German Reorganization Tax Act (“UmwStG”): BFH limits “trade tax pitfall” for new business assets

A tax advisor was the sole shareholder of A-GmbH, to which he also transferred his real property. In 2010, he transformed A-GmbH into A-GmbH & Co KG, following the initial establishment of another GmbH – the later general partner GmbH – by way of a change of legal form in accordance with Art. 190 et seq. German Transformation Act (“UmwG”) while retaining the book values in a tax-neutral manner. B was thus the sole partner of the general partner GmbH and the sole limited partner of A-GmbH & Co. KG. On the same day in 2011, he sold his entrepreneurial partnership interest (shareholding in the general partner GmbH and limited partner shareholding in the GmbH & Co. KG) and his real property. In his tax return, he treated the capital gain from the sale of the entrepreneurial partnership interest as subject to trade tax, while he treated the gain from the sale of the real property as exempt from trade tax. The subsequent tax audit and, consequently, the tax office assessing the tax treated both the profit from the sale of the entrepreneurial partnership interest and the profit from the sale of the property as subject to trade tax. The tax advisor appealed against this and prevailed in both instances.

Problem: Special trade tax treatment for entrepreneurial partnership interests

While the sale of an entrepreneurial partnership interest, including the special business assets, is not subject to trade tax, the sale of a corporation’s business assets is subject to trade tax. For the purchaser, the acquisition of the entrepreneurial partnership interest or the corporation’s assets is advantageous because this “asset deal” creates a tax “step-up”, which gives the purchaser an increased regular depreciation potential, which in turn can be used by the seller to increase the purchase price. This “step-up” does not take place in the case of the acquisition of equity interests (“share deal”) because the object of the transfer for tax purposes is the interest in the corporation and this does not represent a regular depreciation volume.

In this respect, a form-changing transformation of a corporation into a partnership pursuant to Art. 190 et seq. UmwG which, pursuant to Art. 9 in conjunction with Art. 3 et seq. UmwStG and Art. 18 (1) sentence 1 UmwStG, can be carried out in a way that is neutral in terms of both corporate income tax and trade tax if the book value is continued, would be ideal from a tax perspective as preparation for a sale if there were no further tax law provisos, because this would allow the trade tax advantages of selling an entrepreneurial partnership interest to be combined with the purchaser’s interests in a “step-up” through an “asset deal”. This advantage would not exist without the corporation’s change of legal form (or in the case of a transferring transformation), as the change of legal form results in an improvement in tax status.

In order to – understandably – prevent this improvement in status, the sale of an entrepreneurial partnership interest in a partnership resulting from a change in the legal form of a corporation has always been subject to special trade tax treatment.

Historical development of Art. 18 UmwStG and excessive tendencies

In accordance with Art. 18 (4) UmwStG, old version (in the version valid until JStG 2008), the trade tax liability has therefore been extended as follows:

“(4) If the business of the partnership or the individual is discontinued or sold within five years of the transformation, any gain on dissolution or sale shall be subject to trade tax. Sentence 1 shall apply mutatis mutandis if a part of the business or a share in the partnership is discontinued or sold.”

The problem is that Art. 18 (4) UmwStG (old version) related both to sales following an initially tax-neutral change of legal form and sales following a transferring conversion of a corporation to an existing partnership.

According to the pure wording of the law, the trade tax liability therefore covers not only the former business assets of the transformed corporation, but also the business assets of the acquiring partnership. Accordingly, subject to a verbatim interpretation of the wording for trade tax purposes, this prevents not only the improvement in status for tax purposes which would otherwise occur with regard to the transformed GmbH’s former business assets, but would also result in a deterioration in status with regard to the acquiring partnership’s former business assets for a transitional period of five years. Such verbatim interpretation of the wording of Art. 18 (4) UmwStG (old version) was also in line with the tax authorities’ opinion. In this context, literature correctly considered Art. 18 UmwStG to contain a “trade tax pitfall”. 

