Germany: German tax attributes in transactions

Transaction markets have been slow, but are recovering. Deal numbers and volumes were up in 2010 compared to previous years and are expected to continue to recover significantly this year. In addition, stock exchanges are stable to friendly, giving investors willing to sell alternative exit routes. It is therefore worthwhile to compare the German tax consequences of an initial public offering (IPO) versus a sale to one investor, be it a strategic buyer or a financial sponsor.

The most relevant tax attributes from a German point of view are loss and interest carry-forwards and the change of control rule.

Given the economic difficulties of recent years, many companies have incurred losses. To the extent that such losses translate into a negative taxable income they can generally be carried forward in Germany without any time limitation. In a profitable year they can be offset against positive taxable income, though within the scope of the so-called minimum taxation rule. This rule stipulates that only the first €1 million ($1.4 million) of taxable income is fully offset by a tax loss carry-forward, while only 60% of the taxable income more than €1 million is offset, limited, of course, by the amount of the tax loss carry-forward. This rule obviously extends the period in which tax loss carry-forwards can be used in Germany and puts pressure on the recovery of a business after the crisis.

Even if a company weathered the crisis without incurring tax losses, it may have built up an interest carry-forward under the so-called interest capping rule. Net interest expenses (meaning interest expenses less interest income) of a German business are generally only deductible up to 30% of the so-called tax Ebitda (earnings before interest, taxes, depreciation and amortisation) of that business.

There are certain exceptions to this rule, which are mostly referred to as escape clauses. The most relevant escape clause is the equity test, where, in broad terms, the equity ratio (shareholder's equity over total assets) of the German business is compared with that of the worldwide group. If the German business's equity ratio is higher than the global equity ratio, the limitation of the deductibility of interest expenses does not apply.

An interest carry-forward also does not have an expiry date.

Another important tax attribute that keeps German taxpayers busy when thinking about a transaction is the ownership of German situs real estate. The German federal states levy a real estate transfer tax, which applies to the direct transfer of the ownership of real estate as well as the indirect transfer of such ownership, for example, if a company or a partnership owns such real estate. Generally, it is irrelevant whether the investment in this entity is transferred directly or indirectly, for example, where the entity is embedded somewhere in the group that is subject to the transaction. The relevant threshold for the transfer of an investment in such an entity is 95% of the shares or interest. Given that more and more of the federal states are looking to increase the tax rate from the familiar 3.5% to 4.5% or even 5%, the transaction cost resulting from this tax will increase significantly.

Tax loss and interest carry-forwards are subject to change of control rules.

If more than 50% of the shares in a company that has German tax loss carry-forwards or an interest carry-forward are transferred to one receiving person, all of the carry-forwards will be forfeited. This applies both to carry-forwards as per the end of the previous fiscal year and to loss or interest excess incurred up to the date the transfer becomes effective for tax purposes during the fiscal year in which the transfer of the shares is carried out. If more than 25% but not more than 50% of the shares are transferred, the carry-forwards are forfeited in proportion to the shares transferred. If, for example, 40% of the shares are transferred, 40% of the carry-forwards would be lost.

The forfeiture of these carry-forwards will not apply to the extent that the company in question has built-in gain. Such built-in gain is measured by the difference between the fair market value of the shares and the net equity in the tax books of the company, but only if and to the extent to which such built-in gain is subject to tax in Germany. The latter condition regularly poses a problem for holding companies with respect to shares in the subsidiaries it owns. The capital gain from such shares is generally tax-exempt in Germany; the exception to the change of control rule is thus not applicable. The issue here is that generally the loss and/or interest carry-forwards reside in the holding company as a consequence of the Organschaft, the German version of group taxation, while the taxable built-in gains reside in the operating subsidiaries of the holding companies.

One acquirer refers to one single person, one single company or a group of related persons or companies or, as the law puts it, a similar fact pattern.

As mentioned already, the direct or indirect transfer of at least 95% of the interest in an entity that owns German situs real estate triggers real estate transfer tax. This rule again requires a single acquirer or a group of acquirers with one person or entity dominating the group of acquirers.

From the above summary of the rules, which in detail are, as one would expect, very complex and need to be analysed carefully for each transaction, it becomes very obvious that an IPO should generally not affect any of the tax attributes discussed already. On the other hand, a sale to a strategic investor or financial sponsor will typically trigger the above rules and, to say the least, make a transaction more complex. The possibility of sheltering future income with interest and/or tax loss carry-forwards typically increases the equity value of the shares to be transferred or issued. Therefore it may very well be that the value for the selling investor may be higher compared to the proceeds from a sale to one investor in an IPO of a group of companies with these tax attributes.

Once the exit route is confirmed one could consider a pre-sale restructuring aimed at minimising the detrimental effect of the change-of-control rule. For example, in a holding situation one could consider merging the operating entities with the holding company to transfer the taxable build-in gain to the entity that has the tax relevant carry-forwards. Of course, the timing of such a restructuring is essential to avoid stepping in one of the various traps the German tax law provides. And for private equity portfolio companies such a restructuring would need to be agreed with the financing arrangements.

Biography
		Hans-Martin Eckstein PwC Friedrich-Ebert-Anlage 35 – 37 60327 Frankfurt am Main Tel: +49 69 9585 6382 Fax: +49 69 9585 948345 Mobile: +49 160 90591328 Email: hm.eckstein@de.pwc.com Hans-Martin Eckstein is a partner of the German firm of PwC and has served a variety of manufacturing, industrial products and consumer products companies, both public and private, with German, US American and Swiss parent companies. From 2004 to 2007 he was seconded to our New York office, where he was the leader of the European Tax Group in New York and within that the partner responsible for the German Tax Desk. Before his secondment to New York Eckstein was part of the German M&A tax team and has advised on numerous leveraged buy-outs by financial sponsors as well as strategic investments by industrial companies. From 1994 to 1995, he was also on secondment to the New York office, and in 1991/1992 he was on a four months secondment to the Bern office in Switzerland. From 2001 to 2003, he was partner in one of the leading German tax law firms. He first joined PwC in Stuttgart, Germany, in October 1985. Eckstein is a German certified public accountant (Wirtschaftsprüfer) and tax adviser (Steuerberater).