Exit Tax

As in many other countries, the German fiscal administration wants to retain comprehensive access to the tax substrate (tangible and intangible assets) located in Germany for as long as possible. If the tax substrate is moved from Germany, an exit tax might be charged - as is usual in international tax law. Therefore, the international term used in these cases is “exit tax”. The most frequent case is that of a move from Germany to another country. The principle of exit taxation is covered in section 6 Foreign Tax Act (AStG) and, in the case of natural persons, it results in the corresponding application of section 17 EStG in the event of a relocation to another country. This means if a natural persons holds shares (at least 1%) in a corporation as part of his/her private assets and if this person moves abroad, a fictitious sale of the shares is assumed according to sections 6 AStG, 17 EStG and the “profit from the sale of shares in a corporation” is taxed accordingly resulting in the disclosure and taxation of the hidden reserves involved in the shares. The problem entailed in this is obvious: This fictitious sale provided for in law leads to very real tax burdens which can be significant. Since, however, the person involved has not received any sales proceeds and still has to pay taxes this almost always constitutes a very significant problem for liquidity in practice.

The reason for the exit tax is based on the legislator’s will to secure the German tax income. To this end, the German legislator has introduced various taxation mechanisms which are triggered upon a relocation abroad. The so-called exit tax is designed to give the German tax office, in particular, access to existing hidden reserves before these are removed from the fiscal sovereignty of the Federal Republic of Germany. If certain preconditions are fulfilled, the relocation of a person triggers taxation of - fictitious - sales proceeds even if, de facto, no sale was carried out and no purchase price and, as a result, liquidity was generated (cf. example below).

In principle, exit tax applies whenever the German fiscal authority loses the right to tax sales proceeds because of a relocation. In general, the taxation right is tied to the residence. Therefore, anyone giving up their residence in Germany should definitely check whether he/she is affected by exit tax. However, the situation becomes far more complicated in the case of persons who have several residences or are only planning to stay abroad temporarily. In these cases, the double taxation agreements (DTA) have to be checked to determine whether Germany loses taxation rights because of a change in the taxpayer’s personal circumstances as these rights are then allocated to the other country under the relevant DTA. 

For this reason, the fact has to be observed that for exit tax to apply, a taxpayer does not necessarily have to give up any connection to Germany. Fictitious sales proceeds can even be taxed if a residence in Germany is maintained. Most of the DTA concluded by Germany with other countries specify that the respective country of residence has the taxation rights regarding the sales proceeds for shares in corporations. If residence changes in accordance with the DTA provisions, these cases involve the risk of an exit tax. 

Finally, this provision also concerns non-resident taxpayers moving to Germany and establishing a (temporary) residence here. If these, e.g., hold company interests in Germany and abroad and leave Germany again after a few years, the exit tax also applies to these persons with regard to the hidden reserves created during their residence in Germany. 

Example:

Taxpayer (S) moves to the USA with his family but keeps a flat in Germany. Because of his work, he often stays in Germany (approximately 3 months per year) and then lives in this flat. Since S can use this flat at all times and actually uses it regularly, he retains a residence in Germany according to section 8 AO and, as a result, he has unrestricted tax liability in Germany. At the same time, however, he also has unrestricted tax liability in the USA because of his residence. First of all, the threat of double taxation (both countries will tax his global income because of the respective unrestricted tax liability) of the current income has to be resolved. Because of his predominant stay in the USA and since this is the centre of his life - which is assumed as a result of his family’s residence there - S is assumed to be resident in the USA within the meaning of art. 4 DTA USA. Because of his residence there, the USA are said to lead the DTA. Therefore, depending on the type of income, the USA are assigned the taxation right. In contrast, for income sources in Germany (e.g. income from letting of a real estate property located in Germany), Germany still holds the taxation right. 

As a second step, possible consequences of a relocation to the USA have to be examined. If, at the time of the relocation to the USA, S holds shares in a corporation as part of his private assets, the USA would be assigned the taxation rights regarding a possible sale - while Germany would lose this right. This triggers exit tax according to section 6 sub-section 1 sentence 2 no. 2 AStG even though the person still has unrestricted tax liability in Germany. Laypersons in tax matters will certainly not be aware of this and, moreover, there is no reason to suspect such a possibility since the “perceived” tax situation in Germany (unrestricted tax liability) does not change on the surface. The same, e.g., also applies if the taxpayer contributes the shares to a foreign company or a foreign business establishment, section 6 sub-section 1 sentence 2 no. 3 AStG. 

