To date, a debt waiver has been frequently used as a tool to successfully restructure German based companies in financial difficulties. A decision of the German Federal Fiscal Court (Bundesfinanzhof) published on February 8, 2017 currently limits such an option, given that it held that one of the main instruments used by tax authorities to grant relief from an otherwise taxable cancellation of debt income (CODI) in the form of the so-called Restructuring Decree (Sanierungserlass) violates fundamental constitutional rights. The purpose of this publication is to point out (i) the background to the decision of the German Federal Fiscal Court, (ii) the consequences of such decision, (iii) possible alternatives to the Restructuring Decree as well as (iv) to give an insight into the potential legislative path ahead. Background A waiver of debt (or, if the waiver is effected by a shareholder, the impaired portion of the debt) results in CODI which is generally subject to both corporate income tax and trade tax at ordinary tax rates so that the entire restructuring success may be put at risk due to cash tax payments (even in the presence of tax loss carry-forwards). In a restructuring scenario avoidance or at least reduction of CODI is essential and of primary importance. As the tax burden on the CODI is a severe obstacle to recapitalizing German entities, the German Federal Ministry of Finance (Bundesfinanzministerium) released its so-called Restructuring Decree (Sanierungserlass) in 2003 to allow a beneficial tax treatment of the CODI in certain circumstances. Under the decree, the German tax authorities were provided with the option to defer and ultimately cancel the tax payable on the CODI if, inter alia, the debt waivers (together with any other contributions by the stakeholders) provided a sufficient going-concern for the restructured company. The Decision of the German Federal Fiscal Court (Bundesfinanzhof) In the underlying case, the plaintiff challenged a tax assessment notice which imposed a duty to pay income tax. The tax authority argued that the plaintiff generated profit as a result of a waiver of (otherwise uncollectible) debt which the plaintiff and his local bank had agreed upon. The plaintiff, however, argued that this waiver was part of a restructuring plan and would, therefore, qualify as a tax-privileged restructuring profit under the so-called Restructuring Decree. Hence, the duty to pay income taxes could not be based on such profits. Latham & Watkins February 16, 2017 | Number 2078 | Page 2 In a decision published on February 8, 2017 the German Federal Fiscal Court, being the highest jurisprudence authority in Germany for taxes, held that the so-called Restructuring Decree violates the constitutional principle of legality of administrative actions. In essence, the court argued that the Ministry of Finance was not allowed to base the so-called Restructuring Decree on two exceptional provisions in the German Income Tax Act (EStG) that allow on a case-by-case basis for a tax exemption or reduction in the event of undue/unfair hardship. According to the court, these provisions are only relevant if the hardship results from the application of specific tax laws and if the hardship is determined on the basis of the individual case. The general duty to pay taxes or reasons outside of tax law (e.g. general economic, social or other restructuring considerations) may not be taken into account. Due to this lack of a legal basis for the Restructuring Decree, the German Ministry of Finance was, therefore, by-passing parliament, especially, since parliament had previously decided to abolish a statutory law provision that allowed for a tax exemption in restructuring scenarios. Implications of the Court’s Decision While the German tax authorities may still take measures to grant tax relief based on undue/unfair hardship on an case-by-case basis, the court’s decision will nonetheless often impede a tax-efficient deleverage in the course of a restructuring due to the inapplicability of the Restructuring Decree for the time being. It is, therefore, necessary to look for other restructuring measures to achieve a similar economic result without incurring the tax implications resulting from CODI. There are a number of tax structures, which may provide an alternative to the Restructuring Decree. One that has been used in the past is a debt-to-mezzanine swap. Under a debt-to-mezzanine swap the debt converted into a mezzanine instrument by novation, which was typically structured in such a way that it qualified as equity for German GAAP purposes and as debt for German tax accounting purposes. However, a debt-to-mezzanine swap is also generally no longer considered a viable solution for a distressed company in need of deleverage. The reason is that on May 12, 2016 the German tax authorities issued a decree, according to which a debt-to-mezzanine swap, where the mezzanine instrument is structured as equity for German GAAP purposes, in fact triggers taxable CODI based on the general principle that tax accounting follows commercial accounting. Nevertheless, there are other alternative structures that still work, such as (i) a debt push-up, (ii) a debtasset swap, (iii) an internalization of the excess debt or (iv) a deep subordination which are described in more detail below. However, it should be understood that a tax efficient structure primarily depends on the actual circumstances of the distressed company and may, therefore, only be assessed on a case-by-case basis. Alternatives to the Use of Restructuring Decree Option 1: Debt push-up A popular tax-driven restructuring tool is the assumption of debt with a discharging effect by a shareholder of the distressed company with the prior exclusion of any claims for recourse against the debtor. The concept of debt assumption is based on a decision made by the German Federal Fiscal Court in 2001: Upon agreement of the debt assumption between the distressed company and its shareholder, the company receives a respective relief claim against the shareholder by way of a hidden contribution equal to the nominal amount of the debt assumed. Once the creditor has approved the assumption of debt, the debtor is fully released from its obligations