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M&A in crisis – tax challenges

published on 14 November 2022 | reading time approx. 6 minutes

In M&As involving companies in crisis, not only legal challenges but also many tax pitfalls should be considered. With the right structuring, however, it is also possible to take advantage of arising opportunities and optimise taxes.

The current situation, especially the Ukraine war, the energy crisis, the still existing supply chain problems and the cost increases in all areas of life will, on the one hand, that there will again be more company acquisitions and sales during the crisis. On the other hand, enterprises also use such times to streamline their portfolios and divest themselves of unprofitable business areas.

Such transactions often involve specific tax features to consider, which are discussed in this article.

1) Transaction structure – asset deal versus share deal

Especially with a company in crisis, it should be considered which transaction structure to use for the company acquisition.

If the transaction is intended to be structured as an asset deal, the object of the acquisition is not the shares but the individual assets of the target company. The target company continues to exist as a legal entity until liquidation; only individual assets are transferred to the purchaser. In an asset deal, the purchaser generally does not become a party to the existing contractual relationships of the target, unless the contractual partner agrees to the contract being taken over, i.e. to the replacement of its contractual partner.

A particular advantage of the asset deal is the possibility of taking over individual as-sets in a targeted manner (cherry-picking) and the possibility of writing off the purchase price against tax. In addition, the purchaser usually does not assume any previous burdens, and – except for few cases – liability is considerably limited or reduced (e.g. Article 75 of the German Tax Code (AO), liability is even more significantly reduced if the acquisition transaction takes place after the opening of insolvency proceedings). But the specific features of an asset deal as opposed to a share deal should not be ignored. For example, the seller’s existing employment relationships are transferred to the buyer by act of law. In addition, an asset deal may be challenged by an insolvency administrator if the remaining company has to file for insolvency with regard to the remaining liabilities. Asset deals are also often more complicated to implement contract-wise because the assets to be transferred must be sufficiently specified, and the transfer of contracts requires consent of the contractual partners.

In a share deal, the purchaser acquires all rights vested in shares in the target. Thus, the company's owners change, without this (directly) affecting the legal relationships of the company. Contractual relationships of the company with third parties – and thus also with employees – are not affected by the share deal as such. All assets and liabilities are taken over and thus including all relationships that can create liability on the part of the company. This is often the reason why a share deal is usually not the first choice in transactions involving a target in insolvency. In principle, however, a share deal is easier to implement in legal terms, as ultimately only the owner of the target company changes.

In the event of a share deal, it must be examined in the further course of the transaction whether the loss carry-forwards of the company in crisis can be used by the purchaser.

2) Loss carry-forwards – opportunities to utilise losses

First of all, it should be distinguished whether the company to be acquired is a partnership or a corporation, as different rules on the utilisation of losses apply.

In the case of a partnership, pursuant to Article 10a of the German Trade Tax Act (GewStG), loss carry-forwards expire without exception to the extent to which there is a change in the composition of the risk-bearing partners or in the business operations. Applicable is the principle saying that the risk-bearing partners and the business establishment of the partnership must be identical in the year when loss was generated and the year when that loss is utilised.

In the case of corporations, on the other hand, loss carry-forwards are only completely forfeited if more than 50 per cent of the shareholding structure change. And there are exceptions that can be used to save the loss carry-forwards.

Hidden reserves clause - Article 8c (1) sentence 5 et seq. of the German Corporate Income Tax Act (KStG)

If the transferred company has hidden reserves, it may still be possible to save the loss carry-forwards in this amount. Hidden reserves are the difference between the company’s capital disclosed in the books of account and the fair value of the shares, which can be proven by the purchase price. Hidden reserves arising on foreign assets and tax-exempt assets are not taken into account.

If the company's balance sheet shows an excess of liabilities over assets and tax equity is negative, it is important to bear in mind that the purchase price cannot be used to determine hidden reserves and company valuation must be carried out instead.

The structuring can be done in form of targeted contributions or a waiver of claims by the sellers prior to the transfer of beneficial ownership in order to increase tax equity and make it positive.

The same problem arises if the purchase price is very low (e.g. the symbolic 1 euro). Here, too, only a company valuation will help so as to be able to prove a higher enterprise value and corresponding hidden reserves, if necessary.

In the case of companies in crisis, however, it is often no longer possible to prove hidden reserves; thus, the restructuring clause could be applied as a further exemption.

Restructuring clause - Article 8c (1a) KStG

After the European Union’s much toing and froing about illegal aid, the restructuring clause was reintroduced retroactively for share transfers after 31 December 2007 based on ECJ case law. If the requirements of the restructuring clause are met, the deduction of losses is neither completely forfeited following the acquisition of the shareholding, nor must the acquisition be compounded with other share acquisitions made within the five-year period as specified in Article 8c (1) KStG. However, as will be shown below, the corset of the regulation is very tight.

