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In the summer of 1998, the Federal Ministry of Finance released the text of a proposed directive on the application of the most controversial loss utilisation restrictions added to the German tax code by the 1997 "Act for the Further Reform of the Taxation of Business Enterprises" (see articles nos. 80, 99, and 130). This article discusses the proposed directive in the rapidly changing broader context of loss utilisation under German tax law, including the latest changes proposed by the new coalition government of Social Democrats and Greens (so-called "red-green coalition").
If enacted into law, the new loss utilisation restrictions announced by the red-green coalition (see below sec. 1.4 and article no. 151) will constitute the latest in a rapid succession of legislative measures designed to marginalise what was previously a central liberal feature of the German tax system. They come in addition to the cutbacks initiated by the outgoing government in the area of foreign loss utilisation (see below sec. 1.4.3) and would appear to represent the culmination of a movement towards severe loss utilisation limitations.
1. Overview of statutory provisions
1.1 Loss utilisation in general
The German income tax code defines seven categories of taxable income. The initial step in calculating income tax is to determine net income earned in each of the seven categories. The netting of positive and negative income from different sources within the same income category is referred to as "horizontal loss offset" (horizontaler Verlustausgleich). It leads to a single net figure for each of the seven income categories. These seven net figures, each of which can be positive or negative, are then added to arrive at a figure for combined net income. The netting of positive and negative income from the various income categories is known as "vertical loss offset" (vertikaler Verlustausgleich). At present, there are few limitations on horizontal and vertical loss offset (sec. 15 (4), sec. 22 nos. 2, 3 and sec. 23 (3) EStG). One of these restrictions (sec. 22 no. 3 EStG) has recently been declared unconstitutional by the Federal Constitutional Court (see sec. 2.4 below and article no. 150). The new red-green coalition intends to add a major new restriction on vertical loss offset (see below sec. 1.4.2).
Loss carryback (Verlustruecktrag) and carryforward (Verlustvortrag) constitute a third type of loss utilisation under German tax law. Collectively, these are referred to as "loss deduction" (Verlustabzug). Under the relevant provision (sec. 10d EStG), the negative combined net income of a given tax assessment period can currently be carried back up to two years, subject to a limit of DM 10 million, and forward without limit as to time or amount. Changes in the loss carryback are planned, however (see sec. 1.4.1 below). This provision applies for purposes of both the income and corporation taxes. The trade tax law likewise permits losses to be carried forward indefinitely, but does not allow loss carrybacks (sec. 10a GewStG).
Losses not carried back which have not been deducted from positive income in later years are referred to as "remaining deductible loss" (verbleibender Verlustabzug). This is essentially a loss carryforward, which is the term we sometimes employ below for ease of understanding.
Loss carryback and carryforward mitigate the strict principle of periodic taxation by taking account of losses in periods other than that in which they arose. Without such provisions, persons with the same net income over a longer span of time would pay widely differing amounts of tax depending on whether their income was evenly distributed or concentrated in a few high-income years surrounded by years of losses. Failure to take account of losses from other years would not only be inequitable, but also violate the constitutional principle of taxation commensurate with earnings, which the German Federal Constitutional Court has derived from the fundamental principle of equality before the law (Article 3 (1) of the German constitution). The decision of the Federal Constitutional Court reported on in article no. 150 affirms that loss offset and loss carryforward enjoy constitutional protection under certain circumstances.
1.2 Corporate loss utilisation
Under sec. 8 (2) KStG (in conjunction with provisions of the Commercial Code and corporate law), all income of German corporations is deemed to fall into a single income category, that of commercial business income. Domestic corporations are thus rarely affected by issues of horizontal or vertical loss offset. However, issues relating to loss carryback and carryforward are plentiful and likely to proliferate in the future.
This is a consequence of sec. 8 (4) KStG, a provision added to the corporation tax act with effect for assessment years from 1990 on (applying to tax years as early as 1988 under certain circumstances). The provision was part of the same legislation which repealed the previous five year time limit on loss carryforwards. It denies loss deduction (essentially loss carryforward) to corporate entities which are not "economically identical" to the entity which incurred the loss in question.
In 1997, sec. 8 (4) KStG was completely re-written to tighten the requirements for "economic identity". The new version of this statute is the topic of Part A of a recent proposed tax directive, which is discussed in detail under section 3 below.
Sec. 8 (4) KStG is applicable to trade tax loss carryforwards as well (sec. 10a GewStG).
1.3 Corporate mergers and loss utilisation
Under the new German reorganisation law which took effect of 1 January 1995, the loss carryforward of the disappearing corporation(s) is transferred to the receiving corporation in a merger or consolidation (sec. 12 (3) UmwStG).
Initially, transfer was subject only to the requirement that the disappearing corporation(s) not discontinue operations prior to the entry of the merger in the Commercial Register. Under the revised version of the provision, which was legislated in 1997 and applies to mergers filed with the Commercial Register from 6 August 1997 onwards, the "business or sub-business" which caused the loss must continue to operate on a comparable scale for five years after the effective date of the merger in order for the loss carryforward to pass.
This new provision is dealt with in Part B of the recent proposed tax directive, which is discussed in detail under section 4 below.
1.4 Restrictions proposed by the new government
The tax proposals introduced by the new coalition government of Social Democrats (SPD) and Greens on 10 November 1998 (see article no. 151) include several measures affecting loss utilisation.
1.4.1 Proposed loss deduction restrictions
The most far-reaching of the measures would amend sec. 10d EStG to do away with loss carrybacks entirely from the year 2001 onwards. For the years 1999 and 2000, losses can be carried back only one year subject to a reduced limit of DM 2 million. Initially, the new government also intended to enact severe restrictions on loss carryforwards analogous to those proposed by the government of Chancellor Kohl in June 1997 (see article no. 70). These plans have now been abandoned, according to the latest reports.
