Extended trade tax reduction: harmful co-leasing of operating equipment

To determine the trade income, the profit from commercial operations is reduced by 1.2 % of the unit value of the property belonging to the business assets of the entrepreneur and not exempt from real estate tax (so-called simple reduction in accordance with § 9 no. 1 sentence 1 of the German Trade Tax Act. Instead of the simple reduction, § 9 no. 1 sentence 2 of the German Trade Tax Act stipulates that, upon application, companies that exclusively manage and use their own real estate or, in addition to their own real estate, their own capital assets, or that also manage, build or sell residential buildings, etc., may opt for a reduction of the portion of the trade income attributable to the management and use of their own real estate (so-called extended reduction). The extended reduction is particularly important for corporations; it currently results in a corporation income tax liability of 15.825 %, which can lead to a significant liquidity advantage, especially for debt-financed real estate.

According to the case law of the German Federal Fiscal Court, there is no need for exceptions to the exclusivity requirement under § 9 no. 1 sentence 2 of the German Trade Tax Act due to insignificance or on the basis of the principle of proportionality. A violation of the exclusivity requirement, for example, in the context of the simultaneous lease of operating equipment, therefore generally leads to the complete refusal of the extended reduction. However, since the assessment period of 2021, § 9 no. 1 sentence 3 letter c) of the German Trade Tax Act has to be observed, according to which operating equipment can be rented out without affecting the reduction if the other income from direct contractual relationships with the tenants does not exceed 5 % of the rental income.

Due to the far-reaching significance of the extended trade tax reduction, the fiscal courts often have to deal with practice-related questions in this regard and clarify whether the extended reduction applies in individual cases or not, as for example the Hamburg Fiscal Court did in its judgment of May 15, 2024, case reference 2 K 76/22 (final), which was issued for the 2016 to 2018 assessment periods.

In the case in dispute, a landlord let a warehouse with a freight elevator and pallet conveyor system to a limited liability company. The pallet conveyor system was firmly attached to the hall floor and the rear wall and had been installed by the landlord well before the start of the lease with the limited liability company. There was no separate lease for this, nor was a separate rent agreed in the underlying lease. In his/her trade tax returns, the landlord claimed the extended reduction for property companies in accordance with § 9 no. 1 sentence 2 of the German Trade Tax Act for his/her (commercial) income from the lease with the limited liability company. During a tax audit, the tax office rejected this approach and took the view that the extended trade tax reduction was excluded because of the rented pallet conveyor system. The Hamburg Fiscal Court agreed with this.

Pursuant to § 9 no. 1 sentence 2 of the German Trade Tax Act in conjunction with § 68 of the German Property Act, the real estate includes, among other things, the land, the buildings, the other components and the fixtures, but not the machines and other equipment of any kind that belong to a business facility, i.e. operating equipment, even if they are essential components. The distinction between building components and operating equipment depends on whether the equipment is necessary for the general use of the building or whether it directly serves the purpose of the business. As part of the business operations of the limited liability company, goods were stored on a large extent and transported to the intended locations within the warehouse with the help of the pallet conveyor system. The system was thus particularly associated with the limited liability company’s sales and not just with the use of the building, i.e. it was directly used in the GmbH’s business. Consequently, it constituted operating equipment and not a building component.

In this case, renting the pallet conveyor system at the same time was not a harmless secondary business either, since it was not an absolutely necessary part of economically sensible own property management and use. The case law of the German Federal Fiscal Court equates the term “absolutely necessary” with “indispensable”. The question of indispensability is to be determined on the basis of the market situation for comparable properties and is to be rejected if the property management and use could have been carried out under approximately the same conditions without this secondary business.

In the case, the Hamburg Fiscal Court ruled that it was economically possible to use the property as a warehouse without the pallet conveyor system, but only by using the existing freight elevators. Similarly, the fact that the system was permanently attached to the property was not relevant for the application of the extended trade tax reduction. Although the specialist literature considers the co-leasing of some operating equipment, such as lighting, water, air conditioning, fire alarm and sprinkler systems, as well as freight elevators, alarm systems, built-in cabinets or cabling, to be harmless to the reduction. In the case in dispute, however, there was the special feature that in the rented warehouse was a freight elevator in addition to the pallet conveyor system, which could have been used to transport the stored goods equally well. Even the fact that removing the pallet conveyor system would have been difficult and would have required considerable effort does not allow the conclusion to be drawn that it necessarily had to be rented as well.

Notices:

The Hamburg Fiscal Court could also have ruled in favor of the landlord in the case concerning the question of the applicability of the extended trade tax reduction. In its judgment of November 23, 2023, case reference 14 K 1037/22 G F (appeal BFH IV R 31/23), the Düsseldorf Fiscal Court ruled that a construction that can only be removed with difficulty and at considerable effort due to its fixed connection with the building is, as a rule, absolutely necessary for economically sensible property management and use. However, the Hamburg Fiscal Court does not consider that it is necessary to conclude from the demonstrably increased effort involved in removing the pallet conveyor system to the compelling necessity of its being rented along with the property; namely, the system was subsequently installed in the warehouse. Comparable disputed cases should therefore be kept open for procedural reasons with reference to the pending appeal against the judgment of the Düsseldorf Fiscal Court. The different assessments of the two fiscal courts show that the granting of the extended reduction depends largely on the circumstances of the individual case.

As part of a possible arrangement to avoid a disputed constellation, tenancies should be separated into two landlord companies (most securely into two corporations), namely into a property company and an operable equipment company. Both companies then enter into legally and economically independent contracts with the tenant, which is particularly easy to implement in the case of a first or new lease. In the case of the continuation of an already existing lease, the splitting of two leases may encounter resistance from the tenant. A workaround whereby the property company leases the operating equipment from the operating equipment company and sublets it to the end tenant would result in the situation that the property company is using third-party operating assets and thus no longer fulfills the requirement of self-use for the applicability of the extended trade tax reduction.

It is also questionable whether the limitation of the detrimental effect of the reduction should be applied exclusively to activities that are subject to payment or whether the extended reduction is also at risk in the case of activities that are not subject to payment (see the appeal before the German Federal Fiscal Court, case reference BFH III R 23/23). In this context, a constellation in which operating equipment is provided free of charge and the tenant bears the associated other expenses economically may not be recognized for tax purposes. In this context, the sale of operating equipment – if practically feasible – appears to be a safer approach.

With regard to VAT, the European Court of Justice ruled in its judgment of May 4, 2023, in response to a request for a preliminary ruling from the German Federal Fiscal Court, that the leasing of operating equipment that is classified as an secondary service is subject to VAT in the same way as the leasing of buildings, which is generally exempt from VAT. As a result, there is neither a division into a VAT-liable part with regard to the operating equipment and a VAT-exempt part with regard to the building rental nor a refusal of the VAT exemption. In its judgment of August 17, 2023, reference no. V R 7/23, the German Federal Fiscal Court endorsed the opinion of the European Court of Justice, abandoning its previous legal opinion.

The divergence of the German Federal Fiscal Court senates shows once again that the details are tricky and that the facts of the case from an income tax and VAT perspective can lead to unexpected results for the layman, sometimes with serious financial consequences.