Fund Jurisdiction Act: News for Private Equity and Real Estate

According to the explanatory memorandum to the Act, the primary objective of the Fund Jurisdiction Act was to improve Germany’s international competitiveness as a location for employee share ownerships, particularly with regard to start-ups. In addition, the disadvantage for Germany as a Fund Location caused by VAT levying on the administrative services of venture capital funds was to be eliminated as well. Almost unnoticed and shortly before its adoption by the Bundesrat, a significant improvement in the so-called extended trade tax reduction for real estate companies also found its way into the law. This article will briefly introduce the latter two topics with a view to practical applications.

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Link to LM Audit & Tax GmbH at FYB

Author: Thomas Jäger,
Tax Advisor, Managing Director, LM Audit & Tax GmbH, München

Beneficial amendment of regulations regarding extended trade tax reduction for real estate holding SPV`s and Co-letting of operating equipment: all’s well that ends well?

If let properties located in Germany are held by a property company, usually a limited liability company (GmbH), or a deemed commercial partnership with management based in Germany, the letting profits of these companies are generally subject to trade tax in full. An exception is the so-called extended trade tax reduction if these companies – exclusively – manage and use their own real estate or, in addition, their own capital assets. In addition to other pitfalls, a major problem here is the exclusivity requirement, which in the end means that even minor sideline activities result in the de facto trade tax exemption being dropped. Classic examples of such tax-detrimental sideline activities are, for example, the operation of photovoltaic systems for feeding electricity into the public grid or the co-letting of so-called operating equipment, such as freight elevators, air-conditioning systems in server rooms, as well as cold storage rooms or kitchen systems and grease separators in restaurants and canteens, but so-called kitchenettes in office buildings as well.

In this regard, the Federal Fiscal Court (BFH) most recently ruled in 3 landmark rulings on 11/04/2019 that,

• in the case of a hotel, co-letting a beer cellar refrigeration system, refrigerated rooms as well as refrigeration units for counters and buffet systems in the volume of approx. kEUR 134 or approx. 1.14% of the total acquisition or production costs of the building (III R 36/15), or
• in the case of a car dealership, co-letting paint booths with associated supply air and exhaust air facilities (III R 5/18), or
• in the case of a car dealership with a workshop, co-letting a gantry car wash, lifting platforms, compressed air refrigeration dryers as well as advertising facilities and an advertising tower (III R 6/18),

applying the extended reduction is to be refused for violation of the exclusivity requirement.

In a further ruling on 18/12/2019 (III R 36/17) regarding the letting a department store and a filling station, the BFH also qualified the filling station technology belonging to the latter (roadway, petrol pump, pipelines and tanks) as harmful operating equipment.

What was new in all the above decisions was the specification of the exclusivity requirement. Contrary to the previous case law of individual tax courts, the extended trade tax reduction is not applicable to any co-letting of operating equipment, irrespective of the scope of the co-transferred operating equipment. According to the BFH, the law expressly does not provide for a de minimis limit. This very restrictive case law was thus to be applied in all still pending cases. In our article in FYB 2021, we pointed out the persisting problem, in particular the fact that has long become common practice to hold domestic real estate via real estate companies domiciled abroad and also to exercise the management functions at the foreign registered office of the company, as a result of which the domestic permanent establishment is missing as a connecting factor for trade tax.

In this respect, the current Fund Jurisdiction Act has resulted in significant regulations that are advantageous for real estate owners.

If real estate companies have so far been operating the generation of electricity from renewable energy systems in terms of sect. 3(21.) EEG (Renewable Energies Act) or from the operation of charging stations for electric vehicles as well, they lost the possibility of claiming the extended reduction altogether.

