Germany: 228. Clarification Of Loss Utilisation Directive

The Frankfurt Regional Tax Office has issued an administrative order dated 3 July 2000 (S 2745 A – 22 – St II 13 (S); DB 2000, 1541) clarifying the application of certain aspects of the 1999 Loss Utilisation Directive, on which we reported in article no. 176. The Loss Utilisation Directive (hereinafter: "the 1999 directive") deals with the application of § 8 (4) KStG (denying loss carryforwards to a corporation where it is not "economically identical" to the corporation that sustained the losses) and § 12 (3) UmwStG (making the survival of loss carryforwards in merger situations contingent upon the continued operation of the business that caused the loss).

The administrative order was issued on the basis of discussions between the Federal Ministry of Finance and the central tax authorities of the German states (Oberste Finanzbehörden der Länder). Hence, the Federal tax authorities and the tax authorities in the other German states are in agreement with the terms of the order.

Under § 8 (4) KStG, a corporation loses its economic identity inter alia when more than half of its shares are transferred and the corporation continues or recommences its business with predominantly new assets (primary loss forfeiture situation).

By way of exception, the statute provides that injection of predominantly new assets solely for the purpose of rehabilitating a failing business (restoring it to economic viability) is not damaging provided the business continues to operate on a comparable scale for a period of five years (corporate recovery exception). Marginal no. 14 of the 1999 directive limits the injection of new assets under the corporate recovery exception to what is "necessary for the continued existence of the enterprise." The injection of assets in excess of what is necessary to restore the corporation to economic viability (so-called "over-rehabilitation" - Übersanierung) will cause the corporation to forfeit the protection of the exception and lose its economic identity.

The administrative order states that, once five years have passed since the time of the share transfer, the injection of new assets can no longer lead to a loss of economic identity by reason of "over-rehabilitation." The administrative order thus makes clear that the five year period created by marginal no. 12 of the 1999 directive applies for purposes of the corporate recovery exception as well.

Marginal no. 12 of the 1999 directive provides that an injection of predominantly new business assets is generally damaging only if it occurs within five years of the time of the relevant share transfer (five year asset injection period). The administrative order in effect provides that the five year asset injection period is also the relevant time frame for determining whether "over-rehabilitation" has occurred.

The order goes on to say that it does not matter for purposes of the "over-rehabilitation" rule if the five year period during which the business must continue to operate on a comparable scale (five year operating period) is still running when assets are injected. Since the five year operating period does not begin to run until the share transfer has occurred and predominantly new assets have been injected (1999 directive marginal no. 21), it will generally end after the five year asset injection period (and five year over-rehabilitation period) that begins when more than half of the shares change hands.

The five year operating period required by the corporate recovery exception under corporation tax law (§ 8 (4) KStG) is paralleled by a five year operating requirement under reorganisation tax law (§ 12 (3) UmwStG). In connection with the latter five year operating period, marginal no. 42 of the 1999 directive states that it is not damaging if the business is expanded during the five year period. This contrasts with the prohibition on "over-rehabilitation" for corporation tax purposes. The administrative order minimises this latent contradiction by applying the five year asset injection period, not the more restrictive five year operating period, for "over-rehabilitation" purposes.

A before-and-after comparison is necessary in order to determine whether predominantly new assets have been injected into a loss corporation. Marginal no. 9 of the 1999 directive provides that intangible assets – i.e. intangible assets belonging to the loss corporation – are to be counted for purposes of this comparison, even if such assets do not appear on the loss corporation's balance sheet. Counting such intangibles favours taxpayers who acquire loss corporations with uncapitalised intangibles because it permits more new assets to be added without crossing the critical threshold.

The administrative order states that marginal no. 9 of the 1999 directive is to be applied only to self-created intangibles, capitalisation of which is prohibited by § 5 (2) EStG. Intangibles whose capitalisation is barred by the rule against capitalising assets under contracts in the course of performance (contracts executory on both sides) are not to be counted for purposes of comparing the relative weights of newly injected assets to assets pre-existing in the loss corporation.

For instance, patents licensed by a loss corporation from another entity cannot be capitalised by the loss entity as long as its license rights are counterbalanced by an obligation to pay royalties. Under the terms of the administrative order, such licenses are also not counted when determining whether newly injected assets predominate.