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In article no. 88, we reported briefly on the important ruling by an en banc panel (Grosser Senat) of the Federal Tax Court that the contribution to capital which results when a shareholder waives a receivable held against his corporation is limited to the receivable's "valuable portion" (werthaltiger Teil) or actual value (BFH DB 1997, 1693 - 9 June 1997). This article comments at greater length on the Court's ruling and explores its consequences for both the shareholder creditor and the corporate debtor.
1. Questions before the Court and its replies
The 1st Panel of the Federal Tax Court referred the following questions to the joint panel for its decision (see referral ruling of 11 Nov. 1994 - DB 1994, 2269):
1. When [by reason of the shareholder relationship] a shareholder waives a receivable against his corporation and the receivable waived is no longer worth its face value, does this result in a contribution to the capital of the corporation in the amount of the face value of the receivable or only in the amount of its going concern value (Teilwert)?
2. Can a contribution to the capital of the corporation also occur when waiver of the sort described in question 1 is declared by a person related to the shareholder [instead of by the shareholder himself - third party expense]?
3. Does the shareholder's waiver of a receivable against his corporation invariably cause him to receive, in the sense of sec. 11 EStG, the amount of the waived receivable or does this legal consequence depend on the formal manner by which the waiver is accomplished (e.g. by contract of forgiveness within the meaning of sec. 397 BGB)?
The casenote replies of the en banc panel to these questions are as follows:
1. Waiver by a shareholder of a receivable against his corporation which is no longer worth its full value causes the corporation to receive a contribution to capital in the amount of the going concern value of the receivable if the waiver is motivated by the shareholder relationship. This applies even when the receivable in question is attributable to deductible expenditure [by the corporation].
2. Waiver by a shareholder of a receivable against his corporation constituting a constructive contribution to capital causes the shareholder to receive the portion of the receivable which still has value.
3. A constructive contribution to a corporation can also occur when the waiver is declared by a person related to the shareholder [instead of by the shareholder himself - third party expense].
2. Taxable business profits and contributions to capital
A basic knowledge of the German definition of taxable business income and treatment of contributions to capital helps one to understand the issues posed and the Court's reasoning.
The German income tax law defines the taxable profits of a business as follows in sec. 4 (1) EStG:
Net assets at the close of the fiscal year
minus Net assets at the outset of the fiscal year
plus Withdrawals in the course of the year
minus Contributions in the course of the year
= Taxable profits
While the definition is modelled around a sole proprietorship, it applies as well to partnership and corporate business entities. The terms used in the definition are construed in accordance with tax law. Notably, net assets for tax purposes are not necessarily identical with net assets as shown in the commercial accounts.
The subtraction of contributions to capital in determining profits is the aspect of the profit formula which is immediately relevant to the ruling here being discussed. This subtraction is made for tax purposes irrespective of the treatment of a transaction for commercial accounting purposes. When a shareholder cancels a receivable he holds against his corporation, for commercial accounting purposes this results in income to the corporation in the amount of the debt cancelled. This income appears in the profit and loss statement and increases net assets. For tax purposes, the cancellation of debt nevertheless constitutes a contribution to capital if motivated by the shareholder relationship as opposed to arm's length creditor-debtor considerations. To test for transactions motivated by the shareholder relationship, courts commonly ask whether a prudent and experienced businessman would have conferred the same benefit on the corporation.
Transactions constituting contributions to capital for tax purposes, but not for commercial accounting purposes, are referred to as constructive contributions (also as "covert" or "disguised" contributions - verdeckte Einlagen).
The income tax law furthermore provides that contributions to business capital are to be valued at their going concern value (Teilwert) at the time of contribution (sec. 6 (1) no. 5 EStG), subject to certain exceptions not relevant for present purposes. The going concern value of a business asset is defined as the value which a hypothetical purchaser of the entire business would assign to the asset. It is frequently identical with fair market value (replacement cost), which is normally also the upper limit of going concern value.
3. Contribution determined by actual value of the receivable
The Court notes that the waiver of a receivable held by a shareholder against his corporation increases the net assets of the corporation and that this increase in net assets can constitute income for commercial accounting purposes. To the extent the waiver constitutes a constructive contribution to capital, the Court states that the increase in net assets (taxable income) resulting from the waiver is to be neutralised by subtracting the amount of the capital contribution in accordance with the profit determination formula set forth under section 2 above.
