In a decision published on May 12, 2017, the German Federal Constitutional Court has decided that part of one of the core provisions of the German corporate income tax act is unconstitutional. The utilization of carried-forward tax losses by a company following a change in ownership is restricted by the provisions of § 8c German Corporate Income Tax Act. The rule stipulates that corporate tax losses are forfeit on a pro rata basis if between 25% and 50% of the company’s shares have been transferred to a new shareholder. The court found this rule unconstitutional and incompatible with the prohibition of arbitrariness.
The relevant provision
The transfer of shares in a corporation to a purchaser can result in the forfeiture of carried forward tax losses of the transferred company. If more than 25% of the shares are transferred, a proportionate amount of the carried forward losses are forfeit. If more than 50% of the shares are transferred, all of the carried forward losses are forfeit. Both scenarios are considered to be “harmful changes in ownership”. The decision in question only applies at this stage to transfers of more than 25% and up to 50% of the shares in a company (which we refer to in this note as “partial transfers”).
There are several exemptions from this regime. Certain internal group transfers are exempt, as well as transfers of shares in companies with hidden reserves (untaxed capital gains). As recently as December 2016, a new provision was introduced for companies which continued their business operations essentially in the same way before and after the harmful change in ownership. This new “continued operations” exemption applies retroactively for changes of ownership on or after 1 January 2016.
The general loss forfeiture rule was introduced as part of the Corporate Tax Reform Act of 2008. Since 1990, the legislator had passed several legislative initiatives to deal with the utilization of losses following a change of control. The general provision described above was intended to be a “more simple and targeted limitation of loss deduction” than what had gone before, because the earlier regulation had been very complex and difficult to handle in many aspects.
The general loss forfeiture rule is aimed at preventing unwanted loss-buying transactions involving corporate shells, i.e. companies without business operations but significant carried forward losses.
The objective had always been to combat abuse. A change in the shareholder structure was classified as a typical abusive measure.
The arguments of the Federal Constitutional Court
The Federal Constitutional Court acknowledged the intention to prevent abusive practices. However, it considered the way the rule had been implemented was inappropriate and arbitrary. Allowing loss utilization for certain companies and not for others leads to the unequal treatment of taxpayers. Unequal treatment must be justified by objective reasons which relate to why and how taxpayers are treated differently.
The legislator had chosen a partial change in ownership of a corporate taxpayer to be the relevant objective reason to differentiate between corporate taxpayers that cannot utilize their carried forward losses while those without a change in ownership can continue to utilize their carried forward losses. This approach did not find the sympathy of the court.
The court argued that there could be many reasons why a change in ownership occurred, in particular with respect to minority shareholdings , as is the case with a partial transfer. These reasons “do not always relate to making the losses available for use by another company or the new shareholder”. If the standard transaction that triggers a differentiated treatment between taxpayers is not of itself a typical example of an abusive transaction, then it cannot be the basis of a general tax provision that treats all taxpayers undertaking such a transaction as abusive.
The judgement of the Federal Constitutional Court only covers the proportional forfeiture of carried forward losses on a partial transfer. The Court did not make any statement with regard to the complete forfeiture of losses if more than 50% of the shares are transferred. To that extent, the constitutional law implications remain unclear.
The decision also does not apply to the regime as it has operated since 2016. Because of the introduction of the “continued operations” exemption, a carried forward lossnow remains usable following a change of ownership where the operations of the company do not change, albeit this is still regarded as a harmful change in ownership for the purposes of the rules. For the exemption to apply, the company must have exclusively continued to run the same business operations for the three years immediately preceding the shareholder change. The Federal Constitutional Court held that the new exemption must be “separately considered”.
Possible reactions of the legislator
The Federal Constitutional Court did not declare the provision to be void and non-applicable with retroactive effect. Instead, it imposed a deadline of 31 December 2018 for the legislator to remedy the infringement of the constitution for the years from 1 January 2008 to 31 December 2015. It is only if the legislator misses this deadline that the law will be automatically void.
There are several possible reactions. One obvious solution could be to apply the “continued operations” exemption retrospectively to years starting from 1 January 2008. Even if the legislator chose this option, the question remains whether it would use the opportunity to extend it to majority share transfers as well. If not, the uncertainty regarding the constitutionality regarding majority share transfers will remain.
However, the “continued operations” exemption is not a masterpiece of law-making. There are many carve outs and uncertainties which need to be clarified and must be measured against the principle of equality provided for in the constitution. The legislator might take this opportunity to improve the legislation.
Consequences for taxpayers
Taxpayers will have to wait for the reaction of the legislator first of all. Afterwards, they can evaluate the financial consequences and assert claims, if appropriate. Tax assessments in which losses have been treated as forfeited due to a change in ownership should be kept subject to review by filing or keeping up appeals as a measure of precaution.
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