Risk of commerciality: New ruling from the top

The Federal Fiscal Court has decided: What applies to freelancers and asset management under the spillover rule?

Frankfurt am Main

October 25, 2024

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Risk of commercial nature of asset management activities when participating in a commercial partnership

Partnerships can also operate purely for asset management or as freelancers. In this case, the partners earn income from their participation in the partnership, for example, from rental and leasing or freelance income, but not from commercial operations, which would also result in trade tax liability. However, two special tax regulations must be observed in this regard:

Commercial character:

If a partnership, which is essentially engaged in asset management or freelance work, has only one or more personally liable partners, and only these partners or persons who are not partners are authorized to manage the business, it is referred to as a commercial partnership. This particularly applies to the traditional GmbH & Co. KG (limited liability company). In this case, the law stipulates that all of the partnership's income must be classified as commercial. Therefore, trade tax is also payable. However, the resulting trade tax is offset – often not fully – by the partners, who are natural persons, through the tax reduction for income from commercial operations.

Coloring regulation:

If the partnership also carries out a separate commercial activity in addition to asset management or freelance activities, all income is always considered commercial income (so-called spillover rule). However, this effect does not apply if the commercial income is very small (de minimis rule).

This basic rule of the so-called spillover rule is now expanded to include the case where a partnership that is otherwise engaged in asset management or freelance activities holds a stake in a commercial partnership. This case is referred to as upward spillover.

The Federal Fiscal Court clarified further detailed questions regarding this case of upward spillover in its judgment of July 11, 2024 (case number V R 18/22). In this respect, the case law states:

• The mere participation in a commercial partnership does not lead to an upward spillover and thus to the commercial nature of the otherwise asset management or freelance activities of the partnership. Rather, it is necessary that income is also derived from the participation in the partnership's relevant fiscal year.

• However, it is irrelevant whether positive or negative income (losses) was derived from the investment. This has also been clarified by law. Rather, it is sufficient that income from the investment is attributed to the partnership.

• In this respect, there is no de minimis rule. This means that even the allocation of minor income results in the partnership's income being classified as business income.

• The Federal Fiscal Court also ruled that the allocation of only offsettable losses also leads to an upward spillover. Therefore, if a partnership itself participates as a limited partner in a limited partnership and the share of the loss attributable to it is not covered by the capital account, the loss, as a so-called offsettable loss, is not to be taken into account in the subsequent assessment, but nevertheless triggers an upward spillover. The decisive factor is that the limited partner is initially allocated negative income from commercial operations, which is then converted into offsettable losses and subsequently subject to a freeze on realization.

  
  

TaxPro recommendation:

It is still the case that upward spillover can be prevented by ensuring that the shareholding in the commercially active partnership is not held by the otherwise asset-managing or freelance partnership itself, but rather through a separate sister partnership, which can also have completely identical shareholdings.

The Federal Fiscal Court confirms its case law, according to which the upward spillover effect results in the income of a partnership, which is essentially engaged in asset management or freelance activities, becoming commercial income, and this, in particular, results in hidden reserves in the employed business assets being taxed. However, according to case law, the upward spillover effect does not result in the partnership also being subject to trade tax. According to case law, the upward spillover effect enshrined in the Income Tax Act has no effect on trade tax. However, the tax authorities do not follow this view.