Federal Fiscal Court ruling: Business expenses for asset losses caused by relatives

Business expenses even without successful performance or voluntary payment

Under section 4(4) of the Income Tax Act [Einkommensteuergesetz–EStG], business expenses are those caused by the business. What is decisive is the economic connection with the generation of income. In the case of expenses incurred intentionally, what matters is whether they are objectively connected with the generation of income and are subjectively intended to serve it. The reasons for the payment constitute the “triggering factor” of the expenses (fundamentally, Federal Fiscal Court decision of 21 Sep 2009, file ref. GrS 1/06, Federal Tax Gazette [Bundessteuerblatt–BStBl.] II 2010, p. 672).

Proven successful performance is not invariably required for this purpose. A payment made by the taxpayer in the belief that it will bring about a business success may also be deductible. In addition, the expenses must, on an abstract and objective view, be suitable for promoting the business. In the case of contractually agreed services, fraudulent conduct on the part of the contracting partner does not in itself preclude the deduction. A mental reservation [geheimer Vorbehalt] does not affect the validity of the contract under civil law (Federal Fiscal Court judgement of 7 Feb 2018, file ref. X R 10/16, Federal Tax Gazette II 2018, p. 630, para. 32). Incidentally, section 160 of the Fiscal Code [Abgabenordnung–AO] is a bar that can also take effect in this area: among other things, business expenses and income-related expenses [Werbungskosten] are, as a rule, not to be taken into account for tax purposes if the taxpayer fails to comply with the tax authority’s request to name the creditors or recipients precisely.

Moreover, involuntary outflows of value may also have to be taken into account as business expenses, just as the surrender of bribes to the injured employer can give rise to income-related expenses in respect of income under section 22 no. 3 of the Income Tax Act (“income from other services”) (Federal Fiscal Court judgement of 16 Jun 2015, file ref. IX R 26/14, Federal Tax Gazette II 2015, p. 1019). Such “involuntary expenses” [Zwangsaufwendungen] are conceivable in particular in the case of losses due to theft, embezzlement or breach of trust. Here, the term denotes involuntary losses of assets within the scope of section 4(4) of the Income Tax Act. Where there is an intention to make a profit, two points of reference for the business connection come into consideration: either the damaging event originates in the business sphere, or the items or sums of money affected were intended for future business use.

If the damaging event originates in the business, for instance in the case of theft of money by persons working in the business, it is not decisive whether the stolen money previously formed part of business or private assets. If, by contrast, the connection can only be established via the intended use of the money, that intended use must be objectively verifiable. Closed cash-book keeping [geschlossene Kassenführung] and a clear separation of business and private cash inflows can help in this regard. Other indications may also be considered, such as keeping a counted-out sum ready to settle a business liability. These principles also apply to cash-basis accounting [Einnahmen-Überschussrechnung] under section 4(3) of the Income Tax Act: under the “principle of equality of total profit” [Grundsatz der Totalgewinngleichheit], viewed as a whole and over the long term, both methods of profit determination must lead to the same, or at least a substantially equal, overall result (Federal Fiscal Court judgement of 3 Aug 2017, file ref. IV R 12/14, Federal Tax Gazette II 2018, p. 20, para. 20).

The taxpayer bears the burden of proof [Feststellungslast] for the business cause. If serious or insurmountable doubts remain, they are to the taxpayer’s detriment. An estimate helps only where business expenses are established in principle and merely their amount is uncertain (section 162(2) sentence 2 of the Fiscal Code). It does not replace missing proof of the business connection. Where business and private expenses have to be separated, there are, in addition, enhanced duties to cooperate in determining the business portion.

Losses caused by relatives require an overall assessment

The claimant in proceedings X R 21/23 operated a security services business and determined his profit by means of cash-basis accounting. His brother worked for him on security assignments at events in Austria. The claimant claimed expenses of EUR 380,000 for 2008 and EUR 205,000 for 2009. According to his statements, he had handed the amounts to his brother in cash to pay accommodation costs and a commission respectively. By contrast, the managing director of the company that issued the invoices stated that they were sham invoices: the services had not been rendered. He had issued the invoices at the brother’s request in return for payment of a total of EUR 32,000.

The Saxony Fiscal Court [Finanzgericht–FG] refused the deduction of business expenses (judgement of 15 Dec 2021, file ref. 2 K 772/14). A contractual obligation to pay could not be proven. It also rejected a deduction on account of harmful employee conduct: the claimant had trusted his brother because of their family relationship and had not monitored him sufficiently. The Federal Fiscal Court confirms that the finding that a contractual obligation could not be proven is binding for the purposes of the appeal on points of law [Revision]. However, the separate examination of an involuntary loss of assets was based on incorrect standards and insufficient findings of fact.

The mere fact that the loss was caused by a relative does not turn it into a private loss of assets. What is required is an overall assessment of the business and private circumstances. In particular, it must be examined whether, and under what conditions, an unrelated employee could also have caused the same loss. The internal control system, industry-specific practices and the factual basis of the relationship of trust may be significant in this regard. There is no general rule of experience that only close relatives are entrusted with large amounts of cash without further control (Federal Fiscal Court judgement of 16 Nov 2005, file ref. X R 48/03).

Nor does fault on the part of the taxpayer automatically exclude a business cause. If the taxpayer is the victim of an intentional offence, the taxpayer’s own negligence or even recklessness does not, in principle, preclude the business connection. The position is different where the misconduct overrides the business cause as a private motive. The Fiscal Court must therefore establish specific facts instead of inferring a private cause from a failure to exercise control. However, the referral back does not yet mean that the business expenses claimed are recognised: even the actual handover of the alleged cash amounts had not so far been sufficiently established.

Securing the deduction of business expenses through specific evidence

In advisory practice, it is advisable to prepare evidence of payment and evidence of the cause separately. First, the actual flow of money, including its origin, handover and subsequent use, should be reconstructed as far as possible. In the case at issue, a point requiring particular explanation was that, according to his own account, the claimant had borrowed EUR 180,000 from his brother for 2009, briefly paid it into the business cash till and then handed it back to him. Next, it must be substantiated why the loss is attributable to the business sphere. Specific accounting records, correspondence, payment instructions and witness statements can help in this regard. The mere assertion that cash payments are customary in the industry is not sufficient, particularly where large amounts are involved.

Where relatives work as employees, the responsibilities and control procedures actually practised should be presented in a comprehensible manner. A lack of controls does not constitute an independent prohibition on deduction for tax purposes, but may become significant in the overall assessment. It must likewise be clarified whether the business owner was himself the victim of a criminal offence or knew about the sham invoices and the intended use of the funds. Any remaining doubts are to his detriment.

The fact that the money came from a business account does not replace this examination. Conversely, a private source account does not preclude the deduction: funds can be transferred into the business sphere by being dedicated to business purposes. The Federal Fiscal Court thus does not require flawless management of the business as a precondition for the deduction, but it does require reliable proof of a loss caused by the business. The decision therefore strengthens an appropriate case-by-case assessment of losses caused by relatives, without easing the taxpayer’s burden of proof.