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Reform of the Reorganization Tax Act and Related Changes

Presented by: Dr Joachim Englisch, Dr. Jur., Senior Research Fellow, Tax Law Institute, University of Cologne.
The article will be published in European Taxation, Issue 7, 2007.
© copyright by IBFD

Contents

1. Introduction
2. Reform of the Reorganization Tax Act
   • 2.1. Introductory remarks
   • 2.2. Extension of territorial scope
     • 2.2.1. Background and overall effect
     • 2.2.2. Foreign entities
     • 2.2.3. Foreign reorganizations
   • 2.3. Privileged restructuring operations
     • 2.3.1. Mergers, divisions and changes of legal form
     • 2.3.2. Reorganization of transparent entities and singular succession asset transfers
3. Related Changes
   • 3.1. Introductory remarks
   • 3.2. Exit taxes
   • 3.2. Transfer of registered office or place of management
4. Entry into Force
5. Conclusions

1. Introduction

Until recently, cross-border reorganizations have not been facilitated in German corporate law. This began to change when the Council Regulation on the Statute for a European company (Societas Europaea, SE) entered into force on 8 October 2004 *1. In addition, in October 2005, the Council enacted a Directive on the cross-border mergers of limited liability companies *2. The German government has already initiated the legislative process so as to conform the Reorganization Act (Umwandlungsgesetz) to the Directive's requirements *3. The government has also been encouraged to do so as a result of the SEVIC judgment of the European Court of Justice (ECJ), according to which a general refusal to register inboun cross-border mergers constitutes a violation of the freedom of establishment set out in Art. 43 of the EC Treaty *4. The general terms adopted by the ECJ to support its findings suggest that outbound mergers must be facilitated under the same conditions as for comparable internal transactions *5, even though this might imply overruling the earlier Daily Mail *6 judgment.

These developments have finally given practical relevance to the EC Merger Directive *7, which provides for the deferred taxation of capital gains arising from cross-border company restructuring carried out by way of mergers, divisions, transfers of assets or exchanges of shares. Prior to this, the most of this EC law framework for the taxation of trans-frontier restructuring operations within the European Union had been ignored by the German legislator due to a legally inherent lack of materialization regarding most transactions. In view of the advances in the corporate law environment, the German government, however, acknowledged a genuine requirement to adapt the isolationist perspective of the relevant tax rules to the challenges of the Internal Market. The government, therefore, suggested a reform bill, even in advance of the proposed Reorganization Act *8. In December 2006, after a little more than half a year of parliamentary debate and expert hearings, the SEStEG *9 (hereinafter: the SE Tax Act) was adopted. This Act is intended to reconcile the German system for taxing company restructurings with EC law requirements and to increase Germany's attractiveness as a company location, whilst, at the same time securing the entitlement to tax as yet unrealized appreciations in the value of assets *10.

2. Reform of the Reorganization Tax Act

2.1. Introductory remarks

Most, but not all of the provisions regarding fiscally neutral company restructuring are contained in the Reorganization Tax Act (Umwandlungssteuergesetz, UmwStG) *11. The Reorganization Tax Act covers direct taxes on mergers, divisions, the transfer of qualifying assets by way of singular succession, an exchange of shares and a change in legal form if the latter has fiscal implications *12. The personal scope of the Reorganization Tax Act extends to both corporations and fiscally transparent companies *13 as well as to sole proprietors. A transfer of assets, a division or a partial division can, however, only benefit from fiscal neutrality if the assets transferred and, eventually, also the remaining assets, form an "operational unit", i.e. a qualifying business unit capable of sustaining organizationally independent business activities. An exception is made solely in respect of the transfer of a partnership right in a fiscally transparent entity.

2.2. Extension of territorial scope

2.2.1. Background and overall effect
Prior to the adoption of the SE Tax Act, only a few provisions permitted a tax deferral in restructuring operations that involved non-resident corporations *14. In general, only resident corporations could benefit from the rules permitting fiscally neutral reorganizations with regard to federal income or corporate income tax, on the one hand, and local business tax on the other. The reform has considerably extended the territorial scope of the Reorganization Tax Act. It has, however, resulted in the "Europeanization" rather than the globalization of the tax system in respect of company restructurings. This is because transactions involving companies from third countries usually still result in immediate taxation both at company and at shareholder and/or partner level *15.

2.2.2. Foreign entities
For a restructuring operation to qualify for a tax deferral, it is now sufficient that both the transferring and the receiving entity are companies that fall within the meaning of Art. 48 of the EC Treaty or Art. 34 of the European Economic Area (EEA) Treaty, which have been created in accordance with the law of an EEA Member State and which have their registered office as well as their principal place of business in one of these Member States. An SE or a European Cooperative Society (Societas Cooperativa Europaea, SCE) is deemed to satisfy these requirements if its office is registered in a Member State. If a natural person is directly involved in the reorganization, he must be a resident of a Member State for tax purposes. Fiscally transparent companies are also included, but, if they are the transferring or acquired company, the direct or indirect partners who are subject to tax must also normally meet the aforementioned criteria with regard to their seat or place of residence *16.

