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In early April of this year, the Federal Ministry of Finance released a draft directive summarising the position of the tax authorities with regard to the so-called "exchange opinion" rendered by the Federal Tax Court almost 40 years ago. Handed down on 16 December 1958 (BStBl III 1959, 30), the "exchange opinion" is a ruling 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.
The requirements for coming under the exchange opinion are relatively restrictive, for which reason it is not frequently invoked. Still, taxpayers have successfully relied on the exchange opinion over the years and it has been confirmed by subsequent court decisions, one of which expanded its scope to include contributions of shares to a corporation in return for shares in the receiving corporation (exchange of a direct participation for an indirect one). However, the exact status of the exchange opinion in relation especially to the Tax Reorganisation Act, which also deals with tax-exempt restructuring in general and contributions of shares in particular, has never been entirely clear. The draft directive is welcome above all because it establishes the independent applicability of the exchange opinion in situations which cannot be brought under the Tax Reorganisation Act. The exchange opinion thus offers possibilities for tax-exempt reorganisations in addition to those provided by the Tax Reorganisation Act.
It is recalled that, while an exchange constitutes a disposition under German tax law, not all dispositions of shares are taxable in the first place. Dispositions of shares held as private, as opposed to business property, are non-taxable unless they constitute part of a material ownership interest (over 25 % held any time within the last five years) or were acquired in a tax-free reorganisation or sold within six months of acquisition (speculation period). The exchange opinion is of course relevant only to otherwise taxable dispositions. It is likewise inapplicable to transactions which are covered by the Tax Reorganisation Act.
Like the Tax Reorganisation Act, the exchange opinion shields the participants only against tax on income. The exemption does not cover real estate transfer tax or VAT.
KPMG submitted written comments on the draft directive to an umbrella trade organisation (Deutscher Industrie- und Handelstag) in early May 1997.
2. General scope and requirements of the exchange opinion
2.1 Type of qualifying property
The exchange opinion deals only with the exchange of shares in corporations. The draft directive states that its principles cannot be extended to other types of property, such as interests in partnerships. There is support, however, for extending the principles involved to other like-kind exchanges. KPMG urges that this be done in the final version of the draft directive.
The shares being exchanged need not be held as business property. However, shares held merely as passive investments cannot qualify for a tax-exempt exchange.
The shares being exchanged need not be shares in a domestic corporation. However, the draft directive states that an exchange of shares in a domestic corporation for shares in a foreign corporation will trigger tax in certain instances (see following section).
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 (referred to in German by the somewhat old-fashioned term "Naemlichkeit" meaning identity or strict equivalence of the shares). If this requirement is met, the participants to the transaction carry over their old basis in the shares they tender to the shares which they receive without recognising gain.
Equivalence in value is present according to the draft directive if there is no more than a 10 % difference in fair market 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. It is, however, not permissible to divide what is economically speaking a unified transaction into two parts, i.e. an exchange and a sale, so as to stay within the 10 % limit on the exchange part of the transaction. If boot is involved in a qualifying exchange, the draft directive states that gain will be recognised on the transaction to the extent thereof (i.e. if 10 % boot, then recognition of 10 % of the difference between fair market value and tax basis as taxable gain).
Equivalence in type and equivalence in function are lumped together in the draft directive, which provides the following guidance:
- The degree of shareholder influence conveyed by the shares must be approximately the same.
- Neither material advantages nor material disadvantages may be created or eliminated as a result of the exchange.
- No material change in the tax situation with respect to the shares is permitted. For example, the transaction may not create or terminate any participation privilege or create a situation in which a corporation can benefit from the exemption of sec. 8b par. 2 KStG on sales of shares in foreign corporations. Both restrictions operate as a rule when shares in foreign corporations are received by a domestic corporation so as to cause the shareholding to climb from under 10 % to 10 % or more.
- If the shares tendered are part of a material ownership interest under sec. 17 EStG (shares held as private property exceeding 25 % of the share capital), those received must also form part of such an interest. However, according to the draft directive, the exchange of shares forming part of a material ownership interest in a domestic corporation for shares which are part of a material interest in a foreign corporation will trigger immediate tax.
