VC-raising through a U.S. entity may result in disclosure of hidden assets.
German start-ups still tend to look to the United States when thinking of raising capital. Unfortunately, this can create German tax issues for the founders.
The reason the US is so attractive lies in its much more developed Venture Capital infrastructure. The capital market for VC-financings in the U.S. is by far larger than the German market and valuation is generally higher. Additionally, deeper sectoral diversification often leads to better know-how of investors which can be of much help for further development of the company or for the exit process. The more technology-based a business model of a start-up is the stronger these effects are. As of seven-figure investments, the U.S. VC-market is clearly the superior market.
Generally, U.S. VC-investors want to invest in a U.S. company (most often a Delaware Inc.) through established and familiar investment instruments. Therefore, the German enterprise has to be transferred to a U.S. company first. Such transfer is feasible, but may create difficulties under German tax law.
Typically, shares in the business-carrying German company are transferred to a U.S. company which then becomes the "parent" company and in turn issues shares to the founders (exchange of shares or so-called "flip"). For German tax law purposes, shares in the German company are deemed to be transferred at a fair market value. A taxable gain will arise, if such value is higher than the book value, the latter often still being equivalent to the initial small capital contribution. Taxability of the gain is particularly unfortunate because the founders do not benefit monetarily from the subsequent entry by the U.S. investor – his money goes into the company.
A common mechanism of mitigating the taxable gain in the EU and EEA is a "roll-over" by way of a transfer of shares at book value (e.g. transfer of shares in a German GmbH to a Dutch BV). However, the roll-over regime is not applicable in the case of a flip into a U.S. corporation. Hence, mitigation of the taxable gain is not possible. However, there are some tax reliefs. In case of a natural person only 60 % of the gain is taxable, which may still have a prohibitive effect in many cases, though. A corporation will often only have to pay tax on 5 % of the gain. For holders of minimum participations, other rules again are applicable.
Contrary to what German tax authorities like to believe and allege, the actual taxable gain of the founders as per the above can typically not be valued based on the VC valuation (e.g. $3 million for 25%). Investments on an early stage usual do not reflect an actual company value but rather finance a mere idea. Moreover, such investments are regularly structured as preferred equity which grants preference payments in case of liquidation or other preferences compared to founders' shares. This demonstrates that the founders do not benefit personally from the entry of the investor in a tax relevant way. Instead, transferred shares should be valued in accordance with common valuation methods.
The foregoing illustrates that corporate structuring should be taken seriously and addressed by the founders at an early stage. Much can be achieved by initially interposing a "personal" holding company that holds the shares in the German start-up company. Also, fees for professional valuation of the founders' shares are likely to be well spent. The U.S. investment itself should be looked at to disprove the tax authorities' approach of basing German tax values on the VC valuation. Further structuring options should be assessed on a case-by-case basis.
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