Currently, the regulation of sect. 9(1.) sentence 2 GewStG (Trade Tax Act) has been extended in a new sentence 3 by an exemption for the supply of electricity and the operation of charging stations. This requires that it can be shown that the income generated in this way does not exceed 10% of the income from the transfer of use of the real estate in the business year. In addition, the electricity may only be fed into the grid or supplied to the tenants of the property company, but not to final consumers who are not tenants of the system operator (e.g. to the owner or the tenants of a neighbouring residential or office building). Operating charging stations for the public, in turn, remains an activity not eligible for tax relief, just like the operation of a combined heat and power plant (as a result of the explicit reference to sect. 3(21.) EEG).

Almost at the last minute, a further benefit with considerable practical significance was included in the law. According to the new sect. 9(1.) sentence 3, letter (c) GewStG, the extended reduction for real property will also be retained in future if the income from other activities in the financial year does not exceed 5% of the income from the transfer of use of the real property and originates from direct contractual relationships with the property tenants.

In plain English, this means that co-letting previously financially detrimental operating equipment, such as freight elevators, exhaust air systems and grease separators as well as kitchen equipment in the catering trade, but also cold storage rooms in supermarkets or kitchenettes in offices or air-conditioning systems in server rooms, is now possible without any problems in principle, provided that the limit of 5% of the income is complied with.

This regulation is most welcome, as it brings to an end the long-running dispute in the courts over the exclusivity requirement for letting.

It should be noted, however, that even if the income in question is exempt, no tax exemption applies in this respect. The exemption continues to apply only to direct letting income; the income from sideline activities must be determined separately and is subject to trade tax. As a rule, the profit attributable to the letting of the business equipment and thus the trade tax will probably be manageable in most cases.

In addition, the new regulation is also consistent with sect. 15 (3) InvStG (Investment Tax Act), which provides for a trade tax exemption for investment funds holding real estate since the InvStG 2018 if the share of the income generated from active entrepreneurial real estate management in a financial year is less than 5% (de minimis threshold) of the total income of the investment fund (for details, see the BMF letter dated 21 May 2019 on application issues relating to the Investment Tax Act in the version applicable as from 1 January 2018). The previous unequal treatment or preferential treatment of investment funds for trade tax purposes has now also been eliminated and equal treatment has been established irrespective of the legal form.

The bill was passed by the Bundesrat on 28 May; the new regulation on the extended reduction will apply as from the 2021 assessment period.

Practical Tip:

As much as the new regulation is to be welcomed, there is currently still no regulation as to how the limits of 10% or 5% of the “income from the transfer of use” are to be determined, here in particular whether it is the cold rent or whether apportionments for operating costs are to be included. In addition, it is unclear whether proceeds from the sale of operating equipment are still covered by the new regulation as well, which is doubtful when focusing on income from the mere transfer of use. Last but not least, it is also questionable how the agreed rent for a partial area or an entire building is to be used to determine the proportion of the rent that is attributable to the letting of the operating equipment included in the rent, especially as this is often not recorded separately in the fixed assets, particularly in the case of existing buildings, and data on historical acquisition and production costs are often not available, which means that the “valuation discussion” with the tax office is sure to follow here as well – as is so often the case in tax law, the pitfall is again in the detail.

In practical application, it must therefore continue to be ensured that

– the relevant percentage is not exceeded, even if the building is partially vacant,

– relevant income is subject to trade tax,

– equipment must therefore continue to be clearly identified, in particular at the time of purchase, and, where appropriate, the corresponding pro rata purchase prices must be shown in the purchase contract and

– operating facilities continue to be spun off to separate companies if the relevant limits are exceeded or if they are to be sold, separately or together with the real estate.

Further developments in this area therefore remain to be seen, and especially transactions should continue to be handled with a sense of proportion and, in case of doubt, with caution. Previous models will probably not lose their validity completely.

Author Tax Advisor Thomas Jäger

Press Release No. 77/2021 of 18 August 2021

– Interest on back taxes and tax refunds –

In an order published today, the First Senate of the Federal Constitutional Court held that the interest incurred on back taxes and the interest paid for tax refunds pursuant to § 233a in conjunction with § 238(1) first sentence of the Fiscal Code (Abgabenordnung – AO) is unconstitutional insofar as the interest is fixed at 0.5% per month for periods from 1 January 2014.