In order for the waiver to constitute a contribution to capital, it must be motivated by the shareholder relationship, as opposed to arm's length debtor-creditor considerations. Assuming this to be the case, the Court holds that the amount of the contribution is determined by "the actual value of the receivable, not by its face value and not by the amount shown as a liability" on the books of the corporation. If the receivable is worth less than its face value, a contribution to capital results in this lesser amount.
The Court derives this result from the basic rule of sec. 6 (1) no. 5 EStG that property contributed to a business is to be valued at its going concern value on the books of the business. The going concern value of an account receivable from a business is, in the Court's view, the amount which the owner of the business would have to pay to buy the receivable or to secure its waiver. This, the Court says, corresponds to the portion of the receivable which still has value (noch werthaltiger Teil der Forderung).
The Court's comments on this, the crux of its decision, are short and almost apodictic. While it cites in a footnote more than 20 scholarly articles advocating equation of the contribution with the value of the disappearing liability on the books of the corporation, the Court does not deal at length with their arguments. Behind the Court's reasoning is the assumption that bad debts would never be purchased for full value by a third party, and furthermore that assignment by a shareholder to his corporation of a partially bad debt claim against a third party would not yield a contribution in the face amount of the claim. In the Court's view, the mere fact that the assignee of the claim is also the claim debtor should not alter the result.
The basis of the shareholder in his shares increases by the amount of the contribution.
4. Consequences for the corporation: majority view
The waiver causes the net assets of the corporation in its statutory accounts to increase by the book value of the respective disappearing liability. Since, however, the amount of the resulting contribution to capital is limited to the actual value of the waived receivable, the subtraction of the amount of the contribution in accordance with the definition of taxable profits given under section 2 above will not fully neutralise the increase in net corporate assets triggered by the waiver if the actual value of the receivable is below the book value of the corresponding liability. This assumes, however, that net assets for tax purposes in this case follow the statutory accounts, which may not be the case (see alternative view in section 5 below).
The majority view at this time is that this difference which remains constitutes taxable income to the corporation. Under this view, the waiver results in an increase in net assets under basic accounting principles. This increase can be neutralised for tax purposes only in the amount of the contribution, which will be less than the increase whenever the waived receivable is not worth full value.
The majority view is espoused by at least three articles in professional journals (Groh BB 1997, 2523; Hoffmann DStR 1998, 196; and Gebhardt DStR 1998, 225), by the tax authorities, and by a decision of the 1st panel of the Federal Tax Court (I R 58/93, dated 15 October 1997 - see section 12 below).
The majority view admits of one exception, however. Where the waiver was prompted by the corporation's poor economic situation, the income resulting from the valueless portion of the waived receivable may well be tax free under sec. 3 no. 66 EStG, a provision of the income tax code in force through 1997 (now repealed) which exempts gain realised on cancellation of debt provided the debt cancellation was intended to restore a failing corporation to viability. A number of conditions must be met to qualify under this provision. Notably, the cancellation of debt must not have been motivated by the shareholder relationship. Here one can persuasively argue that waiver of the valueless portion of a receivable is never motivated by the shareholder relationship because a third party creditor would also have been willing to cancel the non-recoverable portion of his claim in order to secure collection of the rest (see Groh, BB 1997, 2523, 2524/2). Whether the other requirements of the exemption are fulfilled will vary from case to case. The exemption has been repealed with effect for fiscal years ending from 1998 on.
It will furthermore also frequently be possible to net any gain resulting from the cancellation of debt against current losses or losses carried forward. Of course, such losses would then no longer be available for future use.
5. Consequences for the corporation: alternative view
Nowhere does the ruling by the en banc panel of Germany's highest tax court state in so many words that the debtor corporation realises gain to the extent of the excess of the book value of its liability over the contribution to capital resulting from waiver of the corresponding receivable. The ruling is explicit only with respect to determination of the amount of the contribution to capital.
Conceptually, the Court appears to analogise the transaction to a non-cash contribution to the capital of a corporation effected by assigning a debt claim against a third party. This transaction would clearly result in a contribution only in the amount of the fair value of the assigned claim, because the corporation has only received property of value in this amount.
If one accepts the view that the result is no different when the assigned receivable is against the assignee corporation itself because the corporation is still only enriched to the extent of the actual value of the property received, then the actual value of the property received must likewise be the limit of the increase in net assets which results from the transaction.
