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1. INTRODUCTION 1
1.1 Buying a business: the target entity 1
1.2 Commercial and non-commercial activity 3
1.3 Non-tax considerations 4
2. STRUCTURING THE PURCHASE: ASSETS OR OWNERSHIP INTERESTS? 5
2.1 Assets or partnership interests? 5
2.2 Assets or shares? - Buyer's perspective 6
2.3 Assets or shares? - Seller's perspective 7
2.4 Share purchase and the corporation tax credit 8
2.5 Purchase of shares from foreign persons - sec. 50c EStG 10
2.6 Purchase of shares from resident persons: dividend
writedowns 13
2.7 Liability aspects of asset and ownership interest
purchases 13
2.8 Other considerations 15
3. OVERCOMING THE TAX DISADVANTAGES OF SHARE PURCHASES 16
3.1 Internal asset purchase 16
3.2 Reorganisation in partnership form 17
4. FUNDING: THIN CAPITALISATION RULES 19
5. OTHER TAX CONSIDERATIONS 21
5.1 Utilisation of preacquisition losses 21
5.2 Tax consolidated groups 22
5.3 VAT 23
5.4 Real estate transfer tax 23
PURCHASE OF A BUSINESS IN GERMANY
For disclaimer and copyright see end of this article.
1. Introduction
This article provides orientation to foreign investors considering the purchase of a German business for cash. Both asset and share purchases are covered. With respect to the most common acquisition situation, namely purchase of the shares in a German corporation, we discuss the pros, cons, and procedures involved in converting the acquired corporation into partnership form to achieve a stepped-up basis for depreciation.
The article assumes a basic knowledge of German taxation, especially the taxes on income and on capital. General information on this subject is available upon request. The examples given in this article ignore the solidarity surcharge currently in effect in Germany unless otherwise stated.
1.1 Buying a business: the target entity
When buying a business, it is necessary to understand the form of business association in which it is presently conducted. Most business activity in Germany is done in one of the following forms:
Sole proprietorship (Einzelunternehmen)
General partnership (offene Handelsgesellschaft - oHG)
Limited partnership (Kommanditgesellschaft - KG)
Limited partnership with corporate general partner (GmbH & Co. KG)
Limited liability company (GmbH)
Stock corporation (Aktiengesellschaft - AG)
The law governing the above enterprises is uniform throughout Germany (national not state law). While possible in theory, situations in which a German partnership is treated for tax purposes as a corporation or vice versa are virtually unknown in practice. Partnership income is attributable to and taxable in the hands of the partners for German income tax purposes (personal or corporate income tax). However, commercial partnerships are taxable entities for trade tax purposes. Partnership losses reduce the partner's basis in his partnership interest and can in principle be netted against other income. For partners with limited liability, this applies only as long as their basis remains above zero.
Of the above forms of business associations, the latter three (GmbH & Co. KG, GmbH, and AG) provide liability limited to the owners' agreed capital contributions. In the case of the GmbH & Co. KG, this applies strictly speaking only for the limited partners. The general partner GmbH need not make any capital contribution nor be entitled to any share of profits. The management of the GmbH & Co. KG usually rests with its general partner GmbH, but this is not mandatory.
The limited liability company or GmbH is the most widely used form of business association. The GmbH is a corporate entity with separate legal identity having one or more shareholders and share capital of at least DM 50,000. Shares in GmbHs are not certificated. The purchase and conveyance of shares in an existing GmbH requires recordation of the contract before a qualified notary. The management of a GmbH rests with one or more general managers (Geschaeftsfuehrer) appointed by the shareholders. The names of the general managers and their authority to represent the company vis-a-vis third parties (e.g. individually or together with a second general manager) are matters of public record in the Commercial Register. The general managers can be subjected to close supervision and control by the shareholders and are required to respect instructions issued to them by shareholder resolution. The shareholders control distribution of net earnings.
The stock corporation or AG is likewise a corporate entity with separate legal identity, but with minimum capital of DM 100,000 and a more rigid dual management structure under which a supervisory board elected by the shareholders appoints and monitors the actions of a board of management, which exercises sole management responsibility. Its members are subject to removal, but not direction, by the supervisory board. Supervisory board approval is required for certain actions. Only stock corporations are permitted to sell their shares on stock exchanges. There are at present some 660 publicly listed German AGs out of a total of 2,800 such companies. By way of comparison, there are some 460,000 GmbHs in all. The law of stock corporations was liberalised in 1994 to encourage "small" AGs and now permits e.g. formation by a single shareholder. The shares in AGs are certificated. Bearer shares are conveyed by delivery and registered shares by delivery and endorsement. The shareholders control distribution of part (usually one half) of net earnings.