1.4.2 Proposed vertical loss offset restriction: "minimum taxation"
The new government also intends to limit vertical loss offset (see sec. 1.1 above). To this end, income is divided into the categories "passive" and "active". Passive losses can be set off against active income up to DM 100,000. Above this amount, passive loss offset is limited to half of the amount of the remaining active income. For example, a taxpayer with active income of DM 200,000 could offset passive losses of only DM 150,000 (DM 100,000 + half of remaining positive income = DM 50,000). Passive losses not offset can be carried forward (as normal or passive loss carryforward, depending on amount). Joint filers are treated as separate for these purposes, but benefit in that each may use the other's losses.
Unlike certain other major industrial nations, which have rules providing that passive activity losses may only be set off against passive activity gains, Germany has so far permitted individuals to offset their earned income with real estate rental losses and losses from limited partner activities of many sorts, subject only to a requirement that the losses deducted not exceed the actual amount at risk (sec. 15a EStG).
Under the new proposal, income from the rental of real property would be a prime example of passive income as would income from certain types of limited partnership interests. The definition of active income bears a relation to the types of "active" foreign loss deductible under sec. 2a EStG (see sec. 1.4.3 below).
Loss offset within a single category (horizontal loss offset) is also restricted in certain circumstances. For instance, since not all commercial business income is "active" income under the new rules, there would be restrictions on offsetting "active" commercial business income against "passive" commercial business income. This extends the impact of the new rules to corporations and partnerships which derive exclusively commercial business income.
The proposal would not create an alternative minimum tax, but is intended to ensure a certain "minimum taxation" of higher income individuals.
1.4.3 Proposed limits on use of foreign branch loss
The German treatment of foreign losses is governed by sec. 2a EStG, an income tax provision which applies to domestic corporations as well. Stated in broad terms, the provision classifies foreign losses into various types and permits them to be deducted only from positive foreign income of the same sort from the same country. Foreign loss which cannot be deducted under this rule in a given tax year is carried forward indefinitely. As an exception to the general rule, foreign losses from active foreign commercial branches (as defined) receive normal loss treatment, that is, they can be set off against domestic commercial business income and against income from the other six basic income categories; excess loss can be carried back two years and forward indefinitely (under current law). This basic scheme is set out in sec. 2a (1) and (2) EStG.
In addition to the above basic scheme, sec. 2a (3) and (4) EStG contain what is essentially a tax subsidy for German businesses operating abroad. These provisions have long been part of the German tax code. They permit German businesses with foreign branches in tax treaty countries to use the foreign branch losses in Germany even when the applicable treaty exempts the branch's business profits from German taxation. Absent the exception, branch losses would also be excluded from the German tax base. The exception only applies to active foreign commercial branches (whose losses could be offset under the basic scheme but for the treaty exclusion) and is elective. If the election is exercised, subsequent foreign branch profits are taxable in Germany to the extent of the losses previously used.
Draft legislation introduced by Chancellor Kohl's CDU/CSU government in the summer of 1998 would have imposed a five year limit on the deduction of qualifying foreign branch loss and tightened the rules for recapture of the deducted foreign branch loss upon sale or transfer of the branch or its incorporation.
Instead of enacting the CDU/CSU measure, as was originally anticipated, the draft legislation introduced by the red-green government on 10 November 1998 would abolish sec. 2a (3) and (4) EStG outright with effect for fiscal years ending from 1999 onwards.
1.4.4 Other loss-related measures in the new legislation
The new legislation also contains a provision limiting loss offset with respect to margin transactions (e.g. option contracts and commodities futures contracts - sec. 15 (5) EStG) and modifying sec. 22 (3) EStG to take account of the decision of the Federal Constitutional Court referred to in sec. 2.4 below (and in a separate article no. 150).
1.5 Other legislative restrictions
Other notable legislative developments in the area of loss utilisation include:
- the repeal of the tax exemption for recapitalisation gains (enacted in 1997)
- limits on loss usage on conversion from corporate to partnership form (enacted in 1997)
- denial of tax deduction for accruals for future losses relating to ongoing contracts (enacted in 1997)
1.5.1 Repeal of tax exemption for recapitalisation gains
Repeal of the tax exemption contained in sec. 3 no. 66 EStG for gains resulting from waiver of debt for purposes of "recapitalising" or "rehabilitating" failing businesses was part of the 1997 "Act for the Further Reform of the Taxation of Enterprises" (see articles nos. 80, 99, and 130). The provision has been repealed with effect for fiscal years ending from 1 January 1998 onwards.
To fall under the now-repealed sec. 3 no. 66 EStG, waivers of debt generally had to be made pursuant to a recovery plan and involve the participation of outside lenders. In the event of waiver by related-party lenders, the waiver had to be motivated by arm's length considerations, not by the direct or indirect ownership relationship.
While failing businesses do not invariably have large loss carryforwards, this is generally the case. Hence, the effect of the repealed exemption was often to avoid use of these loss carryforwards to cover the income generated by the waiver of debt. Instead, the loss carryforwards remained available to help in the recovery phase. Repeal of the provision indicates that, as a policy matter, it is considered better to force restructured companies to expend their loss carryforwards right away, even if this makes successful restructuring more difficult or even impossible in some instances.
Just how important the tax exemption for recapitalisation gains can be is illustrated by its repeal. This was originally intended to apply to fiscal years ending from 1997 onwards. Before the repeal could take effect, legislation was passed retarding its effective date by one year, apparently because the exemption was essential to the 1997 corporate rescue plan for Saarstahl AG, which involved debt waivers in excess of DM 1 billion. See Fueger/Rieger DStR 1998, 64.
