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Employment relationship between spouses has to stand up to an arm’s length comparison

Where employment contracts are between close relatives the salary payments can be deducted as business expenses if they comply with the arm’s length principle and are also actually ‘put into practice’. In a recent ruling, the Federal Fiscal Court (Bundesfinanzhof, BFH) expressed its views on the arm’s length principle.

In the opinion of the BFH judges, the crucial point is whether or not the allocation of the opportunities and the risks complies with the arm’s length principle. In the event of an unequal allocation the recognition for tax purposes may be withdrawn so that, among other things, the business expense deduction for salary payments would be lost. The facts of the case relating to the BFH ruling from 28.10.2020 (case reference: X R 1/19) were that a businessman had hired his wife as an office worker and, besides an employment contract, had concluded a supplementary agreement for a working time credit model. This model envisaged that the allocation of remuneration components to the credit balance would not trigger social security contributions and payroll tax since no remuneration would have been paid to the employee.

Specifically, the agreement included a provision that the wife would be able to use an unlimited amount of her remuneration to build up working time credit in order to, among other things, retire early, reduce her working hours or take a ‘block of free time’ off. The intention here was for most of the gross remuneration for the wife of the businessman to be allocated to the working time account. The profit-reducing provision that was set up for the working time credit was not recognised by the tax office. 

The BFH judges adopted the opinion of the tax office. It was doubtful that the agreement would stand up to an arm’s length comparison and thus the concomitant likely imbalance in the allocation of opportunities and risks would be to the detriment of the employer spouse. 

Please note: This assessment was based on the fact that the wife was able to save up an unlimited amount of working time credit and that, here, the duration, point in time and frequency of phases when she was not obliged to work could be selected almost arbitrarily.

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