From a purely commercial and legal perspective, many restructuring measures are conceivable. However, it is very complex to also implement the restructuring in a tax efficient way. Here the tax aspects associated with the most common debt restructuring measures will be summarised from a debtor’s perspective.
Many German companies have been badly affected by the financial crisis which erupted in autumn 2007 and culminated in September 2008 in Lehman Brothers’ filing for bankruptcy. In particular, for highly leveraged private equity and real estate investments it has often turned out that in times of shrinking turnovers the obligations to settle interest and redemption obligations cannot be fulfilled.
In principle, a partial or full waiver of the principal amount of a debt instrument (and/or accrued interest) leads to a taxable profit for the debtor. Available current tax losses would – without limitation – reduce such a profit. With respect to loss carry-forwards, only 60 per cent of the profits exceeding €1m can be offset against loss carry-forwards (with 40 per cent of such profits being subject to the so-called minimum taxation).
If a waiver is made in the context of a restructuring of a distressed company, the debtor may, however, benefit from the exemption for the amount of the waiver exceeding tax losses and tax loss carry-forwards under the so-called Restructuring Decree (Sanierungserlass). The Restructuring Decree requires (inter alia) that a restructuring is necessary and the waiver qualifies as an appropriate measure to a successful restructuring. Generally, the Decree’s prerequisites are deemed to be fulfilled if a restructuring plan is provided or if all creditors of the company waive their debts. If the requirements are met, the competent authorities (which are the tax authorities for corporate income tax and the municipalities for trade tax) will initially grant a tax deferral (ie, the according tax liability would remain in the balance sheet of the debtor); relief will generally be obtained after the completion of the tax assessment for the subsequent year.
The application of the Restructuring Decree should become more predictable as the federal fiscal court recently overruled the tax court of Munich and acknowledged that, in principle, the tax authorities are entitled to stipulate the preconditions for a tax waiver in a decree. Nevertheless it is advisable for the debtor company to apply for a binding ruling (verbindliche Auskunft) in advance with the competent authorities to avoid uncertainties on whether the Restructuring Decree is applicable.
Statements by the creditor that he will not demand repayment (without formally waiving the debtor’s obligations), a long-term de facto lack of collection activities by the creditor or an expiry of a relevant statute of limitations on the right to claim for repayment may be considered to qualify as an implicit waiver and this may require profit recognition by the debtor without the waiver exemption being applicable.
If the creditor at the same time holds shares in the debtor (or is related in a corporate manner) and it can be shown that the waiver would not be granted by an unrelated third party creditor, the amount waived is considered a tax neutral (hidden) equity contribution for tax purposes to the extent the loan receivable has value (ie, is not distressed). If and to the extent the loan receivable is lacking value (ie, the fair market value of the claim is below its nominal value) the difference results in a taxable gain. As the tax authorities generally apply the Restructuring Decree only to a waiver for restructuring purposes (ie, declared for business reasons) and not to pure intra-group debt waivers, such a gain (to the extent not reduced by available tax losses) is taxable, unless the waiver (by the shareholder) is embedded into a broader restructuring including the cancellation of third party debt and it can be proven that the waiving shareholder suffers a real loss by taking into account their acquisition costs of the respective loan receivable and their equity participation in the owing company.
Generally, it has to be noted that the abovementioned principles do only apply to a waiver vis-à-vis a corporation. A waiver of debt granted to a partnership by one of its partners is subject to different principles. This is due to the particular tax regime applicable to the taxation of partnerships. Normally, a waiver made by a partner would remain tax-neutral even if the market value of the partner‘s claim against the partnership is below its nominal value.
Conditional Debt Waiver
A debt waiver of a loan receivable can also be combined with a so called “debtor warrant” (Besserungsschein), ie, the loan receivable is waived under the subsequent condition that the debtor recovers. Initially, this results in a complete cancellation of the debt waived with the above described tax consequences. In principle, any resulting (waiver) profit may benefit from the Restructuring Decree (subject to the conditions described above). However, the payment of the respective tax on the waiver gain (the remaining portion after offsetting losses) will only be deferred until the expiration of the recovery period. The tax claim will only be waived if recovery turns out to be impossible.