1.5.2 Limit on loss on conversion to partnership form
The 1997 "Act for the Further Reform of the Taxation of Enterprises" also imposed loss utilisation restrictions for reorganisations of corporations into partnerships (sec. 4 (5) (6) sent. 2 UmwStG). These apply to transactions as to which the request for entry in the Commercial Register was filed after 5 August 1997 (see also sec. 4.2.6 below). Realisation of reorganisation losses is denied tax effect to the extent due to the negative value of the assets transferred. Reorganisation loss not excluded entirely by this change must be spread over a period of 15 years, instead of being immediately offsetible.
1.5.3 End of accruals for losses from ongoing contracts
Effective for fiscal years ending from 1997 on, accruals for future losses relating to ongoing contracts will no longer be accepted for tax purposes (sec. 5 (4a), 52 (6a) EStG). Accruals set up for prior fiscal years must be reversed within six years (minimum of 25 % in the fiscal year ending in 1997 and 15 % each in the succeeding five fiscal years).
2. Recent court decisions on loss utilisation
Not only the legislative trend, but also that of the case law is towards more restrictive loss utilisation:
- Ruling of an en banc panel (Grosser Senat) of the Federal Tax Court regarding waiver of shareholder debt claims (article no. 126 )
- Decision of the Federal Tax Court interpreting the 1990 version of sec. 8 (4) KStG (article no. 107)
- Recent decision by the Federal Tax Court on the application of the 1990 version of sec. 8 (4) KStG to pre-1990 losses.
Below we summarise the loss utilisation implications of the first two cases, which were dealt with at length in the prior articles cited, and report on the new Federal Tax Court decision. Brief mention is also made of a decision of the Federal Constitutional Court which voids an existing statutory restriction on personal loss utilisation and hence favours the taxpayer (sec. 2.4 below).
2.1 Waiver of shareholder debt
In its ruling of 9 June 1997 (DB 1997, 1693), an en banc panel (Grosser Senat) of the Federal Tax Court held that waiver by a shareholder of a loan to his corporation (or other debt claim against it) causes the corporation to receive a contribution to capital in the amount of the "actual" value of the claim if the waiver is motivated by the shareholder relationship. If the loan is shown at face value on the books of the corporation, as will typically be the case, a difference arises between the amount of the contribution to capital and the amount of the disappearing liability whenever the loan is worth less than its face value. Under the prevailing view, the corporation derives taxable income in the amount of this difference (see article no. 126 sec. 5 for an alternative view).
Waiver of shareholder loans (or other shareholder debt claims) is typically motivated by the need to avoid corporate insolvency (an excess of liabilities over assets at fair market valuation) and hence the necessity for declaring bankruptcy (required by law for insolvent corporations). As in the case of the repealed exemption for recapitalisation gains, the corporation will frequently have loss carryforwards in such situations. The effect of the court decision will thus often be to cause these loss carryforwards to be used up as a result of the cancellation of debt which restores the corporation to solvency. However, since there is no guarantee of a perfect match between waiver and loss carryforward, positive income could easily result as well.
The simplest means by which a 100 % shareholder could avoid this result would of course be to first contribute new equity to the corporation and then cause the corporation to repay the debt using the new funds. Depending on the facts in a specific instance, such structures may well fail under Germany's general abuse of law provision (sec. 42 AO), however. There may also be non-tax problems, as the funds would be exposed to the reach of general creditors and the debt repayment potentially subject to avoidance under bankruptcy law. Our above-cited article discusses a more complicated avoidance structure not requiring the injection of new funds (article no. 126 sec. 13).
2.2 Loss carryforward decision under 1990 statute
We reported in article no. 107 on the first high court decision (BFH DStR 1997, 1843 - 13 August 1997) interpreting the loss utilisation restrictions introduced by the 1990 Tax Reform Act (the now superseded version of sec. 8 (4) KStG). The court upheld the tax authorities in their refusal to permit the new owners of a GmbH to use the losses accumulated in prior years.
The decision must be regarded as a major victory for the tax authorities in at least two respects:
- The court held that the situation specifically referred to in the statute is not the only one to which it can apply. Instead, the statute applies to all circumstances which are "economically comparable" to the situation specifically mentioned. The court accordingly showed willingness to apply the loss utilisation restrictions to structures designed to evade the statute.
- The court held that the determination whether a corporation has recommenced its business using "primarily new business property" is to be made with respect to the asset side of the balance sheet only. It thus makes no difference whether corporate equity has increased. Assets purchased with newly borrowed funds can therefore apparently constitute "new business property" within the meaning of the statute. Furthermore, new assets purchased without new borrowings, much less new capital infusion, would also appear to constitute "new business property". This aspect of the decision is discussed further in sec. 3.2.3 below.
The proper interpretation of the decision is still controversial, however (see sec. 3.2.3 below).
2.3 Application of 1990 statute to "old" losses
In a more recent decision (DStR 1998, 1087 - 11 February 1998), the Federal Tax Court has also confirmed the tax authorities' interpretation as to the effective date of the 1990 loss carryforward restrictions, holding that the assessment period (calendar year) in which losses accrued is irrelevant to the operation of the new restrictions, which apply generally to assessment periods from 1990 on (and to assessment periods as early as 1988 if the transaction leading to the loss of economic identity was entered into after 23 June 1988).
In the case decided, the transaction leading to the loss of economic identity (more than 75 % change in ownership) took place in 1987, hence the new restrictions applied starting with the 1990 assessment year. The taxpayer corporation sought to deduct loss carried forward from 1983 on its 1990 return. The deduction was denied on the grounds that the new restrictions applied irrespective of the year in which the loss in question arose. The Federal Tax Court upheld the lower court and the tax authorities in refusing the deduction, rejecting in particular the taxpayer's objections that application of the statute to losses which accrued prior to its effective date would violate the constitutional prohibition on retroactive tax legislation. See also the report in article no. 149.