- The draft directive states 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. A material change affecting another group member could be enough to prevent a tax-free exchange. Account is likewise to be taken of a participant's ownership interests in other companies.
- On the positive side, the draft directive states that the shares exchanged need not be in corporations belonging to the same industry in order to qualify as equivalent in type and function.
2.3 KPMG comments on equivalence in value, type, and function
KPMG is critical of the strict 10 % limit for boot (the Federal Tax Court spoke merely of "approximate" equivalence in value) and believes that qualifying exchanges involving non-cash boot should be tax-neutral with respect to the boot as well.
Regarding equivalence in type and function, KPMG points out that the relevant issue is whether the advantages created are approximately equal in weight to those surrendered, it being inevitable that new advantages will attach to new shares.
With regard to the requirement of no material change in tax position, KPMG suggests including a clarifying statement to the effect that the creation or destruction of the requirements for a tax consolidated group (Organschaft) is irrelevant to the analysis of equivalence of type and function. For purposes of this analysis, KPMG opposes taking account of intra-group relationships and interests in other companies as it is in practice often difficult to assess the consequences of such factors in advance.
Regarding the situations involving material ownership interests in which the draft directive stipulates immediate taxation, KPMG points out that it would be sufficient to provide for deferred taxation upon disposition of the shares received. This is the solution employed by the Tax Reorganisation Act in similar situations.
3. Special provisions for contribution of shares to a corporation
Under the Tax Reorganisation Act, it is possible to contribute shares in a corporation to a domestic corporation in return for the latter's newly issued shares if, after the transaction, the receiving corporation holds a majority interest in the corporation whose shares are contributed (sec. 20 par. 1 UmwStG). It is also possible to contribute shares tax-free to a foreign European Union corporation. The same condition applies (after the transaction, the receiving EU corporation must hold a majority interest in the corporation whose shares were contributed and the contributor must receive newly issued shares from the receiving EU corporation). The tax exemption is lost, however, if the EU corporation disposes of the shares received within 7 years following the exchange (sec. 23 par. 4 and sec. 26 par. 2 UmwStG).
The exchange opinion permits a tax-free contribution in circumstances where the above provisions cannot apply for one of the following three basic reasons:
- The shares held by the receiving corporation before the contribution together with those it receives in addition are not sufficient to give it a majority interest; or
- The receiving corporation is neither a domestic corporation nor a EU corporation (i.e. a foreign, non-EU corporation); or
- The receiving corporation transfers its own shares in return for those received, but the shares it transfers are not newly issued shares.
The draft directive states generally that no contribution is covered by the exchange opinion unless Germany retains its right of taxation upon ultimate disposition of the shares received. It then goes on to create two additional 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 an 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 are interrelated. In the case of EU receiving corporations, the draft directive seeks 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 directive instead insists on a long holding period.
KPMG considers the contemplated solution infelicitous. The first requirement makes the tax exemption contingent on an aspect of foreign tax accounting law. The foreign treatment should be of no importance for German tax purposes, even in the case of an EU corporation. Even within the EU, harmonisation is still a long way off in the relevant areas of the law.
The second requirement is welcomed to the extent it requires a 7 year holding period. This accords with the holding period under sec. 26 par. 2 UmwStG for a similar transaction. However, the longer holding period of 10 years for pre-1992 contributions should be shortened to 7 years, as this was the period provided for in analogous situations under German tax reorganisation law prior to 1992 as well.
4. Matters not covered by the draft directive
The draft directive does not comment on the application of the exchange directive to an exchange of shares in connection with a division (split-off or split-up) in which the percentage ownership of the owners in the entities created does not mirror their percentage ownership of the entity which was divided. The draft directive on the Tax Reorganisation Act recognises that such transactions can qualify for tax-exempt treatment. The draft directive on the exchange opinion should do likewise.
The draft directive will be the subject of debate over the coming months. We will report on this matter as further developments warrant.
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