I. Exit taxation
The objective of the German exit tax (also known as Entstrickungsbesteuerung) is to tax the capital gains on shares (at least a 1% share of the company’s capital within the preceding five years) when the shareholder emigrates. Otherwise, Germany, as the exit state, would no longer be able to tax any capital gains on a later sale of shares, even though the increase in value arose at the time of Germany’s unrestricted right to tax. Under most double taxation treaties, the right to tax capital gains on shares in a corporation is allocated to the country of residence of the shareholder, and consequently, following a change of residence, in the country in which the shareholder emigrates to (host state).On the basis of this objective, a sale of the shares in a corporation held as private assets with a minimum participation of 1 % (shares as defined under section 17 German Income Tax Act [Einkommensteuergesetz – EStG]) is simulated in accordance with section 6 para. 1 AStG when the domicile or habitual residence is relinquished, so that at the time of the termination of the unlimited tax liability, the capital gains on these shares is taxed. Due to the European fundamental freedoms, an unlimited and at the same time interest-free deferment of payment of the tax is to be granted in case of moving to a member state of the EU or the European Economic Area (“EEA”). Pursuant to section 6 para. 5 AStG, Germany has implemented such a deferment regulation, the scope of which is explicitly limited to EU/EEA cases according to the wording of the law.
When a taxpayer transfers his domicile to Switzerland, it has so far been assumed that deferment of payment is not required under European law owing to a lack of EU/EEA membership. However, the ECJ ruling explained hereinafter demonstrates that in certain constellations a deferral of the exit tax must also be granted in relation to Switzerland.
II. Initial case and ECJ decision
The ECJ ruling of 26 February 2019 is based on a situation in which a German citizen has transferred his residence from Germany to Switzerland. At the time of his emigration, he held a 50 % share in a corporation based in Switzerland as shareholder-managing director. As a result, the criteria for exit taxation under section 6 para. 1 sentence 1 AStG were essentially fulfilled. However, with regard to the (exit) tax that had been determined, the German tax authority refused the tax deferral by pointing out that it would only be possible if the person emigrated to an EU/EEA member state.
In contrast, the person liable for tax argued that this could not be reconciled with freedom of establishment. The competent fiscal court in Baden-Württemberg decided to stay the proceedings and to refere the matter to the ECJ for a preliminary ruling. In simple terms, the question was put to the ECJ as to whether, under certain conditions, a possibility of tax deferral also exists in relation to Switzerland. To answer this question, the ECJ had to assess the potential restriction of the freedom of establishment in relation to Switzerland on the basis of the Agreement on the Free Movement of Persons (hereinafter “AFMP”). The AFMP was agreed in 1999 between the member states of the European Community and Switzerland (OJ 2002 L 114, p. 6) and is intended, among other things, to guarantee a certain degree of freedom of movement within the territory of the EU and Switzerland.
When examining the scope of application and the provisions of the AFMP, it should be noted that an explicit principle of equal tax treatment is provided only for employees, self-employed persons and dependent cross-border workers as well as self-employed cross-border workers (Annex I, Article 9(2) AFMP; Annex I, Article 15(2) AFMP; Annex I, Article 7 AFMP or Annex I, Article 13 AFMP). In the present case, therefore, the taxpayer’s activity as an IT consultant for a company based in Switzerland, of which he is the managing director, was initially to be classified accordingly. During the examination as to whether the employment in question is to be regarded as “dependent employment” or “self-employment”, the ECJ based its assessment on the existence of an obligation to follow instructions or a relationship of superiority/subordination. Due to the position as shareholder-managing director, there is no relationship of subordination in the present case, so that in the opinion of the ECJ the taxpayer is to be classified as a self-employed person within the meaning of the AFMP. Thus, the scope of application of the AFMP is broadened and a possible unequal treatment can be examined under consideration of the AFMP.
In the course of this examination, the ECJ found that the German exit tax regulations lead to a liquidity disadvantage without the possibility of a tax deferral. This in turn can prevent a taxpayer from actually exercising his right of establishment (under the AFMP). In the view of the ECJ, the exit tax in question in the original proceedings would be in breach of the freedom of establishment guaranteed by the AFMP for all those who wish to take up self-employment in the other contracting state (host state). The unequal treatment stated by the ECJ becomes particularly clear in a direct comparison with a purely domestic case without emigration in which taxation takes place only at the time of the actual sale of shares.
In cases where there is such a restriction or unequal treatment, it must in turn be examined whether it is justified by overriding reasons in the general interest. In this respect, the ECJ states in the present case that although exit taxation may be suitable for achieving the objective of preserving the allocation of powers of taxation, this does not mean that the refusal of a tax deferral is also justified. After all, in the event of deferment, Germany will not finally waive its tax claims.
The ECJ also considers that the objective relating to the effectiveness of fiscal supervision cannot be used as an argument for completely waiving a tax deferral scheme. At this point, the ECJ refers to the double taxation agreement between Germany and Switzerland which guarantees the exchange of tax information. When examining a further justification, the ECJ states that the early collection of the exit tax at the time of the transfer of residence can in principle be justified by the necessity to ensure the effective collection of tax debts. However, the ECJ considers that this measure goes beyond what is necessary in order to achieve that objective.
Thus, it remains to be determined whether the exit taxation system at issue in the main proceedings constitutes an unjustified restriction on the right of establishment provided for by the AFMP in cases without the possibility of deferral. As a result, an immediate taxation of the undisclosed reserves of shares in corporations within the meaning of section 17 EStG is to be classified as disproportionate in the present case. According to the ECJ, the provision for payment in installments contained in section 6 para. 4 AStG does not affect this, as this does not eliminate the liquidity disadvantage.
III. Consequences for the practice
The German exit taxation can lead to a considerable liquidity disadvantage without the possibility of deferralof payment of the tax payable in the event of a transfer. From the taxpayer’s point of view, it is therefore generally to be welcomed if, on the basis of a ruling of the ECJ, the scope of application of an existing deferral regulation is to be extended with respect to Switzerland. However, this does not generally apply to all cases of emigration to Switzerland. The prerequisite is that the taxpayer can invoke the AFMP’s principle of equal tax treatment on the basis of his (non-)self-employed activity. In all other cases, the current legal situation continues to provide for immediate taxation in accordance with section 6 AStG, so that other arrangements must be examined in order to avoid exit taxation.
In addition, it should be noted that due to the lack of administrative support and mutual assistance in the recovery of tax between the Federal Republic of Germany and that State are guaranteed, the tax deferral can be made dependent on the provision of any guarantee. The German tax authorities may therefore order the provision of guarantee (e.g. a bank guarantee) for the entire period of the deferral in relation to Switzerland. In the end, it remains to be seen how the legislator will react to the ECJ ruling. The honert+partner newsletter will keep you up to date on the latest developments.