Taxpayers incur interest of 0.5% for back taxes after the expiry of an interest-free grace period (generally 15 months). This amounts to unequal treatment of taxpayers whose taxes are only assessed after the expiry of the grace period in relation to taxpayers whose tax assessments become final during the grace period. Measured against the general guarantee of the right to equality following from Art. 3(1) of the Basic Law (Grundgesetz – GG), this unequal treatment is constitutional with regard to interest incurred from 2010 to 2013, but it is unconstitutional with regard to interest incurred in 2014. Applying a lower interest rate would be an at least equally suitable means for achieving the purpose of the law, while resulting in less unequal treatment. The interest paid to taxpayers for tax refunds pursuant to § 233a AO is also incompatible with the Basic Law. The provisions continue to apply for interest periods until 2018, but they are declared inapplicable for interest periods beginning in 2019. The legislator must enact provisions that are compatible with the Constitution by 31 July 2022.

Facts of the case:

§ 233 AO governs the interest taxpayers incur on back taxes and the interest paid to taxpayers for tax refunds. Taxpayers are liable for interest from the time the tax arises, even before they receive a tax assessment (according to the principle of interest on taxes from the time they arise). However, interest does not start to accrue at the end of the calendar year in which the tax arose, but only after an interest-free grace period of generally 15 months. Thus, the imposition of such interest payments only affects those taxpayers whose taxes are initially assessed or amended after a rather long period of time has passed since the tax arose. Of practical relevance in this context are (amendments to) tax assessments, in particular following a field audit. Pursuant to § 238(1) AO, interest is 0.5% for every full month, amounting to 6% per annum. Interest is only incurred in respect of the types of taxes listed in § 233a(1) first sentence AO: income tax, corporation tax, capital tax, VAT and trade tax. The interest works both in favour of taxpayers (in case of tax refunds) and to their disadvantage (in case of back taxes). The reasons for a late tax assessment, and in particular whether it is due to the taxpayers or the tax authority, are irrelevant to calculating interest.

The constitutional complaints concern the charging of interest on trade tax arrears pursuant to § 233a AO following a field audit. The complainants challenge the ordinary court judgments upholding the charging of interest. They indirectly challenge § 233a AO, insofar as § 238(1) first sentence AO is applied when calculating interest. The period under review in this case is the period from 1 January 2010 to 14 July 2014.

Key considerations of the Senate:

I. Interest on back taxes pursuant to § 233a in conjunction with § 238(1) first sentence AO was initially constitutional. However, the provision is no longer compatible with Art. 3(1) GG insofar as an interest rate of 0.5% per month is applied to interest periods in 2014.

1. As the law currently stands, taxpayers whose taxes are only assessed after the expiry of the grace period are treated unequally in relation to taxpayers whose taxes are assessed during the grace period. Only the former group is subject to interest charges.

2. Especially strict proportionality requirements apply when it comes to the justification of such unequal treatment.

a) The general guarantee of the right to equality under Art. 3(1) GG does not preclude all differentiation on the part of the legislator. Differentiations, however, must always be justified by factual reasons commensurate with the aim and the extent of the unequal treatment. Depending on the subject matter of the legislation and the criteria for differentiation, the legislator must observe varying limits, which may range from a mere prohibition of arbitrariness to strict proportionality requirements. Stricter limits for the legislator may arise from the freedoms affected in a given case. Moreover, the constitutional requirements become stricter where statutory differentiation is based on grounds that individuals can only influence to a lesser degree. This general standard derived from the right to equality also applies in respect of setting out how the interest is incurred (on taxes when they arise, pursuant § 233a AO) and fixing the interest rate (§ 238 AO).

b) Based on these standards, stricter proportionality requirements apply in the present case. The interest incurred by taxpayers on the basis of taxes as they arise pursuant to §§ 233a and 238 AO essentially only affects the general freedom of action under Art. 2(1) GG. By contrast, freedom of property guaranteed by Art. 14(1) GG is unaffected from the outset given that imposing an obligation to pay interest is not so onerous as to have a fundamental impact on the financial circumstances of the taxpayers. That being said, the timing of the tax assessment and thus whether the grace period will have expired is largely out of taxpayers’ control. The timing of the tax assessment lies in the hands of the tax authorities or – in the case of trade tax – usually also of the municipalities.

