Summary
Since its introduction in 2011, Section 7 para. 8 of the German Inheritance and Gift Tax Act treats a person’s contribution to a corporate entity as a taxable gift to the individual or individuals who directly or indirectly hold shares in the entity if the contribution has resulted in an increase in value of their shares.
The Münster Fiscal Court now has ruled that the taxable event of Section 7 para. 8 German Inheritance and Gift Tax Act requires a subjective element in the sense of an awareness of the (partial) gratuitousness of the contribution to the corporate entity as a corrective to the overly broad wording of the law.
Practical significance
Due to the absence of a restriction in the wording of Section 7 para. 8 German Inheritance and Gift Tax Act, any form of benefit to a corporate entity can potentially be a taxable gift to the co-shareholders. The provision of Section 7 para. 8 German Inheritance and Gift Tax Act applies without distinction to all corporations and contribution transactions, also between third parties. Therefore, there is a large number of corporate transactions affected by Section 7 para. 8 German Inheritance and Gift Tax Act (e.g. establishment of start-ups, joint ventures, M&A transactions with roll-overs, management equity programs etc.). The taxation results are often bizarre.
Example
Investor A is a foreign-based taxpayer and makes a disproportionate capital contribution to the German X-GmbH in which he holds shares. Other investors in X-GmbH are two further foreign-based taxpayers and five Germany-based taxpayers who make no contribution to the entity. Result according to the wording of Section 7 para. 8 German Inheritance and Gift Tax Act: The five Germany-based investors must pay tax on the “increase in value” in their shares resulting from A’s disproportionate contribution as a gift from A. There are no German gift tax effects for the two other foreign-based investors. Besides this, A, who is foreign-based, as the “donor” is also liable for the German gift tax of the five Germany-based investors.
Investments in German corporations have become less attractive, particularly for foreign investors, due to the implementation of Section 7 para. 8 German Inheritance and Gift Tax Act. For years, there has been great uncertainty in practice as to whether a planned corporate transaction could trigger gift tax for individual parties in addition to the respective income tax consequences.
The clear ruling by the Münster Fiscal Court is very helpful in view of the prevailing legal uncertainty in many standard corporate transactions. The judgement is clear in terms of both its reasoning and its result.
Facts of the judgment of the Münster Fiscal Court (simplified)
The plaintiff and his brother were shareholders of the German A-GmbH. Due to serious differences between the brothers, the plaintiff’s brother sought to leave A-GmbH and concluded a purchase and assignment agreement with A-GmbH in his own name and as authorized managing director of A-GmbH, according to which he sold all his shares in A-GmbH to A-GmbH. The purchase price for the shares in A-GmbH was set out in the purchase and assignment agreement. Five years following the conclusion of the contract, the shares of the plaintiff’s brother were assigned in rem to A-GmbH as the acquirer.
The competent tax office assessed gift tax against the plaintiff which was calculated on the basis of the difference amount between the agreed purchase price and the tax value of the transferred shares determined pursuant to Sections 199 et seq. German Valuation Act. The tax value of the transferred shares as determined by the tax office amounted to approx. EUR 7.5 million more than the purchase price stipulated in the purchase and assignment agreement. As a result, the transaction was to be taxed as a mixed gift in accordance with Section 7 para. 8 German Inheritance and Gift Tax Act in the opinion of the tax office.
The plaintiff appealed against the assessment of the gift tax on the grounds that there was no intention to make a gift between siblings who are at odds with each other. However, such an intention to benefit the donor would be necessary for taxation. The competent tax office did not follow the appeal as Section 7 para. 8 German Inheritance and Gift Tax Act does not depend on the donor’s intention to make a gift. Furthermore, the tax office pointed out that the significant difference in value between the purchase price on the one hand and the tax value of the shares on the other hand was sufficient to evidence the willingness to gratuitousness.
The plaintiff then sued the tax office for revocation of the gift tax assessment.
Decision of the Münster Fiscal Court
The Münster Fiscal Court upheld the claim. The transfer of shares by the plaintiff’s brother to the GmbH did not constitute a gift taxable event. In particular, the requirements of Section 7 para. 8 German Inheritance and Gift Tax Act were not met.
The interpretation of the law reveals that a subjective element in the sense of an awareness of the gratuitousness of the benefit is required. Besides the terms “donor” and “donee” the legal systematics as well as the purpose of the provision argue in favor of the requirement of a subjective element. Without a subjective element restricting the scope of Section 7 para. 8 German Inheritance and Gift Tax Act, the contributing party could be held liable for gift tax at any time, which, if Section 7 para. 8 sentence 1 German Inheritance and Gift Tax Act were interpreted extensively, would be equivalent to an ‘’absolute liability‘’ for gift tax purposes in case of transactions with corporations.
Moreover, the legal obligation to notify the German tax administration of a gift can only be fulfilled by someone who is at least aware that there is no (full) consideration for his/her contribution to the corporate entity. By using the wording “deemed gift”, the legislator expresses the fact that the taxable event of Section 7 para. 8 German Inheritance and Gift Tax Act is a legal fiction of a gift. However, in the opinion of the Münster Fiscal Court, the wording of Section 7 para. 8 sentence 1 German Inheritance and Gift Tax Act only bridges the legally missing direct benefit to the beneficiary. This does not result in a complete fiction of all elements of a true gift according to Section 7 para. 1 no. 1 German Inheritance and Gift Tax Act, i.e. the “benefit” must be provided by the donor in the awareness that this will increase the value of the indirect beneficiary’s share without receiving equivalent consideration from the latter.
In addition, with the implementation of Section 7 para. 8 German Inheritance and Gift Tax Act in 2011 the legislator wanted to create an anti-abuse provision that covers scenarios in which the donor’s contribution to a corporate entity is aimed at enriching the (other) shareholder of the corporation. This inevitably presupposes that the contributing person is aware of the fact that his contribution is (partially) gratuitous.
Besides this, the Münster Fiscal Court emphasizes that the mere existence of a (possibly large) discrepancy between the performance of both parties is not sufficient to evidence the intention to make a gift to somebody. The required willingness to gratuitousness is only given if the donor is aware of the gratuitous nature of his performance to such an extent that he renders his performance without obligation and without any legal connection to a consideration.
Effects
The German tax administration has appealed against the decision of the Münster Fiscal Court. Nevertheless, the decision is very important for the corporate practice in Germany. As a continuation of the ruling of the Saxony Fiscal court (judgement of May 6, 2021), the decision of the Münster Fiscal Court provides a further, remarkably clear indication that Section 7 para. 8 German Inheritance and Gift Tax Act irrespective of any objective discrepancy between the respective contributions of the shareholders does require a subjective element to limit the scope of the provision.
It is therefore recommended to document all contribution transactions under corporate law in detail. All gift tax assessments issued on the basis of Section 7 para. 8 German Inheritance and Gift Tax Act should be kept subject to amendment and repeal until the German Federal Court of Finance has decided on the appeal.