The following, less common forms of association may also be encountered:
Stock Limited Partnership (Kommanditgesellschaft auf Aktien - KGaA)
Private Association (Verein)
Cooperative (Genossenschaft)
Foundation (Stiftung)
Associations and cooperatives may be of use in structuring cooperation between several independent parties. Foundations resemble to some degree trusts in anglo-saxon law. These three organisations are popular for non-profit activities but not widely used for business purposes. The stock limited partnership is a seldom used business entity.
1.2 Commercial and non-commercial activity
German company and tax law distinguishes between activities constituting a trade or business (commercial activity) and other independent activities, principally professional services and passive asset management. Capital gains are as a rule only taxable if the property sold is part of a commercial activity. Otherwise, capital gains are tax exempt as long as a minimum holding period is observed. Besides tax liability for capital gains, the principal tax consequence of commercial activity is liability to trade tax, which is only imposed on commercial enterprises. The company law consequences of commercial activity are manifold. There is a large body of law, contained in the Commercial Code (Handelsgesetzbuch - HGB) which only applies to commercial enterprises. The corporate forms discussed above (GmbH and AG) are engaged in commercial activity for both company law and tax purposes by the mere fact of their corporate form. Commercial activity is also implicit in the definitions of partnership forms listed above, and they are known as commercial partnerships. A separate partnership form (the civil law partnership or Gesellschaft buergerlichen Rechts) exists for non-commercial activities and is often used for single-purpose joint ventures in consortium form between commercial entities as well. Since, however, it is the fact of sustained commercial activity under a single trade name, not the formal organisation of a partnership entity, which distinguishes a commercial partnership from a civil law partnership, situations are conceivable in which it may be difficult to decide what sort of partnership one is in fact dealing with.
1.3 Non-tax considerations
In Germany there are no governmental controls or restrictions on investments in assets and business entities, nor are there restrictions on capital movements into or out of Germany. There are, however, requirements under the Foreign Trade Regulation (Aussenwirtschaftsverordnung) for reporting certain flows of capital for statistical purposes. The Foreign Trade Act (Aussenwirtschaftsgesetz) also empowers the government to restrict the acquisition of interests in German companies and real estate by foreign persons. At present, no such restrictions are in force and there is no reason to expect that any will be imposed in the foreseeable future.
Germany has antitrust legislation in place for the purpose of safeguarding free competition. Mergers and acquisitions of a certain dimension (e.g. involving companies or corporate groups with cumulative sales exceeding DM 500 million) must be registered with the Federal Cartel Authority and can be prohibited by this Authority if considered to be detrimental to competition. European Union antitrust law may preempt German antitrust law, or operate in addition to it, with respect to certain transactions.
Account should also be taken of labour law considerations when planning the purchase of a business. Under a provision in force in one form or another throughout the European Community, the purchaser of a business automatically assumes all employment contracts associated therewith. It makes no difference in this respect whether shares or assets are purchased, although there can be difficult questions posed when less than all of the assets of a business are acquired, e.g. one of several business divisions (branches of activity). Assumption of the employment contracts does not ipso facto prevent downsizing immediately following the acquisition, but this must be conducted in accordance with the general German labour law legislation which, compared with that of many countries, is fairly generous to labour.
Furthermore, Germany has an employee co-determination system in effect for virtually all businesses. The system has several variants, the simplest of which involves election by employees of a so-called "works council" (Betriebsrat), which has a variety of rights to be informed and to be heard on personnel and other internal company matters. Companies with 500 or more employees must in addition permit employee representation on the supervisory board. Limited liability companies which cross this threshold must form a supervisory board if they do not already have one. While proponents of the system regard it as at least partially responsible for the traditionally good German management-labour relations and low level of strike activity, it is often surprising to foreign owners unfamiliar with its operation.
2. STRUCTURING THE PURCHASE: ASSETS OR OWNERSHIP INTERESTS?
2.1 Assets or partnership interests?
When the target business is operated in partnership form, it should not make any tax difference to either the buyer or the seller whether assets or partnership interests are acquired. This is because the sale or purchase of partnership interests is in any case treated for tax purposes as the pro rata sale or purchase of the partnership assets. The generally pleasant consequence of this for the buyer is that, for tax purposes, his basis in his pro rata share of partnership assets acquired is stepped up to equal the full purchase price. That part of the purchase price not attributable to acquired assets, including self-created intangibles such as patents or know-how not appearing on the partnership balance sheet prior to the purchase, is generally attributable to goodwill. Goodwill is depreciable over 15 years for tax purposes in Germany. If less than all the interests in a partnership are acquired, the technical means by which the step-up is achieved will probably involve creating a supplemental (or shadow) balance sheet for the new partner on which that part of the price he paid for his share in excess of his pro rata share of book value of the assets on the basic partnership balance sheet is attributed first to those assets up to their full going concern values, then to specific self-created intangibles, and finally to goodwill.
