Subordination agreements between a debtor and its shareholders are a frequently used restructuring tool for German companies.
A subordination agreement reduces the likelihood of a debtor having to file for insolvency on the grounds of over-indebtedness, as it allows the debtor to ignore the subordinated shareholder claims for these purposes. The legal consequence of the subordination of shareholder claims is that after the opening of insolvency proceedings, such claims may be satisfied only after the settlement of all other creditors' claims. However, subordination agreements also usually restrict payments on the subordinated debt before the opening of insolvency proceedings and prescribe the circumstances in which such repayments can be made.
Care needs to be taken so that a subordination agreement does not amount to a waiver which may potentially give rise to an increased tax burden. This would arise if the subordination were to result in the subordinated claims not constituting part of the debtor's current liabilities.
A Federal Finance Court decision highlighted that the decisive factor in the treatment of debt is the wording of the relevant subordination provision and, in particular, the circumstances under which the debtor must repay the subordinated claim.
On November 30 2011 the Federal Finance Court decided that it was not possible to treat the repayment of claims under a shareholder loan which were subject to a subordination agreement as liability for the purpose of the balance sheet.
The case concerned the claim of a German limited liability company against the tax authorities which had requested it to remove the subordinated claims (which were subject to a subordination agreement) from the balance sheet as a liability. The wording of the subordination agreement obliged the debtor to repay the shareholder loan only if there were future profits or any remaining liquidation proceeds.
The court held that the decisive factor was whether the claims under a subordination agreement actually created an economic burden for the company at the date of the balance sheet. In its view, this was not the case if the subordination agreement foresaw a repayment of the shareholder loan only by way of future profits or any remaining liquidation proceeds. This meant that as at the date of the balance sheet, the claims did not have to be settled with the available assets and could therefore no longer be included on the liability side of the balance sheet. This led to an extraordinary profit of the company and thus increased tax payments.
The court made clear that its decision was based on the specific facts of the case and resulted from the particular wording of the subordination agreement, which foresaw a settlement of the shareholder's claim only by using future profits or any remaining liquidation proceeds. If the wording had also foreseen a settlement by using any other free assets, the decision would have been different. In this case, an economic burden would have already been incurred as at the date of the balance sheet; the claim could therefore have been included as a liability and would have led to lower profits and reduced tax payments.
The ruling provides some useful clarification on what needs to be considered when drafting a subordination agreement so as to avoid a taxable profit for the debtor in relation to the subordinated claim.
In order for the subordinated claim to be included in the balance sheet, and thus to avoid increasing the tax burden, the wording of the subordination agreement must be extensive insofar as it obliges the debtor to repay the subordinated claim in a way which ensures that – despite its subordination – it remains an actual financial burden for the company. Therefore, the drafting of such agreements needs special attention.
Commonly used wording in subordination agreements provides for debtors to "settle such claims using future profits, any remaining liquidation proceeds or any other free assets". This wording complies with the court's explicit requirements that there be an economic burden at the balance sheet date. Accordingly, a claim under such a subordination agreement can be included on the liability side of the balance sheet and should not increase a company's taxable profit.
The court has provided no guidance on what would happen if the agreement contained no detailed provisions on which moneys were to be used by the debtor for the settlement of the claim. In such a case it cannot necessarily be concluded that the parties have agreed on a prospective settlement of the claim. To be on the safe side, and in light of the court ruling described above, it seems advisable to include a detailed provision obliging the debtor to repay the subordinated amount which meets the requirements set out by the court. The ruling shows that a subordination agreement must be drafted carefully, and that the importance of the repayment provisions should not be underestimated. Getting the subordination right is key in the context of a restructuring, as it ensures that liquidity is preserved; but care must be taken that it does not give rise to additional tax burdens further down the line.
For further information on this topic please contact Stefan Sax or Oda Lehmkuhl at Clifford Chance LLP by telephone (+49 69 7199 01), fax (+ 49 69 7199 4000) or email (email@example.com or firstname.lastname@example.org).