German court rejects loss set-off restriction of EUR 20,000 due to unequal treatment, ability to pay

If you invest in forward transactions, you can make large profits, but also incur high losses. But how are these losses treated in relation to the tax? In a recent appellate decision, a German federal court ruled that the EUR 20,000 loss set-off restriction results in unequal treatment of gains and losses from forward transactions. The court expressed doubts on the restriction’s constitutionality due to its violation of the equality and ability to pay principles.

Previously, the Rhineland-Palatinate tax court expressed doubts about the constitutionality of the loss set-off restriction for forward transactions. On 7 June 2024, the Federal Tax Court (Bundesfinanzhof) confirmed these doubts in case no. VIII B 113/23 (AdV) when ruling that the loss set-off restriction of EUR 20,000 leads to unequal treatment of gains and losses from forward transactions.

Forward transactions are financial transactions where the time of fulfillment is in the future

Forward transactions include speculation on the performance of shares, currencies, commodities or other underlying assets. An example of a forward transaction is a contract for difference (CFD), where only a fraction of the underlying asset need be deposited as collateral, but the full profit or loss from the price difference can be realised, and profits can also be made from options, such a futures, in the form of crypto assets. Gains and losses from forward transactions are part of the income from capital assets and are generally governed by a withholding tax of 25% (plus a solidarity surcharge and church tax, if applicable) for persons subject to income tax.

What is the loss set-off restriction?

Since the 2021 assessment period, however, there has been a set-off restriction of losses from forward transactions in accordance with Section 20 (6) Sentence 5 German Income Tax Act. This means that losses from forward transactions can only be set off against gains from forward transactions or income from option-writer premiums up to EUR 20,000 per year. Losses that have not been offset can be carried forward to later assessment periods but are subject to the same set-off restriction.

Loss set-off restriction deemed unconstitutional

The legislator justifies this unequal treatment of gains and losses from forward transactions with the speculative nature of these transactions, which should lead to a limitation of investment volumes and the associated risks to investors.

Initially, in a decision dated 5 December 2023 (case no. 1 V 1674/23), the Rhineland-Palatinate tax court suspended the enforcement of an income tax assessment that applied the loss set-off restriction for forward transactions. The tax office, however, lodged an appeal against the decision with the Federal Tax Court, which rejected the appeal as unfounded.

The applicants, a married couple, had made high gains and losses from CFD investments in 2021, which the tax office had only offset in the amount of EUR 20,000 instead of in full. The tax assessment resulted in an effective tax of over 100% of the actual gains made. The tax court and the Federal Tax Court have expressed serious doubts as to the constitutionality of this regulation, which leads to a violation of the principle of equality and the ability-to-pay principle.

Ruling states the law violates the general principle of equality (Art. 3 (1) German Constitution)

The legislator's freedom of design does not release him from the obligation to structure taxation within the schedule of capital income in a consistent manner (i.e. in accordance with the principle of equality). This obligation also includes taxing positive and negative investment income within the schedule and with consistency.

The unequal treatment of negative investment income from forward transactions is exacerbated by the fact that the law leads to an asymmetrical taxation of gains and losses from forward transactions (even within the loss set-off group) contrary to the requirements of the objective net principle. This asymmetry means that gains from forward transactions not economically realized in a year in which a loss is incurred can be taxed if the difference between gains and losses from the forward transactions exceeds EUR 20,000 in the year in which the loss is incurred.

Investor protection is not the task of the tax legislator

The tax court and the Federal Tax Court agreed with the prevailing opinion in the literature, which criticises the immediate taxation of profits and the delayed recognition of losses from forward transactions. The courts found no objective reason for interfering with taxation based on financial performance, which is impaired by the loss set-off restriction.

The tax court pointed out that this would lead to a disproportionate and absurd result, given that in extreme cases taxpayers would have to pay tax on negative total income from forward transactions. It also rejected the legislator's justification that the regulation was intended to protect investors from speculative and risky financial transactions. The court stated that it was not the legislator’s job to curb speculative financial transactions through corresponding regulations if this leads to a violation of the objective net principle, which states that profits and losses must be treated equally for tax purposes.

Parallels with share losses

Finally, it cannot be assumed by way of a standardised approach that losses from forward transactions are fully offset in the overall period. Even if the double limitation of loss compensation and loss set-off leads to an extension of the loss set-off from forward transactions, which is not constitutionally objectionable if there is no risk that loss compensation is completely excluded in the complete period of its life.

The court also refers to a decision by the Federal Tax Court dated 12 January 2021 (case no. VIII R 11/18), which questions the constitutionality of the loss set-off restriction for share disposals in accordance with Section 20 (6) sentence 1 German Income Tax Act. This regulation is similar to Section 20 in regard to forward transactions, except that the loss set-off is limited to gains from the sale of shares. The Federal Tax Court has submitted this regulation to the Federal Constitutional Court for review (case no. 2 BvL 3/21). In the opinion of the courts, there are certain parallels, meaning that the decision of the Federal Constitutional Court could also have an impact on the regulation for forward transactions.

Implications for affected investors

The decision of the Federal Tax Court is of great importance to affected investors since it gives them the opportunity to take action against the taxation of their forward transactions and, if necessary, apply for a suspension of enforcement so that no tax is initially paid.

Investors should be prepared for lengthy proceedings given that the decision of the Federal Constitutional Court on the constitutionality of the loss set-off restrictions is expected to take several years.

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