Gift tax on disproportionate contributions and indirect increase in the value of shares - The gift fiction of Section 7 (8) Inheritance Tax Act

According to the provision of Section 7 (8) of the German Inheritance Tax Act (ErbStG), a merely indirect increase in the value of shares in a corporation or cooperative through a payment to this corporation is also subject to gift tax. It is noteworthy that, contrary to the system, this does not require a contribution to the shareholders' assets.

In principle, circumstances are covered by Section 7 (8) ErbStG in which a benefit is provided to the company that is not offset by corresponding consideration from the company. The resulting reflex increase in the value of the company shares is taxed as a gift to the shareholders.

In any case, this includes contributions in kind to the company and, in the opinion of the tax authorities, also so-called contributions for use, i.e. the transfer of assets free of charge. The case of application originally envisaged by the legislator were so-called disproportionate contributions, where a shareholder makes above-average contributions to the company's assets. According to the wording, however, contributions from third parties outside the company that represent a particularly favorable transaction for the company are also included.

Summary

Due to the broad scope of application of the regulation, the gift tax risk described below must be kept in mind in each individual case, particularly in the case of capital measures and other transactions between the company and its shareholders. If there are any doubts as to the balance of the shareholders' contributions, some effort should be made to justify the (subjective) balance of the contributions and, at best, to document this contractually.

The latest decisions of the Federal Fiscal Court from April 10, 2024

The standard has been criticized for its potentially unlimited scope of application. The Federal Fiscal Court (BFH) has now issued two recent rulings (Ref.: II R 22/21 and II R 23/21) that provide a better understanding of this fictitious gift. It becomes clear how broadly the BFH views the scope of application of the standard. Accordingly, any action, toleration or omission that leads to an enrichment of the company should be subject to gift tax if further requirements are met. Unfortunately, the BFH has thus done little to limit the scope of the standard.

In both decisions, the BFH ruled that the acquisition of own shares by the company can be treated as a gift to the remaining shareholders. This should be the case if the purchase price paid by the company for its own shares is lower than the value of these shares, thereby indirectly increasing the value of the other shares and indirectly enriching their holders. As a result, the BFH has also deemed a taxable gift to the remaining shareholders in these cases.

Classification of the decision

The fiction of a gift to the shareholders in the event of an increase in the value of shares is assumed in various situations, particularly under company law.

Firstly, there is the (hidden) contribution of a shareholder without other shareholders also making a comparable contribution or this additional contribution being offset by other circumstances. This was the constellation that the legislator was primarily concerned with when enacting the standard.

Even if a shareholder receives fewer shares for his contribution in the context of a capital increase than he is entitled to in terms of value, this is gift taxable in application of the standard, as the shares of the other shareholders also indirectly increase in value as a result.

Finally, gift tax may also arise in the context of a merger of two companies. This is the case if the transferring shareholders agree to a shareholding in the remaining company that is too low compared to its value.

Furthermore, due to the broad scope of application of the standard, numerous other cases of application that have not yet been dealt with by case law are conceivable.

Design options for avoiding gift tax

However, the interpretation of the standard also gives rise to aspects for restricting its application, which, if observed, can reduce the risk of a generally unexpected inheritance and gift tax burden.

Business exemption rule not applicable

When transferring business assets, gift tax can be largely avoided by applying the so-called business exemption rule. In principle, this regulation also favors the transfer of shares from a minimum holding of 25% on the part of the donor or donee. However, since in the case of the fictitious gift under Section 7 (8) ErbStG, the relevant facts are not a transfer of shares, but their increase in value, the business exemption rules are unanimously rejected by the courts and tax authorities in this case. This was reaffirmed in the decisions under consideration here.

Overall consideration with other benefits and agreements

In the opinion of the tax authorities, value-increasing payments to the company are not to be considered in complete isolation, but rather as part of an overall consideration with other payments or agreements:

On the one hand, services provided by other shareholders to the company that are provided in a temporal and factual context should also be taken into account as part of an overall consideration. If this results in an overall increase in the value of the shares of all shareholders corresponding to the shareholding ratios, there should be no taxable benefit within the meaning of Section 7 ( 8) ErbStG. Compensatory payments by the shareholders to each other are also relevant in this respect, which compensate for the increase in value.

On the other hand, disproportionate contributions by individual shareholders do not lead to a taxable increase in the value of the shares of co-shareholders if this is associated with the acquisition of additional rights in the company. This can occur through a different distribution of current profits or exit proceeds, for example through a liquidation preference.

Increasingly, it is also considered permissible to make the contribution by posting a personal capital reserve, which may only be paid out to the shareholder making the contribution in the event of its reversal. However, this model causes consequential problems in terms of income tax treatment, as the personal nature of the capital reserve does not change the fact that all profits must first be distributed subject to capital gains tax before the tax-free distribution of the capital reserve.

Awareness of the balance of benefits

With the special provision of Section 7 (8) ErbStG, unlike in the case of gifts, no intention to enrich the shareholder is assumed. However, the tax authorities and, as a result, the courts are now also reading the unwritten, subjective constituent element of awareness of benefits into the standard. So far, however, this has only been confirmed by the tax courts and not by the Federal Fiscal Court.

For example, the parties involved must be aware that the mutual benefits are not balanced overall in order to justify taxability. The decisive factor is the shareholders' knowledge and perception of value at the time when the benefit is realized, even if this proves to be incorrect on the basis of better knowledge gained at a later date. However, the tax authorities draw the line rather arbitrarily at a difference in value of 20 percent, above which such an obvious imbalance is to be assumed that an awareness of the imbalance of the benefits can be supposed. To date, there is no case law on this. Particularly in the case of the usually complex agreements between shareholders, it would be difficult to subjectively price the respective contributions of the shareholders so precisely that they can be assumed to be aware of the imbalance. In our opinion, this is one of the most promising starting points for avoiding inappropriate taxation.

Contributions between corporations

If an uncompensated payment is made by a corporation to a corporation (and not by an individual), there must be an enrichment intention for the transaction to be subject to gift tax. This exception is based on the fear that otherwise any hidden profit distribution within the group would qualify as a transaction subject to gift tax.