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In April 1997, the Federal Ministry of Finance issued in draft form a highly detailed directive setting forth the position of the German tax authorities on numerous issues associated with the new Tax Reorganisation Act which took effect on 1 January 1995 (see article no. 5 "New German Reorganisation Law"). The draft directive is 179 pages in length and is the subject of comments which KPMG Germany submitted to the Institute of German Accountants (IDW) at the end of May 1997. The IDW issued its own comments in early June 1997. These agree in substance with those of KPMG unless otherwise stated.
The draft directive is too voluminous for comprehensive treatment and, being merely a draft, may yet change considerably before a final version is issued. The following article therefore focuses on those aspects which appear most significant, especially from the perspective of foreign investors. It is emphasised that not even all of the issues raised in KPMG's comments are covered, much less all those contained in the draft directive itself. Furthermore, the amount of time available for analysis of so complex a document has not been sufficient to ensure identification of all significant issues. Many of the matters omitted may be of considerable importance in a given reorganisation.
The sections of the Tax Reorganisation Law are cited in this article by section number followed by the abbreviation "UmwStG" (Umwandlungssteuergesetz). Those of the draft directive are cited as "no." followed by the abbreviation "DD" for "Draft Directive". The structure of the draft directive by and large mirrors that of the statute. For example, no. 01.01 DD refers to sec. 1 UmwStG, no. 02.01 DD to sec. 2 UmwStG, and so forth. The draft directive in addition contains an introductory part (numbered 00.01 - 00.14) and three subparts on special topics with special numbering (O.01 - O.10, GL.01 - GL.15, and 8a.01 - 8a.06, presently situated in the middle of the draft directive following the comments on sec. 18 UmwStG).
The Tax Reorganisation Act should not be confused with the Business Reorganisation Act (Umwandlungsgesetz) which defines the types of reorganisations permitted under company law (statutory reorganisations). Generally speaking, it is only statutory reorganisations under the Business Reorganisation Act which can be accomplished tax free under the Tax Reorganisation Act.
2. Positions taken in the draft directive on selected issues
2.1 Denial of reorganisation loss and stepped up basis for trade tax purposes
The most controversial position taken by the tax authorities in the draft directive is that, when a corporation is merged into or otherwise reorganised as a partnership, any step-up in the value of the assets received by the partnership from the disappearing corporation (sec. 4 par. 6 UmwStG) will not apply for trade tax purposes. Instead, the draft directive states that a separate calculation of taxable income based on the transfer values of the assets received is to take place for trade tax purposes. Furthermore, the draft directive would deny recognition for trade tax purposes to any reorganisation loss realised by the receiving partnership on the reorganisation (no. 18.02 DD). In situations where a step-up would otherwise occur, in particular where the reorganisation follows closely after purchase of the corporation at a premium, the denial of the step-up would typically lead to a reorganisation loss under the general rules.
KPMG considers that there is no basis in law for either of the above positions. For a discussion of the background issues involved, see section 4 of article no. 5 and article no. 28 "Share Deal Purchases Under the Tax Reorganisation Act").
2.2 Linkage of tax and commercial balance sheets
It is a general principle of German tax accounting law that, unless specifically provided otherwise, the commercial balance sheet controls for tax purposes as well (linkage of tax to commercial balance sheet - Massgeblichkeitsprinzip). The draft directive at various points contends that such linkage exists as well in reorganisation situations notwithstanding the apparent intent of the tax reorganisation law to create exceptions in which the tax balance sheet need not follow the commercial balance sheet. Hence the draft directive contends that upon merger of a corporation into a partnership the choice by the corporation of a transfer value above book value is impossible for tax purposes because the option created by sec. 3 UmwStG does not exist for commercial accounting purposes. Conversely, it is contended that the exercise of an option created for commercial accounting purposes by the Business Reorganisation Act (sec. 24 UmwG) for the receiving entity to value property received above the book values in the closing balance sheet of the transferring entity causes the transaction to lose the protection of the Tax Reorganisation Act altogether (no. 03.01, 03.02, 11.01 DD).
With respect to both issues, the tax authorities have failed to appreciate that instances are involved in which the tax regulations are independent of the commercial law regulations. KPMG has therefore urged that the respective passages in the draft directive be deleted in their entirety as without basis in law.
