Lower Tax Court rules on recognition of subordinated liabilities in tax balance sheet

The case involves a sole shareholder that granted a loan to an over-indebted German corporation and subsequently subordinated its claim. The subordination agreement provided that the debt should be repaid only from future profits and liquidation proceeds. There was no specific agreement on a repayment from other free net assets.

The German Income Tax Act (in contrast to the treatment under German GAAP) provides that liabilities are disregarded in the tax balance sheet if their future repayment depends on the generation of future profits. The tax authorities apply this provision to subordination agreements in accordance with a decree issued by the Federal Ministry of Finance on 18 August 2004. In case of a simple subordination, the tax authorities require that the repayment be out of future profits, liquidation proceeds and other free net assets for the liability to be recognized in the tax balance sheet.

Because the subordination agreement in the case decided did not refer to other free net assets, the tax authorities took the view that the liability should be disregarded in the tax balance sheet and, thus, a taxable profit should be generated. The lower tax court of Munich (case reference: 7 K 1396/08) disagreed, concluding that the liability should be recorded in the tax balance sheet. According to the court, the reference to the liquidation proceeds in the subordination agreement was sufficient because liquidation proceeds comprise future profits, as well as existing (net) assets and built-in gains.

The decision has been appealed and is pending before the BFH (case reference: I R 100/10).

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