3. § 233a in conjunction with § 238(1) first sentence AO initially satisfied the stricter justification requirements applicable in this context and was constitutional.

a) The imposition of interest from the time taxes arise aims to compensate for the fact that taxes are assessed and become payable at different times for individual taxpayers. This is a legitimate aim. Interest is imposed on back taxes based on the assumption that taxpayers whose taxes are assessed late have a theoretical interest advantage. The interest incurred under the challenged provisions is aimed at neutralising this advantage. Interest incurred from the time taxes arise is suitable for helping achieve this aim. In principle, this also holds true when considering the amount of interest charged, given that at least until 2014, it was generally still possible to earn interest on the market.

b) As such, the interest incurred from the time taxes arise is also necessary. No equally suitable means is available for achieving the purpose of the differentiation: neutralising taxpayers’ actual liquidity advantage is not equally suitable, nor is designing the obligation to pay interest in such a way that interest on tax arrears is only payable if the taxpayers themselves are responsible for the late tax assessment. There are no concerns as to the necessity of the interest incurred, also with respect to the fixed rate. Variable interest rates do not per se lead to less inequality than fixed interest rates.

4. However, imposing interest of 0.5% per month is no longer necessary for periods in 2014 and violates the right to equality under Art. 3(1) GG.

a) In order to simplify administrative processes, the legislator may in principle apply typification (Typisierung) to determine taxpayers’ interest advantage arising from a late tax assessment. However, the legislator may not choose an atypical case as its model; when establishing standards, it must realistically base its determination on a typical case. Since the legislator never provided explicit reasons for the amount of interest charged, an overall examination of the ascertainable motives and considerations is required in order to establish the – at least presumed – main criteria for the calculation of the interest rate. The legislator imposes interest on back taxes to cancel out an advantage. This is based on the legislator’s assumption that the advantage to be cancelled out here is a potential interest advantage. The legislator set this interest advantage at 0.5% per month in 1990, based on the existing provision determining interest for other cases in the Fiscal Code, § 238 AO. The only reason for this provided by the legislator was the practicality of the existing fixed interest rate. However, it is also ascertainable that this decision was tied to the discount rate at that time, which has been replaced by today’s base rate. The legislator evidently took into consideration the market rate, setting the same rate for interest charged on back taxes and interest paid for tax refunds. Overall, these criteria used by the legislator for setting out standards for fixing the interest rate adequately reflect the potential advantage taxpayers may gain from a late tax assessment.

b) Based on these considerations, the interest of 0.5% per month payable on back taxes was initially constitutional. When the 1990 Tax Reform Act – which introduced the current interest system into the Fiscal Code – was adopted, the legislator was correct in assuming that this interest rate reflected the potential advantage gained from a late tax assessment. The annual interest rate of 6% roughly corresponded to the conditions on the money and capital markets, which were relevant for establishing the standard in this regard.

c) Even though the legislator generally has a prerogative of assessment, applying an interest rate of 0.5% per month is no longer justified when the interest rate determined by way of typification proves to be obviously unrealistic over time due to changed factual circumstances. This has been the case since at least 2014.