The BFH has already opposed this verbatim interpretation of the wording in Art. 18 (4) UmwStG, old version, in previous rulings and applies this interpretation to Art. 18 (3) sentence 1 UmwStG (current version as successor provision to Art. 18 (4) UmwStG, old version). According to the BFH, there was no such trade tax pitfall (deterioration in status with regard to the acquiring partnership’s existing business assets), the wording only prevented an improvement in status with regard to the transformed or transferring corporation’s former business assets. Thus, only the transformed or transferring corporation’s business assets were taxable for trade tax purposes in connection with the sale of the entrepreneurial partnership interest.

IV Senate of the BFH remains true to its case law of teleological reduction

In its decision of March 14, 2024, the Federal Fiscal Court literally states with reference to the previous case law:

“With regard to Art. 18 (4) UmwStG 1995, the BFH has repeatedly stated that, on the one hand, the legislator of the Reorganization Tax Act 1995 pursued the goal of a preferably tax-neutral transformation of the corporation into a partnership and, in doing so, refrained from any trade tax burden on the transformation through the right to continue the book value (Art. 3, Art. 4 UmwStG 1995) and the exemption of the transfer gain (Art. 18 (2) in conjunction with Art. 4 (4), Art. 5 (2) UmwStG 1995). On the other hand, however, it disregarded the principle according to which capital gains on the sale of a business are subject to trade tax for the corporation (cf. Art. 2 (2) Sentence 1 GewStG), but generally not for the partnership. Based on this, Art. 18 (4) UmwStG 1995, as a subsidiary exception to Art. 2 and Art. 7 GewStG, was intended to prevent within its factual limits (including a five-year period) the corporation’s trade tax liability from being undermined by the fact that the business was sold or discontinued by the partnership only after the transformation had been completed and the profit achieved in this context was not subject to trade tax in accordance with the general principles set out above (cf. only BFH ruling of March 26, 2015 - IV R 3/12, BFHE 249, 233, BStBl II 2016, 553, marginal note 14, with further references). 

When accessing the capital gain on disposal or discontinuation generated within the five-year period of Art. 18 (4) UmwStG 1995, the legislator was guided by the idea that the transformed corporation’s assets would continue to be subject to trade tax, by assuming that, under the conditions of this standardizing provision, not the (historical) undisclosed reserves dormant in the corporation’s business assets at the time of the transformation but the current undisclosed reserves available at the acquiring legal entity at the time of the disposal or sale would be subject to trade tax. Accordingly, the BFH assumed for the legal situation until the amended version of Art. 18 (3) UmwStG (as the successor provision to Art. 18 (4) UmwStG 1995) by the Annual Tax Act 2008 that, according to Art. 18 (4) UmwStG 1995, the undisclosed reserves that were dormant in the recognized book values of such business assets which already existed in the absorbing legal entity’s business prior to the transformation would not be subjected to trade tax as well (BFH rulings of November 16, 2005 - X R 6/04, BFHE 211, 518, BStBl II 2008, 62 and from November 20, 2006 - VIII R 47/05, BFHE 216, 103, BStBl II 2008, 69; see also BFH ruling from March 26, 2015 - IV R 3/12, BFHE 249, 233, BStBl II 2016, 553, marginal note 15).

These considerations also apply to Art. 18 (3) UmwStG, as amended, which is applied in the case in dispute (Art. 27 (1) sentence 1 UmwStG). The teleological background of Art. 18 (3) UmwStG corresponds to that of Art. 18 (4) UmwStG 1995. The regulatory content of Art. 18 (3) sentence 1 half-sentence 1 UmwStG has remained unchanged.”

Thus, the BFH sees Art. 18 (3) sentence 1 UmwStG (Art. 18 (4) UmwStG, old version) as a standardized abuse provision and interprets it restrictively.

Extension of the facts by Art. 18 (1) sentence 2 UmwStG is interpreted as a “non-application law” to be construed narrowly

Against this background, the extension of the facts of the case by introducing Art. 18 (3) sentence 1, half-sentence 2 UmwStG has been interpreted by the BFH in the current decision of March 14, 2024 as a “non-application law”.

Art. 18 (3) sentence 1 UmwStG (as amended) reads:

“If the business of the partnership or the individual is discontinued or sold within five years from the transformation, any capital gain on the discontinuation or sale is subject to trade tax, even to the extent it is attributable to the business assets that already existed in the acquiring partnership’s or the individual’s business prior to the transformation.”

