Due to the ongoing financial crisis and the economic downturn accompanied therewith, many German companies are or will be struggling with default and insolvency problems. The recently introduced so-called Interest Barrier Rules (Zinsschranke) within the course of the German Business Tax Reform Act 2008 (BTRA) will lead to additional problems for distressed companies as these rules will trigger additional tax payments caused by the non-deductibility of a major portion of any interest expenses payable by a company (for details see "Mitigation of the Tax Disadvantages arising from an application of the German Interest Barrier Rules" below). On the other hand, there are professional investors such as vulture funds which have an excess of money to invest and which specialize in turnaround strategies with respect to distressed companies. For such investors the current business environment offers opportunities to invest in or take over distressed companies, for instance by making use of debt to equity swaps.
In the following we will briefly outline selected German tax implications arising in connection with debt to equity swap transactions caused by recent changes in the German tax laws introduced by the BTRA effective since January 1, 2008.
Structure of a Debt to Equity Swap
A debt to equity swap is often structured in a manner that a third party creditor and/or shareholder sells its claim vis-à-vis a German company to an investor at a discount which intends to acquire a shareholding in the company and to benefit from the upside potential after a successful turnaround. In connection with some other typical recapitalization steps, the company then conducts a capital increase in the course of which the investor contributes the acquired claims into the capital of the company and thereby obtains the position of a new shareholder. As a further consequence the claims against the company expire.
Tax Effects at the Level of the Company
Realization of taxable income
The resulting increase of the stated capital at the level of the company, however, is only possible to the extent the amount of the capital increase is equivalent to the nominal value of the contributed receivable. As a rule, the value of the capital increase will, instead, be equivalent to the lower actual value of the contributed receivable. This is mandatory for corporations under the aspect of capital preservation (Kapitalerhaltung). Accordingly, the share capital increase will not amount to the nominal value of the contributed claims. As this is regarded to be an obstacle in German equity swap transactions there is some room for structuring alternatives depending on the economic goals of the creditors which are, however, not further discussed within this article.
Correspondingly, for tax purposes the contribution is made by the investor (only) in the amount equal to the actual going concern value rather than the nominal value of the claim. As regards the amount of the valueless part, the claim will be considered as waived. Therefore, if and to the extent the capital increase and the contribution would be equivalent to the lower actual value of the receivable, the debt equity swap would result in taxable income for the company in the amount of the difference between the nominal value of the claims and their lower value.
Minimum taxation ("Mindestbesteuerung") and tax remission on the basis of the recapitalization decree ("Sanierungserlass")
As a result of the above, a debt to equity swap would lead to an additional taxable income of the company. In case the company has tax loss carryforwards available, such income could be offset with existing tax loss carryforwards of the company, however, subject to the restrictions of the German minimum taxation rule pursuant to Sec. 10 d German Income Tax Act (ITA). According to this provision, the taxable profits of the company arising from a debt to equity swap can be fully sheltered with available tax loss carry forwards up to an amount of €1 million only. With regard to any taxable income realized exceeding €1 million the offsetting with available tax losses carried forward would be limited to 60 percent of such income, i.e. 40 percent of the gain would be subject to tax and would lead to additional tax payments ("Minimum Taxation", "Mindestbesteuerung").
As such a result could be counterproductive and could jeopardize the willingness of investors or creditors to invest into distressed companies, in the past, recapitalization gains had been tax-free under the former sec. 3 No. 66 ITA. However, as this rule has been abolished without substitution, the German tax law currently does not provide for any tax exemption with respect to recapitalization gains.
Currently it is only possible to apply to the tax authorities for a deferral and remission of tax on recapitalization gains for reasons of equity (Billigkeitsgründe) on the basis of a decree of the Federal Ministry of Finance issued on 27 March 2003 ("Recapitalization Decree", "Sanierungserlass"). A recapitalization gain would be any increase of the business property due to a full or partial debt forgiveness by a creditor of the company for the purposes of a recapitalization and restructuring of the company. However, according to the Recapitalization Decree, the benefit of a deferral and remission is only granted if the additional requirements of (i) a restructuring need of the company, (ii) a restructuring capability of the company, (iii) a suitability of the debt forgiveness to achieve a restructuring of the company and (iv) the intention of the creditor to primarily support the corporation’s restructuring with the debt forgiveness, could be fulfilled. According to the Recapitalization Decree these requirements could be assumed as fulfilled, if the company provides for a restructuring plan (Restrukturierungsplan).
Risk of forfeiture of tax loss carried forwards
It must further be taken into account that a debt to equity swap will cause a risk of forfeiture of any existing tax loss carried forward of the company according to the revised rules, preventing loss trafficking in sec. 8 c Corporate Income Tax Act (CITA). According to this provision, the tax loss carried forwards of the company will be pro rata lost if more than 25 percent but no more than 50 percent of the shares or voting rights are transferred to (i) one acquirer or (ii) related parties to his acquirer, within a time period of five years, directly or indirectly. In case more than 50 percent of the shares or voting rights of the company are directly or indirectly transferred to (i) one acquirer or (ii) to related parties to the acquirer transferred within a time period of five years, the entire existing loss carry forward of the company will be lost.
