A recent decision by the German Federal Fiscal Court (BFH) has caused significant concerns in the restructuring community because it will severely complicate future restructurings in Germany or even make them impossible overall. In its decision dated 28 November 2016 (GrS 1/15, published on 8 February 2017) the court held that the so- called restructuring decree (circular on taxation of restructuring profits / Sanierungserlass) dated 27 March 2003 (IV A 6 S 2140 8/03, BStBl. I 2003, 240, amended by circular letter dated 22 December 2009 (IV C 9 S 4140/07/10001-01, BStBl. I 2010, 18) (the "2003 Circular") was unconstitutional because there was no statutory basis for the tax administration to issue such a decree.
The 2003 Circular provides for a tax relief for restructuring profits and has proven to be a helpful instrument in many restructurings involving some form of waiver of indebtedness by creditors. Such cancellation of debt results in a book profit and results in a taxable profit for both corporate income and trade tax purposes. The 2003 Circular was a reaction to the abolishment of Section 3 No. 66 German Income Tax Act (Einkommensteuergesetz) which provided for a general tax relief for such restructuring profits. In essence, the 2003 Circular requires that, as a first step, the restructuring profits be set off against existing tax losses and tax loss carry forwards (without applying any restrictions on the use of loss carry forwards such as the German minimum taxation regime) and then, as a second step, allows for a relief of taxes on the exceeding part of the restructuring profit.
In many financial restructurings to date market participants had relied on the operation of the 2003 Circular, but the German Federal Fiscal Court has, for the time being, set an end to this established practice in the German market.
Reaction of the Tax Administration: The Circular Letter Dated 27 April 2017
On 27 April 2017 the German Ministry of Finance issued a new circular letter (the "2017 Circular") which deals with the application of the 2003 Circular and the tax treatment of restructuring profits in the light of the above-mentioned court decision. The 2017 Circular distinguishes between the following scenarios:
a) In cases where the waiver has been fully effected on or before 8 February 2017 (the date when the decision of the German Federal Fiscal Court was published) the 2003 Circular shall—as one could expect—continue to apply. If the waiver forms part of an insolvency plan, the waiver shall be deemed as fully effected when the decision of the insolvency court approving the insolvency plan has become final and non-appealable.
b) Given that it was only possible to grant a tax relief based on the 2003 Circular after the tax liability had already arisen, it was common practice to apply for a binding tax ruling (verbindliche Auskunft) confirming the tax treatment prior to implementing a restructuring. In cases where such a binding tax ruling regarding the application of the 2003 Circular has been issued on or before 8 February 2017, this binding ruling shall—again not surprisingly—not be revoked or withdrawn, provided that the waiver has been fully (or at least to a substantial degree) implemented before the tax authority is due to make a decision on such revocation or withdrawal or, under the individual circumstances of the case, there is a legitimate expectation of the debtor that the ruling will continue to apply (e.g. the execution of the insolvency plan/waiver by the creditors can no longer be influenced by the debtor).
c) In cases where a binding ruling in respect of the application of the 2003 Circular has been issued after 8 February 2017 such binding ruling shall generally be revoked or withdrawn, unless the waiver has been fully effected prior to the tax authority's decision on such revocation or withdrawal.
d) In all other cases (i.e. before 8 February 2017 no waiver was declared and no binding tax ruling has been issued) a decision on an actual tax relief under the 2003 Circular will no longer be possible for the time being. In theory, it is still possible to make a deviating tax assessment (e.g. to take into account a set-off of loss carry forwards against the restructuring profit without applying the German minimum taxation rules) or defer the payment of the tax in accordance with the 2003 Circular and issue a related binding tax ruling. However, such deviating tax assessment or ruling may only be granted subject to revocation (Widerrufsvorbehalt) and shall be revoked once a statutory basis regarding the tax treatment of restructuring profits either (i) comes into force or (ii) has not come into force until 31 December 2018. The idea behind this concept is that either a statutory provision will replace the current administrative regime or in the absence of a statutory basis the continuing application of the 2003 Circular is no longer justified after a certain transition period has expired.
e) Decisions based on general equitable considerations under the individual circumstances of the case which do not fall within the scope of the 2003 Circular will not be affected and remain possible in theory.
Reactions of the Legislator
The legislator reacted promptly after the publication of the decision of the German Federal Fiscal Court and proposed on 27 February 2017 to amend the German Income and Trade Tax Acts. On 27 April 2017 the German Parliament (Bundestag) passed a new law that, once it has become effective, will provide for a tax exemption of restructuring profits under certain circumstances, without discretion of the tax authorities. The main features of the new law are as follows:
- In essence, the new provisions adopt the concept of the 2003 Circular but shall not only apply to income tax (Einkommensteuer) but also to trade tax (Gewerbesteuer). This is major progress because it will reduce the complexity and avoid the uncertainty of obtaining a tax relief also with respect to trade taxes. The responsibility for imposing trade taxes lies with the municipalities and therefore a debtor with various permanent establishments needs to apply for parallel reliefs from various municipalities. At the moment this is a cumbersome and time-consuming process which, above all, suffers from the uncertainty that all required reliefs will be granted and that an individual municipality may only be prepared to grant a relief if all others had followed suit. The new regime will ensure a consistent application.
