Germany: 005. New German Reorganisation Law

Last Updated: 14 June 1995
KPMG Germany Webpage
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1. Introductory
2. Tax-free reorganisations in general
3. Merger and consolidation
4. Mergers of partnerships into corporations and vice versa
5. Divisive reorganisations (divisions)
6. Change of business form

1. Introductory

In November 1994, two basic German laws were reissued in completely revised form: the Business Reorganisation Act (Umwandlungsgesetz) and the Tax Reorganisation Act (Umwandlungssteuergesetz). The Business Reorganisation Act consolidates the existing statutes covering business reorganisations into a single law and expands considerably on their scope. Its 326 sections specify in detail the statutory procedures for accomplishing the various permitted reorganisations. The receiving entities in such reorganisations take by operation of universal succession or partial universal succession. The Tax Reorganisation Act prescribes the tax consequences of business reorganisations as permitted by the Business Reorganisation Act, i.e. states when and under what conditions such reorganisations can be accomplished free of tax. Reorganisations not permitted by the Business Reorganisation Act lead to realisation of any gain inherent in the assets being transferred.

Both new laws went into effect on 1 January 1995. Reorganisations commenced, but not completed, before this date may, however, still be subject to prior law.

Both new laws have as their general objective to liberalise the existing law by providing a clear statutory basis and relief from tax for a broader spectrum of reorganisations. In particular, the new laws remove a number of tax obstacles to certain restructuring plans.

It is important to note that the new legislation applies to reorganisations involving both commercial partnerships and corporations (as well as a number of less commonly used business associations, including for some transactions sole proprietorships). For commercial partnerships, the new law brings considerable improvements, especially as far as mergers or changes in business form are concerned. However, the new legislation does not apply to foreign corporations and thus does not solve the problems of cross-border reorganisations.

Entry in the Commercial Register is required for all reorganisations.

2. Tax-free reorganisations in general

The comments in this section are intended to convey basic information on the mechanisms by which tax-free reorganisations are performed and require qualification with respect to particular transactions.

The new legislation allows all statutory business reorganisations free of taxes on income (including the trade tax on earnings) under certain conditions. Above all, the receiving entity must generally carry forward the basis of the transferring entity in the assets transferred (carryover basis). In this connection, the law requires the transferring entity to prepare a balance sheet showing the assets and liabilities being transferred. For mergers, split-ups and split-offs (see below), the law grants an option to value the assets on this balance sheet at the following transfer values:

- book value (minimum),
- going concern value (maximum, roughly equivalent to fair market value), or
- any intermediate value.

The transferring entity realises taxable gain to the extent it selects a value above book value, but the receiving entity can then depreciate the assets received from the same higher value. When assets are revalued upwards, all assets previously shown on the balance sheet are increased pro rata up to their maximum value. However, assets not previously appearing on the balance sheet, in particular self-generated intangibles such as goodwill, cannot be capitalised by reason of the reorganisation on the closing balance sheet of the transferring entity. In certain circumstances, such assets can appear on the balance sheet of the receiving entity. See in particular the merger of a corporation into a partnership (section 4 below).

Freedom from tax is generally subject to three further basic conditions:

i. The assets transferred must constitute a branch of activity, an interest in a commercial partnership, or a 100 % share of a corporation.
ii. Eventual taxation of the hidden reserves in the hands of the receiving entity must be assured.
iii. Boot is severely restricted.

Assets and liabilities constitute a branch of activity (Betrieb or Teilbetrieb) if they have a certain degree of independence and are potentially capable of functioning as an independent business. Eventual taxation of the hidden reserves is, for example, assured when the receiving persons (natural or legal) are subject to tax in Germany on their worldwide income. Consideration given to the owners of the transferring entity in connection with a reorganisation other than shares or interests in the receiving entity (boot) is allowed only within narrow limits and leads to proportionate taxation of the hidden reserves in the assets transferred.

Regrettably, the new legislation provides no exemption from the 2 % real estate transfer tax in connection with reorganisations. However, the base on which the tax is calculated is in certain situations far below the fair market value of the real property transferred.