Following the financial crisis in 2008, an environment of structurally low interest rates has emerged that is no longer a reflection of usual interest rate fluctuations. This becomes clear when considering how the base rate has developed. While the base rate was above 3% in 2008, it rapidly fell to 0.12% in the course of 2009. It has been negative since January 2013. Given that the discount rate was between 2.5% and 8.75% in the fifty years of its existence, and the base rate ranged between 1.13% and 3.32% before 2009, this development represents a low-interest environment no longer indicative of the usual interest rate fluctuations, but rather, at least since 2014, of a structural and lasting nature. The development of interest rates on the capital markets has followed a similar trend. In 2014, the 6% per annum interest rate had already deviated so far from the actual market rate that it was about twice as high as the maximum interest that could still be earned on the market. The lending rates, which must be taken into account for establishing standards in this context, have also followed the downward trend described above. The interest rate of 6% per annum, determined by way of typification, is therefore obviously unrealistic, at least since 2014, given the changed factual circumstances following the financial crisis. In the current environment of entrenched low interest rates, this interest rate is clearly no longer capable of sufficiently reflecting the potential advantage taxpayers may gain from late taxation. Since the current system of interest incurred from the time taxes arise is based on an annual interest rate of 6%, it now generally has an excessive effect, at least for periods in 2014, and has thus become unconstitutional.

5. For interest periods until 2013, the statutory interest rate is increasingly incapable of achieving the purpose pursued with the imposition of interest on tax arrears. However, for these periods, the interest rate does not yet have an obviously excessive effect. Nor does it violate the principle of proportionality in its strict sense. It is not yet disproportionate to such an extent that it is conspicuously misaligned with constitutional law. In respect of these periods, the interest rate also does not violate the prohibition of excessive measures (Übermaßverbot) following from Art. 2(1) in conjunction with Art. 20(3) GG. The fixed interest rate determined by way of typification has advantages for administrative practice that are still in adequate proportion to the resulting unequal treatment of taxpayers liable for interest payments. Until 2013, the low interest rate environment had not yet become so entrenched that the statutory interest rate generally appeared obviously unrealistic.

II. Insofar as it is admissible, the constitutional complaint in proceedings 1 BvR 2237/14 is unfounded given that it concerns interest payable for 2010 to 2012.

III. The constitutional complaint in proceedings 1 BvR 2422/17 is well-founded in part. Insofar as it concerns the interest period from 1 January 2014 to 14 July 2014, the decision of the Administrative Court (Verwaltungsgericht) violates the complainant’s fundamental right under Art. 3(1) GG. The decision of the Higher Administrative Court (Verwaltungsgerichtshof) violates the complainant’s fundamental right to effective legal protection following from Art. 19(4) GG. For the rest, the constitutional complaint is unfounded.

IV. § 233a in conjunction with § 238(1) first sentence AO is declared incompatible with the Basic Law in its entirety for all interest periods from 1 January 2014. Given the comprehensive approach chosen by the legislator, the interest rate pursuant to § 233a AO is not merely incompatible with the Basic Law with regard to interest charged on tax arrears to the disadvantage of taxpayers, but also with regard to interest paid on tax refunds in favour of taxpayers. However, the provision continues to apply in respect of interest incurred from 1 January 2014 to 31 December 2018; the legislator is not required to retroactively enact provisions that are constitutional for this period. By contrast, for interest periods from 2019, the provision remains inapplicable. The legislator is required to enact new provisions by 31 July 2022, which must apply retroactively to all interest periods from 2019 onwards and to all acts of public authority that have not yet become final.

Decision of the Federal Constitutional Court:

Download BVG Court Decision dated 8th July 2021

– BFH confirms positive court ruling from 2016

Management shares, mostly in companies that are part of a group, are a common instrument for incentivising managers.

Not least in the run-up to restructuring and corporate transactions, the aim is also to align the interests of shareholders and management.

Management shares in portfolio companies are thus also common in the private equity fund environment. The question of taxation as wages (fully taxable under the progression system) or (privileged) as capital income subject to withholding tax thus naturally leads to conflicting views between taxpayers and tax authorities.