2.4 Constitutional Court decision on loss utilisation
The Federal Constitutional Court has held that sec. 23 (3) no. 3 EStG unconstitutionally restricts the utilisation of losses from the rental of movable property (DStR 1998, 1743 - 23 October 1998). Income of the sort affected is of relatively minor importance because the statute refers only to rental of movable property which does not involve commercial business activity. Nevertheless, the grounds of the decision may be far-reaching. See the article no. 150 for more detail.
3. Draft directive: sec. 8 (4) KStG
Sec. 8 (4) KStG is a provision in the corporation tax act which applies for trade tax purposes as well. The changes made in this provision by legislation passed in 1997 are the principal topic of a proposed directive dated 7 July 1998 which the Federal Ministry of Finance circulated for comment in the summer of 1998. Below we first provide the old and new statutory text in translation and then discuss selected aspects of the proposed directive.
3.1 Old and new text of sec. 8 (4) KStG
The following is our translation of the old and new wording of the statute:
Old version (1990)
(*1) Loss deduction under sec. 10d of the Income Tax Act on the part of a corporate entity is contingent upon its being not just legally, but also economically identical to the corporate entity which suffered the loss.
(*2) Economic identity is not present in particular when more than three fourths of the shares in a corporation are transferred and the corporation thereafter recommences its business (Geschaeftsbetrieb) with predominantly new business property (Betriebsvermoegen).
(*3) The same shall apply mutatis mutandis with respect to the offsetting of loss [incurred] from the beginning of the fiscal year to the time of share transfer.
Amended version (1997)
(*1) Loss deduction under sec. 10d of the Income Tax Act on the part of a corporate entity is contingent upon its being not just legally, but also economically identical to the corporate entity which suffered the loss.
(*2) Economic identity is not present in particular when more than half of the shares in a corporation are transferred and the corporation continues or recommences its business (Geschaeftsbetrieb) with predominantly new business property (Betriebsvermoegen).
(*3) The provision (Zufuehrung) of new business property is not damaging if the sole purpose served thereby is the rehabilitation (Sanierung) of the business which caused the remaining deductible loss within the meaning of sec. 10d (3) sentence 2 of the Income Tax Act and the corporate entity continues to operate the business on a comparable scale, in light of the overall economic circumstances, during the following five years.
(*4) The same shall apply mutatis mutandis with respect to the offsetting of loss [incurred] from the beginning of the fiscal year to the time of share transfer.
3.2 Highlights of the proposed directive
The following refers to the new version of the statute unless otherwise noted. Item references are to the proposed directive.
3.2.1 Transfer of more than half of the shares in a corporation (item A.1.b)
Transfer of more than half of the shares in a corporation is the first of two elements which, if both present, cause a corporation to lose its economic identity and forfeit its loss carryforwards under sentence 2 of the statute. The draft directive provides that the 50 % threshold generally refers to the corporation's stated capital. Whether the transfer is for consideration or not is irrelevant, except that transfers of shares by way of inheritance (including the partition of the decedent's estate) are exempted from the operation of the statute. Instances of so-called "anticipated inheritance" (a term of art referring to certain inter vivos transfers to relatives) are regarded as subject to the statute.
The draft provides that it makes no difference whether the persons acquiring the shares already hold shares in the corporation or not and that the number of persons acquiring shares and the number of transfers involved are irrelevant as well. All that matters, the draft directive states, is whether more than half of the shares change hands. While the proposed directive does recognise that individual share transfers can only be added together if they occur in the same "overall context" (Gesamtzusammenhang), it provides that the required interrelationship is to be presumed when more than half of the shares change hands within a five year period.
Koerner (DStR 1998, 1495, 1496, 1497) sees no statutory basis for this provision. The question of the necessary overall context must be addressed on a case to case basis. Otherwise, simple addition of share transfers would lead to application of sec. 8 (4) KStG when a 20 % minority stake in a corporation changes hands three times within five years (Koerner's Example no. 1). Reorganisations are also conceivable in which the damaging 50 % threshold is briefly exceeded in connection with a series of steps, the end result of which does not involve a 50+ % change in ownership (Koerner's Example no. 2). Koerner therefore suggests that the determination whether the required change in ownership has occurred be made with respect to the end result of a restructuring plan without taking account of interim phases.
Under the draft directive, the loss carryforward can also be forfeited by virtue of transfer of indirect interests in the loss corporation.
Koerner argues that transfer of indirect interests is not covered at all by the second sentence of sec. 8 (4) KStG and can at most be considered as an equivalent situation under the first sentence (see sec. 3.2.5 below), however only in exceptional circumstances (DStR 1998, 1495, 1497/1).
3.2.2 Events constituting transfer of more than 50 % share (item A.1.b)
In addition to outright conveyances, the following events are considered to constitute transfer of more than half of the shares in a corporation under the draft directive:
- A capital increase in which new shareholders subscribe all or part of the new shares and afterwards hold more than half of the corporation's capital.
- Merger into the loss corporation by which persons who were not previously shareholders acquire more than 50 % of the shares in the loss corporation.
- Contribution of a branch of activity or an interest in a commercial partnership to a loss corporation by which the new shareholders take more than 50 % of the shares.
If existing shareholders increase their percentage shareholdings as a result of the above events, the draft directive states that statutory element "transfer of more than half of the shares" is fulfilled if the overall shift in ownership to new and existing shareholders exceeds 50 %.
3.2.3 Provision of predominantly new business property (item A.1.c)
Provision (Zufuehrung) of predominantly new business property is the second required element for loss of economic identity and forfeiture of loss carryforwards. As a general rule, "new business property" is interpreted by the draft directive as "new business property provided from outside of the corporation" (emphasis added) through loans or new equity capital, focusing on the asset side of the balance sheet. New business property can also be provided by merger of another company into the loss corporation. New business property predominates, the draft directive states, if the going concern value of new assets exceeds that of the assets which were present before commencement of provision new business property.
