This case examined the German roll-over relief rules which permit a deferral of the capital gains tax arising on the sale of certain assets if the proceeds of the sale are reinvested in replacement assets. Deferral is only allowed under the rules if the replacement assets form part of the assets of a permanent establishment in Germany.

This CJEU decision is the culmination of lengthy infringement proceedings initiated by the European Commission in 2009. The discrimination was established, despite Germany arguing that it was justified to preserve their taxing powers and achieve their policy objectives of encouraging reinvestment in particular. The CJEU robustly disagreed. The administrative difficulties, linked with the necessity of taxing assets situated outside Germany, did not justify this hindrance to the freedom of establishment. The policy objective of encouraging reinvestment could be achieved with cross-border investment.

The UK roll-over relief rules (Section 152-157 of the Taxation of Chargeable Gains Act 1992) have similar, though not identical, restrictions. No infringement proceedings have, as yet, been initiated against the UK, but if no action is taken to amend the UK rules it seems unlikely, following this decision, that this will remain the case.

Background and key arguments

Under German tax law, tax payable on the disposal of certain capital assets used in permanent establishments located in Germany can be deferred until the sale of the replacement assets; this is on the condition that the replacement assets form part of the assets of a permanent establishment also situated in Germany. Such deferral is therefore not possible if the assets belong to a permanent establishment situated outside Germany but within the European Union.

The European Commission (EC) sought a declaration from the CJEU that these provisions were in breach of Article 49 (freedom of establishment) of the Treaty on the Functioning of the European Union (TFEU) and Article 31 of the EEA Agreement.

Paragraph 6b of the Law on Income Tax (Einkommensteuergesetz; “the EStG”) provides for rollover relief in subparagraphs 1 to 4. This is subject to the following specific conditions (amongst others):

“2. the economic assets sold must have constituted an integral part of the assets of a permanent establishment located within national territory for an uninterrupted period of at least six years at the time of the sale,

3. the economic assets acquired or produced must form part of the assets of a permanent establishment located within the national territory,

4. the capital gain realised on the sale must not be omitted from the calculation of the taxable profit within the national territory…………..”

In 2009, the EC sent a letter of formal notice to the Federal Republic of Germany (“Germany”) drawing its attention to the risk that Paragraph 6b of the EStG might be incompatible with the free movement of capital. Germany disagreed contending that the legislation in dispute did not come under the free movement of capital, but solely under the freedom of establishment, with which it was compliant.

A supplementary letter of formal notice was then sent by the EC to Germany in 2010. This acknowledged that the legislation came under the freedom of establishment but expressed the view that after examining its arguments, the legislation infringed Article 49 TFEU and Article 31 of the EEA Agreement. Responding to that letter, Germany took issue with the EC’s position, maintaining that the legislation at issue was compatible with the freedom of establishment.

Thereafter, the EC sent Germany a reasoned opinion confirming its position set out in the supplementary letter of formal notice and requesting that Germany comply with that reasoned opinion within two months of its notification. Germany subsequently replied repeating that the EC’s position was incorrect. The EC then decided to bring the present action.

Germany disputed the admissibility of the action on two grounds. First, that there was a delay in bringing the action. Secondly, that the subject-matter of the action had been altered. The EC disagreed.

The Court agreed with the EC holding that in its application the EC may clarify its initial complaints, provided, however, that it does not alter the subject-matter of the proceedings (Commission v Poland, C-281/11 and the case-law cited).

In the present case, both in the pre-litigation procedure and before the Court, the EC made it clear that it was criticising Germany on the ground that, under Paragraph 6b of the EStG, it had failed to fulfil its obligations under Article 49 TFEU and Article 31 of the EEA Agreement. Consequently, the head of claim relied on by the EC remained unchanged throughout the pre-litigation procedure and the judicial proceedings. Therefore the EC’s action was admissible.

The EC arguments

The EC submitted that Paragraph 6b of the EStG is contrary to the provisions of the TFEU Treaty and of the EEA Agreement on the freedom of establishment.

Under Paragraph 6b, a taxable person is entitled to transfer to certain replacement assets, without taxation, capital gains realised on the sale of certain investment assets forming part of a permanent establishment located within Germany. In the EC’s view, such a deferral is only possible if those replacement assets are part of a permanent establishment in Germany.

If the same replacement assets form part of a permanent establishment outside Germany, the capital gains resulting from the sale of the replaced asset are immediately taxable.

An economic operator will therefore take account of the fact that a reinvestment made outside Germany is fiscally less advantageous than a reinvestment carried out within Germany. That difference in treatment is liable to deter a company located within Germany from carrying out its activities through a permanent establishment located elsewhere with the EU/EEA.

Such a difference in treatment cannot be justified by an objective difference in situation. Justifications based on the territoriality of the tax are unfounded. The case concerns capital gains generated within German territory on the sale of the replaced asset. Germany is unquestionably entitled to tax those capital gains. That right is exercised by the immediate taxation of those capital gains in cases of reinvestment outside German territory.

The argument that Germany would have to defer the date on which capital gains tax is due in cases where the reinvestment is made outside Germany does not in any way alter the allocation of taxing powers in relation to those gains.

Germany had also argued that the justification was based on the need to preserve the coherence of the national tax system. However in the EC’s view this can succeed only if there is a direct link between the tax advantage concerned and the offsetting of that advantage by a specified tax burden.