3. Merger and consolidation

Merger (Verschmelzung) includes consolidation and is defined as a transaction in which one or more entities transfer their entire assets and liabilities to another entity, either pre-existing or formed for this purpose, whereby the transferring entities are dissolved without being liquidated. The interests of the owners of the transferring entities are replaced by interests in the receiving entity. For corporations, boot is permitted up to 10 % of the nominal or accounting par value of the shares in the receiving corporation. Permitted boot leads to proportionate gain, as stated above, whereas exceeding the boot limit means that the transaction is no longer a statutory merger and hence enjoys no tax protection.

The provisions relating to merger of corporations are not new as such. The treatment of the transferring and receiving corporations is described under section 2 above. As under prior law, no tax is triggered at this level provided the transfer is at book value. For the shareholders, a merger of corporations involves a simple exchange of shares with each shareholder taking his old tax basis in the new shares received.

An important innovation for corporate mergers permits the receiving corporation to assume the loss carryforwards (trade tax and corporate income tax) of the transferring corporation, in addition to its other tax attributes. The loss carryforwards are lost, however, if the transferring corporation has ceased to do business by the time the merger is entered in the Commercial Register.

Important non-tax changes compared with prior law include better protection for minority owners, the obligation in certain situations to offer cash compensation to former owners who wish to withdraw, and the elimination of the obligation to transfer at the book value as shown in the commercial balance sheet. For corporate mergers, an outside audit is required, in some cases only if any shareholder so requests. This includes review of the reasonableness of the consideration paid to settle with withdrawing minority shareholders.

4. Mergers of partnerships into corporations and vice versa

Merger of a partnership (including GmbH & Co. KG) into a corporation is possible free of tax, provided the partners are all domestic persons. Any partnership trade tax loss carryforward is, however, forfeited. (Other loss carryforwards, having been allocated to the partners, are not affected.)

Merger of a corporation into a partnership is more complicated. If the transfer value of a shareholder's pro rata share of corporate assets exceeds his tax basis in his shares, tax will arise on the difference, assuming gain on sale of the shares would have been subject to tax. Germany does not tax gain on the sale of corporate stock by individuals unless they hold more than a 25 % share or have not respected a six month holding period requirement. Furthermore, Germany's tax treaties generally relinquish the right to tax gains on the sale of all shares in German corporations held by foreign persons.

Taxable gain on the transfer of the corporation's assets (excess of transfer value over share basis) is increased by the amount of any corporation tax associated with earnings retained in the transferring corporation at the time of the merger. By the same token, however, this associated corporation tax is creditable to the partners. The consequences of these provisions can vary greatly depending on the composition of the retained earnings as shown by the corporation's equity accounts and the relationship between share basis, book value before merger, and transfer value.

If the pro rata transfer value is less than the tax basis in the shares, the tax basis of the assets transferred is, for each partner (= former shareholder), stepped up to that of the partner's old basis in his disappearing corporate interest at no tax cost, subject to the maximum valuation limit (going concern value). If an excess still remains after stepping up all assets appearing on the disappearing corporation's last balance sheet to going concern value, the remainder is attributed to intangible assets previously not capitalised including, above all, goodwill. Any remaining excess constitutes a tax loss for the partner.

For a discussion of the implications of this new provision in connection with share deal purchases of businesses, see our article entitled "Share Deal Purchases: Existing and Proposed Anti-Avoidance Legislation".

Since the basis of shareholders in their shares can vary widely, the step-up in basis for each new partner is accomplished by supplementing the partnership balance sheet with an individual balance sheet for each partner.

Neither trade tax nor corporation tax loss carryforwards can be transferred from a corporation to a partnership. It may thus sometimes be advisable for a transferring corporation with loss carryforwards to revalue its assets upwards (see section 2 above). Such carryforwards will then offset the reorganisation gain realised by the transferring corporation and secure a higher depreciation base for the receiving partnership. This may, however, be of no additional benefit if the step-up in basis at the partnership level described above is available. Upward valuation may, moreover, lead to taxable gain for the partners of the receiving partnership by creating an excess of transfer value over their share basis. Furthermore, if corporate tax carryforwards exceed those for trade tax purposes, as is often the case, full use of the corporate tax carryforwards may trigger trade tax.

