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Inglorious end of a journey: how the German Constitutional Court stopped the tax administration and the Federal Tax Court, and what taxpayers can learn from it

I. Introduction

Starting with its judgement I R 73/16 from 2019, the First Senate of the Federal Tax Court had embarked on a journey during which it has served an unparalleled series of decisions against German taxpayers and, thereby, has thrown overboard a consistent and well-reasoned legal position on outbound shareholder loan transactions that had been developed by the same senate under the previous leading judge. These false judgements1 have caused significant damage and have undermined the trust in the independence of the Federal Tax Court as far as the work of this senate has been concerned.2

With its decision dated 4 March 20213, the Constitutional Court has repealed that same judgement (I R 73/16) of the Federal Tax Court because it violated the German constitution in depriving the taxpayer of its lawful judge (Art. 101 (1) sent. 2 of the German Constitution ("Grundgesetz")); here the Court of Justice of the European Union ("CJEU").

Beyond the case itself, the Constitutional Court reveals in its explanatory notes of the judgement that the arm's length test (i.e. what third parties do or would have done in a similar situations), and thus the precondition for making and justifying a transfer pricing adjustment in Germany, as a matter of fact, had not been performed in the present case, neither by the tax administration, nor by the Lower Tax Courts, nor was that detected and corrected by the Federal Tax Court despite the existence of the Hornbach4-decision of the CJEU in relation to the very same provision, section 1 of the German Foreign Tax Act. The Constitutional Court used the word "arbitrariness" in this context, and it can be seen as an act of grace vis-à-vis the previous bench of First Senate of the Federal Tax Court, that the Constitutional Court did not dismiss the tested judgement on the basis of Art. 3 (1) Grundgesetz, i.e. the principle of equality in its form of the prohibition of arbitrariness.

II. Main aspects of the decision

1. Facts of the case

The appealed judgement concerned a settlement account on which a German limited liability company had provided funding to its Belgian subsidiary. The account carried interest at 6% p.a.; the parties had not agreed on any kind of security for the benefit of the German lender. The depreciation amount from writing off the balance of that account vis-à-vis the Belgian subsidiary has been adjusted, i.e. not been recognized as a tax deductible expense by the administrative appeals tribunal ("AAT") at the responsible tax office by applying section 1 (1) of the Foreign Tax Act, arguing that independent third parties would have agreed on some kind of security and that the lack thereof was a violation of the arm's length principle and required an adjustment in the form of a complete denial of the write-off. The Lower Tax Court of Duesseldorf repealed that decision of the AAT in its judgement5 and relied on the previous case law of the Federal Tax Court in relation to similar cases in the past, the so-called barrier-effect decisions (Sperrwirkungs-Rechtsprechung).6 The tax administration assumably knew that the previous leading judge of the First Senate of the Federal Tax Court, a former civil servant in the tax administration, would look favourably on the appeal of the Lower Tax Court of Duesseldorf's decision not to allow an appeal of its decision ("Nichtzulassung der Revision") and filed a non-admission appeal ("Nichtzulassungsbeschwerde") that was accepted by the Federal Tax Court and led to the judgement I R 73/16.

2. Violation of the fundamental right not to be deprived of one's lawful judge

The Federal Tax Court followed the approach of the tax administration without much ado and – without any critical distance and consideration of contradicting case law including from the CJEU – waved through the so much wanted transfer pricing adjustment, i.e. the non-recognition of the depreciation of a shareholder loan and the disallowance of the corresponding expense item for tax purposes. By doing that, the First Senate of the Federal Tax Court has violated Art. 267 (3) TFEU by not bringing this case or matter before the CJEU and thus depriving the taxpayer of its lawful judge. The Constitutional Courts dissects the unconstitutional judgement with refreshing clarity.7

It explains that no every denial of access to the CJEU automatically qualifies as a violation of Art. 101 (1) sent. 2 Grundgesetz. The Constitutional Court applies the principle of arbitrariness according to which a violation of Art. 267 (3) TFEU has to be assumed only if the interpretation and application of that provision taking into account the leading thoughts of the Grundgesetz do no longer seem to be explainable and are obviously untenable.8 Among the three different categories, the Constitutional Court considered the incompleteness of case law ("Unvollständigkeit der Rechtsprechung") in the dimension that a further development of existing case law of the CJEU does not appear to be a remote possibility only.

