Company succession: new option trap when exempting operating assets

Background

One core goal in structuring company succession plans is qualifying for full tax exemption for the assets used to conduct the business. In contrast to the standard exemption that tax authorities automatically apply, if stricter prerequisites are met and a separate and irrevocable application is filed, not just 85% but 100% of the operating assets are exempted from inheritance or gift tax.

To qualify for full tax exemption, companies must comply with not only stricter requirements on upholding wage levels and longer retention periods but also stricter restrictions on the ratio of holdings to operating assets. In other words, the market value of the company’s holdings (e.g. real property that is rented out, precious metals, works of art, securities, bank account balances, cash on hand or receivables) cannot comprise more than 20% of the company’s total value.

In practice, determining the ratio of holdings to operating expenses often triggers high costs for tax compliance (not only for the giver, recipient and heirs but also for the tax authorities) and is a primary concern in succession planning. Furthermore, the holdings ratio has only in very rare cases been established with legal certainty by the time the assets are transferred to the recipients or heirs or when the relevant tax returns are filed, not least because no final clarification of numerous legal issues in connection with calculating the holdings ratio has been achieved, especially when the company is a member of a group of companies. The possibility that the tax authorities will arrive at a different ratio of holdings must be included in the calculations. More differences can also occur in the context of a subsequent tax audit. This creates a need to deal with the legal uncertainty that it may not be possible to conclusively determine whether the prerequisites for full exemption have been fulfilled until several years after a gift or inheritance has been received. The question arises as to whether at least the standard exemption (85%), for which the prerequisites are not as strict, should be applied as an alternative in such cases.

Tax authorities adopt Federal Fiscal Court’s strict interpretation

Whenever it became clear at a later date (e.g. based on a tax audit) that a company did not have the holdings ratio required for a full exemption, former standard practice for tax authorities under inheritance tax guidelines was to grant the standard exemption. However, in its ruling dated 26 July 2022 (case no. II R 25/20), the German Federal Fiscal Court (Fiscal Court) decided that it was no longer possible for a company to “fall back” on the standard exemption after it had filed an irrevocable application for full exemption.

In February 2024, the highest tax authorities of each of Germany’s federal states issued orders adopting the Fiscal Court’s legal opinion. In adherence to the principle of protection of legitimate expectations, exceptions apply only to older cases in which the application for full exemption was filed before 25 January 2024. Companies filing applications that are received later will not be permitted to “fall back” on the standard exemption.

If it is subsequently determined that the company does not have the holdings ratio necessary to qualify for the requested full exemption, neither the full exemption nor the standard exemption will be applicable. Consequently, absolutely no exemption will be applied to the operating assets, even if the prerequisites for the standard exemption are fulfilled.

Practical consequences

If it becomes clear in the course of planning a succession that the holdings ratio could exceed the maximum threshold of 20% even with a “safety margin” for valuation and legal uncertainties, careful consideration should be given to the timing of filing an application for full exemption.

Under procedural rules, it is permissible to file the application at any time before the assessment of the inheritance or gift tax has become final and unappealable. For this reason, it is not mandatory to file the application when submitting tax returns. Instead, the application can be filed, e.g. during appeals proceedings against a tax decision or as long as the tax decision is still subject to review.

It should be noted that if an application for full exemption is filed later, the tax authorities are initially required to apply the standard exemption where the prerequisites are fulfilled. As a result, only 85% of the operating assets will be exempted, at least initially, and inheritance or gift tax will be assessed on the remaining 15%. This amount is to be prefinanced until the application for full exemption is filed.