If and to the extent the company recovers (in accordance with the recovery conditions laid down), the debt will revive and will have to be recorded again. The tax treatment of the debt revival will mirror the tax treatment of the initial waiver: to the extent the waiver profit was treated as tax-neutral (eg, in case of a shareholder contribution), no expense would be recognised for tax purposes. To the extent the waiver has resulted in a taxable profit, the revival would in principle lead to a deductible expense. There is a risk that the tax authorities would not recognise such expense for tax purposes if the loss restriction rules become applicable as a result of a share (or voting right) transfer in the period between the debt waiver and the recovery of the company (according to the tax authorities’ approach taken with respect to the former loss restriction rules which have been replaced by new ones in 2008).
Debt Assumption (Debt Push-Up)
As an alternative to the debt waiver, a non-recourse debt assumption could be considered, whereby the debt is shifted from the debtor to its parent. Contrary to a debt waiver, the deletion of the liability at the level of the debtor by way of a non-recourse assumption may not trigger adverse tax consequences. Simultaneously to the debt assumption, it is essential that the parent waives any (down-stream) recourse claim against the debtor. While parent and debtor both remain liable for the debt until the creditor approves the assumption, the debtor has an (up-stream) recourse claim against the assuming parent. According to a decision of the German federal fiscal court this should be regarded as a tax neutral contribution-in-kind of the (up-stream) recourse claim – even if the claim of the creditor against the debtor would not be deemed valuable anymore (due to the financial situation of the debtor). If the creditor agrees to the assumption or the parent pays the outstanding debt, the liability against the creditor and the (up-stream) recourse claim against the parent will both be deleted from the debtor’s books; this should not result in a taxable gain. The assumption of debt is treated differently than the waiver of a shareholder loan which is treated as a constructive equity contribution only to the extent of the valuable portion (see above). While structuring a debt assumption, particular attention should be paid to the details; depending on the circumstances, even an advance ruling may have to be considered.
Through a debt-for-equity exchange (debt-equity swap) the creditor’s loan receivable will be converted into an equity participation in the debtor company. Like a debt waiver the debt-equity swap results in a deletion of the debt and in an according taxable profit at the level of the debtor. Under the conditions laid down above, such profit may benefit from the application of the Restructuring Decree. As a consequence of the debt-for-equity exchange, tax losses, tax loss carry-forwards and interest carry-forwards could cease to be available for the debtor company. If the creditor receives more than 25 per cent and up to 50 per cent of the shares in the debtor company in exchange for the waived debt, an according percentage of losses (and interest carry-forwards) would be eliminated; if more than 50 per cent of the shares are transferred to the creditor, all tax losses (and interest carry-forwards) are lost. The same applies if the relevant thresholds are exceeded (over a period of five years) in case not only the creditor (directly or indirectly) receives shares in the debtor, but also parties related to the creditor or a group acting in concert of which the creditor is a member.
Generally, liability and a corresponding claim cease to exist in cases of a buy-back of debt by the debtor (confusion of rights). If bought back at a discount to the principal amount, the debtor generates a taxable profit on the discount. Subject to the conditions laid down in the Restructuring Decree, such profit may benefit from a tax exemption. However, if the discount is caused by general market circumstances and not by the specific financial distress of the debtor, or if the buy-back is not part of a restructuring of the debtor, an exemption will not apply.
In case the debt is securitised, the buy-back does not automatically result in a confusion of rights; rather, as a result of the buy-back, the debtor would at the same time hold the claim and the corresponding liability. It would then be in the hands of the debtor to limit any subsequent waiver of the repurchased debt to such an amount that the profits triggered can be offset with available tax losses and loss carry-forwards (and without triggering minimum taxation).
A debt restructuring is associated with several tax issues which make the restructurings more complex and stolid. As set forth above, most debt restructurings can only be implemented in a tax efficient way if the tax authorities (and for the trade tax the respective municipalities) are willing to waive taxes triggered by the restructuring in accordance with the Restructuring Decree. The application of the Restructuring Decree should become more predictable as the federal fiscal court recently overruled the tax court of Munich and acknowledged that, in principle, the tax authorities are entitled to stipulate the preconditions for a tax waiver in a decree. In any event, however, it is advisable for the debtor company to apply for a binding ruling with the competent authorities prior to the implementation of a debt restructuring to avoid uncertainties on whether the Restructuring Decree is applicable.