The Court states that "the value of the asset increase is ... equivalent to the amount which the owner of the business [i.e. the debtor corporation] would have had to pay to purchase the receivable or to secure its waiver" (GrS DB 1997, 1693, 1695/1 = sec. C.I.3). The "value of the asset increase" (Wert des Vermoegenszugangs) must for tax purposes be equivalent to the increase in net assets within the meaning of sec. 4 (1) EStG (explained in section 2 above).
It is paradoxical to deny that the corporation has received a contribution in the full amount of the liability on its books, because the waived receivable was worth less than this liability, while at the same time insisting that the net assets of the corporation have been increased not only by the amount of the contribution, but also by the excess of the book value of the liability over this contribution.
The commercial accounts may well indicate such a paradoxical result to be the correct one. However, one may argue that the limit of the contribution is at the same time the limit of the increase in net assets within the meaning of the tax definition of business profits. Under this view, the increase in net assets would be fully neutralised by subtraction of the contribution in the same amount, and the cancellation of bad debt would not lead to taxable income.
A further consideration indicates this alternative view to be the correct one. The definition of taxable profits as the excess of ending net assets over starting net assets applies only to accrual basis taxpayers. Cash basis taxpayers are permitted to determine taxable profits as the excess of receipts over disbursements pursuant to sec. 4 (3) EStG, subject to certain exceptions. As a matter of basic principle, cash basis accounting and accrual basis accounting must, however, yield the same total taxable profit over the entire lifetime of a business (principle of identical overall profit). Only the distribution of this profit over the various tax periods (tax years) can be different. It is obvious, however, that waiver of a bad debt owed by a cash basis taxpayer cannot lead to income because the taxpayer has received nothing. Treatment of the valueless portion of a waived debt claim as income would therefore lead to a discrepancy in the overall results yielded by accrual basis and cash basis accounting. Since such treatment would violate the principle of identical overall profit, it cannot have been intended by the en banc panel of the Court.
6. Formal means of waiver
The Court stated that its ruling applied equally to waivers of shareholder claims against corporations and to assignments of such claims to the corporation because the economic effect was in both cases to destroy the claim and the corresponding liability. Whether this is accomplished by waiver or by merger is irrelevant. A mere agreement not to prosecute a claim (contractual debt moratorium, pactum de non petendo) would leave both receivable and liability untouched and hence not result in a contribution to capital. The same is true of a subordination agreement.
7. Receipt by the shareholder
The en banc panel of the Federal Tax Court also held that a shareholder receives the amount of the waived claim to the extent the waiver results in a contribution to capital. The Court cited cases treating an in-kind contribution to a corporation in return for new shares issued as an exchange of assets and a tax realisation event for the shareholder. If the contribution is effected by waiver of a claim against the corporation, this causes the shareholder to realise the value of the waived claim.
The Court held that the result must be the same when a receivable is waived without issuance of new shares (constructive contribution). The waiver causes the shareholder's ownership rights to be "reinforced" by converting his receivable into equity. This, in the Court's view, was both similar to receipt of new shares in return for an assigned debt claim and akin to conversion of a claim for payment (e.g. for interest or salary payable) into a loan. Such conversion has long been held to constitute "receipt" of the converted amount by the claimholder.
It is emphasised that the amount received on the waiver is limited to the contribution to capital effected thereby.
"Receipt" is a concept under income tax law applying to cash basis taxpayers (sec. 11 EStG). Its importance is not limited to cash basis shareholders, however. One must in each case determine precisely what is deemed to have been received. A repayment of loan principle will, for instance, probably not result in income unless the creditor has taken a special writedown on his debt claim and the deemed repayment exceeds the adjusted amount of the loan receivable.
8. "Loan" receivables and "expense" receivables
The ruling by the en banc panel applies to "loan" receivables and "expense" receivables alike.
Prior to the ruling, many commentators advocated treating liabilities arising out of expense deducted by the corporation (e.g. salary or interest expense - expense receivables) differently from loan liabilities (loan receivables). These commentators in principle believed that the contribution on waiver of a receivable should equal the respective liability on the books of the corporation, but wished to make an exception for waiver of "expense" receivables. Some thought that waiver of an "expense" receivable should trigger gain to the corporation in the amount of the corresponding liability or accrual. Others argued that the waiver of such expense receivables must cause the shareholder to receive the full amount of the receivable.