Koerner argues that comparison with the assets present at the time of the change in ownership (cf. sec. 3.2.1) would be more appropriate (DStR 1998, 1495, 1499/1).
In making the comparison, the draft directive states that no account may be taken of intangible assets not capitalised for tax purposes. Furthermore, it refuses to permit business property provided to be netted against distributions. Both rules are highly disadvantageous for taxpayers and unwarranted by the language of the statute, as Koerner rightly points out (DStR 1998, 1495, 1498/2, 1499/1).
In the event a corporation changes its line of business (Branchenwechsel), the proposed directive states that predominantly new business property has been provided if the majority of the assets used in the new line of business were not present before cessation of the prior line of business. For corporations which change their line of business, the draft directive thus seeks to make an exception to the general rule that new business property must come from outside of the corporation.
If the business property includes interests in partnerships, the draft directive provides that the assets of the partnership are to be included in the comparison, presumably pro rata. A similar rule applies to the dominant company in a tax consolidated group with respect to shares held in the group members. Koerner is critical of this interpretation (DStR 1998, 1495, 1499).
Koerner (op. cit. p. 1498) and Hoerger/Endres (DB 1998, 335, 336) both argue, contrary to the draft directive and the apparent holding of the Federal Tax Court in its only decision to date on point (see sec. 2.2 above), that the concept "provision of new business property" requires that the new property come from outside the corporation in all cases and that new property purchased with borrowed funds is not damaging unless the loan is shareholder-related (made or guaranteed by the shareholder).
The proposed directive recognises that a relationship must exist between the new business property provided and the 50+ % share transfer. It states that account is therefore to be taken only of business property provided within five years of the share transfer.
Koerner objects to this provision on two grounds. Firstly, he argues that the statute only applies to new business property provided due to the influence of the shareholders who acquired 50+ % of the corporation's shares. Whether such a relationship exists should be decided on a case to case basis. Proximity in time may suggest such a relationship, but does not establish it conclusively.
Secondly, Koerner states that a five year period is too long even to use as a time frame for further investigation. A two year investigation period would be more appropriate in his view, as this accords with the maximum time span for planning of this type as an economic matter. See also Hemmelrath DStR 1998, 1033, 1036.
3.2.4 Corporate rehabilitation exception (item A.1.d)
The proposed directive contains a lengthy section on the exception created by the statute for new business property provided solely for the purpose of corporate "rehabilitation" (Sanierung).
In the terms of the proposed directive, business property is provided solely for purposes of rehabilitating the corporation if the corporation is in need of being "rehabilitated", that is, restored to economic viability, and the assets provided to this end do not materially exceed what is necessary "for the continued existence of the enterprise". An example given in this connection involves contributions of stakes in highly profitable companies to a loss corporation so as to use up its loss carryforwards in short order. Since, in the example, such contributions are excessive and not needed to restore the corporation to viability, they lead to complete forfeiture of the loss carryforward.
The new assets must also be used to rehabilitate the business (Geschaeftsbetrieb) which caused the loss. While this wording may appear to suggest that a corporation can have several "businesses" and require identification of the one which caused the loss, the draft directive states elsewhere that each corporation has "a [single] uniform business" (item A.1.c).
In the terms of the draft directive, the business which caused the loss is generally the original business on the scale in which it existed at the initial phase of the loss process. A material reduction in size compared with this point in time prevents a corporation from qualifying for the exception. The draft directive mentions sales, order volume, gross assets, and the number of employees as possible criteria for evaluation. Once a business has been discontinued, it can no longer qualify for the exception. A change in line of business (Branchenwechsel), the draft directive implies, constitutes discontinuation of business unless it is accomplished without material change in the human and material resources employed. Koerner is critical of this interpretation (DStR 1998, 1495, 1498/1, 1500 ff.).
Continued operation of the business on a comparable scale during a five year period is a further condition of the corporate rehabilitation exception. According to the draft directive, the five year period begins when more than half of the shares have changed hands and predominantly new business property has been provided. Such a rule can considerably delay the commencement of the five year period and is controversial. Koerner believes that the period should instead run from the time of the change in ownership (DStR 1998, 1495, 1501, 1502).
The directive provides that any transfer of the business in whole or in part during the five year period other than by universal succession results in retroactive forfeiture of the loss carryforward.
The draft directive assigns the burden of proof to the taxpayer corporation seeking to come under the corporate rehabilitation exception. In the case of transfers of 50+ % of the shares prior to 6 August 1997, the tax authorities are, however, prepared to themselves assume the burden of proof as to continuation of the business on a comparable scale. If they contest this issue and carry the burden of proof, the exception would be denied. The taxpayer would apparently still bear the burden on the issue of provision of new business property solely for purposes of corporate rehabilitation.
3.2.5 Application in economically equivalent circumstances (item A.1.e)
The proposed directive states that sec. 8 (4) applies not just to cases covered by its second sentence, but also, by virtue of the general clause contained in its first sentence, as interpreted in the Federal Tax Court decision of 13 August 1997 (see above sec. 2.2), to all cases which are "economically equivalent" to that set forth by way of example in sentence 2. Koerner is critical of this reading of the decision of the Federal Tax Court (DStR 1998, 1495, 1500). In his view, the specific elements of sentence 2 of the statute must always be fulfilled by economically equivalent circumstances. Vague reference to "economically equivalent cases" is too broad.
In addition to the situation specifically dealt with by the Federal Tax Court (acquisition by a purchaser of a smaller shareholding of a legal position which is "economically similar" to that conferred by transfer of 50+ % of the shares in a corporation), the draft directive cites (without limitation) two other circumstances in which the general clause may apply.
