I. Issue

If a creditor waives existing claims against a debtor for the purposes of restructuring, this will yield a financial profit for the debtor by derecognizing this liability but no financial liquidity will accrue to the debtor in return (so-called restructuring profits).
Based on the so-called recapitalization decree (circular from the German Federal Ministry of Finance (BMF)) restructuring profits were exempted from tax under certain conditions for reasons of fairness. According to the decision of the Grand Civil Panel of the Federal Court of Finance (BFH) dated 28 November 2016 and published on 8 February 2017 the administrative practice based on the recapitalization decree since 2003 violates the principle of legality of administrative actions: The administrative arrangement to waive the income tax and corporate tax on restructuring profits due to objective reasons of fairness does not provide for a sufficient legal basis.
In particular with regard to the improved possibilities for corporate restructuring due to the continued development of insolvency and restructuring law, the practice was in need of an immediate and sustainable solution, as the tax burden on restructuring profits would regularly undermine the creditor’s purposes of waiving the debt.
Recognizing this problem, the German legislature decided subject to the EU commission’s approval with respect to state aid law to exempt such restructuring profits from tax by law.

II. The changing history of the fiscal treatment of restructuring profits

While the tax exemption of restructuring profits was stipulated by legal provisions for more than 30 years (sec. 3 no. 66 Income Tax Act (EStG)), this provision was repealed by the law on the promotion of corporate tax reforms dated 29 October 1997. In response to this, the tax authorities passed the so called recapitalization decree on the income tax treatment of restructuring profits, especially for the tax deferral and for the tax abatement on objective reasons of fairness pursuant to sec. 163, 222, 227 German Tax Code (AO) (BMF circular dated 27 March 2008 – IV A 6-S 2140-8/03). According to this recapitalization decree, restructuring profits could be exempt from taxes based on reasons of fairness when meeting certain conditions.

In its decision dated 28 November 2016 – Grand Civil Panel of the BFH considered this tax authority practice illegal inter alia because of the infringement of the principle of legality of administrative actions (article 20 para. 3 German Constitutional Law (Grundgesetz)). The BFH held that particularly the repeal of the legislative provision on the tax exemption of restructuring profits in 1997 put adequate emphasis on the legislator’s intention not to privilege restructuring profits in future. The tax authorities were not allowed to disregard such intention of the legislator – as happened in practice by the (undifferentiated) application of the recapitalization decree.

III. The tax authorities’ reaction on the BFH decision

The German Federal Ministry of Finance has reacted on the decision of the BFH by its letter dated 27 April 2017. For reasons of protection of legitimate expectations the recapitalization decree shall continue to be applicable unreservedly in cases in which the creditor’s debt waiver was finally completed in accordance with the highest financial authorities of the Federal States by 8 February 2017 (corresponding to the publishing date of the BFH decision). If the debt waiver is part of an insolvency plan, it is deemed to be finally executed when the insolvency court’s order on the confirmation of the insolvency plan becomes non-appealable.