The status of the seller does not affect the result. Their capital gain on sale by an individual of his complete interest in a commercial partnership qualifies for a reduced rate of income taxation under sec. 34 EStG (roughly speaking, half of the normal rate on the first DM 30 million of gain). Furthermore, the gain escapes trade tax completely. However, the gain by the partnership on sale of its entire assets to the buyer would likewise not be subject to trade tax and the partners would likewise receive the reduced income tax rate on their distributive shares of partnership profit.
The situation is analogous if the seller realises a loss on the sale. Such loss can be netted against the seller's other taxable income whether assets or the partnership interest is sold (subject to the same limitations in both cases).
The above analysis is not changed if the seller is a non-resident. Assuming the relevant assets are part of a German permanent establishment, Germany's right of taxation on sale of either the assets or the partnership interests follows from its domestic tax law and Art. 13 par. 2 of the OECD Model Treaty, which is incorporated in most of Germany's tax treaties.
2.2 Assets or shares? - Buyer's perspective
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. For the buyer, a share purchase offers no immediate possibility to step up the assets of the purchased corporation to the share purchase price and obtain a higher depreciation base. Buyers thus typically have a tax interest in buying the assets of a corporation at least where the purchase price exceeds the net book value of the corporation's assets. It should be remembered, however, that Germany has two major taxes on capital, the trade tax on capital and the net worth tax. Purchase of assets can increase the base on which these taxes are assessed after the purchase when, for tax or other reasons, the acquisition is not debt financed to a sufficient extent. While the savings on income taxes (trade tax on earnings and corporate or personal income tax) will probably outweigh the added capital tax resulting from an asset purchase, a calculation of net tax savings is misleading if income tax savings are not reduced by extra capital tax expenditure. The amount of such added capital tax varies greatly depending on the composition of the assets acquired.
Debt financing from foreigners is limited by Germany's thin capitalisation rules discussed in section 4 below. When one domestic corporation holds shares in another, these rules generally require the debt financing to be extended to the parent if it qualifies as a holding company for thin capitalisation purposes and otherwise to the subsidiary. If a domestic purchaser corporation cannot qualify as a holding company, there may be an added reason for it to purchase assets instead of shares in a target corporation, since otherwise the permitted level of debt financing will depend on the (probably low) book values of the target.
2.3 Assets or shares? - Seller's perspective
Sellers who are resident individuals often have a strong tax interest in selling shares in a target corporation. Non-resident sellers, whether corporations or individuals, will almost invariably insist on selling the shares in a target corporation. Resident corporate sellers may be willing to sell assets instead of shares. If the shares in the target corporation are owned by a partnership, the interests of partners who are individuals will resemble those of individual or corporate owners depending on whether the partnership is engaged in trade or business (commercial activity) or not.
The situation of the non-resident seller is easiest to understand. Assuming such sellers are resident in a country which has a tax treaty with Germany, their gain on the sale of shares in a German corporation will generally be exempt from tax in Germany. The gain on sale by their German corporation of its assets would be subject to German trade and corporation tax; distribution of the after-tax profit probably triggers at least 5 % withholding tax (though not if to an EU 25 % corporate shareholder from July 1996 on). The foreign seller generally prefers to take his profit tax-free in Germany and pay tax in his country of residence. If the foreign seller holds, directly or indirectly, no more than 25 % of the shares in a German corporation, his gain on sale of the shares is tax free in Germany even it he enjoys no treaty protection.
The situation of resident sellers is more complicated. Individuals frequently receive substantial tax breaks on the sale of shares which they would lose if their corporation first sold its assets and then distributed the after tax proceeds in a liquidation distribution to them. If an individual holds, directly or indirectly, not more than 25 % of the shares in the target corporation, his gain on sale is completely tax exempt under two conditions:
A six month holding period has been observed, and
The shares are a private, not a business asset in his hands.
Fulfilment of the second condition can be difficult to judge. Some of the considerations involved are touched on in section 1.2 above. If the shareholding exceeds 25 %, the gain still qualifies for the reduced rate of taxation discussed under section 2.1 above under the following conditions:
A six month holding period has been observed, and
The shareholding is a private and not a business asset, or
If a business asset, the business of which it is a part is also disposed of in the same transaction.
If the seller is a resident corporation, its gain on sale of the shares in its subsidiary is subject to tax at the same rate as the subsidiary's gain on sale of its assets. Which structure is preferable will depend on the relation borne by the purchase price to the seller's basis in the shares in the target corporation and to the target corporation's basis in its own assets.