- "In exceptional cases", acquisition of more than 50 % of voting rights without a corresponding acquisition of share capital (as the economic equivalent of acquisition of 50+ % of the shares);
- "In individual cases", provision of new business property in whole or part prior to the transfer of shares (as the economic equivalent of such provision subsequent to the 50+ % change in ownership).
3.2.6 Extent of forfeiture of loss utilisation
The proposed directive states that the losses which accrue prior to the 50+ % share transfer may not be netted against profits earned subsequent to the transfer, whether in the same assessment period (sec. 8 (4) sentence 4) or in subsequent years. Losses arising after the transfer, whether prior or subsequent to the provision of new business property, are available for use without restriction, however.
3.2.7 Effective date: 1997 or 1998?
Sec. 54 (6) KStG governs the entry into force of the new version of sec. 8 (4) KStG and reads as follows:
Sec. 8 (4) first applies to the 1997 assessment period. If the loss of economic identity first occurred in the year 1997 prior to August 6th, sec. 8 (4) first applies to the 1998 assessment period.
The proposed directive interprets this provision so as to distinguish between three time periods:
Time of loss of economic identity Application of new sec. 8 (4) KStG i. Prior to 1997 From 1997 on ii. In 1997 through 5 August 1997 From 1998 on iii. After 5 August 1997 From 1997 on
This differs from our reading of the statute in article no. 107, where we distinguished between only two time periods, i.e. the period prior to 6 August 1997 (the date on which plans to change the loss utilisation rules first became public) and the period subsequent to this date. The original version of the clause on entry into force in the law enacted on 29 October 1997 did not contain the second sentence, which was added by subsequent amendment on 19 December 1997. The apparent purpose was to give at least some protection to transactions planned under the old law. Why this protection, in the form of delayed entry into force of the new law, should be extended to 1997 transactions undertaken in ignorance of the impending change in the law but denied to transactions in prior years, when the ignorance was all the more complete, is unfathomable.
Fueger/Rieger focus on this problem in an article published in early 1998 (DStR 1998, 64). If there is reason to protect taxpayer reliance on the continued validity of the prior loss utilisation restrictions in the period from 1st January to 5th August 1997, then, a fortiori, they rightly argue, there is reason to protect those who so relied in the period prior to 1997. However, they regard the language of the statute as incompatible with this reading. They discuss the literal reading of the statute now adopted by the tax authorities, but reject it as well because it leads to a nonsensical discrimination in favour of losses of economic identity during the first seven months of 1997 against such losses in 1996 and prior years.
Since the literal reading makes no sense, and the sensible reading initially suggesting itself is irreconcilable with the plain language of the statute, Fueger/Rieger advocate a third solution. They would read the first sentence of the statute in light of the second and construe it to mean that the new loss utilisation rules never apply to losses of economic identity which take place prior to 1997. While such a reading would constitute a departure from prior practice (cf. sec. 2.3 above), Fueger/Rieger see it as the only arrangement the legislature could logically have intended.
However, Fueger/Rieger overlook an alternative argument in support of our basic understanding of the statute in article no. 107. As a legal matter, it is improper to assume that a loss of economic identity under the new rules can occur prior to the entry into force of these rules. While the events leading to the loss of economic identity may have transpired prior to this entry into force, the loss of economic identity itself cannot be retroactively projected into the past. Under this view, no loss of economic identity under the new rules can occur prior to 1997, although the events resulting in such loss of economic identity may occur earlier. Hence, the loss of economic identity as a result of events occurring in a fiscal year ending prior to 1997 occurs when the new statute takes effect on 1 January 1997, or would occur then if it were not for sentence 2 of the statute, which delays the effective date of the new rules until the 1998 assessment period.
3.2.8 Application of new rules to "old" losses
Separate from the above issue is whether the new version of sec. 8 (4) KStG applies to losses which accrued prior to 1997 or 1998, as the case may be. The clear position of the proposed directive is that such losses fall under the new rules to the extent not used prior to their entry into force. This position receives support from the new Federal Tax Court decision, reported on under sec. 2.3 above, regarding the application of the old version of sec. 8 (4) KStG to pre-1990 losses. While there are voices to the contrary in the literature, it must at present be regarded as the majority view.
While Fueger/Rieger (see preceding subsection) do not distinguish, formally speaking, between "old" and "new" losses, under their view losses accruing prior to the events causing the loss of economic identity would not fall under the new rules, which is close to the same thing.
3.3 Implications and analysis: sec. 8 (4) KStG
Certain comments on the implications of the positions taken by the draft directive are contained in the sections dealing with its main provisions (sec. 3.2.1 - 3.2 8 above). Below we comment selectively on certain additional aspects.
3.3.1 Crucial role of the "rehabilitation" exception
The 1990 version of sec. 8 (4) KStG only applied to loss corporations which had discontinued business operations, because only inactive corporations could "recommence" business using predominantly new business property. The new version, however, applies to fully functional corporations as well (loss corporations which "recommence or continue" their business using predominantly new business property) unless the new business property is used solely to rehabilitate the business (see above sec. 3.2.4). To come under this "rehabilitation exception", a corporation must be in need of "rehabilitation", i.e. restoration to economic viability.
However, situations are imaginable in which a corporation has large loss carryforwards but is not on the verge of economic ruin. Indeed, the corporation may have exceedingly good long range prospects. If such a corporation seeks additional capital and this leads to a 50+% change in ownership, its loss carryforwards would apparently fall victim to the new rules, because the "rehabilitation" exception will not be available. In positing such a situation, Hemmelrath (DStR 1998, 1033, 1034/1) suggests the legislature has considerably overshot the mark with its new version of sec. 8 (4) KStG and created a statute which will prevent sound business decisions which are not in the least abusive.
The only way to counteract this tendency would be to permit a broad interpretation of the concept of corporate rehabilitation (Sanierung) in sec. 8 (4) KStG. However, the draft directive moves in the other direction and tends to apply the stringent criteria developed under the now repealed sec. 3 no. 66 EStG recapitalisation gain provision (see above sec. 1.5.1) to the new context.
