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Tax Exemption for Reorganization Gains

Not every decision by the Federal Finance Court – Germany’s supreme court for tax matters – has attracted as much attention as the court’s Grand Panel decision of November 28, 2016 (case GrS 1/15). The operative thrust of the judgment: the Federal Finance Ministry’s restructuring ruling of March 27, 2003, which has applied for years, violates the law. Now both the legislature and the Finance Ministry have responded – but these responses still fall short of creating legal certainty.

Numerous experts immediately claimed that the Grand Panel’s decision heralded the end of restructuring for companies before insolvency is applied for, or afterwards through court-supervised plans for composition with creditors. The reasoning: if a company realizes gains on claims waived under such restructuring measures, those gains are taxable under the rules for determining profit, unless they can be fully offset against losses carried forward.

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If creditors waive a part of their claims against a company in need of restructuring, the waived amount must be derecognized in the income statement. The result is income, under both the Commercial Code and the Tax Code. The question arises whether this gain – which is purely a book profit – can be subject to personal or corporate income tax and trade tax, and whether the tax system can thus bring in revenue from all the creditors’ contribution toward a restructuring.It is certainly true that losses may have been incurred in the current fiscal year, and often in previous ones as well. But as a rule, because of minimum taxation and possibly also because of a deleterious change of shareholders, those losses cannot be applied in full during a reorganization. Under the Finance Ministry’s reorganization ruling of March 27, 2003, tax on any restructuring gain that remains after exhausting the loss-offsetting options for income tax purposes could initially be deferred, by request, and ultimately waived after a final audit. Under the Grand Panel decision, this is no longer possible.

However, on April 4 of this year the Bundestag – the lower house of parliament – quickly responded to the court’s decision, enacting a new Sec. 3a of the Income Tax Act (EStG) to cover the tax exemption of restructuring gains (see Bundestag Printed Paper 18/12128). At the same time, equivalent provisions were introduced into the Corporate Income Tax Act (Körperschaftsteuergesetz) and the Trade Tax Act (Gewerbesteuergesetz). The provisions are to apply in those cases where claims have been waived after February 8, 2017. However, subject to ratification by the upper house of parliament (the Bundesrat), the provisions will not take effect until the European Commission determines that they do not constitute state aid, or if they do, that the aid is compatible with the internal market.

The Federal Finance Ministry made a parallel announcement on April 27, 2017, on the further tax treatment of reorganization gains:

In those cases where waiver-of-claim processes were final and complete by February 8, 2017, the old reorganization ruling of May 27, 2003, will continue to apply, in order to protect legitimate expectations.

Binding opinions issued by a tax office under the old reorganization ruling before February 8, 2017, are to be revoked, whether as wrongful ab initio or because of the change of law, only if the associated waiver-of-claim processes have not been largely completed already, or if there are no other reasons to protect a legitimate interest.

Binding opinions issued under the old reorganization ruling after February 8, 2017, are to be revoked if the waiver-of-claim processes have not been completed yet.

In all other cases – i.e., reorganization procedures in an early stage when no binding opinion has been issued yet – the income tax payable on reorganization gains is to be deferred, upon application, until the new legislative provisions take effect. If the new terms of law take effect by December 31, 2018, the deferral is to be revoked, because then of course the tax exemption of reorganization gains will be covered finally and retroactively (the June 2017 issue of novus will deal in detail with the Finance Ministry’s announcement of April 27, 2017, and the new terms of the law).

The Finance Ministry’s transitional provisions seem to pose problems for practice in several different regards, because they establish legal certainty only to a degree.

First of all, there may well be differences of opinion as to when “waiver-of-claim processes [have been] entirely or substantially completed.” As we see it, this can mean only those reorganization procedures – particularly court-supervised plans for composition with creditors – for which plans have been largely completed and a protection of legitimate interests in the issued binding opinion is necessary simply because of the expenses incurred and agreements reached in this regard between the insolvency administrator, the debtor in possession, the trustee, the creditors’ committee and the meeting of creditors, as well as the court. But this will have to be squared once again with the Tax Administration.

Second, the provision does not seem very practicable for reorganization cases that are only in their early stages. Deferring the income tax on a reorganization gain until the EU notification procedure has been completed, which is the alternative provided in this case, will not help if the EU finds that it represents state aid incompatible with the internal market. It would seem unrealistic to carry out the reorganization of a company in reliance on the EU Commission’s assessment of a law, where in case of doubt one would risk (possibly a return to) insolvency for the company and – depending on its legal form – for the shareholders or partners as well, because of the income tax that would then have to be paid.

In these cases, then, there is still no legal certainty without a decision from the EU Commission.

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