Here, the First Senate of the Federal Tax Court had overstepped its competences in that he assumed the existence of an „acte clair" in an arbitrary way or the existence of an „acte éclairé" (no reasonable doubt that existing case law of the CJEU has not left open any aspect of the arm's length principle).9 In other words, it acted as a judge that it should not have been.

By assuming the existence of an acte clair or eclairé, the Federal Tax Court has ignored and put itself in conflict to para. 54 of the Hornbach-decision of the CJEU. A further violation may be seen against para. 49, because the Federal Tax Court pledges for a complete non-acceptance of the depreciation while the CJEU provides for partial application of the arm's length adjustment. What makes the decision of the Constituational Court striking, is its clear statement that the whole case lacks any factual proof about what independent third parties actually do or would have done in the present circumstances. The obvious discrepancy vis-à-vis the Hornbach-decision leaves significant room for doubt that the case no I R 73/16 deviated from the correct application of EU law. Consequently, the Constitutional Court had to repeal the judgement I R 73/16.

III. Conclusion

From the taxpayers' perspective it can be concluded in a positive way that the odyssey of the First Senate of the Federal Tax Court has ended. Beyond that, taxpayers are well-advised to pay careful attention in any German tax audit that the arm's length test, as it is applied by the tax administration, is of a quality that would justify a transfer pricing adjustment. Very many of the "suggested" transfer pricing adjustments in German tax audits fall short of that requirement.

In this light, taxpayers are well-advised to reconsider whether a German tax court may be the better place for a transfer pricing controversy than the potentially collusive setting at a MAP table where taxpayers do not have their own seat. Almost all fact patterns can be distilled down to one or two straight-forward legal questions, the foremost in transfer pricing being whether a third-party has or would have paid a different price than was agreed by the taxpayer in its contested related-party transaction. If courts can be convinced based on the decision of the German Constitutional Court that the transfer pricing adjustment falls short of that legal standard, the violation of the arm's length principle, better outcomes are achievable for taxpayers. It is worth noting in this context that the Federal Tax Court usually does not decide on the amount of the taxable income. As a consequence, the Lower Tax Courts or a subsequent MAP may be used to find the arm's length transfer price and, thus, resolve double taxation.

Certified Tax Advisor Dr. Ulf Andresen, Chartered Accountant (Australien)

Partner, is the Head of the German Transfer Pricing Group of DLA Piper UK LLP based in Frankfurt;

1. The following articles explain why the decisions must be seen as false judgements: Andresen, Skandal im Sperrwirkungsbezirk, Die Unternehmensbesteuerung 2020, p. 685 following; Andresen/Holtrichter, BFH-Urteil v. 27.11.2019 – „In dubio pro fisco germano" oder „Vom Fremdvergleich zum hinkenden Rechtsfolgenvergleich" Deutsches Steuerrecht 2021, p. 65 following.

2. It is worth noting though that with the arrival of a new leading judge in January 2021 and the retirement of the previous leading judge recent oral hearings of that senate suggest that period of misjudgments has come to an end.

3. See German Constitutional Court, decision from 4 March 2021 – case no. 2 BvR 1161/19, Deutsches Steuerrecht 2021, 777 following.

4. See CJEU, decision from 31 May 20218, case no. C-382/16 Hornbach-Baumarkt.

5. Vgl. FG Düsseldorf, Urt. v. 10.11.2015 – 6 K 2095/13 K, EFG 2017, 553 ff. (Revision nicht zugelassen).

6. Vgl. BFH, Urt. v. 24.6.2015 – I R 29/14, BFH/NV 2015 1506-1509 und BFH, Urt. v. 17.12.2014 – I R 23/13, BFHE 248, 170.

7. Vgl. BVerfG, (Fn. 10) Rz. 52; zum gleichen Ergebnis kommend bezogen auf BFH, Urt. v. 27.11.2019 – I R 40/19: Andresen/Holtrichter, DStR 2021, 65, 74.

8. BVerfG, (Fn. 10) Rz. 53 m.w.N.

9. Vgl. BVerfG, (Fn. 10) Rz. 54 m.w.N.