Exit tax does not only comprise those cases in which the taxpayer holding the shares in the corporation moves abroad or contributes these to a foreign company (or business establishment). If the shareholder transfers his shares as a gift or if the shares are transferred to another person in the context of an inheritance which does not have unrestricted tax liability in Germany according to section 6 sub-section 1 sentence 2 no. 1 AStG, exit tax can also be triggered. 

According to the dominant opinion (even though there is no consensus on this in literature), exit tax is incurred in the logical second before the decedent’s death, as a result of which the resulting income tax liability is still incurred in the person of the decedent. The exit tax to be paid by his heirs in the form of income tax can then be deducted as estate liabilities according to section 10 sub-section 5 German Inheritance Tax Act (ErbStG) in the framework of inheritance tax. 

So, if you wish to consider someone in the framework of gifts or in a testament, you should first check whether this can also trigger exit tax, in addition to inheritance and gift tax.

Since a sale is only assumed in the case of exit tax, the sales price (section 17 sub-section 2 EStG) is replaced by the market value of the shares at the material time of the relocation/gift/inheritance, section 6 sub-section 1 sentence 4 AStG. The “market” value is defined in section 9 sub-section 3 Valuation Law (BewG) as “the price (...) which could be achieved in a sale in the usual course of business based on the characteristics of the asset”; i.e. it usually corresponds to the fair market value. 

According to section 6 sub-section 3 AStG the tax claim according to sub-section 1 - i.e. the so-called exit tax - ceases to apply if the end of the unrestricted tax liability (or the fulfilment of the alternative criteria or, in general, the restriction of the taxation right of the Federal Republic of Germany) is based on a temporary absence and the taxpayer becomes subject to unrestricted tax liability again within a period of five years after his relocation (or the fulfilment of the alternative criteria or, in general, the restriction of the taxation right of the Federal Republic of Germany ceases to apply) and the further preconditions are fulfilled. These preconditions, e.g., include the fact that the shares must not be sold in the meantime. 

The tax office can extend this deadline by, at maximum, five years if the taxpayer credible demonstrates that professional reasons are material for his absence and that his intention to return has not changed, section 6 sub-section 3 sentence 2. These reasons have to be credibly shown. 

PLEASE NOTE! The fact that the obligation to submit a tax return for the relocation does not cease to apply as a result and that the lapse of the tax claim is tied to the actual return to the country - so, ultimately, the mere intention to return is not sufficient.

Depending on the design of the matter, the disclosure of the hidden reserves and the accompanying taxation of the fictitious sales proceeds can be avoided, e.g. by restructuring. Another possibility often cited in literature is the establishment of a so-called “management holding” which, as a result of activities exceeding mere asset administration, leads to the establishment of business premises to which the shares in the corporation to be considered can be allocated. 

According to section 13 OECD Sample Agreement, Germany retains the taxation right regarding proceeds from the sale of assets to be allocated to domestic business premises, i.e. those located in Germany. However, the respective relevant double taxation agreement has to be considered since this does not necessarily correspond to the above-mentioned OECD Sample Agreement. 

As in many other cases, the individual case depends on whether and, in particular, how triggering of exit tax can be avoided. Therefore, it is worthwhile calling in a tax adviser to talk about available options early on.

A French provision comparable with section 6 AStG was at the heart of the ECJ ruling ECJ Rs. C-9/02 dated 11/3/04, – de Lasteyrie du Saillant. In this case, ECJ found a violation of the so-called freedom of establishment, one of the “basic rules of the EU”. 

In order to ensure compliance with EU legislation, the German legislator has also adjusted the provision on exit tax so that, in the event of a border-crossing matter within the EU, an interest-free tax deferral (without security) is granted until the time of actual sale - however, the principle of exit tax is preserved. As a result, a tax liability is not incurred at the time of the relocation - or at the time at which the alternative criteria are fulfilled but at the time of the actual sale. However, even in the case of transactions within the EU (and the EAR), the tax office has to be informed of the matter. This means the obligation to file a tax return regarding the relocation.