2.3 Definition of "branch of activity"
It is in various circumstances (e.g. in divisive reorganisations) necessary that the assets being transferred and/or retained constitute a branch of activity, an interest in a commercial partnership, or a 100 % share of a corporation. Assets and liabilities constitute a branch of activity (Betrieb or Teilbetrieb) if they have a certain degree of independence and are potentially capable of functioning as an independent business. At various places (nos. 15.02 and 20.08 - 20.11 DD), the draft directive adopts a definition of "branch of activity" which was developed under the German income tax law to determine when an individual qualifies for a special capital gains tax rate. This definition is stringent and, if applied in reorganisation contexts, would in particular require not just that the assets being transferred be potentially capable of functioning independently, but also that all material assets forming part of the branch of activity as previously operated be part of the transfer.
KPMG considers that the definition used in the draft directive is too strict and not in accordance with the definition of "branch of activity" as used in the EU Merger Directive. The term should be interpreted functionally in light of the purpose of facilitating economically sensible reorganisations. This policy goal differs from that of deciding when a preferential income tax rate should be accorded to an individual under German income tax law. Different policy goals require different interpretations of the term "branch of activity." The fact that certain material assets previously used in a branch of activity are not transferred should not cause the transaction to forfeit tax protection as long as the assets which are transferred constitute a branch of activity in the functional sense even without the assets which are withheld.
2.4 Branch of activity - other issues
In structuring a divisive reorganisation, it is important to have planning flexibility with regard to assets not necessary to any branch of activity of the entity being divided. Furthermore, certain assets may have been used by two or more branches of activity in the past (shared assets). The draft directive should be modified to recognise these problems and permit the taxpayer to assign such assets to the branch of activity of his choice, within reasonable limits. The IDW suggests an option to assign shared assets to the branch of activity of predominant use (comment on no. 15.07 DD).
The draft directive is silent on how to determine the branches of activity of a holding company when this is the subject of a divisive reorganisation. This is a matter of considerable practical significance with which the final version of the directive should deal.
2.5 General anti-abuse provision
At various places, the draft directive contains general descriptions of certain tax planning structures with the comment that, in such situations, the tax authorities are to consider whether or even to assume that the reorganisation in question is "abusive" within the meaning of sec. 42 AO (Tax Procedure Act) and hence to be disregarded for tax purposes. Missing in virtually all of these passages is the recognition of the need to consider whether, in a particular situation, a sound non-tax reason exists for the transaction as planned. If this is the case, the fact that, in addition to achieving a business purpose, a particular structure also yields tax advantages, is not in itself sufficient to bring the transaction under the anti-abuse provision. KPMG has therefore recommended that the passages in question either be brought into line with the leading court decisions on point or be deleted.
It can nevertheless be seen from the draft that the tax authorities are thinking carefully about possible abuse of the tax reorganisation act in a wide variety of contexts.
2.6 Specific anti-abuse provisions for divisive reorganisations
Section 15 par. 3 UmwStG provides that tax will be triggered on divisive reorganisations involving partnership interests or 100 % shares in corporations if the interest in question was acquired or increased in value during the three preceding years by contribution of property which was not itself a branch of activity. The draft directive (no. 15.17 - 15.19 DD) takes this provision very literally and says that any contribution of property to a partnership during the three preceding years will preclude a tax-free division. KPMG points out that such contributions in nominal amounts are common and recommends limiting the provision to material contributions. Otherwise, practically no tax free division involving a partnership interest will be possible.
The IDW argues that the statute in question applies only to the property transferred, not to that retained. In other words, the fact that property not constituting a branch of activity was contributed to the partnership within the preceding three years should make no difference as long as the contributed property stays in the original entity in any division. The IDW recommends deletion of the respective passage in the draft directive.
Section 15 par. 3 UmwStG likewise denies the protection of the statute to transactions which are the economic equivalent of or in preparation for a sale of the interest in question to third persons. No. 15.26 DD states that this is the case in the event of a subsequent transfer in the context of a merger, division, or contribution. However, not all such transactions are ipso facto the economic equivalent of a third party sale. The draft directive should be amended to focus on the legal issue involved. The IDW goes further and recommends a blanket provision that no tax free transfer of assets constitutes a sale or disposition within the meaning of sec. 15 par. 3 UmwStG.
2.7 Retroactivity of a reorganisation for tax purposes
The effective date of a reorganisation can generally be up to eight months before the date of its filing with the Commercial Register. This retroactivity, which is also accepted for tax purposes (sec. 2 UmwStG), poses many questions, some of which are addressed in the draft directive.
One such issue is whether the receiving entity in a merger must have been in legal existence at the effective date. The draft directive contends that this is the case (no. 2.09 DD). However, the retroactivity provided for in the Tax Reorganisation Act is for the purposes of attributing income to the entities involved in a reorganisation. For this purpose, it makes no difference whether the receiving entity was formed before or after the effective date. Similarly, it should make no difference when changing from corporate to partnership business form whether a corporate partner of the partnership-to-be is in legal existence at the effective date, as long as it had been formed by the time of the reorganisation resolution (no. 14.04 DD).