Otherwise, it was feared that, by waiving "expense" receivables, the shareholder could first use the corresponding liability to reduce the taxable earnings of his corporation and then convert the liability into equity by waiving the receivable. Such equity amounts could then be used to fund tax-free returns of capital to the shareholder (sec. 40 no. 2 KStG and sec. 20 (1) no. 1 sent. 3 EStG).
In light of its holding on the main issues, the en banc panel saw no need to differentiate between "expense" receivables and "loan" receivables. Accrual basis shareholders, it said, will have already capitalised the receivable and so recorded it as taxable income. Cash basis taxpayers would be deemed to receive the payment which they waive to the extent such waiver results in a contribution to capital (see also section 7 above).
The en banc panel expressly stated that the treatment of foreign shareholders was no different than that of domestic shareholders. The fact that the income from an "expense" receivable is not subject to German tax thus does not justify refusal to recognise a contribution to capital when a foreign shareholder waives a claim against a domestic corporation.
The Court did, however, issue one caveat: a corporation might be denied a deduction from net assets for a contribution received on waiver of a receivable if for some reason the expense represented by the corresponding liability did not (in principle) result in income in the same amount for the shareholder.
While it is true that an accrual basis taxpayer will realise a receivable when it is capitalised, situations are conceivable in which the capitalised receivable is then neutralised in whole or in part by a special writedown (Teilwertabschreibung). Furthermore, under the imparity principle the corporation may have set up an accrual before the shareholder has entered a corresponding receivable. Perhaps these are situations in which the caveat mentioned in the preceding paragraph might operate.
9. Relevance of EU law?
The en banc panel of the Federal Tax Court based its ruling essentially on the valuation rule of sec. 6 (1) no. EStG. It declined to comment on the controversial question under the 2nd EEC Company Law Directive as to whether waiver of claims by a shareholder in return for new shares issued results in conversion of at least certain sorts of claims into capital at face value. The Advocate-General of the European Court of Justice supports face value conversion of loans which are undisputed and due for repayment (see Groh BB 1997, 2523, 2528 ff.).
10. Third-party contributions
The en banc panel ruled that waiver by a non-shareholder of a debt claim against a corporation can constitute a contribution by the shareholder if the third party is related to the shareholder. The issue turns on the motivation of the related third party in waiving his claim. If the waiver is motivated by the third party's own economic interests, no contribution occurs. If the third party is, for instance, an affiliated corporation owned by the shareholder, then it may well be proper to analyse the waiver as a constructive dividend by the third party affiliate to the shareholder followed by a contribution by the shareholder to his other corporation.
11. The actual value of a receivable
The decision of the en banc panel does not indicate how the actual value of a receivable is to be determined.
In article no. 88, we spoke for reasons of simplicity of the receivable's realisable value. This implies that the actual value of a receivable is the amount which a third party creditor would receive were he to reduce his claim to judgement and seek to enforce it. One could also equate realisable value with the quota which a third party creditor would receive in bankruptcy.
It is, however, by no means clear that such an approach is the proper one. For this reason, the expression "realisable value" may be misleading and is avoided in this article.
It is important to remember that waiver of shareholder debt is often motivated by provisions of company law which require a corporation to declare bankruptcy if it is unable to pay its debts as they fall due or if its liabilities exceed the fair market value of its assets (sec. 64 GmbHG; sec. 92 AktG). An excess of liabilities over assets is not uncommon for new corporations with foreign shareholders.
It is easy to imagine a corporation with liabilities in excess of assets which is nonetheless completely sound financially because all of the debt is held by its shareholders and its economic prospects are rosy. Its insolvency is thus a legal problem, not an economic one. If the shareholder chooses to correct the legal problem by waiving all or part of his debt claims against his corporation, what is the "actual value" of such claims? Is the actual value very low, because enforcement of a hypothetical judgement against the corporation would yield only a small percentage of the loan principal? Or is the "actual value" high because the corporation has good long term prospects and the shareholder is thus certain to cure its insolvency, the only question being how? Even if the proper question to ask is the price which e.g. an outside bank would pay to buy the loan, is it proper to take account of the support which the corporation may receive from the corporate group of which it is a part? For purposes of the thin capitalisation rules, the tax authorities take the position that a lender may be assumed to have recourse on the loan against the foreign parent of a domestic corporation even absent a specific agreement to that effect.