According to section 6 sub-section 4 AStG, upon request, the income tax owed can be deferred at regular partial amounts for a period of, at maximum, five years after the first due date in return for security. This is based on the precondition that an immediate (instantaneous) collection would involve significant hardship for the taxpayer. The reasons for this have to be credibly shown.

In the case of a temporary relocation (section 6 sub-section 3 AStG), see also item 6, a deferral can also be applied for. In these cases, partial amounts are not charged and, if the tax claim is not at risk, the provision of security can even be dispensed with. In this case too, the preconditions have to be credibly demonstrated.

Up until a few years ago, experienced tax advisers were able to legally circumvent the consequences of exit tax by contributing the corresponding shares to a partnership - frequently, a GmbH & Co. KG - before the relocation. Exit tax could be prevented by using this tax trick according to section 6 AStG. The fiscal administration accepted this legal practice to circumvent tax since taxation of the hidden reserves in Germany was not jeopardised by this. This was due to the following tax law constellation: 

The holding companies so established were usually so-called domestic “partnerships of a commercial character” subject to the assumption of a commercial character under section 15 sub-section 3 no. 2 EStG which were, hence, considered commercial operations within the country. The same was assumed at the level of the double taxation agreement so that profits from a later sale were to be qualified as company profits within the meaning of art. 7 OECD SA - and Germany retained the taxation right. 

In 2010, the German Federal Fiscal Court shook this tried and tested system with its ruling dated April 28th, 2010 (Federal Fiscal Court I R 81/09) by stating that the assumption of a domestic commercial character cannot be transferred to the level of the DTA. According to this, the corresponding profits are no longer necessarily corporate profits within the meaning of art. 7 OECD SA but, as a rule, profits from the sale of assets according to art. 13 OECD SA. As a result, the country in which the shareholder is based holds the taxation right - while the country in which the GmbH &B Co. KG is “based” does not. 

This ruling had far-reaching taxation consequences: From one day to the next, the assets and shares which had previously been “parked” in partnerships of a commercial character were withdrawn from German tax sovereignty. However, the specific individual case also has to be considered since even in the case of a company of a commercial character the allocation of the shares held in a corporation to a domestic business establishment can be correct. 

The German legislator acted accordingly in the framework of the Administrative Assistance Guideline Implementation Act of June 26th, 2013 and introduced section 50i EStG. As a result of this provision, Germany retained the taxation right regarding the profits from the sale and withdrawal of assets or shares which were contributed to a partnership of a commercial character prior to June 29th, 2013. This was intended to retrospectively safeguard the taxation of any potential hidden reserves in cases in which the fiscal administration was unable to respond to the new jurisdiction of the Federal Fiscal Court. 

Afterwards, section 59i EStG was repeatedly amended since the provision had a very broad wording and even included cases in which Germany had not lost the taxation right at all. This process has now been concluded with the “Anti-BEPS Law” of December 20th, 2016 in which the legislator finally responded to the criticism and presented an “improved” version of the regulation, which took effect on January 1st, 2017. 

This “new” section 50i EStG essentially comprises two major changes:

On the one hand, section 1 was expanded with another provision. Now, the taxation of (fictitious) profits/a withdrawal in Germany only applies if the “right of the Federal Republic of Germany regarding the taxation of proceeds from the sale or withdrawal of these assets or shares has been excluded or restricted regardless of the application of this section before January 1st, 2017”. This means matters leading to a border-crossing connection after December 31st, 2016 are no longer covered by section 50i EStG.

Even though the restriction of the scope of application to “old cases” puts concerns under constitutional law into perspective and limits the risk of double taxation regarding an increase in value created after the relocation, the disjunction protection granted by this provision so far ceases to apply concurrently. 

Moreover, section 50i sub-section 2 EStG was amended and its scope of application was severely restricted, which is welcomed very much in view of the enormous previous problems. For example, the book value privilege for contributions within the meaning of section 20 UmwStG also ceases to apply; however, only in as far as the right of the Federal Republic of Germany to tax later sales proceeds is excluded or restricted. 

Even though the introduction of the new section 50i EStG has eased the situation - however, care is still required. In particular, the lapse of disjunction protection as of January 1st, 2017 can lead to significant and unexpected tax burdens.