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German Federal Fiscal Court Impedes Restructurings

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Herding Franz Bernhard
Dr Franz Bernhard Herding


Frankfurt am Main

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09 February 2017

In its ruling dated 28 November 2016 (GrS 1/15) which was published yesterday, the German Federal Fiscal Court (Bundesfinanzhof) through its Great Senate declared the so-called Restructuring Decree (Sanierungserlass) unlawful.  The decision affects ongoing restructurings involving a waiver of creditors' claims (a haircut).  It may also affect restructurings which have already been concluded but have not yet been finally assessed in terms of tax.

Cancellation of indebtedness income generally subject to taxation

In the context of restructurings, creditors may waive claims they have against a debtor. Such waiver results in a book profit for the debtor and gives rise to income from the cancellation of indebtedness (COD income) which is generally taxable. Any tax losses or tax loss carry-forwards of the debtor may generally be offset against the COD income. Such a set-off of losses, however, often proves ineffective as the losses actually suffered are not tax-deductible (e.g. write-down on shareholdings) or are ring-fenced or have to be spread over time (in particular due to the German minimum taxation rule).

Accordingly, it is well possible that the COD income could become subject to tax. Since the tax will have to be paid and thus becomes outgoing without being offset by any liquidity inflow, it may impede the restructuring. As a result, the waiver needed to restructure the business may not be feasible due to its tax disadvantages.

The Restructuring Decree of the tax administration

With its Restructuring Decree, the tax administration intended to provide relief in this matter (circular issued by the German Federal Ministry of Finance (Bundesministerium der Finanzen) on 27 March 2003). According to the Decree, the tax authorities were, by way of equitable measures, first to permit a full set-off of all tax losses against the COD income irrespective of the general limitations, and then were to waive the taxes on any remaining COD income, provided certain criteria were met.

The new court ruling

With the ruling published yesterday, the Federal Fiscal Court found that the Restructuring Decree does not comply with the principle of legality of the tax administration. The court stated the following reasons for its decision: The tax authorities are obliged to levy the taxes prescribed by law (§ 85 (1) of the General Tax Code (Abgabenordnung)). They may only refrain from levying such taxes if this is inequitable in the individual case for objective or personal reasons. According to the court, however, such equitable measures may only serve the purpose of alleviating any "hardship in the individual case" which would not be compatible with the outcome actually intended by the legislator. Reasons beyond the field of tax law, e.g. reasons of economic, labour, social or cultural policy, may not be relied on to justify equitable measures. It is the legislator's prerogative to also consider non-fiscal reasons in tax law. It is not up to the tax authorities to promote the inclusion of such non-fiscal reasons into tax law by issuing a general administrative decree.

By eliminating the pre-existing tax exemption for COD income (§ 3 no. 66 of the German Income Tax Act (Einkommensteuergesetz), prior version) in 1997, the legislator made it clear that it was no longer willing to grant tax privileges in respect of COD income. According to the Federal Fiscal Court, it is imperative to further comply with the legislator's will even if circumstances have changed significantly in the meantime, in particular in respect of deducting and offsetting losses. For this reason, the criteria of the Restructuring Decree as derived from jurisprudence relating to the pre-existing law are also no longer applicable. Although the court does not rule out that tax relief for COD income may still be granted based on the principles of equity, it emphasises that such relief could only be given subject to special circumstances and having regard to objective or personal hardship in the individual case. The court, however, did not specify such circumstances.

Assessment and potential remedy

The ruling of the Federal Fiscal Court is regrettable as it will at the very least complicate successful restructurings and will contravene the restructuring efforts of creditors who already bear the losses from the impairment of their claims. This is a significant set-back for Germany as a jurisdiction facilitating restructurings. It remains to be seen how the tax administration and the legislator will react to this decision. Judging from the reasons cited in the ruling, however, the tax administration may find it difficult to replace the Restructuring Decree with a new rule that is based on abstract criteria and enables predictable decisions.

Implications in practice

In the case of already concluded restructurings which have not been finally assessed by the tax authorities the following should apply:

  • If a tax ruling has been issued in which equitable measures are granted, the debtor should be able to rely on such ruling. Although the Restructuring Decree has been set aside, a tax ruling cannot be revoked if the claims waiver has already been effected. Although a tax ruling ceases to apply if the underlying statutory provisions (Rechtsvorschriften) are cancelled or amended (§ 1 (2) of the German Tax Ruling Ordinance (Steuer-Auskunftsverordnung)), the Restructuring Decree as an administrative order (Verwaltungsanweisung) should not constitute a statutory provision. As a rule, the wording of, and the precise nature of the relief granted by, the respective tax ruling are of particular relevance.
  • Where the claims waiver was effected absent any tax ruling, the debtor will probably no longer be able to invoke the Restructuring Decree. Even if all the criteria specified therein are met, there is no claim for equitable measures. Any extended set-off of losses and a waiver of tax may only be granted based on the special circumstances in the individual case. Where no such special circumstances can be shown, there is the risk of the COD income becoming subject to tax. It remains to be seen whether the tax authorities will have at least stick to the tax assessment notices they have already issued on the basis of the Restructuring Decree due to the rules on the protection of legitimate expectation (§ 176 (2) General Tax Code); this may be particularly relevant for the unrestricted set-off of losses against the COD income.

In the case of ongoing restructurings a tax-neutral claims waiver can no longer be achieved by meeting the criteria of the Restructuring Decree. In addition, the following should be borne in mind:

  • It remains to be seen whether the tax authorities will be of help in the individual case by issuing a tax ruling, in particular as the Federal Fiscal Court declared the main justifications from practice for such rulings (preserving local companies and jobs) to be irrelevant. It is therefore questionable whether any assistance can be expected from the tax authorities. Where it is not possible to obtain a positive decision in the individual case, other restructuring measures will have to be utilised, at least as an interim solution until the legislator or the tax administration have created a replacement for the now no longer available Restructuring Decree.
  • Until then, the court ruling will represent a new challenge for restructurings in practice. Instead of the typical claims waiver (potentially against a debtor warrant) other restructuring measures of the creditors could be implemented, such as qualified subordination (qualifizierter Rangrücktritt) or structures involving the assumption of debt. If these do not reach the intended aim for the particular restructuring case, the sustainable restructuring of a company will undoubtedly be impeded and, accordingly, the court ruling may represent an incentive to set up restructurings in a foreign jurisdiction.

In conclusion, despite the upcoming general elections in September 2017, the legislator should urgently correct the current situation because it is essential for every successful restructuring that it is not impeded by taxes on mere book profits. Otherwise enterprises, their assets and employees are at risk.

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