I. General Explanations: Current State of Affairs

While the transfer of individual business assets between different business estates of the same taxpayer, made without consideration, generally constitutes a withdrawal or contribution for tax purposes that leads to the realization of a gain under the general provisions, § 6 (5) sentence 3 of the German Income Tax Act (EStG) mandates the continuation of the book value for certain (among other) transfers made without consideration. Thus, the provision generally allows the taxpayer, in the case of restructuring transactions covered by the provision, to carry forward the hidden reserves associated with the asset in question, even in the event of a change in legal entity.
Controversial in this context is the treatment of transfers made for partial consideration, where the consideration paid falls short of the fair market value of the asset. For income tax purposes, these transactions could be treated either according to the so-called strict separation theory, which is advocated by the tax authorities (see letter regarding questions of doubt concerning the transfer and reassignment of individual assets pursuant to Section 6(5) of the Income Tax Act (EStG) dated December 8, 2011, BStBl. I, 2011 I, 1279, para. 15), or according to the so-called modified separation theory, which is favored in the literature. Although both views initially divide the transfer for partial consideration into a consideration-based and a non-consideration-based portion, they then allocate the book value of the asset to the partial consideration in different ways.
The strict separation theory allocates the book value to the partial consideration only on a pro rata basis (according to the ratio of partial consideration to market value of the asset), so that in the case of a partial consideration, there is always a pro rata gain (market value higher than book value) or a pro rata loss (market value lower than book value). In contrast, the modified separation theory determines the respective capital gain by deducting the entire book value from the partial consideration, so that transactions involving partial consideration are generally not subject to taxation if the partial consideration does not exceed the book value.
The Federal Fiscal Court (BFH) has not yet adopted a uniform position on this issue. While the Sixth Senate of the BFH applies the modified separation theory, the Xth Senate tends toward the strict separation theory and had referred the question of how § 6(5) sentence 3 EStG is to be interpreted in cases of partial consideration to the Grand Senate for a decision (decision of October 27, 2015 – X R 28/12). However, since the tax office had granted the plaintiffs’ request in the underlying appeal proceedings, the proceedings had to be terminated without a decision on the legal question submitted (Decision of October 30, 2018 – GrS 1/16). Thus, uncertainty continues to prevail in this matter.
With the aforementioned ruling, the IVth Senate of the Federal Fiscal Court (BFH) has now confirmed its previous view that the modified separation theory applies to transfers made for partial consideration.

II. Decision of the Federal Fiscal Court

In the facts underlying the judgment, the taxpayer, who was joined as a third party in the appeal proceedings, sold a developed property (market value: EUR 1,028,011) that was part of his special business assets held by the plaintiff, a GmbH & Co. KG, for a purchase price equal to the book value (EUR 920,217) to another GmbH & Co. KG in which he also held a stake. Following a tax audit, the competent tax office issued an amended notice of profit assessment and trade tax assessment for the year in dispute, determining a total profit for the plaintiff that also included a profit from the sale of the developed property. The action brought against this, in which the plaintiff sought a reduction in the profit from the co-defendant’s special business assets, was only partially successful. Specifically, the court of first instance (Rhineland-Palatinate Fiscal Court, judgment of June 14, 2023 – 2 K 1826/20) held that the land and the building situated thereon constituted separate economic assets, such that the proportion of consideration must also be determined separately, resulting in only a minor deviation in favor of the plaintiff compared to the tax office’s assessment. The tax court further confirmed that the tax office had correctly applied the strict separation theory.
The Federal Fiscal Court (BFH) considered the plaintiff’s appeal against the judgment of the Rhineland-Palatinate Fiscal Court to be well-founded and took the opportunity to interpret Section 6(5), sentence 3 of the Income Tax Act (EStG) in accordance with general interpretive criteria, thereby deriving and substantiating its decision in favor of the modified separation theory in detail.
While the primacy of the modified separation theory does not arise either from the wording of the provision or from reasons of legal systematics, the court held that the application of the modified separation theory is supported by the fact that it leads to a consistent tax treatment of the acquisition of individual economic assets and groups of assets for partial consideration (pursuant to Sections 6(3), 16(1) EStG), since even in the latter case, when applying the so-called unity theory, the consideration is compared only to the book value. In this regard, the BFH acknowledges that the assumption of liabilities upon the transfer of groups of assets does not constitute consideration, precisely because these liabilities are part of the group of assets. However, the result is that, under both the unity theory and the modified separation theory, a gain arises only if and to the extent that the partial consideration exceeds the book value of the transferred asset.
From the BFH’s perspective, however, the decisive factor for applying the modified separation theory is ultimately the purpose of Section 6(5), sentence 3, of the Income Tax Act (EStG), according to which restructurings in partnerships involving the transfer of individual economic assets are to be favored. If the intent and purpose of Section 6(5), sentence 3, of the German Income Tax Act (EStG) is to avoid an income tax burden in restructuring as much as possible, the possibility of continuing to use the book value ends only where hidden reserves are definitively removed from taxation. However, this is only the case if the partial consideration exceeds the book value, since in that respect the taxation of the hidden reserves is no longer guaranteed for the transferee.
The court found that the conditions for (re)referral to the Grand Senate had not been met. It argued that this was not a legal question of fundamental importance, as it concerned only specific factual scenarios, and that, moreover, there was agreement that a gain is realized in the case of a transfer of individual business assets for partial consideration outside the scope of § 6(5), sentence 3, of the Income Tax Act (EStG). Furthermore, a referral to ensure uniform case law was not necessary, as the primary scope of application of § 6(5), sentence 3, EStG (commercial partnerships) falls within the jurisdiction of the IVth Senate, and a request for a ruling on a conflict of laws in this regard would have to come from a potentially diverging Senate.

III. Implications for Practice

By confirming its previous case law on the application of the modified separation theory within the scope of § 6(5), sentence 3, EStG, the Fourth Senate generally allows taxpayers to transfer individual assets between different business estates on a tax-neutral basis, even in cases of partial consideration, so that the transferring taxpayer can defer taxation of hidden reserves.
In practice, this is likely to be particularly significant in the transfer of debt-financed assets, especially real estate: Provided the acquirer assumes existing loans and the total consideration remains below the book value, there is no longer a risk of a pro-rata realization of hidden reserves if the Fourth Senate’s view also prevails within the tax administration. At the same time, the need for a time-consuming market value assessment is eliminated, which not only reduces the documentation burden but also minimizes the potential for disputes with the tax authorities.
Even though the ruling is very welcome from a practical perspective, it is currently not advisable to structure transactions in this manner without first obtaining a binding ruling. This is, on the one hand, because the aforementioned ruling has not yet been published in the Federal Tax Gazette and thus cannot be applied beyond the specific case decided. On the other hand, caution is warranted in light of the conflicting case law of the Xth Senate (even if it is not competent in this matter), as it cannot be ruled out that the issue may still be referred to the Grand Senate of the Federal Fiscal Court in a later proceeding, which might then assess the matter differently.
From a practical perspective, it would therefore be desirable for the administration to provide legal certainty for taxpayers in a timely manner. Either by publishing the ruling and amending the aforementioned administrative instruction, or by clarifying that the principles of case law will not be set aside through a non-application decree.