Both Koerner and Hemmelrath criticise the draft directive in this respect (DStR 1998, 1033 and 1495).
3.3.2 Continuation of the business which caused the loss
This is a primary requirement in order to come under the rehabilitation exception. Since the word "business" (Geschaeftsbetrieb) refers to the corporation's overall business activities, it is not necessary to differentiate among several "businesses" which the corporation may have operated and make sure that the "loss business" is continued. Instead, the draft directive defines "the business which caused the loss" in terms of the objective dimensions of economic activity at the outset of the loss phase (see sec. 3.2.4 above).
Furthermore, the draft directive states that a discontinued business can no longer be rehabilitated and seeks to treat change of line of business as an instance of discontinuation. This seems to run counter to the concept of "business" as unitary and uniform. Furthermore, the draft directive proposes to focus on the original business at the outset of the loss phase, to be measured by criteria such as (gross) assets, sales, order volume, and "perhaps" work force.
As Koerner points out (DStR 1998, 1495, 1501), this interpretation makes no economic sense because downsizing may well be necessary as an economic matter to rehabilitate a failing company. Koerner therefore suggests measuring the dimensions of the business to be continued in terms of its scope at the time of the change in ownership, not at the outset of the loss phase. Conversely, upsizing my also be warranted, economically speaking. However, this could well be incompatible with the position of the draft directive that the new business property provided not exceed that which is "necessary" for corporate recovery.
4. Draft directive: sec. 12 (3) sentence 2 UmwStG
Sec. 12 (3) sentence 2 UmwStG is a provision in the tax reorganisation act. The changes made in this provision by legislation passed in 1997 are the second topic of the proposed directive dated 7 July 1998. Below we first provide the old and new statutory text in translation and discuss selected key aspects of the proposed directive.
4.1 Old and new text of sec. 12 (3) sentence 2 UmwStG
Old version (1995)
(*1) [Sentence 1 provides that, upon merger of two corporations, the receiving corporation assumes certain tax attributes of the disappearing corporation.]
(*2) This applies as well for any remaining deductible loss within the meaning of sec. 10d (3) sentence 2 of the Income Tax Act, provided the disappearing corporation has not yet discontinued its business (Geschaeftsbetrieb) at the time of entry of the transfer of property in the Commercial Register.
Amended version (1997)
(*1) [Sentence 1 provides that, upon merger of two corporations, the receiving corporation assumes certain tax attributes of the disappearing corporation.]
(*2) This applies as well for any remaining deductible loss within the meaning of sec. 10d (3) sentence 2 of the Income Tax Act, provided the business (Betrieb) or sub-business (Betriebsteil) which caused the loss continues to operate on a comparable scale, in light of the overall economic circumstances, during the five years following the effective date of the merger.
4.2 Highlights of the proposed directive
4.2.1 Business or sub-business
The conceptual pair "business or sub-business" (Betrieb oder Betriebsteil) is new in German tax law.
The draft directive (item B.1.a) provides that "business" = Betrieb and "business" = Geschaeftsbetrieb both comprise an enterprise's entire economic activity. Hence the translation of different terms with the same English word appears justified.
A "sub-business" (Betriebsteil) is defined by the draft directive as a separately identifiable ("delimitable") economic activity within an overall business to which certain human and material resources can be attributed. The examples given are a product line or, in the case of a holding company, each individual shareholding. A "sub-business" need not meet the more stringent requirements for a branch of activity (Teilbetrieb) under sec. 139 (3) EStR (Income Tax Guidelines).
Koerner criticises the failure of the draft directive to establish a lower limit for "sub-businesses" and warns against an "atomisation" of the enterprise into a myriad of sub-businesses. He also notes that the "sub-business" is not an economic unit for which the taxpayer can be expected to provide separate cost accounting, hence that reasonable estimates must be permissible in deciding which sub-business caused a loss and what its economic scope was (DStR 1998, 1495,1502).
4.2.2 Continued operation of the business or sub-business
The receiving corporation only assumes the remaining deductible loss (loss carryforward) of the disappearing corporation if the business or sub-business which caused the loss continues to operate on a comparable scale in the following five years. The proposed directive provides that the required scale of continued operation shall be determined by the dimensions of the business or sub-business at the outset of the loss phase. If the business or sub-business has been substantially downsized as of the effective date of the merger compared with its scope at the outset of the loss phase, this precludes passage of the loss carryforward under the terms of the draft directive. Sale of production facilities to third parties is given as an example for impermissible downsizing. Expansion of the business or sub-business beyond its original scope is not damaging, however.
The following criteria are suggested without limitation for use as benchmarks by which to judge the operational scale of a business or sub-business: assets, sales, order volume, and perhaps the number of employees.
These criteria match those proposed for evaluating the continued operation of a business under the "rehabilitation" exception to sec. 8 (4) KStG (see sec. 3.2.4 above). However, an important difference exists in that the analysis under sec. 12 (3) sent. 2 UmwStG differentiates between sub-businesses (Betriebsteile), whereas that under sec. 8 (4) KStG is based on the business (Geschaeftsbetrieb) as a whole. This may make it significantly easier to qualify for the rehabilitation exception under sec. 8 (4) KStG than to transfer a loss under sec. 12 (3) sent. 2 UmwStG. This in turn suggests that it may be wiser to merge a profitable corporation into a loss corporation, thus avoiding sec. 12 (3) sent. 2 UmwStG entirely, than the other way around.
If the disappearing corporation holds interests in commercial partnerships, the draft directive states that an assessment of the scale of operations of its business or sub-business is to be based on the business or sub-business of the underlying partnership. The same applies if the disappearing corporation is the lead company in a tax consolidated group (Organtraegerin) with respect to the companies consolidated under it (Organgesellschaften).
