German Federal Fiscal Court overrules German Ministry of Finance and local tax court
The German “exit tax” for individuals pursuant to Section 6 German Foreign Transaction Tax Act (Außensteuergesetz) is a nuisance for founders, entrepreneurs and other income tax residents in Germany owning one percent or more in the equity of any company or corporation (or having owned a respective participation in the five years prior to the exit): Relocating out of Germany, without an actual sale of the participation, triggers a taxation of a deemed capital gain (dry income) with respect to such shareholding.
The underlying Section 6 German Income Tax Act has been amended repeatedly in order to capture deemed avoidance arrangements. Even a donation of relevant shareholdings to recipients abroad may trigger that exit tax (irrespective of a potential inheritance tax on such transaction on top).
The German Federal Fiscal Court (Bundesfinanzhof) has now clarified (decision dated 21st of December 2022, I R 55/2019) that the exit tax does not apply in the event of a “temporary absence”, meaning that the individual moves back to Germany within 5 years (meanwhile extended to 7 years by the German legislator) even if an intention to return at the time of departure was not evidenced.
I. Facts of the underlying case
The plaintiff moved to Dubai (United Arab Emirates) on 1 March 2014, giving up his domestic German residence. At the time of his departure, the plaintiff held relevant participations in various limited companies. He moved into a flat in Dubai and no longer had any residence in Germany.
In 2016, however, the plaintiff moved back to Germany. After settling certain asset management matters in Germany, he “permanently” moved back to Dubai again in 2017.
The German tax authorities assessed an exit tax against the plaintiff for the tax year 2014, in spite of the move back to Germany in 2016. The German tax authority took the view that the requirements of the escape clause pursuant to Section 6 (3) German Foreign Transaction Tax Act (“temporary absence clause”) were not fulfilled, as the intention to return would have had to be presented at the time of the move.
II. Decision of the Federal Fiscal Court
The Federal Fiscal Court overturned the first-instance decision of the local tax court of Münster and rejected an exit taxation for the year in dispute, 2014. The highest German tax court disagrees with the view of the German tax administration according to which the intention to return must have been made clear upon departure. In the event of an actual return to Germany within five years (since the new version of the provision with effect from 1 January 2022: seven years and extendable by five years under further conditions), it was disproportionate and not required by the purpose of the provision to apply the exit taxation due to doubts about an original intention to return.
As a side note, effective for moves abroad as of 2022, the temporary absence clause has been extended to seven years, extendable by further five years further conditions being met.
It was not the subject matter of the dispute whether an exit taxation applies against the plaintiff for 2017 (renewed departure).
III. Practical consequences
Section 6 German Foreign Transaction Tax Act intends to ensure that value created in Germany (hidden reserves) is taxed in Germany and not abroad. An exit tax is generally not necessary with respect to real estate or business partnership shares in Germany because Germany retains a taxation right if an individual moves out of the country. On the contrary, if a relevant corporate participation is sold after the shareholder has left Germany, German tax authorities might otherwise come away empty-handed (depending on the case and the specifics of the underlying double taxation agreement). The right of taxation is then country of residence of the shareholder.
The decision of the German Federal Fiscal Court is correct. In the case of a temporary absence from Germany there is no reason to impose an exit tax. An accidental departure that results in a return to Germany within seven years (according to the legal situation since 2022) does not need to be sanctioned. It is important to note that it is not possible to temporarily move abroad and sell the shares (in order to avoid German taxation) then move back – such return would not benefit from the temporary absence clause and would still trigger the exit tax.
In any event Section 6 German Foreign Tax Act causes considerable issues for those affected, as taxation takes place without an inflow of liquidity. In many cases the income tax can only be paid by selling shares (if possible) or taking out a loan. Moreover, the valuation of the underlying company is typically totally unclear (keyword: excessive valuations in financing rounds).
For moves within the European union, it remains to be seen whether or not the German accident tax rule is compliant with EU laws, specifically the freedom of movement and EU freedom of establishment. In practicality, a number of “immigrant” successful founders leave Germany after six years at the latest, because the provision requires an unlimited tax liability Germany for at least seven years within twelve years. Other taxpayers restructure their shareholdings, e.g., in commercial partnerships, before moving.
Nevertheless, painful unwanted taxation cases remain. It is of little help that, upon application and against providing security (which appears to be an excessive requirement contradicting EU laws) the tax may be paid in seven annual instalments. For these cases, the court’s decision has considerable practical relevance, because the way back to Germany remains open and is not obstructed by accident tax for five years (for exits as of 2022: seven years plus extension option).
