How the German Tax Authorities Help with the Restructuring of Companies: Practical Experience with Tax Exemption of Restructuring Profits

Companies in crisis are facing major challenges. Not only do they have to negotiate with stakeholders about their restructuring contributions and restructuring loans, they also have to make what are often difficult decisions on a wide range of legal issues. Essential components of any restructuring concept are the restructuring contributions of stakeholders, which often consist of waivers of claims by existing creditors. Whether made within or without insolvency proceedings, waivers of claims often result in considerable tax liability for the company to be restructured, which can be a real obstacle to restructuring.

The German legislature recently created a tax exemption to help eliminate this obstacle. However, the legal provisions governing the tax exemption, which have now been in force for about two years, have narrow limits and require a considerable amount of supporting documentation, as well as coordination of timing with the tax authorities, which can place a considerable burden on an already-tight restructuring schedule. The following provides an overview of this tax exemption, as well as practical information about how German tax authorities handle the exemption.

Tax Exemption of Restructuring Income

Pursuant to the law of Dec. 11, 2018, the provisions regarding tax exemption of restructuring profits in §§ 3a and 3c of the German Income Tax Act (EStG; hereinafter the “Income Tax Act”) and § 7b of the German Business Tax Act (GewStG; hereinafter the “Business Tax Act”) took effect retroactively as of July 5, 2017.[1] Under these provisions, income from “debt relief” is tax-exempt if it is part of a business-related restructuring. A restructuring is business-related within the meaning of § 3a(2) of the Income Tax Act if the tax debtor shows that at the time of debt relief the company is in need of restructuring, the company is capable of being restructured, the debt relief is conducive to restructuring, and the creditors have restructuring intent. Moreover, restructuring income may be netted with any tax losses and carryforward losses before being taxed.

The significance of the tax exemption is illustrated by the following example: If a creditor of a German stock corporation waives loan claims in the amount of €100 million in connection with a restructuring of the company, the €100 million will be treated as other operating income for the company. The company may offset this income with losses from the same tax-assessment period, although such losses are in many cases insufficient to fully offset the income, particularly if operational restructuring measures already underway are gaining traction and the company has started to generate some income.

Under German law, up to €1 million of any tax-carryforward losses of a company may be used to offset any restructuring profit, and any tax-carryforward losses in excess of €1 million may be used for offset at 60 percent.[2] Consequently, even if the company in our example had carryforward losses in the amount of €100 million, it would be able to offset the income of €100 million from the waiver of claims with carryforward losses of up to €1 million at 100 percent, but with respect to the remaining €99 million only at 60 percent (approximately €59.4 million). As a result, the company would generally have to pay taxes on profits in the amount of €39.6 million and its tax liability would be approximately 30 percent, which in our example would be about €12 million. Without the offset of losses, tax liability for the waiver of claims would be approximately €30 million (corporate income tax rate of 15 percent plus trade tax rate of approximately 14 percent and solidarity surcharge).

The Scope and Requirements of Tax Exemption

The scope of this exemption has been narrowly interpreted under German law. This is due, in part, to the ambiguous nature of some of the applicable provisions, in particular § 3a of the Income Tax Act. For example:

• § 3a(2) of the Income Tax Act mentions only restructuring income from “debt relief.” It is unclear whether § 3a of the Income Tax Act would also cover restructuring income from other transactions (e.g., debt-for-equity swaps or debt-mezzanine swaps). The current practice of German tax authorities is to interpret “debt relief” as covering only waivers of claims.
• § 3a(2) of the Income Tax Act requires proof that “creditors have restructuring intent.” It is unclear whether this refers to all creditors or only to those creditors who are directly involved in the restructuring process, and what the requirements are for proving restructuring intent. If — as a condition for extending a restructuring loan — a restructuring opinion within the meaning of the German auditor’s standard IDW S6 was prepared that confirmed that the waiver of claims was a necessary condition for the ability of the company to be restructured, restructuring intent is probably present.

Even if the requirements for tax exemption are not satisfied, taxes on the restructuring profits may nevertheless be waived for reasons of equity in accordance with § 227 of the German Tax Code (AO). According to case law from the Federal Tax Court (BFH), collecting a tax is inequitable if it would jeopardize or even preclude the continued existence of the tax debtor from whom the tax is collected or if the tax would trigger a financial emergency for the tax debtor. It is an indispensable requirement for this exemption that the financial emergency of the tax debtor is caused by the assessment or collection of the tax.[3]

In the view of the Federal Tax Court, a tax waiver may even be a stopgap measure designed to temporarily preserve the existence of the tax debtor’s business.[4] Moreover, the Federal Tax Court (BFH) makes reference to case law from the Federal Administrative Court (BVerwG) that likewise provides for a tax waiver for reasons of equity if a waiver is necessary for preserving the existence of the tax debtor’s business.[5] To determine whether the assessment or collection of a tax caused a financial emergency for the tax debtor, the Federal Tax Court will look at the financial condition of the company, such as the amount of liabilities, registered share capital, profits or monthly expenses.[6] The problem is that the financial conditions of the debtor might already be cured — or might at least be much better than before — at the same time that the German tax authorities need to decide on the tax waiver, as such a decision requires that (1) the debtor has already filed its tax declaration for the fiscal year in which the creditors gave the debt relief, and (2) the corresponding tax-assessment note has been established by the tax authorities, which will probably be two or three years after the debt relief has been granted by the creditors. The practical experience is that requests for a tax waiver require a very detailed description of the current and future financial situation of the debtor.

Procedural Issues

The issue of whether the aforementioned requirements for tax exemption are satisfied will generally be reviewed by the local German Tax Office. This applies to both the corporate income tax and the solidarity surcharge collected by the German Tax Office, as well as to business taxes collected by the municipalities, since a company will be exempt from business taxes if it is exempt from corporate income taxes.

Under the normal taxation procedure, a company would not find out whether the requirements for tax exemption are satisfied until taxes are assessed for the tax-assessment period in which the creditor’s waiver becomes effective — i.e., years after the restructuring transaction has closed. The parties involved in the restructuring cannot wait that long, however, and new investors and lenders will often demand that funds loaned to the company be used for the continued development of the company’s operational business.

In practice, the tax debtor will typically request a binding tax ruling from the German Tax Office on the question of whether the company meets the requirements for the tax exemption or whether a tax waiver for restructuring income may be granted when the transaction closes. Such a binding ruling “binds” the German Tax Office to its statements within the ruling. However, any subsequent change in the facts may render a prior tax ruling legally ineffective, and the local German Tax Office would no longer be bound by its ruling.

It is this author’s experience that the tax authorities are hesitant to issue binding rulings on the question of whether a tax waiver is possible (in case the tax exemption is not applicable). Due to its limited decision-making authority under German law, the local German Tax Office must regularly engage the Regional Tax Department, or even the Federal Tax Department, for a review of such requests. Similarly, municipalities must usually obtain a resolution from the local city council before issuing a binding tax ruling. As a result, the decision becomes a political issue, which effectively means additional expenditures of time and money.

Conclusion

The timely coordination of the tax consequences of a restructuring transaction with the relevant tax authorities is a critical requirement for a successful restructuring. It is therefore advisable to keep in mind the tax consequences of a contemplated restructuring transaction from the outset and to contact the local tax authorities as soon as possible. Finally, it should be noted when drafting the restructuring documentation that a precise description of the relevant facts and early involvement of the local German Tax Office and the municipalities are vital to a successful request for a binding tax ruling.