under the assumed debt, in fulfilment of the relief claim. Latham & Watkins February 16, 2017 | Number 2078 | Page 3 If structured properly, this technique should not generate any taxable CODI at the level of the distressed company. In addition, the tax equity account of the company is increased accordingly. Prior to implementation, however, it is advisable to liaise with the competent tax office to first apply for a binding ruling on the tax implications of the intended structure since there are various pitfalls including the absence of official recognition of the mentioned court ruling of 2001 by the tax authorities. It should also be noted that the assumption of debt obviously does not eliminate the debt as such but rather transfers the debt to the parent level. While the distressed company has the benefit of a financially restructured balance sheet, the treatment of the assumed debt at the level of the parent should be planned diligently as part of the overall restructuring concept. Option 2: Debt-Asset Swap In particular circumstances it might also be contemplated to separate the assets together with a sustainable portion of the debt by way of a transfer into a new corporate structure together with a deep subordination of the unsustainable part of the debt followed by a silent liquidation of the old structure. However, potential secondary liabilities of the new structure for tax liabilities of the old structure as well as uncertainties and difficulties in achieving a silent liquidation out of insolvency need to be addressed and factored into the overall assessment of such a structure's viability. Option 3: Internalization of Excess Debt If neither a debt push-up nor a debt-asset swap are viable options, a quick and easy fix is often the internalization of the excess debt portion if the shareholder is located in a suitable jurisdiction. In such a structure the lenders would sell the excess debt portion to the shareholder of the distressed company followed by a deep subordination of such excess debt portion. As part of the consideration for the excess debt the shareholder would grant tracking notes to the lenders under which it is obliged to pass on any recouped amounts under the excess debt (less an applicable margin) to the lenders. Again, the internalization obviously does not eliminate the debt at the level of the distressed company as such but only provides for an increased consolidated equity for the entire group so that the benefit of a financially restructured balance sheet will only be available at a consolidated level. The structural risk of a taxable CODI going forward, if the individual balance sheet of the distressed company needs to be financially restructured, is not eliminated so that the caveats of Option 4 apply accordingly. Option 4: Deep Subordination Another rather straight forward option exists in the deep subordination of any unsustainable debt directly by the lenders. Such deep subordination would have no immediate taxable consequences. In addition, when making an illiquidity or over-indebtedness assessment of the company under German insolvency law such subordinated debt may be disregarded as a (due and payable) debt item. However, even if deeply subordinated, such debt would still be regarded as a debt item on the balance sheet, which may lead to difficulties when looking for refinancing following a restructuring. Outlook: The Road Ahead (re the Restructuring Decree) There have been cases in the past where the German Ministry of Finance issued a so-called nonapplicability decree (Nichtanwendungserlass). By such decree the ministry declares that a certain court decision does not have to be followed in general by the tax authorities and may be regarded as an individual court decision only. However, given that the German Federal Fiscal Court held that the Restructuring Decree violates fundamental constitutional law principles, it is rather doubtful that the German Ministry of Finance would issue such a decree. Latham & Watkins February 16, 2017 | Number 2078 | Page 4 Due to the unsatisfactory current situation following the decision of the German Federal Fiscal Court and the difficulties for distressed companies to achieve a successful financial restructuring without the benefits the Restructuring Decree offered, it may be the case that the German legislator sees the need for urgent action and implements new statutory rules providing for tax exemption for debt waivers in a restructuring scenario. However, given that federal elections will be held at the end of 2017 in Germany and given that any new rules need to be in line with EU funding guidelines it may well be the case that new rules, if any, that could remedy the current situation will not be introduced until 2018. For the time being, the restructuring market in Germany will need to cope with the situation on the basis of the current set of rules and the remaining alternatives. Summary The decision of the German Federal Fiscal Court (Bundesfinanzhof) on the non-applicability of the Restructuring Decree (Sanierungserlass) may impede a tax-neutral restructuring of distressed companies. It cannot currently be predicted when and how the legislator will react to this legislative vacuum. However, until the German legislator has found a solution, other tax-efficient restructuring options are at-hand, which need to be assessed on a case-by-case basis. Latham & Watkins February 16, 2017 | Number 2078 | Page 5 If you have questions about this Client Alert, please contact one of the authors listed below or the Latham lawyer with whom you normally consult: Restructuring Frank Grell firstname.lastname@example.org +49.(0)40.4140.3254 Hamburg, Germany Tax Tobias Klass email@example.com +49.(0)40.4140.3287 Hamburg, Germany Jörn Kowalewski firstname.lastname@example.org +49.(0)40.4140.3237 Hamburg, Germany Thomas Fox email@example.com +49.(0)89.2080.3.8160 Munich, Germany Hendrik Hauke firstname.lastname@example.org +49.(0)40.4140.3402 Hamburg, Germany You Might Also Be Interested In Bond Restructurings in Germany Now Available More Broadly European Commission Proposes an Anti-Tax Avoidance Directive Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. 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