In a first relevant ruling from 2016 (IX R 43/15), the German Supreme Tax Court (Bundesfinanzhof, BFH) denied the qualification of a manager’s share in their employer as wages. The fact that, in the disputed case, the share was offered exclusively to executives and that rights of exclusion and termination applied in the event the employment was terminated was ultimately irrelevant. At that time, the management share was qualified as a special legal relationship independent of the manager’s employment.

This trend in court rulings, which is advantageous for the application in practice, was confirmed by the BFH in 2 further recent rulings from December 2020, both published on 27/05/2021.

In ruling VIII R 40/18, shares in an affiliated company within the group were offered to a selected group of employees (“managers”) for purchase at USD 0.0625 per share, in this case a total of USD 10. The sales proceeds per share achieved a good 3 years later amounted to approx. USD 1,750 per share.

The BFH ultimately ruled that the share was a separate source of income independent of the employment, if:

• the employment contract does not provide for any entitlement to acquire the share and a proportionate share of the sales proceeds as consideration for the employment, and
• the share is acquired and disposed of at the market price (and not at a discount), and
• the employee bears the full risk of loss, and
• no special circumstances arising from the employment can be identified that affect the saleability and performance of the share.

The mere fact that the share is held by an employee of the group of companies and was only offered for purchase to a selected group of employees and moreover, as argued by the tax office, the employee did not bear any significant risk of loss, with the simultaneous possibility of achieving an extraordinarily high return, did not result in the qualification of the sales proceeds as income from employment.

In ruling VIII R 21/17, a self-employed management consultant indirectly held a share in a holding company via a GbR [partnership under the German Civil Code]. The tax office qualified the later significant sales proceeds arising from the share as remuneration for the plaintiff’s consulting services. The action and appeal filed against this at the BFH were successful. Here as well, the BFH ruled that an equity investment only counts as business assets in exceptional cases and confirmed that, according to the BFH’s established practice, financial transactions by members of the liberal professions are generally privately initiated and lead to income from capital assets if the equity investment has its own economic weight compared to the freelance activity, e.g. if the taxpayer is primarily concerned with the capital investment and other aspects such as the acquisition of orders as merely a desirable side effect take a back seat. Moreover, it was also decisive in this case that the investment was acquired and sold at the market price and that the shareholder bears the full risk of loss arising from the investment. The increased chance of profit associated with the possibility of investment did not play a part in this respect, since according to the BFH, such a chance is inherent in every equity investment. As a result, there was no evidence that the plaintiff had earned a non-market-based, increased rate of return that could qualify as an additional bonus payment for his consulting work.

Note from practical experience:

Both rulings from 2020 clearly show that, also in view of the amount of the sales proceeds often at issue in relation to the acquisition costs (ex post), which tend to be classified as low, the dispute with the tax office is often predetermined in comparable situations.

It is also significant in this context that in the case of ruling VIII R 40/18, criminal tax investigations had already been initiated against several employees of the company due to the tax treatment of the proceeds achieved from the sale of shares.

In the case of ruling VIII R 21/17, the auditors came to the conclusion during a tax fraud investigation that the payments made due to the sale of shares were to be regarded as remuneration for the plaintiff’s consulting work.

In this context, it is all the more gratifying that the BFH has now worked out clear guidelines for the treatment of sales proceeds from management shares as capital income and the distinction from treatment as wages and salaries. They should provide taxpayers with good arguments in similar cases.

From our point of view, the transparent disclosure of the facts, e.g. in the income tax return of the managers involved, continues to be important in order to eliminate the accusation of “concealment” later on. The issue of the valuation of the shares in the case of purchase and sale remains unresolved; the BFH did not have to comment on it in the cases dealt with. This means that particular attention will continue to be paid to the issue of share valuation at the relevant taxation dates.

Author: Tax Advisor Thomas Jäger

German Supreme Tax Court Decisions:

Download BFH Court Decision dated 4th October 2016, IX R 43/15

Download BFH Court Decision dated 1st December 2020, VIII R 21/17

Download BFH Court Decision dated 1st December 2020, VIII R 40/18