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The new Tax Reorganisation Act which went into effect in January of this year has opened up an important new possibility for purchasing the shares in a German corporation and then stepping up the basis of its assets to the full purchase price so as to be able to depreciate them with tax effect.
1. Share deals and asset deals in general
In general, a change in the shareholders of a corporation affects neither the legal identity nor the tax status of the company. The purchase price is attributable fully to the shares acquired, which are not subject to scheduled depreciation, although they may be written down to their fair market value. Unlike the goodwill element in a payment for the assets of a business (including acquisition of a partnership interest), which can be depreciated for tax purposes over a period of 15 years, the goodwill element in a payment for shares may not be depreciated. Generally, the purchaser of a corporation is strongly interested in generating depreciation expense based on the full purchase price, not just on the historical book values of the corporation's assets. Goodwill and other self-generated intangible assets not even appearing on the balance sheet of the target corporation are especially important.
The Tax Reorganisation Act presents a major new possibility for reconciling the share deal with the purchaser's desire for full depreciation expense. The fundamental advantage of this new step-up model over the old "internal asset deal" model heretofore employed is that the new structure produces full depreciation of the purchase price without triggering a substantial trade tax in the process. It also does not suffer from an added drawback posed by the solidarity surcharge with respect to internal asset deals.
2. Outline of the step-up model
The new model has several variants, but functions basically as follows:
a) X-GmbH purchases the shares in Target GmbH.
b) Target GmbH is converted into e.g. a limited partnership = Target GmbH & Co. KG. (A new general partner GmbH must be organised; X-GmbH becomes the sole limited partner of Target GmbH & Co. KG).
c) Target GmbH & Co. KG assumes most tax attributes of Target GmbH (but not e.g. its loss carryforwards).
d) The shares in Target GmbH are deemed contributed to the partnership with a book value equivalent to the price just paid for them by X-GmbH. As a result of the conversion, these shares disappear and are replaced by the book values of the assets of Target GmbH. Since these are typically lower than the book value of the disappearing shares, the difference is applied pro rata to the reserves hidden in these assets. The remaining excess is applied to goodwill and other intangibles not previously capitalised by Target GmbH, making the step-up complete.
e) Any excess not attributable to an asset, including the above intangibles, is a tax deductible loss. (This is not likely in transactions implemented shortly after acquisition of Target GmbH.)
By this means, a stepped up basis can be obtained at no income tax cost. This applies both to the corporate income tax and to the trade tax on earnings. The step-up is, however, subject to certain restrictions and, for non-resident persons, to certain uncertainties (see sections 4 and 5 below).
Instead of converting Target GmbH into a limited partnership, it could also be merged into an existing German partnership. Furthermore, Target GmbH could be purchased from the start by a German partnership (so that the GmbH's shares become part of the partnership's German business property) and then merged into this partnership.
3. Retained earnings of the target corporation
The retained earnings of German corporations are for tax purposes divided up into different equity accounts (baskets) depending on the German corporation tax imposed on the revenue earned. Generally, there is an adjustment in this tax burden upon distribution and the recipient of the dividend is, if a resident person, entitled to a credit in the amount of the corporation tax associated with the distribution.
Upon merger of a corporation into a partnership, these equity accounts have to be dissolved, because partnership income is, for tax purposes, attributed directly to the partners and not held in equity accounts pending distribution. The Tax Reorganisation Law takes account of this by providing that the corporation tax paid by a GmbH with respect to its retained earnings is treated as income to the partners upon merger of the GmbH into a partnership. Simultaneously, the partners are entitled to a credit in the same amount, i.e. in the amount of the tax reserves (sec. 4 par. 5, 10 par. 1 UmwStG). The net result of these two provisions in the context of a share deal purchase followed by merger of the acquired GmbH into a partnership is generally a refund of the full amount of the tax reserves to the partners of the acquiring partnership, as is illustrated by the following example:
DM (millions) Share capital 10.0 Retained earnings Earnings before corp. tax 18.2 Less 45 % corp. tax -8.2 10.0 Tax reserves 8.2 Hidden reserves in tangible assets 6.8 Goodwill (self-created, not capitalised) 65.0 Purchase price 100.0 Net asset value of GmbH (at book value) -20.0 Tentative loss on merger (80.0) Deemed income from tax reserves 8.2 Step-up in basis, fixed assets 6.8 Step-up in basis, goodwill 65.0 Net gain / loss on merger 0.0 Tax owing thereon 0.0 Tax creditable 8.2 Tax refund on merger 8.2
The above example simplifies the valuation of the tax reserves in determining the purchase price. In practice, the tax reserves must be discounted to take account of the timing of the tax refund they lead to. Depending on the circumstances, the refund could come as early as a few months after the merger or be delayed for years.
