Court Rejects Zurich Practice to Levy Real Estate Capital Gain Tax on Shareholders in Germany
In a recent court case (GR.2023.22, in German) the Zurich Tax Appeals Court ("Steuerrekursgericht Zürich") confirmed that the sale of the majority of shares in a Swiss real estate company by a German domiciled individual constitutes a sale of financial assets, even though the sale qualifies as an indirect sale of real estate (change of economic ownership) under Zurich tax law. In view of the double taxation treaty between Switzerland and Germany and according to the prevailing academic consensus, the right to tax the capital gain was granted to Germany. As a result, the relevant city in the canton of Zurich does not have the right to levy the real estate capital gain tax on the indirectly sold property. The court decision is not yet legally binding.
Fact Pattern
Several individuals owned a real estate company (hereinafter “Company”) with its registered office in the canton of Zurich. The Company owned a property in an undisclosed city in the canton of Zurich (hereafter “City”). One of the individuals was resident in Germany and the other two individuals were resident abroad, but not in Germany. At the beginning of 2018, the individuals jointly sold the shares of the Company to a Swiss group for approx. CHF 4 Mio.
In the real estate capital gain tax return, the sellers declared a taxable gain of approx. CHF 1m. Relying on the double taxation treaty between Switzerland and Germany (hereafter "Treaty"), the taxpayers claimed that the gain of the German shareholder should be classified as a gain from the sale of financial assets (shares) and not as a gain from the indirect sale of real estate. As a result of this position, the portion of the capital gain from this transaction attributable to the German resident was treated as not taxable in Switzerland and therefore not subject to the real estate capital gain tax of Zurich.
The tax administration did not accept this argument and concluded that the transaction should also be qualified as an indirect sale of real estate for the German individual. As a result, the administration assessed a taxable gain of approx. CHF 1.7m, resulting in a real estate capital gain tax of approx. CHF 346,000. The taxpayers disagreed and appealed to the Zurich Tax Appeals Court ("Steuerrekursgericht Zürich").
Legal Background
Real estate capital gain tax is generally levied on the legal transfer of ownership of real estate from one owner to another (legal change of ownership). In the canton of Zurich - as in most other cantons - the indirect transfer of ownership through the sale of shares in a real estate company is also subject to taxation (economic change of ownership). This means that the sale of a real estate company is treated in the same way as a direct sale of real estate. A company qualifies as a real estate company if the sole or at least predominant purpose of the company is the use the properties for their capital appreciation or as a safe and profitable capital investment.
Court Decision
Both the tax administration and the taxpayers agreed that the Company holding the property in the canton of Zurich qualifies as a real estate company and that the case at hand is considered as an economic change of ownership. Therefore, the court's decision is largely focused on whether the City's right to levy the real state capital gain tax on the German individual's share is limited under the Treaty.
According to art. 13 para. 1 of the Treaty, gains from the sale of immovable properties can only be taxed in the contracting state in which the property is located. Based on art. 6 para. 2 of the Treaty, the definition of "immovable property" shall be determined based on the law of the contracting state in which the property is located. Importantly, art. 13 of the Treaty with Germany does not include a specific real estate company clause as it is covered in the OECD Model Tax Convention and in most other double taxation treaties of Switzerland. According to such clause, the gain deriving from the sale of shares in a real estate company shall also be taxable in the contracting state where the properties are located.
The tax administration argued that art. 6 and art. 13 requires to apply the definition of “immovable property” according to the Zurich tax law because the property is located in the canton of Zurich. Since the Zurich tax law also qualifies the indirect sale of properties via the sale of shares in a real estate company as a taxable event, the City shall have the right to levy the real estate capital gain tax in line with art. 13 para. 1 of the Treaty.
The court did not accept this argument. According to the Vienna Convention (the international convention on the law of treaties including rules for the interpretation of treaties) in connection with the OECD Model Convention (1977 version, basis for the Treaty with Germany) and the protocols to the Treaty, an asset that has no connection with a particular jurisdiction cannot be considered as immovable property, even if it is defined differently in national law. In the present case, shares were sold, not real estate. Moreover, a legal basis in the national law of the respective state alone is not sufficient. Since art. 13 of the Treaty does not contain a real estate clause, the sale of shares in real estate companies must therefore be qualified as a sale of financial assets under the Treaty. Consequently, the capital gain attributable to the German resident must be treated as not taxable in Switzerland and therefore not subject to the real estate capital gain tax of Zurich.
The court decision is not yet final and may be appealed to the Administrative Court of the Canton of Zurich (“Verwaltungsgericht Zürich”).
Deloitte’s View
The court decision requires the tax administrations in Zurich to reconsider their current practice to levy real estate capital gain tax also if case of sellers domiciled in Germany. Although this decision focusses on the Treaty with Germany, it may also have an impact on other similar double taxation treaties that do not include an explicit real estate company clause such as those under art. 13 para. 4 OECD Model Tax Convention. This may therefore be relevant for the following countries where, like Germany, the specific clause is not included in the current treaties with Switzerland: Austria, Czech Republic, Denmark, Indonesia, Italy, Luxembourg, Slovakia, Sweden, and Turkey.
Tax administrations in other cantons that applied a similar practice like the administrations in Zurich will legally not be bound by the decision of the Zurich Tax Appeals Court. However, a change of the practice by the Zurich administration might have a certain impact on certain other cantonal administrations, unless they are willing to force a federal court decision in a similar case.
Next Steps
As the court decision is not yet final and can be appealed by the tax administration, there is no final legal certainty at this stage. However, shareholders (individuals and legal entities) domiciled in the above countries and holding real estate in Switzerland through similar structures should monitor future developments in this case to assess any changes in the practice of cantonal tax administrations.
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