I. Brexit and limited companies: Consequences under corporate law

Brexit is imminent and a “hard Brexit” without any transitional system can currently not be excluded. This has far-reaching consequences for British Ltd.s which have their administrative headquarters in Germany (cf. the article in our 2018 | Q1 newsletter).
Due to the “freedom of establishment” applicable in the EU, the “headquarters theory” applicable in Germany, which determines the applicable corporate law according to the law of the administrative seat, is replaced by the so-called formation theory. This made it previously possible to establish a corporation under English law with its headquarters in Germany. With the entry into force of Brexit, subject to other negotiation results, such as the UK’s joining the EEA or for the duration of the “EU withdrawal agreement” recently adopted by the EU, these companies will in future again be treated according to the headquarters theory. The consequence will be that such Ltd.s will be treated in Germany as a German partnership or as a sole trader without any limitation of liability if they are (only) active in Germany and have no business activities in Great Britain.

II. Planned legislative amendments

In order to avoid these consequences, a transition of affected British Ltd.s into a legal form having a limitation of liability is necessary. Two current German legislative proposals are supposed to ease this process: The draft bill of the Federal Government to amend the Transformation Act (UmwG) of 10 October 2018 and the draft bill of the Federal Ministry of Finance (BMF) on the Brexit Tax Accompanying Act of 9 October 2018.

1. Draft bill to amend the Transformation Act

The UmwG is to be amended in §§ 122 et seq. Two important amendments are planned: A cross-border merger of Ltd.s into commercial partnerships should be possible. This enables the Ltd.s to convert into a German limited partnership (KG), for example, in which either a GmbH or an entrepreneurial company (with limited liability) can participate as a personally liable shareholder (“GmbH & Co. KG” or “UG & Co. KG”).
Further, the new § 122m UmwG contains a temporary provision for all cross-border mergers in which a company under British law is involved as the transferring legal entity and a company under German law is involved as the acquiring legal entity. The merger shall be possible also after the date of the Brexit under two conditions: Firstly, the merger plan must have been notarised before Brexit came into effect and secondly, the merger must be filed for entry in the commercial register immediately, but no later than two years after that date of the Brexit.

2. Draft of the Brexit Tax Accompanying Act

The BMF draft contains an amendment to § 22 of the Transformation Tax Act (UmwStG), which is intended to prevent Brexit from a retroactive taxation of the transfer profit following previous transfers pursuant to § 22 paras. 1 and 2 UmwStG (contribution in kind or exchange of shares below the fair market value).
In addition, § 4g of the Income Tax Act (EStG) is to be amended: Due to the future qualification of Great Britain as a third country, any adjustment items created under the current legal situation for economic assets which were previously allocated to a permanent establishment of a taxpayer in the United Kingdom would have to be dissolved immediately and in full (§ 4g para. 2 sentence 2 no. 2 EStG). This is to be prevented by the new § 4g para. 6 EStG, which stipulates that the withdrawal of the United Kingdom only does not trigger this legal consequence.
According to the opinion of the BMF, however, there is no need to amend the deferral rules in § 6 of the Foreign Tax Act (AStG): According to § 6 para. 5 AStG, a deferment of tax-payment may only be revoked if the relevant shares are transferred to a person resident in a third country or if the taxpayer transfers his residence to a third country. Brexit alone shall therefore not qualify as a ‘harmful event’, but a further act of the taxpayer (such as the free transfer of shares to a person resident in the United Kingdom or the relocation of the taxpayer from the United Kingdom to a non-EEA country) will trigger the subsequent taxation in Germany.
The BMF draft contains no statements in regards to the effects of Brexit concerning the regulation of wage bills according to § 13a para. 3 sentence 11 German Inheritance Tax Law (ErbStG). However, this would have been desirable since the withdrawal of the United Kingdom from the EU and EWR might lead to negative legal consequences regarding the determination of the yearly wage bills, which are to be sustained in order to gain the benefits under inheritance tax law and donation tax law, during the five-year or seven-year observation period.

III. Options for action

Against the background of these changes, the following options arise for shareholders of a Ltd. with administrative headquarters in Germany:

1. Cross-border merger into a German GmbH

Cross-border mergers are governed by §§ 122a et seq. UmwG, which implement the International Merger Directive. A Ltd. has until now qualified as a company capable of being merged within the meaning of the Directive; all German forms of capital companies can be considered as the target legal form.
However, the merger process is relatively complex and time-consuming: In addition to the preparation of a merger report and the drafting of the merger resolution by the GmbH, the application for a merger certificate at the competent High Court of Justice is also required (so-called pre-merger certificate). In the case of a “hard Brexit”, it is unlikely that this procedure can be completed in time. The planned amendment in § 122m UmwG takes this into account, since it will, as explained above, still permit the merger even if the merger process was initiated before Brexit by a notarial merger plan, even if the application for entry in the commercial register is not filed before Brexit.
The advantage of the merger is that all assets and liabilities are transferred to the GmbH by universal succession without the consent of the parties and creditors. The taxable realization of hidden reserves can also be avoided under the conditions of § 11 para. 2 and § 13 para. 2 UmwStG.
The biggest disadvantage in practice, however, apart from the very complicated procedure as such, is the substantial costs incurred thereby. In addition to the notarial costs and the registry costs, substantial attorneys’ fees are incurred, in particular for the hearing before the High Court of Justice, regarding the required representation by a British attorney who is admitted before the High Court.

