Thunderclap out of Karlsruhe: some loss deduction limitations in section 8c of the German Corporation Tax Act unconstitutional

In a decision published today, the German Federal Constitutional Court (FCC) ruled that parts of section 8c of the Corporate Tax Act (CTA) regarding the forfeiture of tax losses for corporations in the event of acquisitions that have a detrimental effect on a tax position are unconstitutional (see decision dated 29 March 2017, case no. 2 BvL 6/11). The FCC ascertained irreconcilability with the general principle of equal treatment found in article 3 para. 1 of the German Constitution (GC).

What cases are affected by the unconstitutionality?

The specific provisions that are unconstitutional and irreconcilable with the general principle of equal treatment (article 3, para. 1 GC) are section 8c first sentence CTA (or section 8c, para. 1, first sentence ACT). This means in particular that the pro rata forfeiture of unused losses of a corporation is affected if more than 25% and up to 50% of the shares in this corporation are transferred within five years.

The dispute at the heart of the matter was based on an older version of section 8c CTA. However, the FCC stated that the irreconcilability also applies to the provision still in effect today in section 8c, para. 1, first sentence CTA. According to the FCC, not even the "silent reserves clause" (section 8c, para. 1, sixth sentence et seq. CTA) and the "group clause" (section 8c, para. 1, fifth sentence CTA), which have been introduced in the meantime, have had any effect on the unconstitutionality of the forfeiture of losses in the event of acquisition of shares between 25% and 50% that have a detrimental effect on a tax position.

It is to be noted, however, that the FCC has limited for now the unconstitutionality of the abovementioned rule to the time period between 1 January 2008 and 31 December 2015.

The FCC expressly left open the question as to whether the new loss-saving clause in section 8d CTA introduced in 1 January 2016 on the "loss carried forward in the event of continuation of the corporation" has remedied the unconstitutionality. Likewise, it expressly did not address whether the complete forfeiture of losses in the event of share acquisition of more than 50% with detrimental effect on tax position currently enshrined in section 8c, para. 1, second sentence CTA is constitutional or unconstitutional. In light of this legal uncertainty, cases with this content should continue to be kept open.

Essential grounds for the unconstitutionality

According to the FCC, the general principle of equal treatment binds lawmakers to the principle of tax justice and thus to taxation according to economic capacity. Particularly section 8c, first sentence CTA (or section 8c, para. 1, first sentence CTA) diverges from this in that it makes the determination of taxable income of a corporation – in particular the use of losses – dependent upon whether or not there has been an acquisition of shares with a detrimental effect on the tax position.

Section 8c, first sentence CTA (or section 8c, para. 1, first sentence CTA) does not even hold up under a test based on the prohibition of arbitrariness. This is because, from the FCC's viewpoint, there is no objective justification for the unequal treatment ascertained by the FCC.

In particular, the goal of combatting legal but undesirable tax structures including trade in losses that can be carried forward ("shell company acquisition") was not considered valid in the case at hand as an objective justification. The court stated that this goal was a legitimate purpose for justifying unequal treatment as described in article 3, para. 1 GC, and lawmakers are permitted to use generalising, stereotyping and oversimplifying clauses without violating the general principle of equal treatment – in so doing, they are not permitted to use an atypical case as their model but must give reality its due by using a typical case. However, in this case, the FCC was of the opinion that the limits of permissible stereotyping had been overstepped if the determining factor for ascertainment of such structures is solely the transfer of a share of more than 25%. It stated that the reason was that this circumstance alone is not an indication of an improper structure because there could be many and various reasons for the transfer of such an interest in a loss-making company. The court continued by saying that such reasons do not usually include using the losses for another company belonging to the new shareholder.

The court was also of the opinion that the prerequisite that the taxpayer that uses the losses must be identical to the taxpayer that causes the losses cited by lawmakers as justification for the unequal treatment fails here in that it defines a change in the economic identicalness solely with the prerequisite that more than 25% and up to 50% of the shares in a corporation are transferred directly or indirectly to an acquirer or person close to such within five years.

Furthermore, in this decision, the FCC rejected as objective justification both the intent to increase tax revenue and the idea familiar from partnership taxation of identical enterprises as a prerequisite for forfeiture of losses.

Lawmakers must act by 31 December 2018

The FCC has not yet declared section 8c, first sentence CTA (or section 8c, para. 1, first sentence CTA) void, but has for now only determined the irreconcilability with the Constitution. At the same time, it gives lawmakers the opportunity to eliminate the unconstitutionality retroactively to the date of the introduction of this law on 1 January 2008. However, if lawmakers do not fulfil this obligation by 31 December 2018, the law will be void retroactively from 1 January 2008.

Although this kind of ruling basically corresponds to the FCC's usual procedure, it is remarkable in a certain way.

In this context, ordering the required amendment to the law to be applied retroactively in particular is interesting. In the past, the FCC has often allowed a clause that has been declared irreconcilable to be applied at least for a transitional period. The new clause was then not applicable until the expiry of the transitional period. Often, this course of action was intended to prevent loss of income due to decreased tax income. However, in the case at hand, the FCC did not follow such considerations.

It is also remarkable that the FCC gives a clear order as to what consequences will occur if lawmakers do not eliminate the unconstitutionality within the time period set by the FCC. In this case, the FCC seems to have learned its lesson from its Inheritance Tax Act decision dated 17 December 2014 (see ruling dated 17 December 2014, case no. 1 BvL 21/12). In the context of the subsequent reform of the Inheritance Tax Act, the FCC was continually confronted with the question of what provisions would apply if lawmakers did not fulfil their remedying obligation before the time period set by the FCC elapsed.

Possible consequences of today's decision

Taxpayers must now wait to see how lawmakers react to this decision by the FCC.

If lawmakers exercise the reform option, they will have to limit the forfeiture of losses to cases of abuse. For this purpose, prerequisites to identify abuse would have to be added to section 8c CTA. There is no way to anticipate exactly what form they will take. Such a new law would apply to all cases for which no final decision has been made; these would then have to be re-adjudicated as regards forfeiture of losses. It is to be expected that in many cases in which the current regulation has triggered a partial forfeiture of losses, such forfeiture of losses will cease to exist retroactively.

However, if the relevant regulation is not amended to comply with the FCC's requirements by 31 December 2018, in all cases that are still pending, the FCC's voiding order should lead to the reversal of the forfeiture to which some losses have been subject, and these losses will become available for setting off. This will probably lead to tax refunds in many cases.

First projection

Thus, it is safe to assume that lawmakers will take advantage of the option granted by the FCC and reform the regulation in section 8c, para. 1, first sentence CTA (or section 8c, first sentence CTA). Otherwise, they risk a drastic decrease in tax income. However, such reform is not to be expected until the coming legislative period because the remaining time until the end of the 18th legislative period will not be sufficient for reforming the law.