2.4 Share purchase and the corporation tax credit
The German imputational corporation tax system can affect the purchase of shares in a German corporation in a variety of ways, both direct and indirect. The German corporation tax is a fully creditable tax for resident persons, both individual and corporate. Non-residents are also entitled to the credit if they hold the shares in the distributing corporation in a German permanent establishment, either directly or through a partnership entity. This means that, when valuing the retained earnings of a target corporation, account must be taken of the creditable German corporation tax paid with respect thereto. Sellers sometimes save this point for last in the negotiating process and then, after a price has been arrived at, claim that it should be increased by the full amount of creditable corporation tax associated with the target corporation's retained earnings.
This contention has validity if the business being purchased is valued, as is often done, with respect to the stream of income it produces after business taxes (primarily trade tax, but for this purpose net worth tax as well) and before personal taxes (corporation tax and personal income tax). The theory behind this approach is that corporation tax is fully creditable against personal income tax, and that therefore, in comparing investment in a corporation with other investments, the yield from which would also be subject to personal income tax, corporation tax should be ignored.
Foreign buyers are often confused by demands for a premium based on creditable corporation tax and frequently respond by asking the seller to distribute all earnings to himself before the sale. If the seller is an individual entitled to a reduced rate of taxation on the sale of his shares, he will obviously resist this request. Furthermore, there may not be sufficient liquidity in the corporation to permit a dividend. The latter problem can generally be solved by some form of debt-financed dividend, but the seller may not be willing or well able to manage this. Of course, if the buyer pays a premium for the corporation intending to distribute a debt-financed dividend, he will also have to consider what discount is appropriate in light of the type of financing selected.
Obviously, further adjustments must be made if the ultimate owners of the purchasing entity are located abroad. As to them, a 30 % corporation tax plus withholding tax is final. However, even as to foreigners, distribution of the fully taxed retained earnings of a German corporation will yield a tax refund, as the following simple example illustrates:
Target corp., earnings after trade tax 100,00
Corporation tax, basic rate - 45,00
------
Retained earnings in target corp. 55,00
Reduction in corp. tax on distribution + 15,00
Dividend to foreign shareholder 70,00
Withholding tax thereon, 5 % (assumed) - 3,50
------
Net dividend to foreign shareholder 66,50
Retained earnings before distribution - 55,00
------
Net refund of corporation tax, after taxes 11,50
======
The value of the net refund of German tax depends on the foreign shareholder's tax situation in his country of residence.
The creditability of corporation tax can be of even greater significance if the buyer is in a position to distribute the retained earnings of the target corporation to a domestic parent corporation with losses sufficient to cover the dividend. This is also best illustrated by an example:
Target corp., earnings after trade tax 100,00
Corporation tax, basic rate - 45,00
-------
Retained earnings in target corp. (assumed liquid) 55,00
Reduction in corp. tax on distribution + 15,00
Net dividend to domestic corporate parent 70,00
Corporation tax credited to parent 30,00
Gross dividend (income to parent) 100,00
Parent's losses from other sources - 100,00
Parent's net income 0,00
Corporation tax payable 0,00
Corporation tax creditable 30,00
Net refund of corporation tax 30,00
Liquidity after dividend (55 + 15 + 30) 100,00
Liquidity before dividend - 55,00
-------
Increase of liquidity on dividend 45,00
=======
Trade tax does not arise in the above situation as long as the parent holds a 10 % share in the distributing subsidiary. The value of the increased liquidity must be calculated under the specific circumstances. Whether the entire value should be passed along to the seller in the form of a higher purchasing price is a matter for negotiation.
2.5 Purchase of shares from foreign persons - sec. 50c EStG
The creditability of German corporation tax lies at the root of another peculiarly German problem posed whenever a purchaser entitled to the German corporation tax credit purchases shares in a German corporation from a seller not entitled to the German corporation tax credit. While non-resident persons are entitled to the corporation tax credit if they hold the shares in a German permanent establishment, either their own or that of a partnership in which they are a partner, the situation generally covered is the purchase of shares by a resident person from a non-resident person. Under sec. 50c EStG, such purchases cause a "blocking amount" to attach to the shares purchased. The same applies if any person not entitled to the corporation tax credit was in the seller's chain of title for the past 10 years.
The "blocking amount" is defined as the difference between the purchase price of the shares and their par value (nominal value). The significance of the blocking amount is to reduce the amount of a "dividend writedown" otherwise available to the purchaser of a corporation by reason of distribution of its retained earnings. It is easiest to understand this dividend writedown by imagining a corporation with no assets except a large amount of cash (retained earnings), no operative business, and no liabilities. After distributing the cash, all that is left in the company is its stated capital. The distributing corporation thus declines in value by reason of the distribution. German commercial and tax accounting law generally permit a writedown to the amount of stated capital in these circumstances.