Another issue relates to dividends, including constructive dividends, paid by the disappearing corporation in a merger in the period after the effective date. This may include dividends paid prior to the merger resolution. The draft directive appears to attribute such dividends to the receiving entity except where they relate to the shares of shareholders who exercise an option to surrender their shares in the disappearing corporation in return for a cash settlement instead of participating in the merger and taking interests in the receiving entity. As to such shareholders, the dividend is to be attributed to the disappearing corporation. KPMG believes that this solution is neither required under the law as it is written nor practical and instead urges attribution of all declared dividends for a preceding fiscal year to the disappearing corporation where the receiving entity is also a corporation. If the receiving entity is a partnership, a declared dividend should still be attributed to the disappearing corporation where the stock of this corporation is widely held (Publikumsgesellschaft).
2.8 Thin capitalisation rules (sec. 8a KStG) and corporate mergers
For mergers and consolidations of two corporations, the draft directive proposes to attribute the shareholder debt of both the surviving and the disappearing corporation to the surviving corporation as of the effective date (no. 8a.01 ff. DD). Since the safe haven ratio for thin capitalisation purposes is determined with respect to equity in the commercial balance sheet at the start of each fiscal year, this can easily lead to serious problems wherever the effective date is not simultaneously the start of a fiscal year. KPMG proposes an option for the taxpayer to make the thin capitalisation calculation without regard to the retroactivity fiction. The IDW instead suggests solving the problem by calculating the thin capitalisation debt-to-equity ratio with respect to equity at the effective date of the merger or at the end of the fiscal year in question.
2.9 Denial of protection of sec. 8b KStG
Section 8b of the German corporation tax act provides a tax exemption inter alia for gains realised by German corporations on the disposition of shares in foreign corporations. The draft directive states (no. 03.11 DD) that any gain from upward valuation of such shares by the transferring corporation on its closing balance sheet shall not benefit from the tax exemption because such revaluation does not constitute a disposition. KPMG considers this unfortunate and suggests that the tax exemption should be accorded under such circumstances. The IDW does not comment on this point.
2.10 Blocking amounts under sec. 50c EStG
Section 50c of the German income tax law is a complex provision which operates generally speaking when the shares in a German corporation which has retained earnings are purchased from a foreign seller. Absent sec. 50c EStG, the buyer could obtain a refund of the corporation tax paid by the purchased corporation on its retained earnings by distributing these earnings after the purchase and then neutralising the resulting dividend income by means of a dividend-based write-down in the value of the shares. The provision is needed to close an otherwise existing loophole because the foreign seller will typically be shielded from German tax liability on his capital gain under the terms of a tax treaty. Section 4 par. 5 UmwStG provides that if a blocking amount exists with respect to the shares of a corporation which is being merged into (or otherwise reorganised as) a partnership, the receiving partnership must treat this blocking amount as income. Nos. 04.19 - 04.26 DD interpret sec. 4 par. 5 UmwStG and sec. 50c EStG in ways which would give rise to such reorganisation income in a variety of questionable circumstances. KPMG proposes deletion from the draft directive of the items in question.
2.11 Retroactivity of 1996 change to sec. 5 par. 3 UmwStG
The cited statute, which applies to mergers and conversions of corporations into partnerships, was amended by law enacted in December 1996. The amendment relates to the value at which shares in the disappearing corporation held by a partner of the receiving partnership in a domestic permanent establishment are deemed contributed to the partnership. The tax authorities have always claimed that the amendment only clarified what the statute meant all along. The draft directive states that the amendment is effective retroactive to 1 January 1995. This is subject to considerable doubt. KPMG hence recommends deletion of the relevant item (no. 05.14 DD). The IDW does not comment on this point.
2.12 Downstream mergers
The draft directive recognises the possibility of merging a parent into its subsidiary, but does so only "for equitable reasons" (no 11.22 ff. DD). KPMG considers that the permissibility of such transactions follows from the statute itself and proposes that the draft directive be amended to say so. The IDW does not comment on this point.
2.13 Loss carryforward of merged holding companies
It is recognised that a holding company carries on a business and hence that a tax loss carryover which it possesses may potentially be transferred when it is merged into another corporation (no. 12.17 DD). KPMG recommends that the relevant passage be amended to make clear that holding a single participation is sufficient to qualify as carrying on a business within the meaning of the relevant statute. The IDW does not comment on this point.
The draft directive will be the subject of considerable debate over the coming months. We will report on this matter as further developments warrant.
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. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. 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.