4. Restrictions imposed by sec. 50c EStG
Section 50c EStG is intended to prevent circumvention of provisions in the tax code denying any credit for corporation tax paid to certain recipients of dividends from German corporations. Most non-resident persons, natural and legal, fall into the category of dividend recipients not entitled to corporation tax credit. An exception exists only if a non-resident holds shares in a German corporation in a domestic permanent establishment, including the domestic permanent establishment of a partnership in which the non-resident person is a partner.
Section 50c EStG provides that a shareholder who has purchased shares in a German corporation from a person not entitled to the corporation tax credit may not write down the value of the shares purchased by reason of a dividend distribution. Otherwise, a resident GmbH could purchase shares in a corporation with retained earnings from a non-resident, whose capital gain on sale would typically be exempt from German tax under a tax treaty, distribute these retained earnings to itself and claim the corporation tax credit which would not have been available to the non-resident seller had he distributed the retained earnings before making the sale. The buyer GmbH could then, in addition, write down the value of the shares just purchased on its books to reflect the diminished value of the purchased corporation after distribution of its retained earnings. Such a write-down, if permitted, would completely neutralise the dividend and in effect result in a refund of corporate tax to the buyer.
Section 50c EStG prevents this result. The statute is a long and complicated one, operating as well when there is any person not entitled to the corporation tax credit in the seller's chain of title for the past 10 years.
Section 4 par. 5 UmwStG provides that no step-up in basis is available upon merger or conversion of a German corporation into a partnership if the sec. 50c EStG would have prevented a write-down of the sort described above after purchase of the merged corporation's shares. Generally speaking, this means that no step-up is permitted following purchase of shares from a seller not entitled to the corporation tax credit or from a seller who has such a person in his chain of title for the last ten years.
The 1996 Tax Act recently adopted by the German legislature originally contained a provision which would have extended sec. 50c EStG to cover purchases from certain resident sellers who, while entitled to the corporation tax credit, are not taxed on their capital gain. The provision was removed from the law, but may be reintroduced at a later time. (See our article on the 1996 Tax Act.) Any extension of sec. 50c EStG would automatically constitute a new restriction for the step-up model.
5. Uncertainties for non-resident purchasers
The section above is concerned with problems posed when the target corporation is purchased from non-resident persons. There are in addition a number of less well-defined problems raised when the target GmbH is purchased by non-resident persons and then converted into a partnership.
If a non-resident person, e.g. a foreign corporation, purchases the shares of a German target corporation from a person entitled to the German corporation tax credit, this transaction in itself poses no problems under sec. 50c EStG. However, if the purchased corporation is then converted or merged into a partnership, the tax consequences become highly controversial.
Before the conversion or merger, the shares in the target corporation belong to a foreign corporation, i.e. not to the partnership into which the target is being merged or converted. The Tax Reorganisation Law (sec. 5 par. 2, 3 UmwStG) provides that the step-up is only available in such cases if the interest held by the shareholder in the disappearing corporation constitutes a "material share" within the meaning of sec. 17 EStG or if the interest is part of the shareholder's domestic business property. In the case of non-resident shareholders, the second condition can only be fulfilled if they have a German permanent establishment and the shares are business property of this permanent establishment. The controversy here surrounds the first condition, i.e. whether a foreign shareholder can hold a "material share". For domestic tax purposes, a "material share" under sec. 17 EStG is any share in a corporation exceeding 25 %, and some authorities contend that a foreign shareholder who meets this quantitative test qualifies for the step-up in the situation posited. However, the tax authorities and other experts have taken the position that a foreign shareholder only holds a "material share" if the gain on sale of this share is subject to German taxation. This is not the case under most of Germany's tax treaties for foreign resident shareholders.
