In the opinion of many M&A experts, transaction activities in 2012 should be stimulated by spin-offs and carve-outs. However, the Federal Ministry of Finance [Bundesfinanzministerium, BMF] has now issued a decree which is calling the tax-neutral transformation of business units into question more than ever. This will hinder divisions, if not even prevent them entirely.
Divisions as an alternative to asset deals
The separation of a business unit can be conducted in the form of an asset deal by selling the assets of such business unit. The disadvantage of such an individual sale, however, is that essential contractual relationships do not transfer automatically, with the result that lengthy renegotiations are required with individual customers and suppliers. The law on mergers and reorganisations offers divisions ["Spaltung"] as an alternative. Here, a business unit is transferred to a company which already exists or is to be set up. Because the law stipulates partial universal succession in this case, all customer relations automatically transfer with the business unit.
A division is also a possibility in cases where enterprises wish to take on a co-investor for a specific business unit or wish to establish a joint venture: By means of a division, the business unit can be given its own legal form in which the co-investor or joint venture partner can participate. This restructuring possibility was still promoted by the legislator in 2007 through deliberate measures taken in the German Company Mergers and Reorganisations Act [Umwandlungsgesetz, UmwG].
Fundamental tax benefit endangered
In principle, divisions are also more favourable from the tax perspective. Under certain circumstances a division can be executed at book values and therewith ultimately in a tax-neutral manner. In this way, particularly in case of distressed business units, the expensive disclosure of hidden reserves is avoided. The prerequisites for a tax-neutral division are regulated in the German Company Mergers and Reorganisations Tax Act [Umwandlungssteuergesetz, UmwStG]. Since its fundamental reform in 2006, numerous clarification questions have arisen in this connection. The fiscal administration subsequently announced a clarifying decree for 2007. Not only did it take four years before it appeared, namely at the end of 2011, but it also disappointed all hopes of assistance in the implementation of reorganisations.
A substantial prerequisite for tax-neutral divisions is the existence of so-called business units, essentially independent corporate units capable of surviving under their own steam. It is often necessary to first establish this independence. In its decree, the fiscal administration is now demanding that the independent character of the business unit already existed on the effective date of the end of the last business year prior to the division. This makes it more complex and time-consuming to create the required independence in the run-up to the division.
If the business unit was not sufficiently independent at the beginning of the business year, one possibility is to draw up an interim balance sheet after establishing the independence and to then implement the division as per the effective date of the interim balance sheet. However, since the interim balance sheet must fulfil the requirements of an orderly financial statement, that is to say may also need to be audited by a public accountant, this entails further costs. On the other hand, an additional delay, which is generally very expensive, can also be avoided in this manner.
Commodities are fundamentally allocable to the business unit they functionally serve. Commodities which do not functionally serve any of the individual business units – such as financial assets unrelated to the actual business – were freely allocable as so-called neutral assets, likewise liabilities and reserves. This free allocation is no longer permitted by the mergers and reorganisations tax decree. Neutral assets are to be allocated pursuant to their economic context, liabilities according to their economic objective. A legal basis herefor is not evident and this creates considerable practical problems. On the one hand it will be difficult to allocate the creation of assets partially acquired some time ago to individual business units in one enterprise. On the other hand, the strict allocation of passive assets will particularly cause problems. It has thus far been possible to ensure via the free allocation of the passive assets that a distressed business unit can also be transferred without it directly being overindebted. Since the liabilities now also have to be transferred in order to secure the tax neutrality, in such cases there is a need to transfer negative assets. However, pursuant to company law such transfer may not be made to establish a new company. A transfer to an existing company is also difficult, since this negatively affects the assets of the receiving company. Depending on the value ratios, this could destroy the economical basis of the company, which in turn also hinders the spin-off of the business unit which is not distressed.
Penetration of the fiction of a business unit
According to the German Company Mergers and Reorganisations Tax Act, entrepreneurial partnership interests, that is to say participations in commercially operative partnerships, and 100% participations in corporations are considered to be business units. The fiscal administration now wants this only to apply to the extent the participations are not functionally allocable to a different business unit. An entrepreneurial partnership interest or the participation in a corporation are therefore to be left with the business unit with which it exchanges services. In corporate groups, however, an exchange of services regularly takes place between a multitude of group companies. Hence, the allocation of a participation to just one business unit can often be ruled out. In such cases, a so-called division impediment arises, since the participation in itself is indivisible and cannot remain with several business units. A tax-neutral division is not possible at all in such case, unless the service relations can be confined to one business unit.
Hence, despite the fact that divisions are a proven means of separating business units from an enterprise, the tax neutrality will be endangered more than ever after the mergers and reorganisations tax decree. Before implementing a division, the sufficient separation of the business units must be checked and, if need be, a sufficient autonomisation procured before the end of the business year.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.