For reasons connected with the German imputational corporate tax system, such a writedown leads to unacceptable tax consequences for the German treasury if practiced following purchase of shares in a German corporation from a non-resident. This is again best illustrated by an example:
Target corp., earnings after trade tax 100,00
Corporation tax, basic rate - 45,00
------
Retained earnings in target corp. 55,00
Reduction in corp. tax on distribution + 15,00
------
Net dividend to domestic corporate parent 70,00
Corporation tax credited to parent 30,00
Gross dividend (income to parent) 100,00
Parent's loss from writedown of shares in the
distributing corporation - 100,00
Parent's net income 0,00
Corporation tax payable 0,00
Corporation tax creditable 30,00
Net refund of corporation tax 30,00
Liquidity after dividend (55 + 15 + 30) 100,00
Liquidity before dividend - 55,00
------
Increase of liquidity on dividend 45,00
======
Since the foreign seller probably enjoyed treaty protection with respect to his gain on the sale, the result of the above is to permit the gain in the target corporation to escape all income taxation (except trade tax). It is worth noting that the parent (purchase vehicle) could also redistribute the dividend received (100) free of all tax (including withholding tax) to its foreign parent since such a distribution can easily be structured as a return of capital (distribution from EK 04).
The blocking amount prevents the above result. Assuming par value to be 10, the purchase price in the above situation would have been 110 (55 retained earnings + 15 tax reduction on distribution + 30 creditable tax + 10 stated capital), yielding a blocking amount of 100 (110 - 10 = 100):
Gross dividend (income to parent) 100,00
Parent's loss from writedown of shares in the
distributing corporation - 100,00
Blocking amount, sec. 50c EStG + 100,00
Parent's net income 100,00
Corporation tax payable 45,00
Corporation tax creditable 30,00
Net corporation tax payable 15,00
Liquidity after dividend (55 + 15 - 15) 55,00
Liquidity before dividend - 55,00
Increase of liquidity on dividend 00,00
======
The blocking amount means that distribution of the earnings retained in the target corporation produces no tax advantage. Redistribution of these earnings to an ultimate foreign parent is no longer a return of capital and results in 30 % final corporation tax plus withholding tax.
2.6 Purchase of shares from resident persons: dividend writedowns
A dividend writedown by reason of a distribution of retained earnings from the target corporation to a domestic purchase vehicle, e.g. a domestic corporation, is available when the sellers are not foreign persons (more precisely, are entitled to the corporation tax credit). This can be a useful device in certain situations.
2.7 Liability aspects of asset and ownership interest purchases
Buyers often expect that by purchasing assets instead of ownership interests they can avoid assuming liabilities, especially contingent liabilities, associated with the target business. This is, however, not necessarily the case.
The buyer of a business assumes liability under existing employment contracts whether he purchases assets or ownership interests (sec. 613a BGB = German civil code). Whether the assets purchased constitute a "business" for labour law purposes is a factual question.
The purchaser of a business also assumes joint and several liability vis-a-vis creditors of the business under sec. 419 BGB if the purchaser thereby acquires the seller's entire or virtually entire property. In answering this question, the purchase price received by the seller is disregarded. Whether the seller's virtually entire property has been acquired is determined with respect to all facts and circumstances. The residual property not transferred must probably amount to at least 10 % - 15 % of the overall property. The purchase of virtually all the assets of a corporation would result in joint and several liability of the purchaser under sec. 419 BGB. The same transaction with respect to a limited partnership results in liability unless the general partners have substantial property. Purchase of shares in a corporation or interests in a partnership also leads to liability under sec. 419 BGB if the purchased shares or interest constitute the seller's virtually entire property. A purchaser held liable for the seller's debts under sec. 419 BGB has a right of recourse against the seller for the full amount of such liability. Liability under sec. 419 BGB cannot be disclaimed, but can be limited to the (gross) value of the assets purchased.
Section 419 BGB has been repealed in connection with the introduction of a planned new insolvency law, but remains in force through the end of 1998.
Under sec. 1365 BGB one spouse requires the consent of the other in order to dispose of his or her "property as a whole". The concept is similar to, but not necessarily identical with, that of "virtually entire property" under sec. 419 BGB. A disposition of one's property as a whole may occur if the remaining property is not at least 10 % - 15 %, with the lower percentage applying to persons with large overall net worth and the higher percentage to less wealthy persons.
Under sec. 25 HGB (German commercial code), the purchaser of a commercial business assumes joint and several liability for its debts if he continues to use the name under which the business was previously conducted. This liability can be disclaimed, but requires the observance of certain formalities including entry of a notice in the Commercial Register. The joint and several liability of the seller expires after 5 years (sec. 26 HGB). The buyer's right to contribution from the seller should be dealt with in the contract of purchase.
