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Germany has introduced a new legislation dealing with the tax exemption of recapitalisation gains. However, it is not yet applicable and the question is how taxpayers shall behave in these times of uncertainty.
In accordance with the case law of the Federal Tax Court (Bundesfinanzhof), waiving a claim against a company generally results in taxable income for that company, even if the claim has been waived with a view of restructuring the company. The financially distressed company is thus additionally encumbered with a tax debt which may finally render the company insolvent unless there are sufficient loss carry-forwards. This may only be different in case a shareholder of a corporate entity waives its claim against the company, at least to the extent that the claim is recoverable as this constitutes a hidden contribution which must not increase the income. The hidden contribution is to be assessed at current value.
After a statutory regulation to exempt recapitalisation gains from tax was suspended in 1997, the Federal Ministry of Finance (Bundesfinanzministerium) published its recapitalisation order in 2003. This provided for a remission on grounds of equity under certain conditions. In its ruling of 28 November 2016 the Grand Senate of the Federal Tax Court declared the recapitalisation order unlawful as it was up to the legislator alone to order a general waiver of tax claims. The tax authorities then held that the tax payer could still rely on the old order if the claim was waived prior to 08 February 2017 (the date of the court ruling). However, the Federal Tax Court again rejected this ruling of as there was no legal basis for it. The Federal Ministry of Finance now declared that this judgement does not apply to open cases by a non-applicability order dated 29 March 2018.
In the meantime, the legislator also reacted to the repeal of the recapitalisation order and among other things added section 3a to the Income Tax Act. Under this section business gains are in principle tax-exempt if they are the result of a waiver for the purpose of a company-related recapitalisation. Business expenditures which have a direct economic link with tax-free recapitalisation income may not be deducted but will reduce the recapitalisation gains. With the introduction of the new section 7b Trade Tax Act it is confirmed that recapitalisation gains are also generally exempt from trade tax.
A Company-related recapitalisation is deemed to exist if the taxpayer can evidence for the period of the remission the need and suitability of the company for recapitalisation, the suitability of the business-related remission for recapitalisation and the intention of the creditors to recapitalise. In so doing the law is based in fact on the requirements of the previous recapitalisation order.
The wording itself makes it clear that there must be business grounds for the remission. This may not be the case if a shareholder alone waives its claims as the reason for doing so may often be related to corporate matters and not to business grounds. The contrary is only the case if third-party creditors also waive their debts in part or in full and if thus it becomes clear that business grounds are responsible for the waiver. A further condition for the tax exemption is that the company exercises its optional tax rights in a way that reduces profit in the recapitalisation year and the following year (e.g. by opting for write-downs).
If the conditions for the new provision are satisfied the recapitalisation income is first reduced by the non-deductible recapitalisation costs. In order to avoid double benefits the remaining recapitalisation gains are then reduced by netting them with the existing loss positions of the company and, where appropriate, related persons. Any remaining recapitalisation gains are tax-free.
Although this new legislation may be very helpful for the taxpayer, at the moment it is not applicable yet. As the provisions may not be compliant with European state aid they are still subject to an approval of the European Commission. However, as can be heard from people in the Federal Ministry of Finance negotiations are not running smoothly so that it is not possible to say whether the approval will be issued by the European Commission.
Consequences for practitioners
What does this now mean for the taxpayer? The new legislation does not apply to recapitalisation gains from a remission before 8 February 2017. However, on the basis of the non-applicability order from the Federal Ministry of Finance the taxpayer can hope that the old recapitalisation order will still apply. In case the debt is waived after 8 February 2017, the outcome mainly depends on the reaction of the EU Commission. If it approves the provisions recapitalisation gains will be tax free, subject to the conditions of the new legislation. On the other hand, if the EU Commission decides that the new provisions are not compliant with European state aid rules, then the recapitalisation gains will probably be taxed. The only legal remedy available in this case is an application of the taxpayer to a divergent tax assessment for reasons of equity pursuant to section 163 German Tax Code or the remission of the tax claim by the taxing authority pursuant to section 227 German Tax Code. However, in this case it must be reviewed on the basis of an individual assessment whether there are personal or objective reasons for such equitable measure. Recourse to the general conditions of the previous recapitalisation order would not be permitted.
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