Germany: Accrual-based tax accounting obligatory for partnerships

Germany’s Federal Tax Court (BFH) issued a decision on December 10, 2014 on the obligation of foreign entities - specifically partnerships - to determine income on an accruals basis.

Germany’s Federal Tax Court (BFH) issued a decision on December 10, 2014 on the obligation of foreign entities - specifically partnerships - to determine income on an accruals basis. In the case, a UK partnership with a German resident limited partner used the accruals basis to meet UK bookkeeping obligations. The UK firm wanted to use the cash basis to account for German income taxes. The BFH held that if foreign bookkeeping obligations are met regarding a foreign source of income, this creates an equivalent German bookkeeping obligation. In such a case, the taxpayer may not opt to use cash-basis accounting with respect to the German partner’s share in the profits of the UK partnership.

The decision could affect other partnerships- especially law firm LLPs - that use cash basis accounting for German tax purposes and may lead to a significant transitional German tax cost.

It is possible that the accruals basis may be required to be applied retroactively for any tax year currently open for amendment. In addition, electronic balance sheet filing obligations may need to be met and cash basis accounting may no longer be possible for German VAT purposes.

Income tax impact

Based on the recent BFH decision Law Firms which are preparing statutory financial statements on an accruals basis may no longer determine their German source income on a cash basis. The BFH decision will generally affect any income tax assessment that is currently open for amendment. Depending on the date of the last tax audit, this may affect up to six prior years, plus any prior year currently under audit.

Any change from the determination of income on a cash-basis to determination on an accruals basis is likely to result in additional profits in the year of transition, potentially giving rise to a German tax cost. Analysis will be needed to confirm the availability of credits in other jurisdictions that could potentially offset the additional tax cost. In years after the transition period, the impact may be low, although inter-generational equity issues will need to be considered.

Additional tax payments are subject to an interest charge as from April of the second subsequent year (e.g. from April 2010 for 2008) of 0.5% each month, i.e. 6.0% per annum.

The above rules generally would apply in determining German-source income for resident and nonresident partners and in determining foreign-source income for German resident partners.

Additionally German-source income determined on the accruals basis, tax balance sheets must be filed electronically (e-balance filing obligation) for tax years as from 2013.

VAT impact

The BFH ruled in 2010 that law firms earning “self-employment income” may use the cash basis method for VAT purposes instead of recognizing agreed fees where there are no (mandatory or voluntary) bookkeeping and recordkeeping obligations. Germany’s Federal Constitutional Court confirmed this position in 2013, and the Federal Ministry of Finance has clarified that taxpayers (e.g. law firms) are not “keeping records voluntarily” if they can apply the cash accounting method for income tax purposes. Conversely, law firms can no longer file VAT on a cash basis if they are required to determine income on an accruals basis, but if permission is granted to determine VAT payable based on received fees, the permission will remain valid until revoked without any retroactive impact.

Open questions

The BFH does not discuss whether in the instant case books were kept for a financial year which was the calendar year. Therefore, the court did not decide whether the same rule would apply for deviating financial years. For German tax purposes, the determination of “self-employment income” can be based only on a calendar year. However, it is likely that even if the foreign books are prepared on a basis other than a calendar year basis, this will not free a German taxpayer from the obligation to determine its income on the accruals basis.

It is not entirely certain that because a foreign entity maintains books, a German permanent establishment (PE) of that entity would also have to meet bookkeeping obligations. For German tax purposes, PEs must be treated as separate entities in accordance with the Authorized OECD Approach. If the deemed separate entity is not subject to bookkeeping requirements, it could be argued that there is no bookkeeping obligation in Germany. However, it is likely that if there are any group statutory filing obligations, the BFH would conclude that German bookkeeping obligations (for PEs) exist.

Recommendations

Law firms that currently use cash basis accounting for tax purposes should address this issue proactively. Depending on the circumstances, the tax authorities may need to be contacted to discuss potential transition procedures.