Tax treatment in the hands of the creditor
If a creditor waives an intra-group receivable, this leads to an accounting loss in the amount of the receivable. Such loss, however, is not automatically tax-deductible in the hands of the creditor.
If the creditor is a shareholder of the debtor (there is no threshold requirement, i.e. even a 1% participation is sufficient) the waiver is deemed to be a capital contribution into the debtor and will, in principle, not be tax deductible for the creditor but will not affect his tax base either. The book value of the debtor’s shares will increase with the nominal amount of the receivable. Correspondingly, the write-down of the receivable is equalised by the increase in book value of the participation in the debtor. However, to the extent that the fair market value of the waived receivable is less than its nominal value (for instance, because the likelihood of reimbursement is low due to the debtor’s financial situation), the shareholder generally realises a loss in the amount of the difference between the nominal value (by which the participation value has been increased) and the fair market value.
If a corporation waives a receivable against another affiliated company, for instance a sister company, such a waiver constitutes a hidden profit distribution up the corporate chain to the common parent company and a contribution down the corporate chain into the sister company. The value of the hidden profit distribution and the hidden contribution is the fair market value of the receivable at the time of the waiver.
However, the German Corporate Income Tax Act includes a provision according to which a reduction in profit resulting from ‘losses’ on shareholder loans (e.g. write downs to going concern value, forgiveness of the unrecoverable portion of a debt claim), economically equivalent instruments, or securities and guarantees in relation to such loans or instruments, may be disregarded. This will be the case if the loan, instrument or security is granted by a substantial shareholder (i.e. a shareholder holding 25% of share capital either directly or indirectly), persons related to substantial shareholders, and third parties with a right of recourse against the aforementioned persons. The statute will apply even if the shareholder is no longer a substantial shareholder at the time of the reduction in profits, but previously held such status.
Tax treatment in the hands of the debtor
A waiver of the liability or loan gives rise to income for German GAAP and tax purposes.
However, if the waiving party is a shareholder, the waiver qualifies as a capital contribution for tax purposes. Such a contribution will reduce the taxable income accordingly. The value of the contribution is the fair market value of the loan or other liability. If a third party purchaser of receivables would pay less than their nominal value, then the equity of the corporation can be increased by a waiver only by the amount of this lower fair market value.
In consequence, a corporation which is in a solid financial situation will not realise any additional taxable income if a shareholder waives a loan or other receivables. However, in most cases, shareholder loans are waived because the corporation is in financial difficulties. In that case, the value of the waived liability is usually significantly lower than their nominal value and the corporation will realise extraordinary income in the amount of the difference between the nominal value and the fair market value. However, in these cases this income normally does not lead to an immediate tax liability but may be offset against current operating losses or tax losses carried forward in prior years.