The "actual value" of a receivable is thus by no means self-evident.
12. Initial high court decision implementing en banc ruling
A decision has been rendered by the 1st panel of the Federal Tax Court with respect to at least one of the three cases which prompted its referral of questions to the en banc panel (Die Wirtschaftspruefung 1998, 421 - 15 October 1997).
The case involved a family-owned GmbH whose principal shareholder had served as the corporation's general manager and acquired pension rights against it. Pursuant to negotiations between the family shareholder group and an outside buyer, the shareholders agreed to sell their shares to the outside buyer. The principal shareholder agreed to waive his pension rights against the GmbH before the sale.
In keeping with the ruling of the en banc panel, the court held that waiver of the pension right would result in a contribution by the shareholder to the GmbH in the amount of the going concern value of the pension rights. Going concern value was to be determined under the general rules considering the creditworthiness of the GmbH. Replacement cost or the price at which the shareholder could have purchased equivalent rights from a comparable company was said to be the standard of measurement.
The court stated that, in the event the value of the pension rights was less that the book value of the corresponding pension accrual, the difference would constitute taxable income to the GmbH (see also, however, section 5 above). If the value of the pension rights exceeded that of the accrual, however, the difference would constitute expense for the GmbH and a contribution to capital for the shareholder.
The court remanded the case to the lower court because it was not clear from the record whether the shareholder had merely agreed to waive his pension rights or actually done so.
Assuming the shareholder to have carried through with the waiver, the consequences of the decision are likely to be as follows: The shareholder will derive taxable employment income in the amount of the going concern value of the waived rights. He will also be deemed to have made a contribution to capital in the same amount. This will increase his basis in his shares commensurately and reduce the capital gain on sale of these shares. The capital gain will probably be subject to a preferential tax rate under sec. 34 EStG (half of the normal rate since the sale was in 1989). The company will derive income in the amount of any excess of the book value of the liability over the going concern value. In effect, the book value of the liability will constitute income either to the corporation or to the shareholder.
13. Planning consequences
Insolvency in the sense of an excess of liabilities over assets can be remedied by any of the following actions with respect to shareholder debt:
1. Subordination of the debt to the claims of all other creditors
2. Outright waiver of the debt
3. Waiver of the debt subject to its revival on fulfilment of a condition subsequent
In light of the ruling of the en banc panel, outright waiver of debt appears to be an attractive option only when the debt claim is worth full value. Otherwise, under the prevailing view, the waiver will trigger taxable income for the corporation in the amount of the difference between the book value of the liability and the actual value of the receivable. At best, such income will be netted against other losses, which will then no longer be available for future use. From 1998 on, there will be no chance to avoid recognition of income using the special exemption of sec. 3 no. 66 EStG for debts waived to rehabilitate failing corporations. Reliance on the arguments outlined under section 5 above must be regarded as risky.
If the only objective is to satisfy the requirements of sec. 64 GmbHG (see section 11 above), a subordination agreement may be the simplest solution.
Waiver of the debt subject to its revival on fulfilment of a condition subsequent (so-called waiver with recovery agreement - Besserungsschein) may be an even better alternative, however. Here the waiver is declared subject to the condition that the debt shall be revived to the extent it can be repaid out of future profits. Such waiver is superior to mere subordination in that the liabilities are then removed from the corporation's balance sheet. While the waiver must still be regarded as triggering income to the corporation to the extent the waived claim is valueless, there is good reason to suppose that repayment of the loan upon occurrence of the condition subsequent (generation of profits) constitutes deductible expense for the corporation to the extent the initial waiver produced taxable income. The revival of the loan obligation can extend to interest as well, including interest which would have accrued in the period between waiver of the debt and its revival.
Under this structure, the deductible expense arising from repayment of the cancelled loans upon fulfilment of the condition subsequent would counterbalance the taxable income accruing to the corporation on cancellation of its bad debts.
This structure is the subject of a recent article by Hoffmann (DStR 1998, 196), who recommends it for more complicated corporate recovery plans involving outside creditors and possible takeover of a failing corporation by a new owner. Before making use of this structure, one must naturally examine its key assumptions with respect both to their validity in general and their application to a particular situation. The treatment of conditional waivers of debt claims under Germany's thin capitalisation rules is, for instance, a matter of controversy, in particular when interest is charged retroactively for the period of the waiver (see article no 116, sec.8.4).
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