Recently the German legislature passed a new law, exempting extraordinary profits created by the waiver of claims under restructurings from income tax liability. The amendment was necessary because the German Federal Tax Court had previously held the original administrative decree (which in a conceptually different manner avoided the tax burden on such profits) unlawful. This article gives a brief overview over the legislative history and the practical consequences of the amendment.
1. LEGISLATIVE HISTORY
1.1 Restructuring Decree
In accordance with a decree issued by the German Federal Ministry of Finance in 2003 (the “Restructuring Decree”), it was a long-standing practice in the past that income taxes on extraordinary profits generated by the waiver of creditor claims were assessed under the unrestricted set-off of tax loss carry forwards, deferred and in the end fully waived.
1.2 Court Decision nullifying the Decree in 2016
In 2016 this common practice came to an abrupt end: The Grand Senate of the German Federal Tax Court (Bundesfinanzhof – BFH) held the decree unlawful for a breach of the principle of legality of administrative action, claiming there was no legal foundation for the administrative exemption in statutory law.
The court found that only the legislature had the legal competence for passing a general waiver regarding taxes on profits resulting from restructurings. Furthermore the court concluded that a waiver of taxes by the tax authorities must always be based on an individual assessment of the individual case (for a more detailed description see Dörr/Herweg/Tschauner/Borries/Eggert, German Federal Tax Court nullifies the Restructuring Decree: http://ehoganlovells.com/rv/ff002e4da92dfe304e1dd9c40e4daef848f6829d/p=2447420).
1.3 Legislative Countermeasures and EU State Aid Law
In order to restore the former legal situation, in 2017 the German legislature finally passed a formal law (Article 2 (2) Gesetz gegen schädliche Steuerpraktiken im Zusammenhang mit Rechteüberlassungen (hereinafter GsSZR) ) amending section 3a German Income Tax Act and explicitly exempting extraordinary profits created under restructurings from income tax liability. In addition the same result was reached for trade tax liability through Article 4 (2) GsSZR, creating a new provision in section 7b German Trade Tax Act. According to Article 2 (4) GsSZR (amending section 52 German Income Tax Act) and Article 4 (3) GsSZR (amending section 36 German Trade Tax Act) both provisions should only cover taxes on creditor claims waived after 8 February 2017.
However, the legislature had substantial doubts about, whether the new law would be in accordance with European State Aid Law. Therefore the lawmaker imposed the enactment of the newly created exemption in section 3a German Income Tax Act and section 7b German Trade Tax Act under the condition (Article 6 (2) GsSZR) that the European Commission would issue a decision (Article 288 (4) TFEU), regarding the new German tax approach not to be in breach of European State Aid law, especially the prohibition of state aid (Article 107 TFEU).
But instead of issuing the requested formal decision, the Commission only issued an informal comfort letter in which it considered the new approach an ‘existing aid’ according to Article 1 (b) (i) Council Regulation (EU) 2015/1589 of 13 July 2015, because the provisions had existed before the TFEU came into force. Therefore, the tax provisions are regarded as lawful as long as the Commission has and will not positively declare(d) them as incompatible with the common market.
Nevertheless the comfort letter does not qualify as decision pursuant to Article 288 (4) TFEU, so that the legal condition under which the new German provision could have come into force was not met.
As a result, the enactment of a new law (Gesetz zur Vermeidung von Umsatzsteuerausfällen beim Handel mit Waren im Internet und zur Änderung weiterer steuerlicher Vorschriften) is forthcoming. Article 19 of the bill amends the GsSZR and repeals the legal condition pursuant to Article 6 GsSZR described above. Therefore Article 2 (2) and 4 (2) GsSZR came into force with retroactive effect on 28 July 2017. Thus profits generated by waivers of claims under restructurings at the level of the debtor which take place after 8 February 2017 can be exempted from income tax liability.
Yet the fiscal destiny of creditor claims waived before 8 February 2017 (the “old cases”) remains uncertain. In reaction to the court decision nullifying the Restructuring Decree the Federal Ministry of Finance issued a new decree on 27 April 2017, stating that the Restructuring Decree would still be applicable to old cases. But as expected the BFH also held this decree unlawful on 23 August 2017 for a breach of the principle of legality of administrative action. Despite the court ruling, the tax authority issued another decree on 29 March 2018, insisting on the general applicability of the Restructuring Decree to old cases. At the moment a constitutional complaint (Verfassungsbeschwerde) regarding (inter alia) the issue, whether the decree is applicable to old cases, is pendent at the German Federal Constitutional Court (Bundesverfassungsgericht).
2. ECONOMIC BACKGROUND
Until the BFH nullified the Restructuring Decree, the waiver of (basically) worthless creditor claims was a standard measure in restructuring proceedings. The waiver creates a balance sheet profit of the debtor in the amount of the nominal value of the claim. Generally under German Tax Law such profit is taxable, but the income tax on such profit could be fully waived by the tax authorities because of the Restructuring Decree in the past.
Following the court decision, according to the court the waiver of such creditor claims was to result in tax payments on the generated profits, reducing the debtor’s liquidity. However, this result makes little sense economically, because the positive effects of the waiver are outweighed by the tax burden. Therefore in many cases between 2016 and 2018 the restructuring process was no longer profitable and forced a number of companies into liquidation, wasting great economic potential. The decrees issued by the Federal Ministry of Finance on 27 April 2017 and 29 March 2018 did not alter this result. Because of the BFH ruling and the pending constitutional complaint, it is uncertain to this day, whether the Restructuring Decree is still applicable to old cases, creating legal uncertainty.
3. PRACTICAL CONSEQUENCES AND CRITICISM
For this reason, the enactment of sections 3a German Income Tax Act and 7b German Trade Tax Act that exempt extraordinary profits created under restructurings after 08 February 2017 from tax liability is an important first step into the right direction in terms of restructuring. The new provision has a huge impact on the usability of insolvency plans and waivers of creditor claims, which both will gain more importance in the future again. Because of this practitioners should be aware of the amendment when deciding, whether a company should be restructured or liquidated.
As the exemption of restructuring profits from the tax base is now also regulated in the German Trade Tax Act, the competent tax office now also decides on the application of the exemption under trade tax law. This is a great advantage compared to the situation under the Restructuring Decree where the different municipalities in which the debtor was operating decided on the application of the rules of the Restructuring Decree for trade tax purposes.
However, as outlined above the legal situation regarding old cases (before 8 February 2017) is still uncertain as long as the German Constitutional Court has not decided about the applicability of the restructuring decree. It is incomprehensible that the legislature, as proposed by the Federal Council (Bundesrat) in the legislative procedure, did not create a provision also exempting old cases from the tax liability.
In addition one must remember, that the comfort letter is not binding for other EU institutions, especially the European Court of Justice (ECJ). If a national court requests a preliminary ruling by the ECJ (Article 267 TFEU), the court will not be bound by the Commission’s opinion issued in the comfort letter.
Overall the legislative approach is a step in the right direction regarding the future of restructurings but does not cover all of the relating problems, especially old cases. In addition, a rest of legal uncertainty remains in the area of European State Aid Law.