In Martin Wächtler v. Finanzamt Konstanz, C-581/17 (CJEU 2/26/2019), the Court of Justice of the European Union (CJEU) determined that application of the German exit tax rules were incompatible with the Agreement on the Free Movement of Persons (AFMP) of June 21, 1999, between the EU and its member states on the one part, and between the EU and Switzerland on the other. [1] The CEJU held that the EU-Switzerland agreement on free movement of persons precludes German exit tax rules applicable to individuals who transfer their residency from Germany to Switzerland as applied to Mr. Wachtler’s share ownership in a company. [2]

German Exit Tax on Wachtler

The case was referred to the CJEU in proceedings between Wächtler and the German tax authority of Konstanz, Germany, concerning the decision of that authority to tax, on Wachtler’s transferring his domicile from Germany to Switzerland, the unrealized capital gains with respect to shares held by him in a company established in Switzerland in which he was also the managing director. Wachtler contended that the German tax violated the Agreement between the European Community and its Member States, of the one part, and the Swiss Confederation, of the other, on the free movement of persons, signed in Luxembourg on 21 June 1999 (OJ 2002 L 114, p. 6; “AFMP”).[3]

Agreement Between The Swiss Confederation and the Federal Republic of Germany

Under 19 Article 1 of the Agreement between Switzerland and the FRG to avoid double taxation, it is provided, in 21 Article 13:

“1. Gains accruing from the disposal of immovable property, as defined in Article 6(2), are taxable in the Contracting State where that property is situated.

  1. Gains accruing from the disposal of movable property ….of a permanent establishment that an undertaking of a Contracting State has in the other Contracting State, or movable property that is part of fixed facilities available to a person who is a resident of a Contracting State in the other Contracting State for the pursuit of a profession, including such gains as accrue from the complete disposal of the permanent establishment (alone or together with the whole undertaking) or of those fixed facilities, shall be taxable in that other State. . . .
  2. Gains accruing from the disposal of any property other than that referred to in paragraphs 1 and 2 shall be taxable only in the Contracting State in which the transferor is resident.
  3. If a Contracting State, on the departure of a natural person who is a resident of that State, taxes the capital gains accruing from a substantial shareholding in a company which is resident in that State, the other Contracting State, when it taxes the gain accruing from a subsequent disposal of the shareholding in accordance with the provisions of paragraph 3, shall, in order to calculate the amount of the gain on disposal, deem the cost of acquisition to be the amount which the first State accepted as the disposal proceeds at the time of departure.”

Under 22 Article 27(1) of the Swiss-FRG Agreement it is further stated:

“The competent authorities of the Contracting States shall exchange any information that may be reasonably required to apply the provisions of this Agreement or for the administration or application of domestic legislation relating to taxes of any kind or description that are levied on behalf of the Contracting States or their “Länder”, cantons, districts, municipalities or groups of municipalities, in so far as the taxation imposed is not contrary to the Agreement. The exchange of information is not restricted by Articles 1 and 2.”

German Law

Paragraph 1(1) of the FRG Income Tax Law “EStG” provides: provides that natural persons who are domiciled or habitually resident in the national territory shall have an unlimited liability to income tax..’

Paragraphs 17(1) and (2) of the EStG gain from a disposal of shares in a company also constitutes income from a professional activity where the transferor has held, either directly or indirectly, at least a 1% share of the company’s capital within the preceding five years. . .the difference, after deduction of the sale costs, between the sale price and the cost of acquisition is considered to be a capital gain within the meaning of subparagraph 1.

Paragraph 6 of the Law on Foreign Transaction Taxation of 8 September 1972 (BGBl. 1972 I, p. 1713), in the version applicable to the main proceedings (‘the AStG’), provides:

“1. In the case of a natural person who has been subject to unlimited tax liability for at least ten years in total under Paragraph 1(1) of the [EStG] and where that person’s unlimited liability ends with the transfer of his domicile or habitual residence, Paragraph 17 of the [EStG] shall be applicable to the shares referred to in the first sentence of Paragraph 17(1) of the [EStG] when the unlimited liability comes to an end, including in the absence of disposal, if the requirements of that provision concerning those shares are also met at that time.

