Loans Amongst Close Relatives
Trusting family members is as normal as can be. Therefore, it is usual that dealing with them is not as formal as it would be amongst strangers. But what happens when you miss a required formality in tax matters? Can you still make a deduction? The BFH gave its input to this question with its judgment of May 12, 2009 (re IX R 46/08).
David built three houses in the years 1991 to 1993. In order to finance this project, he took out a loan from his three minor grandchildren at the end of August 1991. All contracts were signed by the grandchildren's father as their legal representative. A special (court appointed) guardian was not engaged. In April 1992, further contract changes were also only signed by the minors' father. From then on, the grandchildren granted loans to their grandfather over various amounts. In 1998 and via a notary's deed, the loans were acknowledged by a special guardian and mortgages were encumbered on the real estate in order to secure the loans.
However, minors may not be represented by their parents when engaging in legal transactions among relatives in direct line (§1795 I no. 1 BGB). The contract is subject to approval of the guardian (§141 II BGB) because when this is not obeyed, the contracts miss the correct legal form and are null and void (§125 BGB). Following §1909 I 1 BGB, a court appointed guardian is required in such proceedings to represent the father, when parents are not competent to represent their child. This is seldom the case but typical when entering contracts with direct relatives. Everybody knows, a minor has restricted legal capacity (§106 BGB). When the legal representative does not approve the legal transaction then it is generally null and void - the legal representative must affirm it (§107 I BGB). The court held and confirmed previous ruling case law, that when close relatives disregard the civil law formalities, this indicates and implies that seen with from the perspective of tax law, there is no willful consent in binding oneself by the contract.
The tax office refused the interest as a deduction and thereupon increased David's income. The tax office argued that since David did not keep the statutorily required form, the contracts were at first null and void. Even though they were later affirmed by a specially appointed guardian, they cannot be considered. This is because missing the legal form of an obligation among relatives shows that there is no real intention in fulfilling the contract as would be among non-relatives (so-called third-party comparison). When the contractual parties do not take the required formalities seriously then the costs deriving therefrom are not eligible for deduction. However, the tax office may not only rely on one single detail as happened in this case. All the incidents of a case are to be considered in order to make a correct judgment. That is why the BFH dismissed the case and sent it back to the fiscal court (Finanzgericht) that it may do its homework. Since the BFH is only competent to decide on questions of law and not of fact, the lower court has to seek for and consider further facts to render a proper judgment in the case.