4.2.3 Five year continuation period
The five year period begins, according to the draft directive, on the effective date of the merger for tax purposes (item B.1.b). This is in accordance with the statute.
4.2.4 Transfer of part of the loss business or sub-business
The proposed directive requires continued operation of the loss business or sub-business by the receiving corporation. Any sale or conveyance of the loss business or sub-business in whole or in part would result in retroactive forfeiture of the disappearing corporation's loss carryforward. Transfer pursuant to universal succession (for instance, another merger) is not damaging, provided the successor in interest continues to operate the business or sub-business.
4.2.5 Divisive reorganisations
For divisive reorganisations (spin-off, split-off, split-up), the proposed directive provides that the remaining deductible loss (loss carryforward) of the disappearing corporation can pass to the receiving corporations, subject to sec. 15 (4) UmwStG, provided the corporation which receives the loss business or sub-business continues to operate it on the required scale for the required five year period. Under sec. 15 (4) UmwStG, the loss carryforward of a corporation undergoing a divisive reorganisation does not necessarily "travel" with the part of the business which caused the loss. Instead, sec. 15 (4) UmwStG provides for distribution of the loss carryforward according to the pro rata share of net assets taken in the reorganisation.
To use the example given in the proposed directive, assume that the loss corporation X-GmbH is split up into SB 1 GmbH, SB 2 GmbH, and SB 3 GmbH, whereby each of the three new corporations takes one of the three sub-businesses (SB) of X-GmbH. Further assume that the three new corporations take 1/10th, 3/10ths, and 6/10ths of the net assets of X-GmbH respectively, but that all of the losses stem from SB 1, which is taken by SB 1 GmbH. The loss carryforward of X-GmbH is assumed by the three successor corporations in proportion to net assets taken, i.e. 1/10th, 3/10ths, and 6/10ths. Provided SB 1 GmbH, which receives only 1/10 of the loss carryforward, continues to operate the loss business on the required scale for a period of five years, all three successor corporations may deduct the share of loss carryforward assigned to them as a result of the split-off.
Should SB 1 GmbH fail to do this, all three would forfeit their share of the loss.
4.2.6 Entry into force
Under sec. 27 (3) UmwStG, the new statute applies to reorganisations for which application for entry in the Commercial Register is made after 5 August 1997. The proposed directive states that the date of receipt of the application by the Commercial Register is controlling.
While this provision may seem straightforward, Fueger/Rieger point out (DStR 1998, 64, 66 ff.) that the matter is more complicated than it appears. The draft directive addresses only one of the questions they pose, namely whether application to the Commercial Register is made when the application is certified by a notary or actually submitted to the Commercial Register. Fueger/Rieger conclude that the date of notarisation is controlling.
For mergers and divisive reorganisation, several applications to the Commercial Register are required on the part of the various corporations involved. Fueger/Rieger conclude that all such applications must be made by 5 August 1997 to come under the old law, although an argument can be made that the application leading to the entry which is determinative for the consummation of the reorganisation should control. Lastly, the authors discuss the problem of an application which is not a sufficient basis for action by the Commercial Register because certain adjunct documents are still missing.
4.2.7 Relationship of sec. 12 (3) sent. 2 UmwStG to sec. 8 (4) KStG
The proposed directive states that the two provisions are cumulatively applicable. The provision in the tax reorganisation act determines whether the loss carryforward of a disappearing corporation can be assumed by the receiving corporation. Even if the answer to this question is affirmative, one must still determine under the corporation tax provision whether the receiving corporation is permitted to deduct the loss carryforward which it has assumed.
The example is given of merger of two corporations which both have loss carryforwards, by which the shareholders of the disappearing corporation acquire 50+ % of the shares in the receiving corporation and thus fulfil the first element of sec. 8 (4) KStG (50+ % change in ownership) with respect to the receiving corporation. If the other element (provision of predominantly new business property) is also fulfilled, the receiving corporation is prevented from using its own loss carryforward as a result of the merger (unless the rehabilitation exception applies). Assuming at the same time that the requirements of sec. 12 (3) sent. 2 UmwStG are not met, the loss carryforward of the disappearing corporation would not pass to the receiving corporation, and the merger would thus have in effect destroyed the loss carryforwards of both corporations.
Furthermore, a loss carryforward which passes to the receiving corporation under the new version of sec. 12 (3) sent. 2 UmwStG need not invariably be deductible under the rehabilitation exception to sec. 8 (4) KStG. Under the proposed directive, the overall business (Geschaeftsbetrieb) must be "in need of rehabilitation" (sanierungsbeduerftig) to qualify for this exception and the business property provided must serve only this purpose. These requirements are not present in the narrower, "sub-business" oriented provision of sec. 12 (3) sent. 2 UmwStG. Losses which passed under the old version of sec. 12 (3) sent. 2 UmwStG but have not yet been used by the effective date of the new version of sec. 8 (4) KStG may also be barred from deduction by the new corporation tax provision, as the draft directive points out.
5. Concluding remarks
While loss utilisation has not yet vanished entirely from the German tax code, the basic conditions have changed dramatically in the span of a few months and appear likely to worsen if the new government lives up to its promises.
However, as the summary and analysis of the recent proposed directive on two of the central new loss utilisation restrictions has hopefully made clear, the exact extent of the setback dealt by the new legislation is uncertain because of numerous issues it leaves open. Despite the recent court victories of the tax authorities on loss utilisation issues, there is still reason to suppose that the courts will ensure a sensible interpretation of the new laws in the event the tax authorities fail to do so.
For further information, please send a fax stating your inquiry to KPMG Frankfurt, attn. Christian Looks +49-(0)69-9587-2262 or enter text search "KPMG Germany" and "Mondaq".
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