  1. Subject to [Paragraph 6](5), the income tax due under [Paragraph 6](1) must, upon request, be deferred and paid in instalments at regular intervals over a maximum period of five years from the due date of first payment, subject to the provision of a bank guarantee, in so far as immediate recovery would have consequences which would be difficult for the taxpayer to bear. The deferral shall end if, during the deferral period, the shares are sold or covertly transferred to a company, as provided for in Paragraph 17(1) of the [EStG], or if one of the situations referred to in Paragraph 17(4) of the [EStG] arises . . .
  2. If the taxpayer in the situation referred to in the first sentence of [Paragraph 6](1) is a national of a Member State . . . or of another State to which the Agreement on the European Economic Area [of 2 May 1992 (OJ 1994 L 1, p. 3; ‘the EEA Agreement’)] applies, and, after the end of the unlimited tax liability, he is subject to tax in one of those States (host State) comparable to German income tax liability, the tax payable under [Paragraph 6](1) shall be deferred without interest and without the provision of a bank guarantee. This measure is subject to the condition that administrative support and mutual assistance in the recovery of tax between the Federal Republic of Germany and that State are guaranteed. . . .

The deferral shall end in the following cases: (i) where the taxpayer or his legal successor …sells the shares or covertly transfers them to a company, in accordance with the first sentence of Article 17(1) of the [EStG], or if one of the situations referred to in Paragraph 17(4) of the [EStG] arises; (ii) if the shares are transferred to a person not subject to unlimited tax liability, who is not subject to tax comparable to unlimited German income tax liability in a Member State . . . or in a State which is party to the EEA agreement; (iii) if the shares are subject to a levy or another transaction which, under national law, means that the going-concern value or market value are taken into account; or (iv) if the taxpayer or his legal successor within the meaning of the third sentence of subparagraph 1, is no longer subject to tax liability within the meaning of the first sentence because he has transferred his domicile or habitual residence.”

Summary of Facts In Wachtler, supra

Wächtler, a German national, since early February, 2008 has been managing director of a Swiss corporation, the nature of his business being in the field of IT consultancy. Wachtler owns 50% of the company’s stock. On March 1, 2011 Wächtler moved his domicile from Germany to Switzerland. Following that transfer, the German tax authority, pursuant to Paragraph 6 of the AStG and Paragraph 17 of the EStG, levied income tax on the unrealized capital gain with respect to his shareholding in that company. Wachtler brought this action contending is was contrary to the specific right granted under the AFMP.

Court of Justice European Union Analysis

The CJEU’s opinion first announced its awareness that the possibility of deferring the payment of tax relating to unrealized capital gains with respect to company shares, were, in a case like this, a German national transfers his domicile to a Member State other than the FRG or to a third State that is party to the EEA Agreement, was introduced by the national legislature in order to bring the German tax regime into compliance with EU law on the free movement of persons, since a German national who maintains his domicile in the national territory is taxed on the capital gains with respect to company shares only at the time when those gains are realized.

The CJEU perceived as the legal question before it was whether the provisions of the AFMP must be interpreted as precluding a Member State’s tax regime which, in a situation where a natural person, who is a national of that Member State and who pursues an economic activity in the territory of the Swiss Confederation, transfers his domicile from the Member State whose tax regime is at issue to Switzerland, prescribes the collection, at the time of that transfer, of the tax payable on the unrealized capital gains with respect to company shares owned by that person. In other words, does the German tax law provision discriminate against a member of the AFMP and if so, postpone the collection of the tax at the time when the capital gains are realized, that is when there is a [an actual] disposal of the company shares concerned.[language in brackets added]. It answered this question in the affirmative.

