Print Edition
August 2010 
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Recapitalisation In Germany – Tax Snags |
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Dr Frank Schmidt, Dr Axel Mielke and Hansjoachim Koehler, December 2009 |
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The development of the financial markets crisis into a general economic downturn has put thousands of businesses into difficulties. Liquidity shortages make loan servicing problematic and poor results put loan covenants at risk. A default, though, entitles the creditor to foreclose, forcing the debtor to look for alternative finance, probably on less favourable terms. Even fundamentally sound businesses can easily find themselves in financial difficulties. For these companies, recapitalisation may be the answer.
Fortunately, there is a wide range of instruments available. However, the tax implications differ and so must be taken into account individually, with the ultimate objective of paying as little tax as late as possible whilst protecting carry forwards of loss and interest relief. This can be illustrated with the typical recapitalisation instruments of debt waiver, debt push up, and debt / equity and debt / mezzanine swaps.
Debt waiver – creditor loses out to exchequer?
If a creditor waives his rights to a debt, the debtor is absolved from his liability to pay.
Accordingly, both parties no longer show the item in their accounts and the debtor’s apparent financial position improves.
This improvement in the financial position of the debtor is reflected in his balance sheet. If the creditor was a shareholder, the debt waiver, in principle, ranks as a capital contribution and is to be taken to capital reserve. This, though, only applies to the extent the debt had value when waived and only if the waiver of the valuable part does not result in tax deductible expenses for the waiving shareholder. The portion deemed to be worthless is taken to income and is – in general – taxable. If the debt was waived as a last resort in order to avoid bankruptcy, this may apply to the entire amount. If the creditor was not a shareholder, the waiver will generally be taxable as income per se, regardless of whether or not the debt had value at the time. This can prove to be a serious impediment to rescue attempts based on the support of creditors, since a major creditor willing to forgive part of the debt in the interest of future business relationships is likely to see the cash outflow of a tax charge as counterproductive.
Up to 1998, recapitalisation gains of troubled businesses were tax-free by law. Since then, though, tax-freedom can only be granted under the discretionary rights of the tax office to refrain from inequitable taxation. The finance ministry has issued instructions to tax offices in an attempt to establish a uniform approach, although a taxpayer can only be certain of the tax consequences of a debt waiver if he requests a binding ruling from the tax office before the agreements with the creditors are signed.
A debt waiver need not be final. A waiver with a revival clause to take effect on specified conditions of improvement in the company’s financial position will have, in the first instance, the effect of an absolute waiver. Thus there will be income which the tax office might exempt and resolution of the impending insolvency. If fortunes improve and the debt revives, it will be restored as a liability as a charge on current profits. Ideally, the original credit to income will be offset against current losses and the revival charge will reduce current profits. Of course, the revival will not be deductible, if the waiver was exempt.
Debt push up – tax-free transfer to the parent
A subsidiary may restore its equity by transferring a third-party debt to its parent by way of contribution to capital reserve. The Supreme Tax Court has held this operation to be tax-free, even if the market value of the debt is below par. However, the parent must assume the debt free of all rights of recourse to the subsidiary, and must, itself, be solvent. It thus steps into the shoes of the debtor and becomes fully, and solely, responsible for repayment of the amount. The transfer can be advantageous, such as where the parent can offset the profit from the waiver against current or past losses at home or tax it abroad at a lower rate. At all events, the transfer leaves the tax loss carry forwards of the subsidiary undiminished.
Debt / equity swap – taxable income, forfeiture of loss carry-forwards?
There is a wide variety of debt / equity swaps, each with its own set of tax consequences. At its simplest, the classic capitalisation of a debt with the creditor exchanging his rights for those of a shareholder is fraught with all kinds of tax and company law risk. It is thus not an instrument to be recommended without considerable circumspection. However, variations on the theme, such as a swap for mezzanine (secondary) capital may open the way to most of the benefits without most of the disadvantages.
Where a creditor accepts newly issued shares in satisfaction of his claim on the company, the transaction ranks as a capital increase against a contribution in kind. The kind is the debt surrendered and its market value must be at least equal to the nominal value of the shares issued. Inevitably for a troubled business, the debt will not be worth its face value, so there will be a difference to be taken to income. In theory, it might be possible to persuade the tax office to waive the tax charge on this gain although they are likely to insist that the creditor also bears a loss. This is unrealistic if the new investor has just bought up company debt on the open market at a considerable discount. There is also the major disadvantage of the loss relief forfeiture rules on change of shareholder. Where a new shareholder acquires more than 50 percent of the issued capital, the entire loss carry-forward is forfeit; acquisitions between 25 percent and 50 percent lead to forfeiture in proportion to the amount acquired. These rules were suspended for acquisitions under a proper recovery plan in 2008 and 2009 and there is a bill before parliament to extend this indefinitely. However, there are qualifying conditions of job preservation, business continuation and further capital injection.
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