IV. New legal basis

1. Tax exemption on restructuring profits

Due to the legal uncertainty that followed the BFH’s decision and the risk of a dismantling of a high number of businesses capable of restructuring as consequence of the expected tax burden on restructuring profits, the German legislator reacted immediately and settled the tax exemption on restructuring revenue in the „Act against harmful tax practices in connection with the licensing of intellectual property rights“ dated 27 June 2017 (Federal Law Gazette, first part, page 2074) by passing sec. 3a Income Tax Act (EStG), sec. 8 sentence 6 Corporate Tax Act (KStG) and § 7b Trade Tax Act (GewStG).
The new law essentially stipulates that business income from a debt relief for the purposes of a business-related restructuring is exempted from tax (so-called restructuring revenue). The tax exemption on restructuring profits requires the taxpayer to prove the
– Company’s need for restructuring
– Company’s potential for restructuring
– Debt relief’s suitability for restructuring
– Operational merit of the debt relief
– Creditors‘ intention to restructuring
at the time of the debt relief.
With the exception of the criteria of the operational merit, all conditions were adopted from the recapitalization decree. Therefore in the future, it is possible to refer to the respective courts decisions taken hereto in the past.
Even in case of a non-business-related restructuring, the revenues resulting from following restructuring cases are exempted from tax:
– a residual debt discharge pursuant to sec. 286ff. German Insolvency Code (InsO),
– due to an extrajudicial debt settlement plan to avoid a consumer insolvency pursuant to sec. 304ff. InsO,
– due to a debt settlement plan which was accepted in the process of a consumer insolvency proceeding (in case of an increase in business assets or the existing of business income).
Tax-related option rights have to be exercised in a way that decreases the profits in the restructuring year and the year after. Furthermore, business asset reduction or operating expenses as well as disposal costs which are economically directly connected with the tax-free restructuring profits cannot be deducted and reduce the restructuring revenue.
By passing comparable provisions in the Corporate Tax Act (KStG) and Trade Tax Law (GewStG) a harmonization in the tax authority practice should be achieved with regard to the individual tax types.

2. Elimination of “loss carried forward”

The tax exemption is additionally limited by the overriding setting off of losses to the necessary minimum. According to the explanatory memorandum a bare tax exemption on the restructuring profits would result in an objectively not justified double privilege just like under the old version of sec. 3 Nr.66 EStG. The restructuring profit would then not be balanced out by negative income and especially not be reduced by possible determined losses carried forward in accordance with sec. 10 para. 4 EStG which then could be carried forward for an unlimited period of time. Therefore, sec. 3a para. 3 EStG stipulates that existing losses and losses carry forward from previous years, the restructuring year and the year after will be used up to the amount of the restructuring revenue reduced by the non-deductible restructuring costs as laid down in sec. 3 para. 4 EStG. The order of the loss consumption stipulated in sec. 3a para. 3 sentence 2 no. 1 to 13 EStG applies with the consequence that the listed potential offset taxes get lost insofar as the settlement of loses is effective.
Contrary to the initial bill, the generalized elimination of determined losses carried forward by claiming the tax exemption was deleted. Instead an unclear provision was passed which stipulates the reducing amounts according to sec. 3a para. 3 sentences 2 and 3 EStG are finally excluded and do not participate in the respective determinations of losses carried forward, the remaining losses carried forward and any other determinations (sec. 3a para. 3 sentence 5 EStG). Against the historical background of the different bills, especially the refraining from a provision in the current version of the law, according to which the determined losses carried forward are generally cancelled when claiming the tax exemption, the wording of sec. 3a para. 3 sentence 5 EStG (“The reducing amounts according to sentence 2 and 3…”) and the statutory system of sec. 3a para. 3 sentence 2 no. 1 to 13 EStG, according to which the loss allocation has to be carried out (only) in the order stipulated therein, it can be assumed that a general cancellation of the loss deduction at the assertion of tax exemptions does not longer apply, but the loss decline applies to the extent that a loss allocation was carried out within the “waterfall” of sec. 3a para. 3 sentence 2 no. 1 to 13 EStG. The minimum taxation (sec. 10d para. 2 EStG) is also suspended, i.e. the existing loss potential will be (completely) eaten up to the amount of an existing restructuring revenue.

V. Assessment of the new legal regulations and outlook

As of the approval of the EU commission, the new regulations provide for legal certainty and are appreciated with regard to the intended harmonization of the treatment of business-related restructuring profits under Income Tax Law, Corporate Tax Law and Trade Tax Law. While under the previous legal situation the granting of tax exemptions with respect to the trade tax by the local authority which is (furthermore) competent for charging the trade tax always depended on an (additional) individual assessment based on the discretionary of the respective local authority which could result in divergent decisions to the decisions made by the other tax authorities, the decision of the local authority with respect to the trade tax has now to comply with the new sec. 7b GewStG and is mandatory when all legal requirements are met. This will substantially increase the legal certainty.