According to the CEJU, the AFMP falls within the more general framework of relations between the EU and the Swiss Confederation. Although the Swiss Confederation does not participate in the European Economic Area and in the European Union’s internal market, it is nevertheless linked to the EU by numerous agreements analogous to a treaty. The general objective of those agreements, including the AFMP, is to strengthen the economic ties between the EU and the Swiss Confederation. However, since Switzerland has not joined the internal market of the EU, the interpretation given to the provisions of EU law concerning that market cannot automatically be applied to the interpretation of the AFMP, unless there are express provisions to that effect laid down by that agreement.

As to the AFMP, the CEJU felt it was clear from the preamble, Article 1 and Article 16(2) that the aim of that agreement is to secure, for natural persons who are EU nationals or nationals of the Swiss Confederation, the free movement of persons in the territory of those parties based on the rules applying within the EU, the terms of which must be interpreted in accordance with the relevant case-law of the Court prior to the date of signature of that agreement.

The CEJU then went through each relevant provision of the AFMP in determining that the Agreement applied to and could therefore be invoked by Wachtler.

“Since Mr Wächtler pursues his activities as an IT Consultant by means of a company of which he is the managing director and of which he owns 50% of the shares, the relationship of subordination which characterises activity as an employed person is, in this case, absent, as the Advocate General stated in points 38 and 39 of his Opinion. It follows that the economic activity pursued by Mr Wächtler is that of a self-employed person, within the meaning of the AFMP.”

“ Mr Wächtler’s situation is that of a national of a contracting party of the AFMP, namely the Federal Republic of Germany, who has become established in the territory of another contracting party, namely the Swiss Confederation, in order there to pursue, by means of a company, his self-employed activity. That situation falls, therefore, within the scope of Article 12 of Annex I to the AFMP.”

After further analysis, the CEJU opined that in certain circumstances and in the light of the applicable provisions, nationals of a Contracting Party of the AFMP may claim rights under that agreement not only against the State to which they exercise freedom of movement but also against their State of origin (citations omitted).

The Court concluded that the free movement of persons guaranteed by the AFMP would be impeded if a national of a Contracting Party were to be placed at a disadvantage in his State of origin solely for having exercised his right of free movement. It therefore follows that the principle of equal treatment, per Article 15(2) of Annex I to the AFMP, along with Article 9 (Annex 1), can also be relied on against his State of origin by a self-employed person who falls within the scope of that agreement.

The CEJU noted that the central issue was that of tax deferral. It observed that a German national who, like Wächtler, has exercised his right of establishment as a self-employed person under the AFMP suffers a fiscal disadvantage as compared with other German nationals who, like him, pursue a self-employed activity by means of a company in which they own shares, but who, unlike him, maintain their domicile in Germany. That is because the latter have to pay the tax on the capital gains with respect to the shares concerned only when those capital gains are realized, that is when there is a disposal of those shares, whereas a national such as Wächtler is obliged to pay the tax at issue, at the time when he transfers his domicile to Switzerland, on the unrealized capital gains with respect to such shares, and has no right to a deferral of payment until the disposal of those shares. That difference in treatment, which constitutes a tax-flow disadvantage for a German national such as Wächtler, is capable of deterring him from making actual use of the right of establishment he derives from the AFMP. It follows that the tax regime at issue in the main proceedings may impede the right of establishment as a self-employed person guaranteed by that agreement. In this case, it must be stated that, while the determination of the amount of tax at issue at the time of the transfer of domicile to Switzerland is a measure that is appropriate for attaining the objective relating to the preservation of the allocation of powers of taxation between that State and the Federal Republic of Germany, that objective cannot, however, justify it being impossible to defer payment of that tax. Such a deferral does not mean that the Federal Republic of Germany is surrendering, to the Swiss Confederation, its powers to tax the capital gains that have accrued during the period when the owner of the shares concerned had an unlimited liability to pay the German tax.

While the CEJU ruled in favor of Wachtler, it noted that it could hold otherwise were there insufficient collection safeguards in place between the relevant jurisdictions. As regards the objective relating to the need to guarantee the effective collection of the tax in order to prevent the loss of tax revenue, it is clear that the immediate collection of the tax at issue at the time when the taxpayer’s domicile is transferred may, as a general rule, be justified by the need to ensure the effective collection of tax liabilities. However, that measure goes beyond what is necessary in order to achieve that objective in this case and must therefore be considered to be disproportionate. In a situation where there is a risk of non-recovery of the tax payable, particularly where there is no mutual assistance mechanism for the recovery of tax debts, deferral of collection of that tax may be subject to an obligation to provide a guarantee for example.