2.2.3. Foreign reorganizations
In addition to a wider personal scope, the types of formal reorganizations that can benefit from a tax deferral are no longer restricted to the national operations provided for in the Reorganization Act. Instead, the Reorganization Tax Act now extends to "comparable" cross-border or foreign reorganizations governed by the commercial law of any other country, as well as to mergers that result in the creation of an SE or SCE as set out in Art. 2(1)(17) of the SE Regulation and Art. 2(1)(19) of the SCE Regulation, respectively. The preparatory documents specify that a foreign reorganization may be classified as comparable if the entities involved feature the typical characteristics of a national company that would qualify for the relevant procedure under the Reorganization Act and if the operation essentially has the same consequences in substance.

In particular, the government draft referred to dissolution without going into liquidation in respect of a merger or split-up, universal succession and comparable limits for additional cash payments. Remarkably, these prerequisites are somewhat stricter than the definitions of mergers and divisions regarding the substantial scope of Art. 2(a), (b) and (b)(a) of the EC Merger Directive, which do not contemplate singular or universal succession. In effect, there should be no relevant lacunae, though, as the law regarding mergers and divisions is already harmonized within the European Union. In borderline cases, the comparability criterion must be interpreted in conformity with the EC Merger Directive *17.

1) Council Regulation (EC) No. 2157/2001 of 8 October 2001, Official Journal (EC), L 294, 10 November 2001, p. 1. The Regulation provides for the formation of an SE by means of, inter alia, a cross-border merger and features the possibility to transfer the registered office of an SE between Member States without the SE being dissolved. Since 18 August 2006, the parallel Council Regulation on the Statute for a European Cooperative Society also applies. See Art. 80 of Council Regulation (EC) No. 1435/2003 of 22 July 2003, Official Journal (EC), L 207, 18 August.2003, p. 1.

2) Directive 2005/56/EC of the European Parliament and of the Council of 26 October 2005, Official Journal (EC), L 310, 25 November 2005, p. 1. The Directive permits the cross-border merger of a national limited liability company with a limited liability company from another Member State. It must be complied with by 15 December 2007.

3) Draft of the Second Act amending the Reorganization Act (Entwurf eines Zweiten Gesetzes zur Änderung des Umwandlungsgesetzes) of 12 October 2006, BT-Drs. 16/2919

4) ECJ, 13 December 2005, Case C-411/03, SEVIC Systems AG, Para. 20 et seq. If domestic companies may merge and, therefore, transfer their assets by dissolution without liquidation, foreign corporations must, in principle, have the same opportunity, notwithstanding the present absence of directly applicable Community harmonization rules.

5) See C.P. Schindler, "Cross-Border Mergers in Europe -- Company Law is catching up!", 3 European Company & Financial Law Review (2006), p. 117.

6) See ECJ, 27 September1988, Case 81/87, The Queen v. H.M. Treasury and Commissioners of Inland Revenue, ex parte Daily Mail and General Trust plc, Para. 18 et seq., as confirmed in ECJ, 5 November 2002, Case C-208/00, Überseering BV v. Nordic Construction Company Baumanagement GmbH (NCC), Para. 65 et seq.

7) Council Directive 90/434/EEC of 23 July 1990, Official Journal (EC), L 225, 20 August 1990, p. 1, as amended by Council Directive 2005/19/EC of 17 February 2005, Official Journal (EC), L 58, 4 March 2005, p. 19. For more on the changes introduced by Directive 2005/19/EC, see R. Russo and R. Offermanns, "The 2005 Amendments to the EC Merger Directive", 46 European Taxation 6 (2006), pp. 250-257.

8) This Act contemplates forms of reorganization that imply the universal succession of the receiving company, i.e. a merger, a division or a change in legal form.

9) Gesetz über steuerliche Begleitmaßnahmen zur Einführung der Europäischen Gesellschaft und zur Änderung weiterer steuerrechtlicher Vorschriften vom 7.12.2006, BGBl. I 2006, 12 December 2006, p. 2782.

10) See the introductory remarks of the government draft, BR-Drs. 542/06, p. 1. Another stated objective was the simplification of taxation, which is a promise that the final legislation does not really live up to.

