Waiver of Debt No Taxable Event for Non-resident Real Estate Companies
In its decision dated December 7, 2016 (file no. I R 76/14), the Federal Fiscal Court (Bundesfinanzhof; “BFH”) confirmed that the book gain from a waiver of debt at the level of a foreign real estate company is not subject to non-resident taxation (section 49 (1) no. 2f) Income Tax Act (Einkommensteuergesetz; “EStG”)) in Germany. This shall in particular be the case if the waiver of debt occurs at a time when the real estate company has already discontinued its letting business for several months. This decision of the BFH allows foreign real estate investors to achieve a tax-neutral cancellation of the debt of real estate special purpose vehicles in Germany when winding up their investment business.
In the underlying case, a Luxembourg S.à r.l. (“LuxCo”) acquired a real property in Germany which it held as its only asset. The acquisition was financed by an intra-group loan. LuxCo, which neither had a permanent establishment nor a permanent representative in Germany, kept accounting books on a voluntary basis and determined its income on the basis of balance sheets (accruals accounting). After selling the real property, LuxCo was unable to fully repay the intra-group loan it had received to finance the acquisition. The group-internal creditor subsequently waived its claim for repayment of that loan. The parties’ dispute evolved around the question of whether this waiver of debt is covered by section 49 (1) no. 2f) EStG and triggers income from leasing and letting or from the sale of German real estate, respectively, subject to non-resident taxation in Germany.
The tax authorities’ view
The German tax authorities argued that the book gain from the waiver of debt at the level of LuxCo qualified as fictitious business income pursuant to section 49 (1) no. 2f) EStG. As the company voluntarily kept accounting books, German tax authorities held that LuxCo’s fictitious business income was to be determined by way of accruals accounting for German tax purposes according to section 49 (1) no. 2f) EStG. Taxpayers determining their taxable income by way of accruals accounting have to establish balance sheets and a profit and loss account for German taxation purposes. The balance sheets have to show the assets and liabilities related to the business in Germany. In the case of LuxCo, the balance sheet’s assets side thus was to show the German real property, while the liabilities side was to show the liabilities pertaining to the real property. On this basis, German tax authorities argued that any change in the value of the liabilities had an impact on the profit and loss account and, thus, on the amount of income subject to non-resident taxation in Germany.
Decision made by the BFH
The BFH rejected this view and confirmed the decision made in the first-instance proceedings (Tax Court Berlin-Brandenburg, decision of November 12, 2014 (file no. 12 K 12320/12)), arguing that the book gain realized by the foreign real estate company from the waiver of debt was not subject to German non-resident taxation in the case at hand.
- No income from permanent establishment: The book gain from the waiver of debt was not subject to German non-resident taxation within the meaning of section 49 (1) no. 2a) EStG because LuxCo neither had a permanent establishment (section 12 German Fiscal Code; Abgabenordnung, “AO”) nor a permanent representative (section 13 AO) in Germany. Moreover, the BFH further argued that the assumption of fictitious business income pursuant to section 49 (1) no. 2f) sentence 3 EStG did not allow for the assumption of a fictitious permanent establishment in Germany for the purposes of section 49 (1) no. 2a) EStG either. Accordingly, the book gain from the waiver of debt was not to be taken into account for the purposes of determining the profits allocable to a permanent establishment in Germany.
- No income from leasing / disposal of real estate: According to the BFH, the book gain from the waiver of debt did not qualify as income from leasing and letting or from the sale of German real estate within the meaning of section 49 (1) no. 2f) EStG. The BFH held that the assumption of income from leasing and letting was precluded in the underlying case because the waiver of debt only occurred several months after the letting business was discontinued. Hence, there was no sufficient causal connection between the waiver of debt and the letting business conducted previously. The increase in assets resulting from the waiver did not qualify as income from a sale of German real estate, either, because the waiver of the debt under the loan was neither made in consideration for a transfer of the real property nor reasonably linked with the sale of the real property from an economic perspective.
- As a result, it must be noted that the book gain from a waiver of debt does not qualify as income subject to non-resident taxation in Germany, if the real estate company has permanently discontinued its letting business. The other issue in dispute between the parties, i.e. whether Germany does have a taxation right under the Double Tax Treaty Germany/Luxembourg at all, did not have to be dealt with by the BFH in the case at hand.
In summary, it can be noted that, for the time being, a waiver of debt after the sale of the last real property remains a viable means of tax-neutrally reducing or eliminating the debt of foreign real estate companies. It remains to be seen, however, whether the German tax administration will in fact apply the decision made in the case at hand to other cases. Apparently, the German Federal Ministry of Finance argued before the BFH that it was justified to tax the book gain from the waiver of debt in Germany because the interest payable on the loan had reduced the income of the foreign real estate company realized in Germany during the letting period. It would be desirable if the German tax administration reconsidered its position in order not to thwart the BFH case law by issuing a non-application decree or law. Taking into account a book gain from a waiver of debt for German income tax purposes could ultimately lead to a double taxation, if the country of residence of the real estate company also taxes the relevant income and if the countries involved are in dispute regarding the allocation of the taxation right.