Federal Fiscal Court ruling: deduction of losses from other income under section 22 of the Income Tax Act

Consideration of losses for income taxation purposes 

Section 2(3) of the Income Tax Act contains a provision to determine the total income that results in a (horizontal and vertical) loss offset, that is, in an offset within the assessment period (section 25(1) of the Income Tax Act). Horizontal loss offsetting refers to offsetting within one of the seven categories of income. Vertical loss offsetting, on the other hand, implies offsetting between the seven categories of income. Loss deduction beyond the limits of the tax assessment period, however, is found in section 10d of the Income Tax Act, the section on “special expenses” (Guidelines on the Income Tax Act [Einkommensteuerrichtlinien̵–EStR] 2(1) line 8).

However, the loss offsetting mechanism in section 2 of the Income Tax Act is subject to numerous special rules (“loss schedules”). In its decision of 30 Sep 1998 (file ref. 2 BvR 1818–91), the Federal Constitutional Court considered a complete exclusion of loss offsetting for the particular case of current income from the leasing of movable property under section 22 no. 3 sentence 3 of the Income Tax Act to be a violation of the principle of equal treatment under Art. 3(1) of the Basic Law [Grundgesetz–GG]. However, this provision was subsequently amended by the legislature because the Federal Constitutional Court held that the legislature was fully authorised to “compensate for the vagueness of section 22 no. 3 of the Income Tax Act by standardising it … by restricting loss offsetting” (Federal Fiscal Court judgement of 11 Feb 2014, file ref. IX R 46/12, para. 33 with further references). 

Similarly, the legislature has incorporated many other loss schedules into the Income Tax Act. Particularly prominent were the recent rules in section 20(6) of the Income Tax Act, which were initially drafted to be very restrictive but were subsequently relaxed (on the whole matter, see Federal Fiscal Court judgement of 17 Nov 2020, file ref. VIII R 11/18). There are also many other examples, such as in section 15a of the Income Tax Act and section 15(4) of the Income Tax Act. Rules regarding losses from third countries are also particularly strict (section 2a of the Income Tax Act). 

Especially in cases of “other income” (section 2(1) sentence 1 no. 7 of the Income Tax Act), the legislature has laid down strict schedules for income from other services in section 22 no. 3 sentences 3 and 4 of the Income Tax Act and for income from private sales transactions under section 22 no. 2, section 23(3) sentences 7 and 8 of the Income Tax Act. Income under section 22 no. 3 of the Income Tax Act is already subsidiary to all other types of income in the “hierarchy” of income types; this income is also subsidiary to nos. 1, 1a, 2, and 4 of section 22 (section 22 no. 3 sentence 1 of the Income Tax Act). Section 22 no. 3 of the Income Tax Act therefore contains many atypical scenarios (list in Explanatory Notes to the Income Tax Act [Einkommensteuer–Hinweise–EStH] 22.8, “Income from services”).

Strict schedule for losses on income from other services

The narrow scope of this income therefore means that a loss separately determined within it (section 22 no. 3 sentence 4 second half-sentence of the Income Tax Act in conjunction with section 10d(4) of the Income Tax Act) can rarely be utilised because positive income from other services would have to be generated for this purpose. For example, if such a loss arises from surrendering bribes to the employer (as in Federal Fiscal Court judgement of 16 Jun 2015, file ref. IX R 26/14), it will rarely be usable, especially since it lapses on the taxpayer’s death and is not available to the heirs (e.g., Federal Fiscal Court judgement of 23 Oct 2019, file ref. I R 23/17, para. 12 with further references).

The question of how to handle losses on income from other services under sentences 3 and 4 of section 22(3) of the Income Tax Act from a constitutional perspective and regarding equitable measures (sections 163 and 227 of the Fiscal Code [Abgabenordnung–AO]) has once again been addressed by the ninth chamber of the Federal Fiscal Court (file ref. IX R 18/23). The claimant had obtained a ruling from the tax court in first instance requiring the tax authority to take an equitable measure under section 163 of the Fiscal Code: In 2002, the year the loss arose, she had earned real income that was not even enough to pay the assessed income tax. The reason for this was the strict schedules for losses under section 22 nos. 2 and 3 of the Income Tax Act, which she had to sustain from due to losses from stock transactions and the sale of equity interests.

However, the Federal Fiscal Court had already been unable to identify a violation of Art. 3(1) of the Basic Law in its previous rulings on sentences 3 and 4 of section 22 of the Income Tax Act, ruling that the ability-to-pay principle is satisfied if the offsetting of losses is not completely excluded but is extended over time and losses are only taken into account for tax purposes in a different assessment period as necessary. Sentences 3 and 4 of section 22(3) of the Income Tax Act meet these requirements in the same manner as the identical provision in the previous version of section 23(3) sentences 8 and 9 of the Income Tax Act (Federal Fiscal Court judgement of 16 Jun 2015, file ref. IX R 26/14, para. 26). 

The Federal Fiscal Court therefore rejected granting an equity waiver within the limits of its restricted judicial review of discretionary decisions (section 102 of the Fiscal Court Act [Finanzgerichtsordnung–FGO]), reasoning that the case at hand does not involve a particularly exceptional situation in which offsetting losses against future profits within the meaning of section 22(3) of the Income Tax Act would be virtually impossible due to special circumstances.