Liability under the statutes discussed above can be based on any legal theory and thus includes liability for back taxes, including those assessed pursuant to a later tax audit. In addition, sec. 75 AO (tax procedure act) makes the purchaser of a business liable for business and withholding taxes pertaining thereto, notably trade tax, value added tax, wage withholding tax, and dividend withholding tax. There is, however, no liability for corporation tax or net worth tax under the statute. Liability is limited in amount to the gross property acquired and limited in time to taxes arising during or after the calendar year preceding that in which the transfer of title occurs and assessed or reported by the end of the year following that in which the purchaser registers the new business with the tax authorities. Liability cannot be disclaimed.
Lastly, in Germany the owner or, in some cases, the person in possession of real property can be held strictly liable for environmental hazards emanating from the property, e.g. pollution and contamination. The costs of investigating, containing, and/or cleaning up pollution or contamination can be imposed on the owner by local government if it appears inexpedient to proceed against the person responsible for the harm (e.g. if he cannot be found, is no longer in legal existence, or is insolvent). Such liability is based on the waste disposal laws of the German States and their general police laws. If real property is acquired in connection with the purchase of a business, careful consideration should be given to the potential environmental hazard liability.
2.8 Other considerations
The transfer of ownership interests is legally simpler than the transfer of assets. There is no need to specify precisely what is being purchased. Contracts held by the transferring entity remain in place and do not need to be assumed, which requires the other party's consent if it is to be valid against him, or renegotiated. Similar advantages apply to licenses held by the target business.
There are also certain advantages to asset purchases. Where only part of the target entity's assets are desired, it is easier to purchase these selectively. Furthermore, by purchasing assets only, unwanted debt can be left in the selling entity. Of course, this often will require that the purchaser pay a higher price (gross value of assets instead of mere net equity). Furthermore, liability may be assumed anyway under one of the statutes discussed in section 2.7 above.
If an asset purchase is made, the buyer should attempt to persuade the seller to agree to a detailed allocation of purchase price to the assets purchased. Such an allocation will not be binding for tax purposes, but provides a useful starting point. In making the allocation, consideration must be given to the different depreciation lifetimes of the various assets being acquired, and to those assets which are not depreciable at all (above all, land). Non-competition agreements in connection with asset purchases are generally merged with goodwill and do not constitute independent assets.
Purchase of all or a substantial part of the assets of a commercial entity may require formal approval by the owners of the business. A contract of purchase entered into without such formal approval may thus be invalid or unenforceable.
3. OVERCOMING THE TAX DISADVANTAGES OF SHARE PURCHASES
There are two methods of stepping up the tax depreciation bases of the underlying assets acquired in a share deal. The internal asset purchase method has often been used in the past. However, since the new German reorganisation law went into effect at the start of 1995, discussion has centred around reorganisation of an acquired corporation into partnership form. The basic drawback of the internal asset purchase method is that trade tax must be paid on the amount of the step-up. Conversely, the essential advantage of the reorganisation method is that it avoids trade tax.
3.1 Internal asset purchase
Under this method, the desired step-up in basis after a share purchase is achieved by causing the target corporation to sell its assets (with liabilities) to an affiliated company, usually also resident in Germany. The purchase price of the assets is identical to that just paid for the shares in the target corporation. Accordingly, the asset purchaser corporation takes the assets onto its balance sheet at their full, stepped-up values and shows previously uncapitalised intangibles, including goodwill.
The price of the step-up is, of course, full realisation of gain by the target corporation. This would make no sense where a profitable target corporation has been acquired because the tax cost of the step-up would exceed the tax benefit. Provided, however, the target corporation has been purchased through a German corporation (e.g. an intermediate subsidiary of a foreign ultimate buyer), the taxes triggered in the target corporation on the sale of its assets can be largely neutralised.
The mechanism of such neutralisation is the dividend writedown discussed in sections 2.4 and 2.5 above. After realising gain on the sale, the target corporation is empty except for its retained earnings. These are distributed to its German parent, which then writes down the value of its shares in the target corporation to par value. The result is a complete refund at the level of the parent of all corporation tax paid by the target corporation on its profits from the internal asset sale.
There are three problems with the internal asset purchase. Firstly, the dividend writedown is not effective for trade tax purposes. This makes it impossible to recapture at the level of the parent the trade tax paid by the target corporation on its capital gain. The tax cost is somewhere around 17 % of the capital gain, depending on the level of trade tax in the particular community. Secondly, there can be troublesome liquidity problems if the corporation tax refund does not come quickly after the target pays tax on its capital gain. Thirdly, as long as the solidarity surcharge continues in existence, it increases the tax cost of internal asset purchases.
The internal asset purchase is frustrated altogether by sec. 50c EStG on purchases of shares from non-resident persons. See section 2.5 above.
