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1. Current corporate loss carryforward provisions
The 1990 Tax Reform Act repealed the previous five year time limit for use of loss carryforwards and permitted net operating losses to be carried forward indefinitely for income, corporation, and trade tax purposes. For income and corporation tax purposes, the indefinite carryforward applied to losses which could not be carried back to either of the two years preceding that in which they were incurred. The trade tax has no loss carryback provision.
In part in reaction to a recent development in the case law and in part out of general fear that the ability to carry losses forward without time limit might invite trafficking in loss carryforwards attached to corporate shells, the legislature also added a new provision to the corporation tax law in 1990 which provided that a corporation is only entitled to a loss carryforward (or carryback) if it is economically, as well as legally, identical to the entity which incurred the loss (sec. 8 (4) KStG).
The requirements of sec. 8 (4) KStG for "economic identity" were tightened with effect from the tax year 1997 onwards as a result of the "Act for the Further Reform of the Taxation of Enterprises" which entered into force on 31 October 1997 (see articles nos. 80 and 99). As Manfred Orth points out in his recent article on the loss utilisation amendments (DB 1997, 2242), the new restrictions may well have been motivated by the 1992 corporation tax statistics released in the summer of 1997 showing that in the year 1992 corporations alone had already accumulated loss carryforwards of DM 251 billion. Orth reminds us as well that an even more restrictive loss carryforward provision was contained in the tax legislation which failed to win the approval of the Federal Council (see article no. 70, sec. 3) and surmises that this provision or something similar to it may be part of the next major tax bill passed.
2. Recent decision interpreting loss carryforward provisions in force through 1996
The Federal Tax Court recently handed down its first judgement interpreting the loss carryforward restrictions in force through 1996 (BFH DStR 1997, 1843 - 13 August 1997). While the case involves neither large sums nor a typical "big business" context, it provides guidance on a number of key issues. Most importantly, it evidences a determination of the part of the tax courts to construe the requirements of "economic identity" as tightly as possible.
2.1 Requirements for economic identity through 1996
The previous version of sec. 8 (4) KStG first provides that a corporation is only entitled to utilise a loss carryforward or carryback (or the loss for the year in progress) if it is economically identical to the corporation which incurred the loss. Instead of defining "economic identity," the statute describes by way of example a situation in which economic identity is forfeited. Accordingly, economic identity is not present when:
i. More than 3/4 of the shares in a corporation change hands and
ii. The corporation thereafter recommences its business activity and
iii. Uses predominantly new business property (Betriebsvermoegen) in so doing.
While the law provides an example instead of a definition, the example nevertheless sets the standard by which other situations leading to loss of economic identity are judged.
2.2 Facts of the Federal Tax Court decision
X-GmbH was organised in 1987 with the statutory minimal capital of DM 50,000 as a suntan and fitness studio under the management of its sole owner, Mrs. T. By the end of 1989, the GmbH had lost about DM 140,000 and had negative net worth of DM 90,000. In October 1989, Mrs. T sold a 10 % share in the GmbH to Mr. N at face value (DM 5,000). Mr. N also loaned Mrs. T the sum of DM 45,000. The articles of incorporation were amended to extend the business purpose to include "gastronomic consulting and services" and to provide that unanimity was required for all shareholder resolutions. Dispositions (sale, assignment, pledge, loan) of shares in the GmbH were made subject to shareholder approval. Mr. N personally guaranteed the entire bank debt of the GmbH as of 31 December 1989 (some DM 208,000).
The GmbH discontinued its suntan and fitness studio business as of November 1989. It sold the equipment used in this business at a loss, gave notice on its lease, and moved to new premises the same year. The gastronomic consulting business was started up in 1990 and proved to be profitable.
At the end of February 1991, sixteen months after sale of the initial 10 % interest, Mrs. T sold Mr. N the remaining shares in the GmbH at face value (DM 45,000). Payment was effected by cancellation of Mr. N's debt claim against Mrs. T. Mr. N became the new general manager and X-GmbH was renamed "N-GmbH". The business purpose was again changed to relate exclusively to gastronomy.
The GmbH deducted the losses incurred from 1987 to 1989 on its tax returns for 1990 and 1991. The tax authorities denied the deduction and were upheld by the Tax Court (DStRE 1997, 158).
2.3 Court's holding and analysis
The Federal Tax Court affirmed the lower court's decision and held that deduction of the loss carryforwards was barred under sec. 8 (4) KStG because the GmbH was, from 1990 on, not economically identical to the entity which had incurred the losses. The court found that all three statutory elements required for a break in economic identity were fulfilled.