11) This legislation can, broadly, be subdivided into four parts. The first part is concerned with the scope of the application and general aspects of all the operations covered (Sec. 1 and Sec. 2 of the UmwStG), the second addresses the reorganization of corporations in one of the forms provided for in the Reorganization Act (Sec. 3 to Sec. 19 of the UmwStG), the third contemplates the corresponding operations by individuals or fiscally transparent entities as well as informal restructuring by way of a transfer of qualified assets or an exchange of shares (Sec. 20 to Sec. 25 of the UmwStG), and the final part administers the relatively complex issue of temporal applicability (Sec. 27 of the UmwStG). Parts 2 and 3 are subdivided according to the fiscal category of the receiving company and, subsequently, the specific operation carried out. It should be noted that the official system is less sophisticated, as the law only refers to sub-parts.

12) Indirect taxes are charged if the general conditions for their levy are satisfied by the characteristics of the individual restructuring operation. Accordingly, a transfer of ownership of real estate in the course of a reorganization gives rise to real estate transfer tax (an exception exists for a change in legal form) and the transfer of assets in exchange for shares or partnership rights by way of singular succession may be liable to VAT. The latter administrative practice is disputed and could be relinquished following recent ECJ decisions.

13) In Germany, the following companies are treated as fiscally transparent: a limited commercial partnership (Kommanditgesellschaft, KG), a general commercial partnership (Offene Handelsgesellschaft, OHG), a partnership for professional service providers (Partnerschaftsgesellschaft, PartG) and a "civil law association" (Gesellschaft bürgerlichen Rechts, GbR).

14) Most notably, a commercial establishment or an operational unit of a resident corporation could be transferred to a company from a Member State within the meaning of Art. 3 of the EC Merger Directive without capital gains taxation if the corresponding assets were then attributed to a PE of the latter that was situated in Germany or created there in the process. Along the same lines, taxation could be avoided if the assets transferred had already related to a German PE of a transferring non-resident company from a Member State. A fiscally neutral exchange of shares of companies from a Member State to establish or create a majority holding position of the receiving corporation was also possible if the shares granted to the transferring company were still liable to tax in Germany.

15) For some exceptions, see the subsequent detailed analysis in 2.3.

16) Details are provided in the course of the subsequent analysis in 2.3.

17) See the landmark decision ECJ, 10 April 1984, Case 14/83, Sabine von Colson and Elisabeth Kamann v. Land Nordrhein-Westfalen, Para. 26.

2.3. Privileged restructuring operations

2.3.1. Mergers, divisions and changes of legal form
The tax treatment of potentially privileged mergers or divisions that involve the transfer of assets of a corporation liable to corporate income tax depends in a large part on the valuation of these assets on the tax balance sheet, which the transferring corporation has to prepare in respect of the restructuring operation. In general, all the assets transferred in the course of a merger or division by the transferring corporation, including any as yet uncapitalized intangibles, must be accounted for at their fair market value in the tax balance sheet to be prepared in respect of the reorganization. The previously relevant going concern value is, therefore, replaced. This reflects an underlying change in the fiscal perception of the reorganization as a full or partial liquidation of an entity that has to date been subject to tax. The transferring corporation may, however, opt for assessment using the present book value or an intermediate value in as far as the following conditions are satisfied *18: i.e. that any eventual capital gain resulting from the sale of the assets is taxable in Germany to the same extent as before the reorganization and the consideration, if any, consists of shares in the receiving company *19.

Any accounting profits of the transferring company arising from an eventual step-up may be set off against current losses or losses carried over from prior assessment periods within the limits of the general minimum taxation rules *20. The remaining profits are deemed to be capital gains and are taxed accordingly. The assets transferred become the business assets of the receiving company, with the latter being bound by the evaluation of the transferred assets for the purpose of its own tax accounting. The receiving company also assumes the position of the transferring company in all aspects relating to the assets transferred, such as the depreciation method adopted. Given the territorial scope of these provisions, they fully comply with Art. 4 of the EC Merger Directive. In addition, a special provision deals with the transfer of assets effectively connected to a foreign permanent establishment (PE) situated within the European Union in accordance with Art. 10(2) of the EC Merger Directive, i.e. a tax credit is granted for fictitious foreign tax on the capital gain that would have arisen had the assets of the PE been sold at fair market value *21.

