In the case of properties, do step up models constitute a form of abusive structuring?

Facts of the case and the ruling by the BFH

The following is a simplified overview of the facts of the case that formed the basis of the BFH ruling of 22.2.2021 (case reference IX R 13/19). Various properties that formed a part of the taxable private assets had been rented out. The properties here were held by an asset management partnership. This partnership then became commercially active for tax purposes so that the properties consequently became business assets. After three years the partnership ultimately became dormant for tax purposes and, therefore, the properties were transferred again from the business assets into the taxable private assets. A particular feature in the case in question was that, during the three-year period of being classified as a business, no hidden reserves had arisen for the properties and, thus, no taxable gains from the transfer had accrued. The taxpayer and the local tax office were now unable to agree on the amount that could be depreciated following the deactivation of the partnership’s business.

The BFH decided that the fair market value on the date when the change in status occurred had to be used as the assessment base for future depreciation. 

Can this model be used as a structuring instrument?

Ultimately, activating the commercial nature of the partnership and, subsequently, changing its status to inactive meant that it was possible to generate new potential for depreciation; moreover, after the end of the speculation period pursuant to Section 23 of the German Income Tax Act, which was triggered by the withdrawal of the assets, it was nevertheless possible to sell the properties tax-free. Two aspects are particularly relevant here for practical tax planning.

(1) First of all, changing the status of the partnership will result in a taxable gain from relinquishment, i.e., the hidden reserves that arose during the ‘period of commercial activity’ will have to be taxed. At the present time especially, with property prices seemingly going in one direction only, the hidden reserves that would arise during several years of the properties being held as business assets could, potentially, be of a not insignificant magnitude. In the short term, this could therefore result in an additional tax charge. 

(2) Secondly, – and for tax planning this would normally have to be considered – hanging over such a structure is the Sword of Damocles of abusive use pursuant to Section 42 of the German Fiscal Code. This was also the situation in the case in question where the local tax office (Finanzamt, FA), at least in the alternative, had contended before the tax court that there were was no economic rationale behind the structure and, in fact, the paramount goal had been solely tax optimisation and the taxpayer should be put in such a position that would have existed if the structure had been omitted.

However, the BFH ruled that the FA had not adequately countered the taxpayer’s narrative and their arguments with respect to the non-tax-related reasons for the structure. In the statement setting out its grounds, while the BFH assigned the issue of abusive use merely to a margin number, it is nevertheless all the more important to evaluate this. This is because the Munich-based judges, at least, provided pointers as to the reasons for a change in status to inactive that would be deemed to be sufficiently weighty and economically justifiable.

Please note: Even if, from our present point of view, the structure would have surely been, in part, different, nevertheless the ruling shows that ‘bold’ planning can certainly lead to success. However, the planning needs to be well thought through because, as always, what matters here are the details of the regulations as they will determine tax success.