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In general, a change in the shareholders of a German corporation (hereinafter referred to as a GmbH) affects neither the legal identity nor the tax status of the company. The purchase price is attributable fully to the shares acquired, which are not subject to scheduled depreciation. However, they may be written down to their fair market value. Unlike the goodwill element in a payment in an asset deal (including acquisition of a partnership interest), which can be depreciated for tax purposes over a period of 15 years, the goodwill element in a payment for shares may not be depreciated. However, the purchaser of a corporation usually wishes to subject the part of the purchase price allocable to the goodwill and perhaps other intangible assets to scheduled depreciation in order to generate higher tax deductible expenses. Under German law, there are two possibilities for securing depreciation on such intangibles (and other hidden reserves) following a share purchase.
Below please find a brief description of these two possibilities followed by a short summary of the existing and proposed anti-avoidance legislation in connection with these models.
2. Share deal and "internal" asset deal
Under this model, the share deal is followed by an "internal" asset deal. As a first step, a new German GmbH (A-GmbH), wholly owned by the purchasing group, buys the shares in the Target GmbH from the independent third party seller. After this share deal, the Target GmbH in addition sells all of its assets to A-GmbH. The results of this are as follows:
- a step-up in the tax basis of the assets purchased in the hands of A-GmbH including capitalisation of goodwill not previously shown in the balance sheet of the Target GmbH, and
- realisation of gain by the Target GmbH on the sale of its business to its new parent.
The after tax proceeds of this gain are then distributed to A-GmbH, which accounts for them as dividend income. A-GmbH, however, may take a write-down on the shares of the Target GmbH due to the fact that this entity no longer owns any assets and has distributed all of its profits. In other words, the Target corporation is now an empty shell and its shares held by A-GmbH may be written down accordingly for corporation tax purposes. This write-down largely offsets the profit realised on the distribution. Since A-GmbH receives a full refund of any corporation tax and withholding tax paid by its subsidiary (imputation credit), the gain realised by the Target GmbH on the "internal sale" of its assets is neutralised as far as corporation tax is concerned.
Whereas this strategy may prove effective in the context of corporate tax rules, it does not function for trade tax purposes. A second disadvantage is that there will be no tax refund on the surcharge on corporation tax at the level of the target company (surcharge = 7.5% of corporation tax, effective 1995 ff.). A further point to consider is the time lag of up to one year between the time at which the Target GmbH has to remit corporation tax (on its capital gain) and withholding tax (on the dividend distribution), and the time at which A-GmbH will receive a tax refund. In a few instances, the tax authorities have agreed to defer payment of the corporation tax for up to five months.
3. Share deal and reorganisation under the new German Merger/Reorganisation Law
In order to avoid the drawbacks described above, it could make sense to use the new tax provisions effective for all reorganisations/mergers carried out after January 1, 1995. Under the new provisions, it is possible to change the legal form of the Target GmbH into a partnership without triggering any capital gain taxes. Furthermore, the partnership would be able to obtain the desired step-up in basis.
The procedure involved is roughly as follows :
a) X-GmbH purchases the shares in Target GmbH.
b) Target GmbH is converted into e.g. a limited partnership = Target GmbH & Co. KG. (A new general partner GmbH must be organised; X-GmbH becomes the sole limited partner of Target GmbH & Co. KG).
c) Target GmbH & Co. KG assumes most tax attributes of Target GmbH (but not e.g. its loss carryforwards).
d) In addition, the basis of Target GmbH & Co. KG in its assets (= the former assets of Target GmbH) can be stepped up by the amount of the excess of the purchase price paid by X-GmbH for the shares of Target GmbH over the old basis of Target GmbH in its assets.
e) If the share purchase price exceeds the fair market value of the capitalised assets of Target GmbH, the excess is attributed to assets previously not capitalised, including goodwill.
f) Any remaining excess is a tax deductible valuation loss.
By this means, a stepped up basis can be obtained at no income tax cost. This applies both to the corporate income tax and to the trade tax on earnings.
4. Anti-avoidance legislation
4.1 Existing legislation
The two models described only achieve their tax purpose under the following conditions:
- The "internal asset deal" only functions if the purchasing company is allowed to write down its investment in the Target GmbH after the latter has distributed its profits.
- The "reorganisation model" only functions if the new partnership is allowed to spread the difference between the purchase price of the shares in Target GmbH and the book value of its equity over the assets transferred (including goodwill) and other intangibles.
However, section 50c EStG prevents a tax write-down of shares caused by a dividend distribution if the shares have been purchased from a person not entitled to the corporate income tax imputation credit. Most foreign persons fall into this category. The purpose is to prevent foreign persons from indirectly benefiting from the corporate tax credit, to which they are not entitled. If no special provision existed, the domestic purchaser could pay his foreign seller a higher price reflecting the tax benefit which the purchaser could derive from the corporation tax credit in conjunction with a tax write-down of the purchased shares as described in section 2 above.
The new German Tax Reorganisation Act contains a similar provision (section 4 par. V) according to which the amount to be spread over the assets of the partnership has to be reduced by the difference between the acquisition price paid for the shares and the nominal value of the shares if these shares have been purchased from, generally speaking, foreign persons.
Consequently, when purchasing shares from foreign persons the buyer must consider the limitations on his depreciation possibilities which result from the provisions here discussed. Shares purchased from foreign persons may well be worth less than shares purchased from resident entities.
4.2 Draft legislation
From the German legislature's point of view, a similar "problem" exists when shares are acquired from individuals who, while entitled to the corporation tax credit (in principle, German residents), do not have to pay income tax on a capital gain realised in connection with the share deal. For such shareholders it would make sense to accumulate earnings in a corporation over a long period and sell the shares afterwards, thus realising a tax free capital gain instead of receiving taxable dividends from year to year or instead of selling the assets of the corporation and distributing the profit out of the sale, which would also be taxable. The purchaser then would be able to obtain the desired stepped-up basis through one of the models described above and would thus not object to the purchase of shares instead of assets.
Under German law, individuals (natural persons) holding 25% or less of the shares in a corporation can in fact sell these shares tax free, provided they have held them for more than six months.
In order to avoid "abuse" by such individuals, the Draft 1996 Tax Reform Act contains a provision which would prevent a write-down of shares caused by a dividend distribution from being tax effective if the shares have been purchased from individuals who would not realise a taxable gain out of the share deal. A similar provision would apply for share deals followed by a reorganisation of the sort discussed above, hence reducing the step-up in basis for the new partnership.
It is at present uncertain whether the proposed new provisions will be enacted into law.
Disclaimer and Copyright
This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.