- In line with the 2003 Circular, the requirements for a tax exemption of restructuring profits under the new law are that the debtor is in need of the restructuring and is capable of being restructured, the debt forgiveness is an appropriate measure for the restructuring and is caused by business reasons and last but not least the creditor granting the waiver intends to restructure the debtor.
- The tax exemption shall only apply after setting-off tax losses and tax loss carry forwards available in preceding years, the year in which the restructuring takes place and the following year. In this respect the new provisions provide for a waterfall regarding the sequence of setting-off several kinds of tax items such as tax losses, tax loss carry forwards, interest and EBITDA carry forwards against the restructuring profit.
- Expenses directly related to the tax exempt restructuring profit shall not be deductible for tax purposes irrespective of whether they have accrued prior to or after the restructuring.
- Last but not least the new law provides for certain provisions dealing with its application in specific cases, e.g. where the debtor forms, or used to form, part of a fiscal unity (Organschaft).
The new provisions will have a retrospective effect and shall generally apply for any waiver taking place after 8 February 2017. The new law is however subject to approval by the German Federal Council (Bundesrat) and, in addition, will only come into force after the European Commisison has confirmed that the tax exemption does not constitute a state aid measure in violation of European law.
The decision of the German Federal Fiscal Court has given cause for considerable concern and uncertainty within the German restructuring market. The prompt reaction of the legislator is therefore a welcome development.
The new tax bill will—once coming into effect—have a huge practical impact. It casts the concept of the 2003 Circular into law and even goes beyond the scope of the 2003 Circular since it will also apply to trade tax. The new law will, taken as a whole, lead to enhanced transaction security and make the tax structuring process more predictable. Further, tax losses and tax loss carry forwards as well as other items to be set-off against the restructuring profits such as interest and EBITDA carry forwards are only supposed to forfeit up to the amount of the restructuring profit and not in total as provided by the first draft bill.
Whether the new law will come into force in the form as recently passed by Parliament depends in particular on the state aid approval of the European Commission which causes some uncertainty also in respect of timing. On the one hand the European Commission once has already overthrown a German tax provision which was supposed to grant tax privileges in restructuring scenarios. On the other hand, as also highlighted in the preamble of the new tax bill, the proposed tax exemption is meant to support the Commission's agenda to improve the conditions for an early restructuring of enterprises in financial difficulties. It is hoped that this rationale will also guide the Commission's analysis when evaluating the new German tax provisions as they will significantly contribute to a restructuring-friendly environment in Germany.
During the interim period until the new law comes into force the 2017 Circular will be helpful for cases where the restructuring prior to 8 February 2017 has been finally implemented or where a binding tax ruling was obtained and the waiver has been fully or substantially executed prior to the decision of the tax authorities on a possible revocation of such binding tax ruling. For all other cases a tax relief will only be possible on the basis of equitable reasons given the individual circumstances of the case or, if based on the application of the 2003 Circular, only temporarily subject to revocation. As it is generally difficult to predict whether the administration will be prepared to grant equitable relief in a specific case and it is unlikely to obtain a tax ruling on that basis, the interim framework does not seem to offer a suitable basis to design a financial restructuring with the required legal certainty and durability.
During the interim period it is therefore advisable to seek alternative structures that achieve the intended economic outcome without triggering a detrimental tax on restructuring profits. As always, the devil is in the details and there is no "one size fits all" approach as each alternative has its own advantages and disadvantages that need to be evaluated in the individual case at hand. One option could be to merely subordinate the unsustainable portion of the debt in a way that it no longer needs to be accounted for as liability in the balance sheet drawn up for determining over-indebtedness (so called deep subordination). In other cases, the debt has not been subordinated but converted into an equity-like instrument. However, following an aligned statement issued by the highest German tax authorities last year, tax authorities apparently no longer accept such hybrid instruments as debt item and thus a debt-to-hybrid-swap seems no longer to be an available option. An alternative could be to push up the unsustainable part of the debt to the shareholder in a way that does not lead to a recourse claim against the debtor. A third option could be the transfer of the viable part of the business and the sustainable debt to an affiliate of the debtor by way of carve-out or spin-off. This structure would essentially leave the original debtor behind owing the unsustainable portion of the debt and ultimately result in its liquidation. The examples show that alternative structures are available, but the recent decision of the German Federal Fiscal Court has made restructuring transactions in the German market more complex and challenging for the time being until the new law will become effective.
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