German tax law denying corporate loss carryforward is unconstitutional, court rules

by Ninja-Antonia Reggelin

A German court has struck down portions of a controversial law that denies tax loss carryforwards following a change of shareholders, ruling that the provisions are unconstitutional.

The German Federal Constitutional Court concluded on May 12 that § 8c Corporate Income Tax Act (KStG), applicable from 2008 to 2015, is in breach of the principle of equality anchored in the German constitution.

Under the law, from 2008 to 2015 a corporation’s carried forward tax losses are partially or completely forfeited in case of a share transfer. If at least 25% of the shares are transferred, the loss carryforwards will be forfeited proportionally. If more than 50% of the shares are transferred, a complete loss occurs. These cases are known as “harmful participation acquisitions.”

The Court struck down the portion of the law that covers partial denial of loss carryforwards in the case of pro rata shareholder changes of more than 25% up to 50%.

German limits on tax losses

The limitation of the loss deduction was introduced as an anti-tax abuse measure to prevent transactions that generate loss-making companies, i.e., companies without activity but with loss claims. The law includes several minor exemptions, such as for transactions occurring within 100% controlled groups, and provides exceptions to extent that taxable built-in gains in assets exist at the level of the loss entity.

Since its introduction in 2008, the restriction received repeated criticism, not only from corporations, but particularly from the start-up sector.

Young entrepreneurs argued that investors are less likely to finance their undertakings if losses have accumulated, especially during the founding phase, to fund research and development expenses that cannot be used later on. This was seen as a possible deterrent for the venture capital industry in Germany.

These issues were addressed by the legislature in a law passed last year. A new exemption (§ 8d KStG) applicable from 1 January 2016 allows corporations to use losses upon a change in shareholders if the business has been operating exclusively with the same business purpose for the three years before the change in ownership or since its foundation, if established for less than three years.

Court decision

In its decision, the German Federal Constitutional Court ruled that article 8c sentence 1 KStG does not comply with the principle of equality of article 3 para 3 of the German Constitution.

The Court declared that there was a lack of a factual reason for the discriminatory treatment of corporations, because disallowance of the deduction did not depend on whether or not such a harmful participation was involved.

The Court acknowledged the legislature’s attempt to prevent tax abusive structures. Nonetheless, it classified the chosen provision as unsuitable and arbitrary. Disallowance of the  loss deduction of certain companies, but not others, would be an unequal burden on taxpayers. Such unequal treatment would have required a specific factual reasoning which was not the case at hand.

The Court did not declare the regulation per se invalid and retroactive. Instead, the legislature is given the option to amend the unconstitutional provision by 31 December 2018.

Implications

It is important to note that the decision only covers the partial loss of loss carryforwards in the case of pro rata shareholder changes of more than 25% up to 50%. The court did not make any statement about the total forfeiture of losses for the transfer of more than 50% of the shares.

To this extent, the constitutional assessment of the provision remains open. Moreover, the new legal situation since 2016, i.e., the extension of new exemptions to the forfeiture, is also expressly not subject of the judgment.

Various outcomes are possible. One solution could be that the legislature extends § 8d KStG, introduced in the past year, to tax years after 1 January 2008.

Section 8d KStG may not be precise enough, though, to pass constitutional muster.  Many uncertainties still remain that need clarification and must also be measured against the constitutional equality principle.

If the legislature fails to comply with the court order, article 8c clause 1 KStG (now § 8c para. 1 clause 1 KStG) shall be considered invalid for the scope and timeframe stated in the decision.

There has been no public reaction by the legislature yet. It can be expected that the ruling will only be properly addressed after federal elections in September 2017 have taken place and the new government has started its work.

In general, affected taxpayers must first wait for the response of the legislature by 31 December 2018. Tax assessment notices dealing with § 8c KStG should be kept open as a precaution.