive, which seems certain to give rise to litigation.

The directive thus rests on a questionable legal foundation, namely that a transfer to a corporation can constitute an indirect gift to its shareholders. Even if the indirect gift theory is upheld, a particular transfer must still be subjectively motivated by donative intent in order to come under the gift tax law. The issue of intent is examined on the basis of the objective circumstances.

3. Details of the directive

A distinction is drawn between transfers to corporations by shareholders on the one hand and by non-shareholders on the other. As to transfers by shareholders, the directive further distinguishes between shareholders related by blood, marriage, or marriage-like ties on the one hand and shareholders who are not so related on the other. Whether by intention or clumsiness of drafting, the directive speaks generally of related and unrelated shareholders in the sense described instead of focusing on the relation or non-relation of the shareholder who has made the transfer in question to the other shareholders, which would seem to be the only aspect of possible legal relevance.

For non-related shareholders (which we would interpret as meaning a transfer made by a shareholder who is not related to any of the other shareholders irrespective of their relation to each other), the directive states that the tax authorities are to assume that donative intent is lacking as to the transfer, hence that it is of no gift tax relevance. Only where the transfer is conspicuously large in amount and difficult to explain in terms of the isolated interests of the transferor does the directive instruct the tax authorities to consider whether donative intent may in fact exist.

For related shareholders, the approach is the exact opposite. The directive provides that a "rebuttable factual presumption" arises merely by reason of the interrelationship of the shareholders (or of the transferring shareholder and the other shareholders) that the transfer is intended as an indirect gift to the other shareholders (donative intent). One may question whether a "rebuttable presumption" established by administrative fiat has any effect on the allocation of the burden of proof in litigation.

The directive does not discuss the possibility that some, but not all of the shareholders may be related to each other. This circumstance would presumably be weighed with all the other facts.

The directive treats at some length various forms of transfers to corporations for less than full consideration: constructive contributions with and without subsequent distribution to certain shareholders, contribution of the use of an asset without ownership thereof (including interest-free or low-interest loans), contributions in kind valued under the full value of the contributed asset, selective issuance of new shares at under full value (to benefit the subscriber) or at above full value (to benefit the other shareholders), non-exercise of preemptive rights, redemption of shares, acquisition by the corporation of its own outstanding shares pursuant to a shareholder's withdrawal or exclusion or pursuant to cancellation of his or her shares.

If a taxable gift has occurred, the directive makes clear that its value is not to be equated with that of the transfer received by the corporation, but rather depends on the increase in the value of the shares of the benefited shareholders which results from the transfer. (An exception can apply where the transfer is followed by a distribution.) For corporations whose shares are not traded on public exchanges, this increase in share value is in turn to be determined under the so-called Stuttgart Procedure, a carefully defined valuation procedure which arrives at the value of a company by combined consideration of asset value and capitalised earnings value. The Stuttgart Procedure is popular with the tax authorities because it avoids dispute and with taxpayers because it operates predictably, hence permitting planning, and tends to yield fairly conservative results for most companies.

If the taxable gift is a distribution instead of an increase in the value of the shares, the directive states that the gift is the amount of the distribution without creditable corporation tax but including withholding tax.

With regard to transfers to a corporation by a non-shareholder, the directive instructs the tax authorities to identify the actual intent of the transferor on the basis of the objective circumstances and to consider whether a gift to the corporation or to some or all of its shareholders could be involved. The directive states that one should as a rule assume that the transferor intends to enrich individuals (natural persons) as opposed to legal persons.

The tax authorities do not intend to grant the "anticipated inheritance" benefits under sec. 13a ErbStG for indirect gifts to shareholders through a corporation. See section 9.4 of article no. 58 on the 1997 Annual Tax Act for a short discussion of the anticipated inheritance benefits.

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