A second much discussed issue relates to sec. 50c EStG. The sixth paragraph of this complicated section provides that it operates when a person not entitled to the corporation tax credit with respect to a particular shareholding becomes entitled to the credit with respect to this shareholding. The intention is to prevent foreign shareholders who contribute their shares to domestic permanent establishments, thereby qualifying for the corporation tax credit, from taking a write-down on the shares to offset a dividend distribution. The controversy here involves a highly technical point. If the foreign shareholder's 25+ % share in a domestic corporation constitutes a "material share" within the meaning of sec. 5 par. 2 UmwStG, then the share is deemed contributed to the receiving partnership in the moment of the merger/conversion. While it then immediately disappears, because the corporation has ceased to exist, certain authorities nevertheless contend that, for a logical second, it was part of the shareholder's domestic permanent establishment, hence conferred a right to a corporate tax credit, and so triggered sec. 50c EStG, precluding the step-up in basis which the foreign shareholder hoped to achieve.
If a foreign shareholder has no "material share", some writers further contend that any retained earnings of the disappearing corporation are deemed distributed to the shareholder under sec.7 UmwStG, while others believe that no such adjustment should take place. It seems relatively clear, however, that most foreign shareholders will not have deemed income to the extent of any tax reserves of the disappearing corporation and will not receive any credit for this tax because the relevant provisions only apply if gain on sale of the shares would have been subject to German tax. This is not the case under most German tax treaties, hence the provisions do not apply to most non-resident persons (sec. 10 par. 2 UmwStG).
To summarise, it appears inadvisable for foreign persons to acquire shares in German corporations directly with the intent of profiting from the step-up possibilities presented by the Tax Reorganisation Act. Alternative structures (purchase through an interposed German GmbH, purchase through a German partnership so that the shares purchased become part of the partnership's German permanent establishment) are as a rule readily available.
6. Other considerations
The same basic model discussed above with respect to a single German corporation applies as well when purchasing a German holding company under which several operating subsidiaries are held. By converting all the companies in the purchased group into partnership form, a step-up in basis can be obtained for all entities purchased.
After having converted to partnership form, it appears necessary to do business in this form, at least for a time. Immediate reconversion to corporate form would probably lead to attack by the tax authorities under Germany's general anti-abuse provision, sec. 42 AO. Once lapse of time or changed circumstances permit reconversion to corporate form as a general matter, a number of possible methods exist for accomplishing this. One of the most interesting of these for a partnership with e.g. two partners, one resident in Germany (a management GmbH) and the other resident in another EU member state (the non-resident limited partner) involves withdrawal by the German partner. This terminates the partnership (for want of a second partner) and causes the partnership property to pass by operation of law to the non-resident partner, who now has a German permanent establishment, which can be converted into a GmbH under a special provision in the new Tax Reorganisation Law (sec. 23 par. 2 UmwStG).
If a corporation is converted/merged into a partnership and the partnership's business is thereafter sold or terminated within five years, any resulting gain will be subject to trade tax (sec. 18 par. 4 UmwStG). The situation on sale of an interest in the partnership is unclear.
Finally, achieving a successful step-up in basis using the Tax Reorganisation Act is not the only consideration when planning the acquisition of a German company (or group of companies). Careful attention must in particular be given to financing costs, to the German thin capitalisation rules, and to the differences in the tax rates for German corporations (30 % distribution rate + withholding tax) and for German permanent establishments (partnerships) of foreign corporations (42 %). Furthermore, partnerships under German law can be the lead or dominant member of a consolidated tax group, but not subordinate members. The step-up model may thus pose loss-sharing problems under certain circumstances.
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