3.2 Reorganisation in partnership form
Reorganisation in partnership form offers a more elegant, if to date untested means of obtaining a step up in basis at no tax cost (except possibly real estate transfer tax in certain situations) following a share purchase of a German corporation. Under certain conditions, the acquiring partnership is deemed to have surrendered the recently purchased shares in the target corporation for the corporation's assets as valued on the books of the corporation. To the extent the purchase price of the shares exceeds net asset book value, a tentative reorganisation loss results. Assuming this tentative loss is not adjusted by a blocking amount under sec. 50c EStG or creditable corporation tax, the assets taken by the partnership can be stepped up in basis by the amount of the tentative loss. This is done in stages, first by increasing assets on the balance sheet of the transferring corporation to their full value, then by doing the same with any self-created intangibles not previously capitalised, including goodwill.
If the transferring corporation has creditable corporation tax, this generally reduces the tentative reorganisation loss and hence the step-up. However, the amount of such tax may be creditable to the partners of the receiving partnership and lead to a tax refund.
The principal drawbacks are associated with the partnership form itself.
- For consolidation purposes, a partnership cannot be a dependent member of a consolidated tax group. This is a disadvantage above all for trade tax purposes, because trade tax losses are thus "stuck" in the partnership and cannot be passed on to other affiliated companies. A partnership can, however, be the company under which consolidation occurs (group leader - see section 5.2 below).
- A partnership is often a poor choice to hold shares in foreign corporations, because it may not qualify for the participation exemption with respect to these shareholdings.
Partnership form has, however, at least one tax advantage: Partnerships are not subject to the thin capitalisation rules discussed under section 4 below.
The desired step-up is not achieved on purchase of shares from non-resident persons. The reason is again the blocking amount under sec. 50c EStG (see section 2.5 above). Various proposals for circumventing this problem have been advanced, but it is at present uncertain whether any of them will prove successful.
It is also unclear whether the step-up is achieved if non-resident persons purchase shares in a German corporation and then convert it into a partnership. This problem can generally be avoided by forming a German corporation to act as the purchase vehicle.
The tax authorities appear alarmed at the volume of transactions seeking to profit from the new tax planning opportunity. Most recently, argument has been heard that the step-up amount might be subject to trade tax after all. This is contrary to the weight of opinion. Legislative action to restrict the scope of tax-free step-ups cannot be ruled out.
4. FUNDING: THIN CAPITALISATION RULES
To prevent foreign shareholders from draining off the earnings of their German subsidiaries in the form of interest on loans (or other compensation paid for debt capital), an anti-earnings-stripping provision was added to the German tax code (sec. 8a of the Corporation Tax Act). The new thin capitalisation rules went into effect on 1 January 1994 for loans then or thereafter outstanding to German corporations. Transition provisions exist only for profit-linked loans made before 9 December 1992.
The new thin capitalisation rules apply to loans received by German corporations from foreign shareholders holding, directly or indirectly, more than 25 % of the shares in the corporation or from foreign persons related to 25 % shareholders. They also apply to loans made by unrelated third parties (e.g. banks) if such third party has any recourse against a foreign 25 % shareholder or foreign persons related to him (or against a domestic related person if the shareholder is a foreign person). A major exception to this rule exists for loans made by unrelated third parties (e.g. banks) who are themselves resident in Germany (or otherwise entitled to the German corporation tax credit) if it can be demonstrated that the income derived by the third party from the loan is subject to German tax. In particular it must be shown that such income is not drained out of Germany through a back-to-back loan arrangement.
The new rules establish safe havens in differing amounts depending on whether the compensation paid for the use of the debt capital is measured in terms of the loan principal (i.e. interest, either fixed or variable), or in terms of some other factor (e.g. profit or gross sales). To the extent shareholder loans exceed the safe haven, deductibility is denied for corporation tax purposes for the interest (or other compensation) paid or accrued on the excessive part of the debt capital. Furthermore, when such non-deductible interest (or other compensation) is paid, this constitutes a constructive dividend and leads to dividend withholding tax at the applicable rate.
For fixed or variable interest bearing loans, the interest paid is non-deductible to the extent the loan amount exceeds three times the pro rata capital of the 25 % shareholder (safe haven). In addition to the safe haven, the taxpayer may make a showing that it could have obtained the loan on the same terms from an unrelated party. If this burden of proof can be carried, interest bearing loans will escape the new rules even if the debt-equity ratio permitted under the safe haven is exceeded.
Banks are exempted from the 3 : 1 limit with respect to interest bearing loans taken out to finance their own standard banking transactions.
For loan compensation linked to profits or sales, the applicable debt-equity ratio is 1 to 2 instead of the more generous 3 to 1. Furthermore, there is no opportunity to show that an unrelated third party would have made the same loan and no exemption for banks.