The CEJU held, therefore, that under the AFMP, a tax regime of a Member State is precluded from taxing the unrealized capital gains with respect to shares of a national who transfers his domicile to the Swiss Confederation. Instead, the collection takes place only at the time when the capital gains are realized, i.e., upon disposal of the shares.

 

This blog post is intended solely for informational and educational purposes. It neither constitutes nor was intended to constitute the rendering of legal advice by this author or by Fox Rothschild LLP for which reliance may be placed by the reader. Moreover the author is not admitted to practice law in the Federal Republic of Germany, the Swiss Confederation or as a licensed attorney in any other licensed Member State of the EU and can not render advice on the law of such jurisdictions. Persons interested in being advised on this issue must consult with applicable foreign tax counsel to be advised on this matter. However, for further information on the Wachtler case or EU tax decisions, you may contact your lawyer with Fox Rothschild LLP or Jerry August c/o jaugust@foxrothschild.com.

 

[1] The EU law is applied the same in every EU participant country and EU institutions must abide by EU law. The Court of justice of the European Union (CJEU) is comprised of 1 judge from each EU country plus 11 advocates in general. The General Court has recently been increased to 56 judges with 2 from each EU country. The CJEU sits in Luxembourg.

On matters of taxation, the EU does not have a direct role in collecting taxes or setting tax rates. The amount of tax each citizen pays is decided by their national government, along with how the collected taxes are spent.The EU does however, oversee national tax rules in some areas; particularly in relation to EU business and consumer policies, to ensure: (i) the free flow of goods, services and capital around the EU (in the single market); (ii) businesses in one country don’t have an unfair advantage over competitors in another; and (iii) taxes don’t discriminate against consumers, workers or businesses from other EU countries.

[2] The Court’s order was worded as follows:

“The provisions of the Agreement between the European Community and its Member States, of the one part, and the Swiss Confederation, of the other, on the free movement of persons, signed in Luxembourg on 21 June 1999, must be interpreted as precluding a tax regime of a Member State which, in a situation where a natural person who is a national of a Member State and who pursues an economic activity in the territory of the Swiss Confederation transfers his domicile from the Member State whose tax regime is at issue to Switzerland, provides for the collection, at the time of that transfer, of the tax payable on unrealized capital gains with respect to shares owned by that national, whereas, if domicile is retained in that Member State, the collection of the tax takes place only at the time when the capital gains are realized, that is on a disposal of the shares concerned.”

[3] The European Community and its Member States, of the one part, and the Swiss Confederation, of the other part, signed, on 21 June 1999, seven agreements, one of which was the AFMP. By Decision 2002/309/EC, Euratom, of the Council and of the Commission as regards the Agreement on Scientific and Technological Cooperation of 4 April 2002 on the conclusion of seven Agreements with the Swiss Confederation (OJ 2002 L 114, p. 1, and corrigendum OJ 2015 L 210, p. 38), those seven agreements were approved on behalf of the European Community and entered into force on 1 June 2002. Under Article 1 of the AFMP, the benefit of nations of Member States of the EU and Switzerland, is: (i) to accord a right of entry, residence, access to work as employed persons, establishment on a self-employed basis and the right to stay in the territory of the Contracting Parties; (ii) to accord a right of entry into, and residence in, the territory of the Contracting Parties to persons without an economic activity in the host country; (iii) to accord the same living, employment and working conditions as those accorded to nationals. Under Article 2, pertaining to “Non-discrimination”, it is provided: “Nationals of one Contracting Party who are lawfully resident in the territory of another Contracting Party shall not, in application of and in accordance with the provisions of Annexes I, II and III to this Agreement, be the subject of any discrimination on grounds of nationality.” Other pertinent parts of the AFMP were recited in the opinion of the CJEU.