With its judgment of 28 November 2016, the German Supreme Tax Court (Bundesfinanzhof; BFH) dismissed the application of the tax administration's so-called restructuring decree (Sanierungserlass). The restructuring decree allowed, subject to certain conditions, a suspension and abatement of taxes on so-called cancellation of debt income (COD Income) otherwise resulting from certain recapitalization measures such as the waiver of debt and debt-to-equity swaps. The BFH decision caused material problems to the restructuring practice because it is associated with increased legal uncertainty regarding the tax treatment of restructuring gains. A draft bill introduced by the German Bundesrat is now intended to establish a legal basis for the exemption from taxation of restructuring gains (section 3a EStG-E, section 3a GewStG-E).
Current legal situation
The waiver and/or cancellation of debt leads to a book gain in the tax accounts of the debtor which is not accompanied by a corresponding cash inflow. If the measure is not induced by the shareholder relationship but by business reasons, the income resulting from such book gain is subject to personal / corporate income tax and trade tax at the level of the debtor.
The taxation of this book gain with ailing companies (so-called restructuring gain or COD Income), however, makes recapitalizations considerably more difficult, since the original debt waived or otherwise cancelled is partially replaced by a tax liability in the books of the debtor, which is not subordinated and which becomes payable at some point in the near future.
So far and after the abolition of section 3 no. 66 EStG in 1997, the so-called restructuring decree of the Federal Ministry of Finance (Bundesfinanzministerium; BMF) (BMF dated 27 March 2003, BStBl. I, p. 240) served as the basis for an initial suspension and subsequent abatement of such taxes.
The restructuring decree set forth general conditions for relief and was essentially tied to the necessity and capacity of a recapitalization of the company, the suitability of the debt cancellation for recapitalization purposes and the creditors' recapitalization intention. It also required that all possibilities to set off existing tax losses and tax loss carryforwards had to be exhausted beforehand.
BFH overturns restructuring decree
The BFH decided on 28 November 2016 (file no. GrS 1/15) that the restructuring decree is not compatible with the rule of law in Article 20 (3) of the German Constitution (Grundgesetz; GG). According to the BFH, the rule of law requires that generalizing rules without case-by-case review have to be established by the legislator itself by way of statute and not by the tax administration.
Furthermore, the BFH held that the restructuring decree did not meet the requirements set forth in sections 163, 227 of the German Fiscal Code (Abgabenordnung; AO) for a relief from taxation. In the view of the BFH, by nullifying section 3 no. 66 EStG in 1997 the legislator made it very clear that it was actually its intention to tax restructuring gains. The BFH stresses that tax consequences actually intended by the legislator cannot be mitigated by the German tax administration by way of granting relief.
Noteworthy, the BFH did not comment on the controversy among tax scholars as to whether the restructuring decree might violate the prohibition of state aid under EU law. Thus, the decision of the BFH does not provide comfort to taxpayers who were in the past granted relief under the restructuring decree. The time bar for prohibited state aid runs 10 years.
Content of the planned revision
Upon proposal of the Finance Committee of the German Bundesrat dated 27 February 2017 (Bundesrat paper 59/1/17), the former tax exemption for restructuring gains in section 3 no. 66 EStG shall now be reinstated by introducing a new section 3a EStG-E and section 3a GewStG-E under the "Act against Harmful Tax Practices in Connection with the Provision of Rights" (Gesetz gegen schädliche Steuerpraktiken im Zusammenhang mit Rechtsüberlassungen).
Pursuant to section 3a EStG-E, restructuring gains shall, upon application, be tax exempt if the business requires recapitalization and is capable of recapitalization and if the debt cancellation is suitable as a recapitalization measure and is effected for business reasons and with a recapitalization intention of the creditors. A business-related restructuring gain in this sense is not deemed to exist if the increase of the business assets almost exclusively results from waivers of claims by shareholders.
Furthermore, it is planned that, as a consequence of the tax exemption, any loss carryforwards that have arisen before the restructuring year shall be cancelled and any negative income generated in the restructuring year can neither be offset nor carried forward or back. Besides, operating expenses that are directly associated with a tax-exempt restructuring gain (e.g. restructuring costs and payments on debtor warrants) may not be deducted. The trade tax provisions are structured accordingly, but can be invoked irrespective of the income tax provisions.
The new rule shall also apply to assessment periods before 2017 and, thus, to all pending and future cases. However, the entry into effect of the new rule is subject to the condition precedent that the European Commission grants its approval under state aid law. In cases where a binding ruling has already been issued on the basis of the restructuring decree, the taxpayer’s legitimate interests in the persistence of such ruling are protected (section 176 (2) AO) notwithstanding the dismissal of the restructuring decree by the BFH. However, it is to be noted that taxpayers are not protected if measures based on the restructuring decree are found to have violated the prohibition of state aid under EU law.
Assessment and outlook
In principle, the planned exemption for restructuring gains is to be appreciated. If the legislation enters into force, the current situation will change insofar as it will become possible for businesses to obtain an exemption from personal / corporate income tax and trade tax imposed on restructuring gains by filing corresponding applications with the respective business's local tax office. The time-consuming and potentially unsuccessful additional discussions with local trade tax authorities to achieve an abatement of trade tax, which have been required so far, will no longer be necessary.
As compared to the current tax abatement on the basis of the restructuring decree, which only required that all possibilities to set off losses had to be exhausted beforehand, the planned legislation is stricter insofar as it provides that any loss carryforwards reported as of the end of the preceding assessment period shall be canceled at the beginning of the restructuring year and any negative income arising in the restructuring year shall not be set off against any other positive income and shall not be deductible in other assessment periods either. Insofar, it is to be carefully reviewed by way of an analysis of the advantages and taking into account the provisions on minimum taxation to what extent it is reasonable to file applications for exemption from personal / corporate income tax and / or trade tax.
As we understand, the bill was drafted in cooperation with the BMF and the legislative procedure shall be completed by May 2017. Until the planned legislation enters into effect, i.e. until it is approved by the EU Commission, a suspension and / or abatement of the tax on restructuring gains may thus only be based on personal or material reasons of equity in the individual case (sections 163, 227 AO), unless the BMF grants protection of legitimate interests under transitional provisions.