For German holding companies, a higher 9 to 1 ratio applies to interest bearing debt, but this must suffice to finance all of the subsidiaries under the holding as there is no safe haven for shareholder loans made directly to them. If an interest bearing loan is made to such a subsidiary, the possibility remains to demonstrate that an unrelated third party would have made the same loan.
Since the applicable debt-equity ratio for purposes of the safe haven is determined at the outset of each fiscal year, considerable planning may be necessary to ensure that adequate equity is injected in time. While equity added during the fiscal year will not count for safe-haven purposes until the start of the following year, any increase in debt during the year can lead to a loss of safe-haven status. There are special provisions regarding declines in equity due to operating losses.
The new rules do not apply for purposes of the trade tax on earnings, where, it will be recalled, half of all long term interest is non-deductible in any event irrespective of whether it is paid to a shareholder. The new rules also do not apply to partnerships, even to partnerships with a corporation as sole general partner. They likewise do not apply to the German branches of foreign companies.
5. OTHER TAX CONSIDERATIONS
5.1 Utilisation of preacquisition losses
In Germany, business losses may be carried forward indefinitely for both trade tax and personal or corporate income tax purposes. Corporation tax losses only may also be carried back up to two years in an amount of up to DM 10 million. Utilisation of preacquisition losses is thus in principle possible if ownership interests are acquired. For partnerships, this applies only to trade tax losses, since income tax losses are immediately attributed to the partners. However, direct acquisition of the interests in a partnership destroys the partnership trade tax loss carryforwards. Acquisition of the interests must therefore be indirect, i.e. by acquiring the ownership interests of the entities which are partners in the target partnership. Even so, later utilisation of the partnership trade tax losses is subject to the limitations applying to corporations.
For corporations, purchase of a corporate shell with large loss carryforwards is not sufficient to permit netting of the past losses against future profits. The purchased shell must in addition be "economically identical" with the entity which suffered the losses. The exact meaning of "economic identity" is a subject of controversy. If more than three fourths of the shares in a corporation change hands and it then recommences business with predominantly fresh capital, economic identity is not present.
Distribution of earnings by a subsidiary to a domestic parent corporation with offsetting losses results in refund to the parent of the corporation tax, but not the trade tax, paid by the subsidiary. Complete pooling of losses can, however, be achieved by creating a consolidated tax group.
5.2 Tax consolidated groups
There are three types of tax consolidation in Germany: VAT consolidation, trade tax consolidation, and corporation tax consolidation. In all three cases, group members (Organgesellschaften) are consolidated under a group leader (Organtraeger). In all three cases, consolidation requires the financial, organisational, and economic integration of group members into the group leader.
- Financial integration requires at least a direct or indirect majority interest of the consolidated group leader in a particular group member.
- Organisational integration requires the ability of the group leader to assert management influence on a group member, e.g. because the same persons manage both companies or because the group member has contractually delegated management authority to the group leader.
- Economic integration requires a substantial economic relationship between the activities of the group member and those of the group leader, ideally such that the group member functions economically like a branch of the group leader. This is often the most difficult of the three requirements to meet, especially when the intended group leader is a pure holding company.
For VAT and trade tax purposes, consolidation is automatic if the above requirements are met. Corporation tax consolidation is subject to additional formal requirements, including entry into a contractual profit and loss assumption agreement between each group member and the group leader. This agreement is subject to various formal requirements and must be performed in fact. It is furthermore enforceable by creditors, e.g. to compel a group leader to transfer funds to a group member to equalise its losses.
Only corporations qualify as potential group members. However, the group leader can be any German resident person or entity engaged in a commercial enterprise, e.g. a commercial partnership. (For VAT consolidation only, the actual group leader can be a foreign entity; a domestic group member will then be deemed to be the group leader for consolidation purposes.)
Losses sustained by group members after the effective date of consolidation are attributed to the group leader for trade and corporation tax purposes. Pre-consolidation losses are not affected by consolidation and remain in the particular group member for use after the consolidation is terminated.
5.3 VAT
Asset purchases of a business or a division thereof (branch of activity) are not subject to the German VAT law (sec. 1 par. 1a UStG).
Purchases of ownership interests in a corporation or a partnership are zero-rated under sec. 4 par. 8 (f) UStG.
5.4 Real estate transfer tax
Acquisition of real property in an asset purchase is subject to 2 % real estate transfer tax. If ownership interests are purchased, the same applies to the real property indirectly acquired when a complete change of ownership occurs, i.e. when all of the shares or ownership interests are acquired by a new owner or united in his hands. Certain attribution rules apply in deciding when this occurs. If the transaction triggering the tax involves no consideration, then the tax base is the standard assessed value of the real property. At present, this is approx. one fourth or less of fair market value. Standard assessed value is expected to increase for real estate in the near future, however.
DISCLAIMER AND COPYRIGHT
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