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1. Introduction

As reported briefly in article no. 131, the Federal Ministry of Finance has released the final version of a directive summarising the position of the tax authorities with regard to the so-called "exchange opinion" (directive of 9 February 1998 - DB 1998, 394; hereinafter the "Directive"). The "exchange opinion" is a ruling dated 16 December 1958 (BStBl III 1959, 30) by an en banc panel (Grosser Senat) of Germany's highest tax court that the exchange of shares in one corporation for shares in a second corporation will by way of exception not result in taxable gain to either party if the shares exchanged are economically equivalent in value, type, and function.

Article no. 72 contained a detailed discussion of a preliminary draft version of the Directive. The final Directive differs in only a few material respects from the draft version. This article focuses on material differences and does not repeat all information contained in our previous article. Occasionally cited below is an article by Blumers/Schmidt (DB 1998, 392) on the new Directive.

2. General scope and requirements of the exchange opinion

2.1 Qualifying property and transactions

The exchange opinion deals only with the exchange of shares in corporations. Like the draft version, the final Directive states that its principles cannot be extended to other types of property, such as interests in partnerships. This position is criticised in the literature (cf. Blumers/Schmidt p. 392/2).

The relation of the taxpayers exchanging shares is irrelevant. The exchange opinion can therefore apply both to an exchange of shares in X-Corp. held by Corporation No. 1 for shares in Y-Corp. held by Corporation No. 2 (genuine exchange) and to an exchange of shares in X-Corp. held by Corporation No. 1 for shares in Corporation No. 2 (contribution).

2.2 Equivalence in value, type, and function

The primary requirement of the exchange opinion is that the shares exchanged be economically equivalent to each other with regard to value, type and function.

Equivalence in value is present according to the Directive if there is no more than a 10 % difference in value between the shares being exchanged. It is permissible for the party receiving the shares with higher value to compensate his counterparty in cash or other property (boot) for the difference. The final version of the Directive makes clear that permissible boot is measured with respect to the more valuable of the two shareholdings changing hands. Boot leads to pro rata gain. The 10 % limit on value difference has no definite basis in the case law and was retained despite criticism.

Equivalence in type and equivalence in function are lumped together in the Directive.

In addition to the factors cited in the draft version, the final Directive also notes that equivalence in type and function is not present if shares to which sec. 50c EStG applies are exchanged for shares to which this is not the case (Directive sec. 15). For a discussion of sec. 50c EStG see sec. 2.10 of article no. 134.

The preliminary draft version stated that the analysis of equivalence of type and function must take account of a participant's relationship to other entities, especially that of a group company to other members of the group. Under this test, a material change affecting another group member might frustrate a tax-free exchange. Account was likewise to be taken of a participant's ownership interests in other companies.

The final Directive reverses this position and provides that the equivalency analysis is limited to consideration of the two taxpayers involved and the shares which are changing hands (Directive sec. 17).

It should be noted that equivalence in type and function does not necessarily presuppose equal percentage shareholdings. Blumers/Schmidt (393/2) point out that there are decisions of the Federal Tax Court on record which permit large variations if the management influence conferred is comparable as a practical matter. For instance, in a corporation with widely dispersed shares, a relatively small percentage shareholding may suffice to elect members to the board of directors. Both the draft and final versions of the Directive are worded to imply that shares must in principle confer the same voting rights, but that "other factors" may correct any imbalance in exceptional circumstances (Directive sec. 8).

3. Special provisions for contributions

The Directive states that the exchange opinion can operate on the contribution of shares to a corporation in return for its own shares only if the situation is outside of the basic scope of the Tax Reorganisation Act with respect to such transactions. For details see sec. 3 of article no. 72. It also provides that Germany must retain its right of taxation upon ultimate disposition of the shares received in order to come under the exchange opinion.

In addition to the above, the preliminary draft version created two further requirements:

  • If the receiving corporation is an EU corporation, it must show the shares received on its balance sheet at the same value as they had in the hands of the contributor (carryover basis).
  • If the receiving corporation is a non-EU foreign corporation, the exemption is lost if the corporation disposes of the shares received over the next 10 years for contributions received prior to 1 January 1992 and over the next 7 years for contributions received from this date on.

The two requirements were interrelated. In the case of EU receiving corporations, the draft version of the Directive sought to prevent disposition of the shares received without full taxation by requiring a carryover basis, which would result in a normal capital gain on disposition. For non-EU receiving corporations, the draft version instead insisted on a long holding period.

The final Directive retains the two requirements (Directive sec. 23). However, the first requirement now applies only if the receiving corporation is a domestic corporation and the second requirement applies if the receiving corporation is a foreign corporation, including non-German EU corporations. The change is in response to criticism that the tax authorities could not dictate, or make operation of the exchange opinion contingent upon, the balance sheet valuation of the shares received by a foreign EU corporation.

The change is positive in so far as non-German EU corporations are concerned, as otherwise the tax law of the other EU country might have prevented a transaction from qualifying under the exchange opinion. However, Blumers/Schmidt (p. 394) are critical of the requirement of a carryover basis for a domestic receiving corporation. They point out that the Federal Tax Court has in the past refused to require a carryover basis in such circumstances because it is sufficient for the transferring corporation to apply its old basis to the shares it receives in order to preserve Germany's eventual right of taxation.

Regrettably, the tax authorities have declined to shorten the holding period for pre-1992 contributions to foreign corporations from 10 years to 7 years.

4. Conclusion

The Directive has the benefit of all codifications in that it makes the position of the tax authorities easier for taxpayers to ascertain and promotes the uniform application of the tax law. However, the Directive is restrictive with regard to the permissible difference in value (rigid plus-or-minus 10 %, although now measured by the more valuable of the two shareholdings) and indicates that equivalence of type and function will be strictly scrutinised. On the positive side, such equivalence is no longer to be analysed with respect to relationships to affiliated companies. Furthermore, the Directive no longer seeks to prescribe a carryover basis on contributions to EU corporations.

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