The passive loss of the German right to tax (“Entstrickung”) of assets

The loss of the German right to tax (“Entstrickung”) of assets

According to the General Tax Code, a tax arises (Sect. 38 of the General Tax Code) as soon as the legal elements to which the law attaches the obligation to pay are fulfilled. According to Sect. 3(1) half-sent. 1 of the General Tax Code, the tax is imposed on all persons to whom the facts of the case apply to which the law attaches the obligation to pay. In most cases, the fulfillment of tax obligations by taxpayers is driven by their own will and triggered, for example, by everyday sales transactions. This is also generally the case for withdrawals from business assets (Sect. 4(1) sent. 2 of the Income Tax Act): These must - apart from the “book value privilege” (“Buchwertprivileg”) under Sect. 6(1) no. 4 sent. 4, 5 of the Income Tax Act - be valued at fair market value and thus trigger a tax consequence under income tax law. As gratuitous transactions, they also do not permit any mitigation, such as a rollover of reserves under Sect. 6b of the Income Tax Act (Annotation 6b.1 to the Income Tax Directives, “Withdrawal”). However, a withdrawal under Sect. 4(1) sent. 2 of the Income Tax Act specifically requires “an act of withdrawal through which the intention to sever the asset’s connection to the business is unambiguously expressed” (Judgement of the Federal Tax Court dated December 2, 2025, file number IV R 20/23, margin no. 52).

However, in its circular dated October 26, 2018 (Circular of the Federal Ministry of Finance dated October 26, 2018, Federal Tax Gazette I 2018, p. 1104), the tax authorities stated that, among other things, the provision governing the loss of the German right to tax enshrined in Sect. 4(1) sent. 3 of the Income Tax Act, which leads to a fictitious withdrawal, does not require any action on the part of the taxpayer. Accordingly, the exclusion or restriction of a German right of taxation can be triggered “independently of an action by the taxpayer through a change in the initial legal situation - so-called passive loss of the German right to tax (“Entstrickung”).” The tax authorities consider the relevant point in time for the passive loss of the German right to tax (“Entstrickung”) to be the "time of the first applicability of the DTT concluded or revised for the first time", i.e. regularly 1st January at 0 a.m. (for the first application dates of the German DTTs for tax purposes, see e.g. Circular of the Federal Ministry of Finance dated January 7, 2026, Federal Tax Gazette I 2026, p. 132, Annex I).

Passive loss of the German right to tax (“Entstrickung”) before the Federal Tax Court

In addition to Sect. 4(1) sent. 3 of the Income Tax Act, this also includes Sect. 12(1) of the Corporate Income Tax Act, the corresponding regulation for corporations, as well as Sect. 6 of the German Foreign Transactions Tax Act (“Außensteuergesetz”), the regulation for the loss of the German right to tax shares within the meaning of Sect. 17 of the Income Tax Act, which are part of the financial authorities view on the passive loss of the German right to tax (Circular of the Federal Ministry of Finance dated October 26, 2018, Federal Tax Gazette I 2018, p. 1104). Sect. 6 of the Foreign Transactions Tax Act has already been assessed by the Federal Tax Court on the question of "passive loss of the German right to tax (“Entstrickung”)". However, no decision on the merits was made, as the ninth chamber of the Federal Tax Court had already come to an allocation of a possible loss of the German right to tax (“Entstrickung”) that differed from that of the tax authorities: In the opinion of the Federal Tax Court, this would have had to be recognized as early as 2012, not - as happened in the case at hand - in the year in dispute 2013 (Judgement of the Federal Tax Court dated April 16, 2024, file number IX R 38/21). Well after the year in dispute, the legislature made it clear through Sect. 6(1) sent. 2 no. 3 German Foreign Transactions Tax Act that (also) in the case of an “exclusion or restriction of the Federal Republic of Germany’s right of taxation with respect to the gain from the sale of the shares,” it assumes the notional sale to have taken place “immediately prior to the date on which the exclusion or restriction of the right of taxation takes effect”.

This issue of the allocation with regard to time also arises in the judgement of the Federal Tax Court, file number I R 41/22 (dated November 19, 2025; see also the parallel judgement, file number I R 6/23 of the same date): The Federal Tax Court has once again ruled that any “passive loss of the German right to tax (“Entstrickung”)” resulting from a revision of a double tax treaty (here: the 2011 DTT with Spain) occurs at the very last legal moment before the exclusion or restriction of the right to tax takes effect (i.e. at the very last second of December 31). Once again, in this proceeding, the disputed assessment had been issued during the assessment period in which the revised DTT first became applicable. 

However, the Federal Tax Court now also makes “strong” statements regarding passive loss of the German right to tax (“Entstrickung”), which in this case had to be applied pursuant to Sect. 4(1) sent. 3 of the Income Tax Act, since the shares at issue constituted special business property II (“Sonderbetriebsvermögen II”) in a partnership. In its view, passive loss of the German right to tax (“Entstrickung”) is legally required due to a “change in the legal situation” - the Federal Tax Court does not see a “requirement for active action by the taxpayer to bring about the loss of the German right to tax” (margin no. 18).

Loss of the German right to tax (“Entstrickung”) remains a contentious issue 

In the case of “passive loss of the German right to tax (“Entstrickung”),” the Federal Tax Court has now issued its first decision on the matter. In advisory practice, it will therefore be increasingly important to pay close attention to future changes in the network of German double tax treaties. “Annex II” of the Circular of the Federal Ministry of Finance dated January 7, 2026 (Federal Tax Gazette I 2026, p. 132) allows this development to be predicted in principle. One example is the 1973 South Africa DTT, which remains applicable to this day, while the 2008 South Africa DTT is still listed in “Annex II” as a “future agreement.” There, too, the problem arises that the “old” DTT does not contain a “real estate rich” clause (Art. 11(2) DTT South Africa 1973), whereas the “new” DTT does (Art. 13(2) DTT South Africa 2008): This is precisely the problem that led to the current decisions on “passive loss of the German right to tax (“Entstrickung”)” during the transition from the 1966 Spain DTT to the 2011 Spain DTT.

Most recently, the “active” loss of the German right to tax (“Entstrickung”) under Sect. 4(1) sent. 3 and 4 of the Income Tax Act has also caused some concern: From the statements by the Federal Tax Court regarding the relationship between sent. 3 and sent. 4 (“standard example”) of Sect. 4(1) of the Income Tax Act in its judgement dated March 26, 2025 (Judgement of the Federal Tax Court dated March 26, 2025, file number I R 5/24 (I R 99/15), margin no. 20, 21), the impression has arisen that the mere fulfillment of the standard example in sentence 4 (“… if an asset previously attributable to a domestic permanent establishment of the taxpayer is to be attributed to a foreign permanent establishment”) already triggers the loss of the German right to tax (“Entstrickung”), without there having to be an exclusion or restriction of the German right of taxation under sent. 3 of Sect. 4(1) of the Income Tax Act. Due to Sect. 12(1) sent. 2 of the Corporate Income Tax Act and Sect. 16(3a) half‑sent. 2 of the Income Tax Act, this issue also arises in other provisions governing the loss of the German right to tax (“Entstrickung”).