If the corporation merges or splits into a fiscally transparent company, the law now states that all or a corresponding part *22 of its disclosed reserves are then taxed as if they were distributed to the shareholders on a pro rata basis as dividends. For non-resident shareholders, this means that Germany applies treaty provisions resembling those in Art. 10 of the OECD Model Convention (hereinafter: the OECD Model) and exercises its right to levy a withholding tax up to a maximum of 20%. As, in reality there is no cash flow, this newly introduced feature that is designed to secure source state entitlement to what would have been prospective profit distributions could significantly adversely affect the liquidity of the shareholders and amount to a serious obstacle for company restructuring. Notwithstanding this, a violation of the EC Merger Directive cannot arise, since, as a fiscally transparent company, the receiving entity is not entitled to the tax exemptions contemplated in Art. 7 and Art. 8 *23. Whilst, however, resident shareholders can often reclaim all, or, at least, most of the withholding tax, in a later tax assessment or ultimately pay only 1.25% if they are corporations, due to a shareholder relief *24, the ensuing tax burden for non-resident shareholders is significantly higher, as they are ineligible for the relief, unless a treaty inter-corporate dividend exemption applies *25. In the light of recent ECJ rulings regarding the discriminatory denial of dividend exemptions to non-resident shareholders *26, an appeal should be filed against any such treatment.

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18) A special rule provides for the mandatory carry-over of book values under these conditions if both the merging and the receiving company are corporations subject to German corporate income tax and resident of the same third country outside the EEA. Apart from this peculiarity, third country involvement results in the denial of any tax deferral.

19) If the receiving company is considered to be fiscally transparent, the second requirement must be satisfied for each corporation or physical person who, directly or indirectly, (i.e. via other transparent entities) holds partnership rights. This implies that the option may be exercised only partially, but uniformly in respect of all the assets affected, if only some but not all of the relevant partners are residents or domiciled in a state that permits unrestricted German taxation to the extent possible before the reorganization.

20) Current losses and a loss carry-over of up to EUR 1 million may be fully set off. In excess of this threshold, only 60% of the remaining profits may be set off against the remaining loss carry-over. The possibility for a loss set-off is the main incentive for the choice of an assessment with a certain intermediate value that partially discloses hidden reserves. It must, however, be remembered that the reserves thereby disclosed could be taxed in the hands of the shareholders, as demonstrated in the next paragraph of the main text.

21) No such tax deferral is available for the assets attributable to a PE located in a third county, which is an EEA Member State. This unequal treatment is inherent in Art. 10(2) of the EC Merger Directive, but is, nevertheless, hard to reconcile with the prohibition of any discrimination included in the freedom of establishment as set out in Art. 31 of the EEA Agreement. Anyway, the entitlement to subsequent taxation in Art. 10(2) of the EC Merger Directive is of little importance for Germany, which usually agrees on the exemption method in the tax treaties it concludes. This may, however, have effect mainly in respect of PE activity clauses.

22) In respect of a split-off, the reserves are allocated pro rata, based on the relationship between the fair market value of the assets transferred, on the one hand, and the fair market value of the corporation's entire assets, on the other.

23) If the receiving fiscally transparent company is non-resident, Germany may derogate from Art. 8(1) to (3) of the EC Merger Directive and apply the same treatment as it would if the receiving company had been resident by virtue of Art. 10a(3) and (4). Fiscally transparent companies resident in Germany for tax purposes, in turn, do not usually fall within the personal scope of the EC Merger Directive as specified in Art. 3(a), as Germany has listed only non-transparent corporations in the Annex. In the exceptional case of a qualifying partnership that has been formed in another Member State and has later moved its registered office to Germany, it is, at least, not considered in itself to be resident in any Member State and, therefore, fails to satisfy the requirements of Art. 3(b) of the EC Merger Directive.

24) Individual shareholders are assessed at their personal income tax rate only on half of the dividend, which can also be set off against negative income, in particular, against an eventual "transactional loss" discussed in the next paragraph of the main text. Corporate shareholders benefit from an inter-corporate dividend exemption and only 5% of the gross amount is deemed to be non-deductible business expenses, which are subject to corporate income tax at 25% (plus local business tax, in respect of which no withholding tax applies)

25) The exemption from withholding tax contemplated in Sec. 43b of the Income Tax Act (Einkommensteuergesetz), which implements Art. 5 of the EC Parent-Subsidiary Directive, does not provide any relief, as it has been amended to exclude explicitly fictitious dividends of the kind discussed above. Whilst this does not violate the EC Parent-Subsidiary Directive, as the latter also only covers a real rather than a fictitious cash flow, the exclusion is, nevertheless, contrary to the spirit of the reform. The new rule is intended to secure an existing source state entitlement, but, had the disclosed reserves actually been distributed, Art. 5 of the EC Parent-Subsidiary Directive would have prevented taxation. Accordingly, Germany would not be entitled to a withholding tax in the first place.

26) See ECJ, 12 December 2006, Case C-374/04, Test Claimants in Class IV of the ACT Group Litigation v. Commissioners of Inland Revenue, Para. 68 and ECJ, 14 December 2006, Case C-170/05, Denkavit Internationaal BV, Denkavit France SARL v. Ministre de l’Économie, des Finances et de l’Industrie, Para. 34 et seq.