In the EC’s view, the desire to promote restructuring and reinvestment does not constitute a legitimate objective. It is irrelevant whether such a general and economic objective is capable of constituting an overriding public-interest ground in a specific case. In any event, Germany neither argued nor demonstrated that that objective could not be achieved without the cross-border reinvestments at issue being made subject to discriminatory treatment.

Turning to the issue of proportionality, the EC maintained that, in the absence of any relevant justification, this was not relevant.

Germany’s arguments

Germany submitted, primarily, that the action was unfounded. It took the view that the situation of a permanent establishment located in another Member State is not objectively comparable to that of an establishment located within Germany. It also contended that if a restriction were found to exist, it would be justified by overriding grounds of public interest based on the tax-territoriality principle and on the need to preserve the coherence of the national tax system.

According to Germany, the objective pursued is to improve the cash flow of undertakings and to facilitate restructuring by encouraging reinvestments in the undertaking itself. Such reinvestments are necessary to enable previous levels of production to be achieved, by coping with the wear and tear of production assets or with technical progress. Opting out of the immediate taxation of the capital gains realised on the sale of the replaced asset allows the undertaking concerned to adapt, in economic terms, to the structural changes linked to production techniques and to distribution, or to changes of a regional nature.

The reinvestment of those capital gains will facilitate the major restructuring of undertakings and also avoid the taxation of the particularly high capital gains which are realised on the sale of the asset concerned.

The tax regime has the effect that the replaced asset and the replacement asset are considered to form a single asset, since, in economic terms, those two production assets generate revenue within German territory.

The legislation is justified, in any event, by the overriding public-interest ground based on the need to maintain the division of powers of taxation between the Member States and is further justified on the need to preserve the coherence of the national tax system. Lastly, it is justified by the overriding public-interest ground based on the political will to encourage reinvestments in the undertaking with a view to maintaining or modernising the production assets and to safeguarding continuity of production as well as preserving employment.

That objective, which consists of encouraging reinvestment in the undertaking itself, in order to acquire a new capital asset corresponding to that which has been sold, can be achieved only if the taxation of that new asset is also a matter determined by the German tax authorities.

Decision

Article 49 of the TFEU requires the elimination of restrictions on the freedom of establishment. That freedom includes, for companies established in accordance with the legislation of a Member State and having their registered office, central administration or principal place of business within the European Union, the right to exercise their activity in other Member States through a subsidiary, branch or agency. That freedom is also applicable to the transfer of activities from the territory of one Member State to another Member.

Although, the provisions of the TFEU on freedom of establishment are aimed at ensuring the benefit of national treatment in the host Member State, they also prohibit the Member State of origin from hindering the establishment in another Member State of one of its nationals or of a company incorporated in accordance with its legislation.

All measures which prohibit, impede or render less attractive the exercise of the freedom of establishment must be considered to be restrictions on that freedom.

In the present case, the legislation in Paragraph 6b of the EStG has the effect of making the benefit of the deferral of the tax due on the capital gains arising subject to the condition that those capital gains are reinvested in the acquisition of replacement assets within the same territory.

The difference in treatment for reinvestments made outside Germany is liable to make those reinvestments less attractive than reinvestment within Germany. Such a difference cannot be explained by an objective difference in situation. Thus, the legislation constitutes a restriction on the freedom of establishment.

It is therefore necessary to determine whether that restriction may be objectively justified by overriding public-interest grounds recognised by EU law. According to case-law, freedom of establishment may be restricted by national legislation only if the restriction at issue is justified by overriding reasons in the public interest. It is also necessary that that restriction should be appropriate to ensuring the attainment of the objective in question and not go beyond what is necessary to attain that objective.

Justification based on the need to preserve the balanced allocation of the power to impose taxes between Member States is a legitimate objective recognised by the Court. It is also settled case-law that, in the absence of any unifying or harmonising measures of the European Union, Member States retain the power to define, by treaty or unilaterally, the criteria for allocating their powers of taxation, with a view to eliminating double taxation.

In the present case, the issue in question is the taxation of capital gains resulting from the sale of the replaced asset which were generated within the ambit of the fiscal jurisdiction of Germany. In that regard, the EC does not dispute the right of that Member State to tax those capital gains.

A reinvestment of capital gains coming under the taxation powers of Germany, for the purposes of the acquisition of replacement assets intended for a permanent establishment within another Member State, cannot mean Germany is required to abandon its right to tax the capital gains generated within the ambit of its powers prior to the transfer of those capital gains outside its territory, on the ground that they were reinvested for the acquisition of such replacement assets.

Even if Germany was not entitled to tax the revenue generated by those replacement assets, that Member State would not be deprived of its right to tax the capital gains arising from the sale of the replaced assets which were generated within its territory prior to that reinvestment. That right is exercised by the immediate taxation of those capital gains at the time of such reinvestment.

The fact that either an unrealised capital gain or a realised capital gain is at issue is irrelevant. What is important is that similar transactions, carried out in the purely domestic context of Germany, unlike a cross-border transaction, did not result in the immediate taxation of those capital gains.

Agreeing with the Commission, the CJEU found that the provisions hindered the freedom of establishment and went further than necessary. Allowing the deferral of tax in circumstances where the replacement assets are situated outside Germany would not force Germany to abandon its right to tax capital gains generated within the ambit of its powers of taxation. Taxable persons wishing to reinvest outside Germany should therefore be given the choice between immediate payment and bearing the administrative burden of deferral.

The Court ordered Germany to pay the costs.

The full judgement of the case is available from http://curia.europa.eu