The “Act on the further development of the tax loss carry forwards for corporations” enacted on 20 December 2016 goes back to an old controversy. Under the heading of “shell purchase”, the strict limitation of tax loss utilisation to loss-bearing companies has long been a topic of discussion. Essentially the goal is to prevent companies from disposing of losses by transferring the “formal corporate structure”, i.e. the shares in the legal entity representing the loss-bearing company (“loss trafficking”). The pertinent existing provision in Sec. 8c Corporate Tax Act (KStG) makes the restriction on loss deduction solely dependent on changes to the circle of shareholders (level of the legal entity). For example, share transfers and certain capital-related measures may lead to the prorated (transfer of more than 25 %) or total (transfer of more than 50 %) forfeiture of the tax loss carry forwards. The only exception relates to specific intra-group restructuring measures (“group clause”). Moreover, companies can save loss carry forwards not fully used if they have hidden assets (“built-in gains clause”).
This regulation has generally been criticised as too restrictive as it also punishes companies whose (loss-bearing) business operations are not affected by any changes to the circle of shareholders. Obviously, not every such change will necessarily trigger illegitimate loss trafficking. Hence, the new law basically endorses a single simple concept in order to eliminate the overshooting tendency of Sec. 8c KStG, namely that loss carry forwards will in the future be lost only if, besides changes at the shareholder level, also structural changes to the business activity (i.e. at the corporate level) occur.
With this new legislation, the German government is pursuing the declared goal of removing obstacles to investment for start-ups relying on the injection of external capital. In the past, especially start-up companies have suffered from growth hindrances due to the forfeiture of tax loss carry forwards. The new regulation entered into force retroactively as from 1 January 2016.
2. Key features of the law
The central part of the new law is the introduction of the new Sec. 8d KStG, which “saves” any non-used losses, upon request, despite a qualified harmful shareholder change (“continuity-bound loss carry forward”).
(a) Application and legal consequences In future, companies can determine whether or not, following a qualified shareholder change, loss carry forwards are lost pursuant to Sec. 8c KStG. If a written application is filed together with the tax return for the fiscal year in which the qualified shareholder change occurs, the “continuity-bound loss carry forward” will be assessed separately as per Sec. 10d (4) Income Tax Act (EStG). In this process, future profits will be assessed primarily applying the continuity-bound loss carry forward and only afterwards on the basis of the “standard” loss carry forward. Parallel provisions are in place for purposes of trade tax loss carry forwards and of interest carry forwards on account of the interest barrier (Sec. 4h EStG).
(b) Prerequisite: continuation of consistent business operations Sec. 8d KStG assumes that a company has continuously operated one and the same business establishment in the three fiscal years prior to filing of the application or – if the company was established less than three fiscal years ago – since its formation, including after any change of shareholders. A business establishment is to comprise “a company‘s sustained, complementary activities having a beneficial effect on one another and driven by a unified intention of making a profit” and is to be defined “by qualitative criteria in an overall context” (Sec. 8d (1) s. 3 KStG). This definition aims at bundling all existing company activities in a single business establishment in order to create a broad comparative yardstick for the situation after a qualified change of shareholders. This is to prevent the offsetting against each other of any losses from different business establishments operated simultaneously or consecutively.
A business operation meeting this definition must be continued without limitation (Sec. 8 (2) s. 1 KStG). Otherwise the continuity-bound loss carry forward will be forfeited unless the underlying losses are covered by built-in gains, i.e. existing hidden reserves (Sec. 8d (1) s. 1 KStG). Besides a complete cessation of advertising, a reduction of ongoing business activities to an insignificant level − as compared with previous activities − is to be equally harmful. Further, a company is not to be permitted to temporarily suspend its business operations. Hence, for example, the letting on lease of a business establishment will not suffice for averting affirmation of a harmful cessation of business operations.
In addition, the law includes a number of substitute criteria of forfeiture (Sec. 8d (2) s. 2 KStG). In particular, such harmful criteria also include any change to the purpose of the business establishment or the taking up of another business operation. The former is deemed to exist where a company changes industries or modifies its corporate purpose as laid down in its statutes. “In particular, the services or products offered, the customer and supplier base, the markets served, and the skills and qualifications of the workforce” are to be used as criteria for evaluating whether any relevant change has occurred (Sec. 8d (1) s. 3 KStG). Further substitute criteria of forfeiture are intended to prevent any inappropriate structures. It is thus to be harmful, for instance, if a company becomes a controlling entity or enters into a partnership or if assets are transferred to it which it recognises at less than the fair market value. This is to prevent “external” proceeds from being shifted to a company so as to be offset against tax-reducing continuity-bound loss carry forwards.
The intention underlying the reform, namely the avoidance of any economically unjustified forfeiture of loss carry forwards, is to be welcomed. Especially innovative start-ups will benefit from the fact that loss carry forwards are no longer lost in the course of capital-related measures. Many sellers of enterprises will appreciate that the acquirer can use a loss carry forward even after the transaction and that this enables them to charge a markup on the purchase price.
Nevertheless, the recently enacted law has been legitimately criticised in many ways:
- If regulations regarding the continuity of the loss-bearing business operation are violated, the continuity-bound loss carry forwards will be lost (except where the “built-in gains” clause applies). Through a combination of the existing regulation in Sec. 8c (1) KStG and the new provision in Sec. 8d KStG it may even happen that a significantly higher portion of loss carry forwards is lost than in the case of isolated application of Sec. 8c KStG. Consequently, tax payers run a considerable selection risk. This may well cause companies, in the case of a merely prorated forfeiture of loss carry forwards (harmful acquisition of shares in the “corridor” between 25% and 50%), not to make use of their right to file an application under Sec. 8d KStG, since they might risk losing more than they can win.
- For an unlimited period of time, and thus theoretically forever, continuity-bound loss carry forwards are subject to the exclusion criterion of cessation of business operations or any other harmful change.
- Companies making use of the new option must at the same time put up with tax structuring hindrances, such as restrictions on direct participation in partnerships – e.g. as a joint venture partner – or on forming a fiscal unity with subsidiaries.
However, the new law is of interest to companies able to rely on a continuation of ongoing business operations and which would certainly forfeit loss carry forwards due to the inflexible provision in Sec. 8c KStG.