On 29 September 2021, the German Federal Fiscal Court (“BFH”) gave a ruling on the tax legal concept of economic ownership in the context of securities lending. The German tax authority in two recent decrees shows a tendency to allocated securities out on loan to the lender (not: the borrower) under its concept of economic ownership. The BFH’s decision can be interpreted as limiting an over-shooting practice of tax authorities.
The case recently decided by the BFH concerned an insurer that entered into global securities lending agreements with multiple banks, according to which both parties could be the lender as well as the borrower. The court’s ruling however concerns the tax treatment of securities out on loan as well as the corresponding receivable from the viewpoint of the lender.
As a general rule under a securities lending transaction, German tax law assigns an asset - and the respective income streams - to the civil law owner of the asset (i.e. to the borrower of the asset). However, in situations where a different person is able to exclude the civil law owner from exercising ownership rights over the asset for the general operating life of an asset, the tax-legal ownership of the asset and its income streams are allocated to that different person, the so-called economic owner (i.e. the lender of the asset).
In its recent decision and in line with the before described general rule and settled case law, the BFH holds that the lender usually loses the civil law ownership through a securities lending transaction and also loses (tax legal) economic ownership of the security out on loan. The court emphasizes that the allocation of economic ownership for tax legal purposes differing from civil law ownership is the exception, not the rule. The exception has to be identified on a case by case basis. In the decision at hand, the exception did not apply, i.e. the economic ownership did not remain with the lender, as the economic risk and chances of the security out on loan were transferred to the borrower. The court highlights that the borrower does not have to effectively use the risks and chances, it suffices that the borrower has the possibility to do so. Further, the short notice period of 3 or 5 bank working days for the termination of the securities lending agreement by the lender does not erode the economic opportunity and risk of the borrower. This is due to the fact that listed shares - especially in today’s stock exchange trading - may face considerable price volatility at short notice.
Additionally, the court does not apply the German general anti-abuse rule (GAAR) to the securities lending transaction. German GAAR applies when the main economic background of a transaction is obtaining a tax benefit. The BFH emphasizes that generating a lending fee from a securities lending transaction is a valid economic reason for the transaction. Especially, if the two parties involved in the securities lending transaction are - as was the fact in the case at hand - institutional investors, for which it is common to enter into securities lending agreements.
Since the security out on loan in the case at hand was not allocated to the lender, the lender instead had to activate a corresponding receivable. The BFH confirmed the practice of activating the receivable with the book value (not: the market value) of the underlying security. The court also confirmed the possibility to partially write off the receivable, if the underlying security’s value decreased more than 5%. The partial write-off does not have to be corrected off balance sheet for tax purposes.
The above described BFH decision is interesting especially in the context of recent administrative decrees. In July 2021, the German Ministry of Finance (“BMF”) published two administrative decrees on economic ownership and securities lending transactions, one general decree and one covering specifically so called cum-cum transactions.14 The decrees describe under which circumstances tax authorities will usually assume that the economic ownership of a security out on loan remained with the lender. One of the indicators is a weak economic position of the borrower, which – according to the BMF – is the case if the loan agreement can be terminated by the lender on short notice of 3 to 5 business days. As the notice period of 3 to 5 business days is market standard, the BMF’s indicator was criticized as too narrow, as it would cover most standard lending agreements. The recent BFH decision now fuels this argument, possibly leading to an overhaul of the tax authority’s view on what qualifies as a ‘weak economic position’ of the borrower.
The BMF’s decrees also cover the application of German GAAR to securities lending transactions. In last year’s decrees, the BMF gave up its previous opinion that German GAAR does not apply to securities lending, if the borrower obtained a positive pre-tax return from the transaction. The BFH’s recent decision clarifies that a mere assertion of a lack of profitability of a securities lending transaction without a tax benefit is not a sufficient argument to question the transfer of the economic ownership of the securities to the borrower.
In 2021, Germany introduced the possibility to issue fund units on a DLT (e.g. blockchain) without physical certificates. The implementation in the market is now facing difficulties because the German tax authority is concerned of losing WHT on the crypto fund’s output side (fund investor side). This is due to the fact that the German crypto fund units do not necessarily have to be deposited with a German custodian that can be held liable for levying WHT.
The issue at hand is only the tip of the iceberg, it is not limited to fund units on DLT but exists for all other assets in the case of which the deduction of WHT is outsourced to an agent in the current world of assets. The potentially disruptive effects of the blockchain technology within the FS sector are not limited to securities trading or the safe custody business, but concern WHT issues too.
WTS is working with market players towards an efficient solution that might include tax data relevant for levying WHT directly on the DLT.
If you wish to discuss these topics, please contact: WTS Germany, Frankfurt
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