According to the view of the German tax administration such a harmful transfer of shares or voting rights will also be assumed if, within the scope of a capital increase, a newly admitted shareholder will be granted a shareholding (or any other participation right) of more than 25 percent of the share capital of the company or an existing shareholding will be increased by more than 25 percent. Therefore, if and to the extent the investor will – as in our example assumed – be granted a shareholding of more than 50 percent within the scope of the debt to equity swap any available tax loss carry forwards of the company will entirely be lost. Of course such result is not in the interest of an investor and the German legislator has provided for an exception of the loss trafficking rule in case of specially defined German venture capital funds under certain circumstances. However, as foreign vulture funds will normally not be able to make use of this exception, again, there is need for tax planning in order to circumvent or mitigate the forfeiture of the loss carry forwards.
Mitigation of the tax disadvantages arising from an application of the German Interest Barrier Rules
Due to the Interest Barrier Rules (for a general description see below) most of the distressed companies will in future suffer further disadvantages as the interest expenses cannot be fully deducted as business expenses for tax purposes. This will cause a further heavy negative impact on the cash flow and the financial situation of such companies.
The Interest Barrier Rules (Secs. 4h ITA, 8a CITA) limit the deductibility of interest payments for corporate tax purposes and trade tax purposes and applies irrespective of the nature of the creditor whether they be shareholders or third-party banks. The interest deductibility is generally limited to 30 percent of the taxable EBITDA (earnings before interest, tax, depreciation, and amortisation) plus the amount of interest received in the same fiscal year. Non-deductible interest expenses can only be carried forward and will generally be deductible in subsequent fiscal years, subject to limitations similar to those applicable in the current year.
Although there are some exemptions from the application of the Interest Barrier Rules ((a) net interest expenses are below €1 million; (b) relevant company is not part of a consolidated group (e.g. IFRS); (c) relevant company is part of a consolidated group but its equity ratio is higher than or equal to the equity ratio of the consolidated group to which it belongs (missing that ratio by up to 1 percent is not harmful); additional requirement (counter exception) for cases (b) and (c): no more than 10 percent of the excess interest expense is paid on certain shareholder loans or intercompany loans other than from consolidated group companies), most of the distressed companies could not rely on one of the exemptions.
In the ordinary case the above described exemptions will therefore not be available so that a decrease of the debt volume by a debt to equity swap could provide for a relief insofar as it would lead to a reduction of the net interest expenses of the company enabling the company to escape or mitigate the Interest Barrier Rules. Instead, the improvement of the debt-ratio (being relevant for exemption (c)) will likely not be relevant in our example given the better debt equity-ratio of the consolidated group.
Tax Effects at the Level of the Shareholder
As LuxCo is resident in Luxembourg under the Luxembourg/German double taxation treaty (DTT) and the EU Parent Subsidiary Directive it may receive dividend payments and capital gains without any German taxation.
However, in 2007 Germany introduced a Anti-Treaty-Shopping Rule (Sec. 50d ITA) according to which DTT or Directive benefits will not be granted to a shareholder of a German company if the shareholder would not be entitled to the benefit if the income were earned directly (not through an intermediary company) and if at least one of the following three conditions is met:
- no economic or other sound reasons justify the interposition of the foreign entity; or
- the foreign entity does not earn more than 10 percent of its annual gross income from its own economic activities; or
- the foreign entity does not participate in the general market using a business establishment appropriate for its business purpose.
The Act defines that organisational or commercial circumstances of related entities will be disregarded. Neither the administration of assets nor activities which have been outsourced will be considered an "own economic activity" of the foreign entity.
The Anti-Treaty-Shopping Rule will, for example, apply to vulnerable structures of private equity funds which operate with a minimum amount of substance. Accordingly, vulture funds must consider whether they (i) may be able to realize return on investments only on a future exit by selling the German company, (ii) can delay dividends payments until necessary restructurings have been implemented or (iii) a different corporate investment set up is chosen (e.g. interposing a German partnership between the Fund and the LuxCo).
As regards the old shareholder, it should be noted that if such shareholder sells its shareholder loan to an investor, they will, as a rule, suffer a loss. According to the newly introduced provision of Sec. 8b para. 3 sentence CIT, since 2008 it must be taken into account that a loss occurring in connection with the sale of loan by (i) a shareholder holding directly or indirectly more than 25 percent of the capital of the corporation ("Major Shareholder"), (ii) a related party to a Major Shareholder or (iii) a third party creditor with recourse to a Major Shareholder is no longer tax deductible, unless it can be proven that an unrelated third party creditor would – under the same circumstances – have granted the loan as well and would not have reclaimed the loans in the meantime as well. It follows that a sale of shareholder etc. loans, for tax purposes, has become less efficient compared to the past.