2. Cross-border merger into a commercial partnership

Following the planned amendment of §§ 122a et seq. UmwG, commercial partnerships may in future also be involved as acquiring legal entities in a cross-border merger, whereby a merger into a general partnership (OHG) or a limited partnership (KG) could also be considered. In the case of a merger of a limited company into a KG, for example, the company would not have to meet the threshold of minimum capital requirements, if the personally liable shareholder of the KG were an entrepreneurial company (with limited liability). In addition, a tax-neutral book value continuation in Germany in accordance with §§ 3 et seq. UmwStG is in general possible.
However, there is great uncertainty as to the exact procedure to be followed: The merger of a corporation into a commercial partnership is not covered by the scope of the Merger Directive. According to the system of §§ 122a et seq. UmwG, however, a merger certificate of the British Companies House would also be required for this process. However, since there are no corresponding procedural rules on the British side, the process could already fail due to resistance from the Companies House. Moreover, this procedure would also involve the same amount of time and expenses as the merger into a corporation.

3. Cross-border change of legal form

A cross-border transformation of the Ltd. into a GmbH or a UG (with limited liability) could also be considered. In several decisions, the European Court of Justice has declared the cross-border change of legal form within the European internal market to be permissible. So far, however, there is a lack of standardized European and national procedural rules.
For this reason, the British Companies House, which has so far refused to recognize the cross-border change of form, is currently encountering opposition in practice. On 25 April 2018, the EU Commission presented the draft of the so-called Company Law Package, which, inter alia, provides for the creation of a standardized legal framework for cross-border changes of legal form. However, it cannot be assumed that these new rules will enter into force in reasonable time before Brexit.

4. Contribution in kind and exchange of shares

Finally, the transfer of the Ltd.s´ operations (contribution in kind) or the transfer of the Ltd.s´shares (exchange of shares) to a German corporation in exchange for new shares could also be considered. However, such transactions are subject to a blocking period pursuant to § 22 UmwStG and as a result of Brexit there is a risk of a retroactive taxation of the so-called transfer profit. The reason for this is that it has not yet been decided yet, how Ltd.s with their administrative headquarters in Germany are to be treated taxwise.
According to one opinion, the same principles apply as from a civil law point of view. As a result of Brexit, the reason for the previous legal recognition of a Ltd. in Germany would cease to apply, with the result that a change in the taxation regime would occur and the company would, in future, be treated for tax purposes as a partnership or as a sole proprietorship. The legal existence of a Ltd. as a corporation would thus cease, and, as a result the capital gain would have to be taxed retroactively in accordance with § 22 para. 1 sentence 1 UmwStG in the event of the transfer of the business or in accordance with § 22 para. 2 sentence 6 in conjunction with para. 1 no. 3 UmwStG in the event of the exchange of shares. Such taxation would, however, not be prevented by the new § 22 para. 8 UmwStG either, since the triggering event for the subsequent taxation would not be Brexit itself.
According to another opinion, the tax treatment of a Ltd. differs from the civil law treatment. According to this opinion the principles of the so-called type comparison apply, which stipulates that companies not formed under European law but according to their articles of incorporation, are equivalent to a corporation must also be treated as corporations in Germany. Accordingly, a Ltd. would continue to be subject to unlimited taxation in the same way as a corporation and its “tax shielding effect” would continue to exist. For transactions that were already legally effective prior to Brexit, the blocking period of § 22 UmwStG would therefore not be interrupted due to the planned amendment of the Transformation Tax Act and there would be no retroactive taxation of the transfer profit. However, this only applies as long as the company continues to exist in the UK. If the Ltd. will be deleted from the British Commercial Register, for example due to non-compliance with the obligations incumbent on the shareholders with regard to publicity and payment of fees to the UK Commercial Register, the company would also be dissolved and wound up in Germany, resulting in retroactive taxation of the so-called contribution profit.

IV. Conclusion

The efforts on the German side to enable British Ltd.s to make an orderly transition to a German legal form in view of Brexit are encouraging. For Ltd.s with administrative headquarters in Germany, however, the new statutory regulations are only partially effective. In particular, procedural uncertainties remain with regard to the cross-border merger into a German commercial partnership and the cross-border transformation of legal form. It also remains to be seen how the British Companies House will react to these events in the future. In the case of transfer of assets by way of contribution in kind or exchange of shares, it is currently not foreseeable whether a retroactive taxation of the contribution profit can be prevented due to the ambiguities in the tax classification of Ltd.s after Brexit. In practice, only the cross-border merger of a Ltd. into a GmbH or an UG (limited liability) is, therefore, a tax-neutral solution. However, this entails an expenditure of time and money that should not be underestimated.
It remains to be seen what the outcome of further negotiations at EU level will bring. For example, the withdrawal agreement approved on 25 November 2018 by the heads of state and government of the EU member states provides for a transitional phase until the end of 2020 (renewable once until the end of 2022), during which EU law continues to apply to cross-border situations between the UK and the EU states. The consequences under company law for Ltd.s described above would then only occur after expiry of this period and subject to any further interstate agreements. Due to the political uncertainties that are associated to the withdrawal agreement for the UK, however, it cannot be foreseen whether the British Parliament will approve this agreement or whether a “no deal” scenario with all the consequences involved will take place in March.