5. Divisive reorganisations (divisions)

The new legislation distinguishes between three types of divisive reorganisations (Spaltung):

i. Split-up (Aufspaltung)
ii. Split-off (Abspaltung)
iii. Drop-down (Ausgliederung; for tax purposes Einbringung)

Split-up is a transaction by which an entity transfers its entire assets and liabilities to two or more receiving entities, either pre-existing or created for this purpose, whereby the transferring entity is dissolved without being liquidated and the owners of the transferring entity take ownership interests in the receiving entities in return for their disappearing interests.

Split-off is a transaction by which an entity transfers part of its assets and liabilities to one or more receiving entities, either pre-existing or created for this purpose. The owners of the transferring entity take ownership interests in the receiving entity in return for surrender of their indirect ownership rights in the property transferred. Split-off includes both transactions in which the owners of the transferring entity all receive pro rata ownership rights in the receiving entity (sometimes called "spin-off"), and transactions in which certain owners of the transferring entity surrender all or part of their interest in this entity in return for an increased interest in the receiving entity.

Drop-down is a transaction by which an entity transfers part of its assets and liabilities to one or more receiving entities, either pre-existing or created for this purpose, and itself takes in return ownership rights in the receiving entities. Certain transactions in which a partnership is the transferring entity fall under this category. For tax purposes, each partner is then deemed to be a separate transferring entity.

All divisive reorganisations of a corporation can be accomplished free of tax. For split-offs, both the assets and liabilities retained and those transferred must constitute a branch of activity, an interest in a commercial partnership, or a 100 % share in a corporation. For split-ups and drop-downs, the same applies to the assets transferred. However, if shares in a corporation are being dropped down into another corporation, it is sufficient that the receiving corporation hold a majority of the first corporation's voting shares after the reorganisation.

For split-ups and split-offs, the tax merger rules apply by analogy. There are separate tax reorganisation rules for drop-downs.

Complete continuity of ownership between the transferring corporation and the receiving entity (i.e. no separation of shareholder groups) is a condition of tax-free treatment in split-offs and split-ups unless the shareholders in the transferring corporation have held their shares for at least five years. It is, however, not necessary that all shareholders of the transferring corporation take pro rata ownership interests in the receiving entity. In other words, the interest retained in the transferring entity can be reduced in return for an increased interest in the receiving entity and vice versa. This requires unanimous shareholder approval, however.

If within five years after a split-up or split-off interests in the entities involved corresponding in value to more than 20 % of the original interests in the transferring entity are conveyed to outside persons, this will lead to retroactive imposition of tax on the entire reorganisation.

When a corporation is divided by split-up or split-off, it is possible to transfer part of the transferring corporation's loss carryforward to the receiving corporation(s).

6. Change of business form

An entity may reorganise itself in another legal form, i.e. change its form of business association, e.g. from a partnership to a corporation or vice versa. Such transactions involve no transfer of assets and the entity undergoing reorganisation preserves its economic and legal identity.

Reorganisation from one type of corporate entity to another type has never had any tax consequences, and the new legislation makes no change in this respect. Under prior law, reorganisation of a corporation as a partnership (or sole proprietorship) was a taxable event. Under the new law, the transaction can occur completely tax free subject to the conditions for merger of a corporation into a partnership (see section 4 above as to possible gain taxable to shareholders). As under prior law, the Tax Reorganisation Act permits tax-free reorganisation of a partnership as a corporation. Trade tax loss carryforwards are, however, lost. Other loss carryforwards (for income or corporation tax purposes, depending on the status of the individual partner) are not tax attributes of the partnership to begin with since they are allocated to the partners.

Disclaimer and Copyright
This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.

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