In its recently published judgment of 30 November 2011, the German Federal Finance Court (Bundesfinanzhof) once again deals with tax treatment of a shareholder loan with qualified subordination – judgment of 30 November 2011, I R 100 / 10. The ruling has significant practical consequences.
Subject matter of the judgment
The decision deals with a loan contract with a subordination agreement between the sole shareholder of a limited company and the company itself. In accordance with the subordination agreement, if the company becomes over-indebted the shareholder’s claim resulting from the balance in the loan allocation account is automatically subordinate to the claims of all other creditors. Under the agreement, the shareholder could only demand satisfaction of her claim from future annual net profits, provided they exceed existing losses carried forward, or potentially from liquidation proceeds.
In subsequent years, the company became over-indebted. Following a field audit, the tax authorities came to the conclusion that the corresponding liability to the shareholder carried on the balance sheet should be released to income. On the basis of section 5(2a) of the Income Tax Act 1997 (Einkommensteuergesetz, EStG), the authorities held that recognition of the debt as a liability in the tax balance sheet was not possible.
Debts dependent on future profits not to be carried as liabilities
The Bundesfinanzhof agreed with this view. It held that a debt should only be recognised in the balance sheet if the businessperson is bound towards a third party by an obligation that has a determinable content and value and which can be enforced by the creditor and represents a financial burden. In the matter at hand, there was no such financial burden.
The Court said that provided satisfaction of the liability was limited to future profits, the rationale behind section 5(2a) of the EStG could be used to establish the lack of a current financial burden. Under this section, a liability or accrual should not be recognised for obligations that must only be fulfilled if future income or profits arise until said income or profits have arisen. This provision also applies to cases where subordination agreements have been made; it relates to all obligations that must only be fulfilled in the event of future profits.
The Court stated that the conclusion cannot be any different even by taking into consideration that such loans were not only to be satisfied from future profits but also from any surplus liquidation proceeds. While the Court held that section 5(2a) EStG did not apply directly because repayment of the loan did not depend solely on future profits, prohibition of recognition of a liability nonetheless applied because there was no current financial burden. Payment obligations to be met from liquidation proceeds did not affect current assets because liquidation did not yet need to be considered under the going concern principle, and until such time reserves were available in their entirety to cover losses and satisfy other creditors.
The Bundesfinanzhof did not make a definitive statement on the consequences of a subordination agreement which provides that claims are to be satisfied “exclusively from future surplus liquidation proceeds”. However, it did hold that recognition of a liability would only be possible if liquidation was impending and corresponding surplus proceeds were to be expected.
Subordination and waivers of recovery agreements are comparable
In terms of economic efficiency, the Bundesfinanzhof emphasised that despite the differing civil law basis there is no difference between a waiver with a recovery agreement and an agreement according to which debts are only to be satisfied from future profits or surplus liquidation proceeds. Such subordination agreements do not place a greater burden on the debtor than if the debt had been waived in return for a corresponding recovery agreement. It is therefore justified that such liabilities be treated in the same way as waivers with recovery agreements, with the consequence that the loan liability (whether newly agreed or existing) should be released to income by the debtor in accordance with section 5(2) of the EStG. If insufficient losses are available for offsetting (taking due account of minimum taxation), this will lead to a tax liability for the debtor.
Consequences in practice
In light of the Bundesfinanzhof’s judgment, attention must be paid to the exact form of words when agreeing qualified subordination, such that unintended tax consequences are avoided. The Bundesfinanzhof’s ruling is a clear rejection of the view that section 5 of the EStG does not apply to cases of subordination because in subordination the debt already legally exists. Qualified subordination agreements must therefore provide that repayment of the debt can also be made “from other (available) assets”. On the other hand, the decision may also offer new possibilities in cases where there is a desire to intentionally create taxable income (e.g. in order to utilise taxable losses that are otherwise not usable for other reasons).
It should be noted that under the new MoMiG Act to modernise the law governing limited liability companies, simple subordination would be sufficient for the avoidance of over-indebtedness. In such a case, it can be assumed that the creditor is to be satisfied not only from future profits or future surplus liquidation proceeds but also from other available assets, such that section 5(2a) EStG does not apply.