The acquisition of shares must take place at a time when the insolvency or the excess of the corporation’s liabilities over its assets is at least imminent or has already occurred (acquisition of shares in a company in crisis). Here, the corporation bears the objective burden of proof for evidencing that the restructuring requirements are met. It must present documents that both

transparently document the cause of the crisis that has occurred;
evidence that specific measures to address this crisis have been taken.

Acquisitions of shareholdings that took place before the company plunged into crisis are not subject to Article 8c (1a) KStG.

From a factual point of view, the company must be capable of being restructured and the measures taken for the restructuring must be objectively suitable to lead the corporation out of the crisis in a sustainable manner in the foreseeable future (restructuring suitability). As a rule, the respective proof is provided in form of a restructuring plan, which can also be used to demonstrate the need for restructuring of the company, the demonstration of which is a requirement. The restructuring measures must be related to the acquisition of shares and must be carried out within one year of the acquisition. Restructuring measures can be for example as follows:

Cost-cutting measures
Reorganisation of business
Acquiring new sources of financing
The acquiring shareholder is not required to contribute its own financing.

In addition, the company's fundamental operating structures must be maintained. According to Article 8c (1a) sentence 3 KStG, this requires adhering to a works agreement containing employment arrangements, comparison of wage bills before and five years after the acquisition of shareholdings (Lohnsummenvergleich), or increasing business assets by means of contributions within 12 months following the acquisition of the shareholding. A measure is not a restructuring measure if the corporation has basically stopped its business operations at the time of the acquisition or changes the branch of industry it operates in within five years of the date of acquiring the shareholding.

Thus, the conclusion is that the application of these regulations often falls flat because of the strict requirements.

Deduction of losses due to continuation of business according to Article 8d KStG

If neither the hidden reserves clause not the restructuring clause are applicable, the company may still fall back on applying the so-called deduction of losses due to the continuation of business. Upon request, the loss carry-forwards can be carried over and utilised as long as the company carries out exclusively the same business after the change of the ownership structure.

It is important to know that the exemptions under Articles 8c and 8d KStG cannot be combined. If the hidden reserves are not sufficient to fully cover the existing loss carry-forwards, the remaining losses that are at risk of becoming subject to the prohibition of deduction cannot additionally be carried over based on a request filed pursuant to Article 8d KStG.

A major disadvantage of the regulation is that the deduction of loss carry-forwards due to the continuation of business very much restricts the buyer's freedom of action. For example, starting business operations in an additional branch of industry or participating as a risk-bearing partner in a partnership can be viewed as the so-called harmful events and lead to the forfeiture of the right to deduct the loss carry-forward due to the continuation of business. It is therefore always recommended to primarily use the exemption regulation arising from Article 8c KStG.

If it turns out later, for example during a tax audit, that the hidden reserves clause or the restructuring clause do not apply, it is still possible to file a request under Article 8d KStG as long as regulations of the German Tax Code (AO) allowing amending tax assessment or notices of assessment or regulations allowing amendment under individual tax laws apply.

3) Selected restructuring measures and their tax consequences (here waiver of claims, sale of receivables)

When a distressed company is bought, it usually comes with serious losses incurred prior to the sale and has been supported by the shareholder through shareholder loans. When it comes to the sale of the company, the question arises as to how to treat such shareholder loans. This is because the obvious solution being a waiver of claims often leads to unintended tax consequences. This is because a waiver of claim triggers income if the claim is no longer recoverable – which is often the case for companies in crisis. Admittedly such income can be offset against current losses incurred in the financial year and, subsequently, against losses carried forward. However, when offsetting against loss carry-forwards, the minimum taxation rules must be observed. Only a loss carry-forward in the amount of EUR 1 million may be freely offset against current income; any income excessive of this threshold must be taxed at the rate of 40 percent.

If, on the other hand, the shareholder loan is not repaid and the purchaser takes over the company along with that liability, the situation is even more critical, as there is the risk that loss carry-forwards have been forfeited. A waiver of claims is then no longer an option, unless the requirements for tax-exempt restructuring gains according to Article 3a of the German Personal Income Tax Act (EStG) are met.

A solution could be the repayment of the intercompany loan by the seller prior to the acquisition (cash circle).

Alternatively, it could be considered to sell the loan for 1 euro, for example. It is important to note here that gains arising from the repayment of the loan are fully taxable in Germany, according to Article 20 (2) (7) EStG also gains in private assets, so the tax burden resulting from a fully taxed gain arising from the repayment of the loan is higher than in the case of profit distributions. If, in the individual case, acquisition can be handled through a foreign company, ideally in a jurisdiction where such a gain is not taxable, the gain from the repayment of the loan could be paid out on a tax-free basis. But the structure of this arrangement would have to be planned precisely. In addition, the reporting obligation according to DAC6 must be observed.

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