The second part of the sentence, which expressly includes the acquiring partnership’s business assets existing prior to the transformation, is interpreted as a non-application law in relation to the case law described.

Special characteristic of the present case “new business assets”:

The real property transferred to the GmbH for use, which is owned by the partner, was not a business asset of the transformed corporation, but only became a business asset of this co-entrepreneurship as a special business asset of the partnership in the course of the transformation itself.

Whether or not these “new business assets” are subject to trade tax in the event of a sale in accordance with Art. 18 (3) sentences 1 and 2 UmwStG (as amended) has been disputed.

In the 2011 UmwStE, the tax authorities have argued that these new business assets, which only arise in the course of the transformation, are also subject to trade tax in the event of a sale (of the entrepreneurial partnership interest) (marginal note 18.09 2011 UmwStE). This is also supported by large parts of the literature.

The lower court held that Art. 18 (3) sentence 2 UmwStG did not apply to a change of legal form, as the provision refers to an “acquiring partnership” and this required a transfer of assets, which does not exist in the case of a change of legal form. The BFH did not follow this civil law accessory reasoning, as it was in line with supreme court case law to equate the change of legal form with the transferring transformation from a “tax” perspective.

Nevertheless, the BFH holds the opinion that the partnership’s new business assets which only arose as a result of the change of legal form are not covered by Art. 18 (3) sentences 1 and 2 UmwStG (as amended). It is also irrelevant to the BFH that the real property belonged to the partner’s business assets in the context of a business split. The BFH states verbatim:

“Art. 18 (3) sentences 1 and 2 UmwStG relates to the gain from the (discontinuation or) sale of the business of the partnership (co-entrepreneurship) or a part of the business or a share in the partnership (co-entrepreneurship). According to the (open) wording of the standard, this also includes the gain attributable to undisclosed reserves in the co-entrepreneurship’s “newly formed business assets”. This applies equally to the profit from the sale of the real estate that is part of the co-entrepreneur’s special business assets I (newly formed in the course of the transformation) at the acquiring partnership.

However, such an interpretation would contradict the meaning and purpose of Art. 18 (3) sentences 1 and 2 UmwStG. The facts of the case must therefore be reduced teleologically (likewise Levedag in UmwStG-eKommentar, § 18 marginal note 50). The wording of the standard permits this.

Art. 18 (3) sentence 1 UmwStG is intended to prevent the corporation’s trade tax liability from being undermined by the fact that the business is sold or discontinued by the partnership only after the transformation has been completed and the profit generated in the process is not subject to trade tax. However, such a circumvention of the trade tax liability is not to be feared in the case of “newly formed business assets”. This is because these business assets were never part of the corporation’s transferred assets (so-called static assets, see BFH ruling of November 16, 2005 - X R 6/04, BFHE 211, 518, BStBl II 2008, 62, under II.2.d cc), but always only the partnership’s business assets. However, the discontinuation or sale of a partnership’s business, just like the discontinuation or sale of an entrepreneurial partnership interest, is not subject to trade tax on its merits. Accordingly, the transformation of a corporation into a partnership cannot have led to an improvement in status with regard to “newly formed business assets”. An abuse of any kind is not recognizable (see Bohnhardt in Haritz/Menner/Bilitewski, UmwStG, 6th edition, § 18 Rz 178). However, Art. 18 (3) UmwStG does not pursue a purpose other than the prevention of abuse or circumvention (BVerfG, non-adoption decision of November 6, 2008 - 1 BvR 2360/07, marginal note 10; Trossen in Rödder/Herlinghaus/van Lishaut, UmwStG, 3rd edition, § 18 marginal note 79).”

Follow the BFH’s view on “new business assets” in open cases

It remains to be seen whether the tax authorities will follow this view and amend the reorganization tax decree accordingly or whether they will react with a “non-application decree/act”.

In open cases, the BFH’s view on “new business assets” should definitely be followed and appropriate legal remedies should be lodged. It will be interesting to see how comparable cases are to be treated in future with regard to the reporting obligations for domestic tax structures.