Recommencement of business activity:
It is was obvious that X-GmbH had discontinued its suntan and fitness studio business in November 1989 and commenced an entirely new business a few weeks later. A business is discontinued when its selling activity ceases, not when the winding up phase, which may be protracted, is finally concluded.
Use of predominantly new business property:
This aspect was problematic because there was apparently no infusion of new capital into the company. It seems that the personal guarantee of Mr. N kept the banks from foreclosing on their loans and that, with the help of the liquidity raised from selling the equipment of the old suntan studio, the company was able to operate its gastronomy business. This business generated profits, hence there was no need for additional capital.
The court stated that, while the term "business property" (Betriebsvermoegen) was often synonymous with "equity" in other contexts, here the logic of the statute required "business property" to be construed as referring only to the asset side of the balance sheet. We quote: "The Court understands the factual findings of the lower court to be that the business property of the terminated business was sold by and large. It was not used in the new business.... The newly started business was operated by and large using newly provided (neu zugefuehrte) assets." This affirms the position taken by the tax authorities in their controversial 1990 directive (BStB1 I 1990, 252).
While it does not come right out and say so, the court thus appears to believe that it is above all the fixed assets which decide whether a recommenced business uses "predominantly new business property" or not. If more than half of the fixed assets are new, this would appear to fulfil the element in question.
The court's justification for looking only to the asset side of the balance sheet (which we think is tantamount to looking to fixed assets) is that otherwise sec. 8 (4) KStG could be easily avoided by purchasing new business property with borrowed funds. Obviously, equity will not be affected by a loan of funds.
Transfer of more than 3/4 of the shares in the company
Transfer of more than 3/4 of the shares in the company did not occur until February 1991. This was more than 16 months subsequent to the recommencement of the business and hence not legally relevant since the transfer must precede the recommencement.
However, the court in effect held that the legal position acquired by Mr. N in October 1989 was tantamount to purchase of the entire company at this date. It called attention to the changes in the articles of incorporation to require unanimous shareholder resolutions and noted that the later purchase of the rest of the shares was accomplished by cancelling a loan extended in 1989. (The court could also probably have noted that, at the time of sale, a 90 % interest in the GmbH was worth more than the face value of the shares because the company had been earning profits for two years straight.) Above all, the court inferred that purchase of the company must have occurred as an economic matter in 1989 because there was no other reason why Mr. N would have guaranteed the debt of an entity with negative net worth and nothing of value except its loss carryforward. The fact that Mr. N later assumed full management control was cited as evidence that it was his know-how and energy which had guided the company in fact from 1990 on. Hence, he was regarded as having acquired economic ownership of the GmbH in October 1998.
2.4 Comments on the court's holding
The most significant aspect of the court's holding is its understanding of the term "new business property" within the meaning of sec. 8 (4) KStG. Here the court establishes a criterion which is at the same time objective and very strict.
The court's understanding of the term "new business property" also differs from that which we employed in our previous article on the "Act for the Further Reform of the Taxation of Enterprises" (article no. 80) in which we interpreted the term as referring to capital, whereby we meant to include both equity and possibly debt capital. The court definitely appears to have rejected this reading of the law, however.
The specific circumstances leading the court to conclude that economic ownership had passed considerably in advance of the transfer of formal ownership are unlikely to reoccur in the same constellation in future cases. The significant fact here is the court's willingness to look critically at attempts to conceal passage of economic ownership until sometime after the recommencement of the business.
3. Loss utilisation from 1997 on
From 1997 on, the basic "example situation" of sec. 8 (4) KStG has been revised so that economic identity is broken if the following occurs:
i. More than 1/2 (previously 3/4) of the shares in a corporation change hands and
ii. The corporation thereafter recommences or continues its business activity and
iii. Uses predominantly new business property (Betriebsvermoegen) in so doing.
An exception is created, however, if the new business property is used solely to recapitalise the business activities which generated the losses in the first place and the corporation continues to operate this branch of the business on a similar scale, viewed economically, for the following five years.
The provisions of the new law apply starting with the 1997 tax year. In a recently published essay (DStR 1997, 1427, 1436 ff.), Fueger/Rieger interpret this provision as referring to the tax year in which loss carryforwards are utilised, not the tax year in which the events occurred which caused the corporation in question to lose its "economic identity". If they are correct, this would mean that recapitalisations or purchases of loss corporations in years prior to 1997 which did not cause a loss of economic identity under the old law but result in such loss under the new wording would be affected by the new law to the extent they have not exhausted their loss carryforwards by 1996 at the latest.
However, an amendment is expected in the new law which would retard the effective date by one year for corporations which lost their legal identity (under the new stricter standards) prior to 6 August 1997. For such corporations, the new provisions would apply starting with the 1998 tax year, permitting them to use their loss carryforwards for the last time in 1997. See also article 99.
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