New option model for partnerships – Part III Will exercising the option founder over special business assets?

Last time, in the second article of our series of detailed explanations of the German Act on the Modernisation of Corporation Tax Law, we discussed the effects of the notional change of legal form on special business assets. In this issue of our newsletter, we have taken the Federal Ministry of Finance’s (Bundesministerium der Finanzen, BMF) draft on the option to be treated as a corporation for tax purposes (Section 1a of the Corporation Tax Act [Körperschaftsteuergesetz, KStG]), of 30.9.2021, as the basis for our examination of the effects of withholding special business assets.

The BMF draft on the option to be treated as a corporation for tax purposes (Section 1a KStG)

The German Act on the Modernisation of Corporation Tax Law, 25.6.2021, introduced, among other things, the option to be treated as a corporation for tax purposes pursuant to Section 1a KStG. The BMF, in its draft circular on the option to be treated as a corporation for tax purposes (Section 1a KStG), addressed a series of questions of interpretation. The BMF’s opinion on dealing with special business assets deserves particular attention because, in individual cases, this could materially affect the decision for or against exercising the option. 

The basis for the option

According to Section 1a(2) sentence 1 KStG, exercising the option constitutes a notional change of legal form within the meaning of Section 1(3) no. 3 of the Reorganisation Tax Act (Umwandlungssteuergesetz, UmwStG). Consequently, for tax purposes, the notional change of legal form is treated in the same way as a genuine change of legal form of a partnership into a corporation so that Sections 1 and 25 UmwStG have to be applied accordingly; moreover, pursuant to Section 20(2) UmwStG, each shareholder has the right to elect to separately recognise assets at book value or a higher value but, at most, at their fair market value. 

The contribution

A tax-neutral contribution of company shares at book value, pursuant to Section 20(2) sentence 2 UmwStG, requires all the economic assets that are essential for operations for the entire shareholding to be contributed to the company that has elected to exercise the option. A contribution at book value would be precluded if economic assets that are essential for operations but are held as special business assets were withheld. These economic assets would be deemed to have been withdrawn if, at the start of the financial year when the option is activated, they form a part of another set of business assets. 

Recommendation: Therefore, particular caution is required if shareholders do not want to transfer economic assets that are essential for operations but are held as special business assets to the company that has elected to exercise the option because, in such a case, there would be a risk that the measurement option would be disallowed and the hidden reserves realised.

Withholding economic assets

Withholding special business assets 

If a shareholder keeps back economic assets that are essential for operations that they hold as special business assets (e.g., a piece of real estate) then, pursuant to Section 20(2) sentence 2 UmwStG, the shareholding in the company transferred by the shareholder will be precluded from being recognised at book value because the entire shareholding will not have been transferred to the company that has elected to exercise the option. In such cases, the respective share in the company will be deemed to have been relinquished. The hidden reserves in the shareholding and the special business assets would have to be realised. 

Withholding an equity interest

According to the BMF’s draft circular, if a shareholder of the company that has elected to exercise the option does not transfer to the company that has elected to exercise the option their equity interest in the general partner GmbH [a German limited liability company] whose function as general partner company is limited to the management at the company that has elected to exercise the option and which, in view of the circumstances of the individual case, should be classified as business assets that are essential for operations then this would preclude a transfer of assets at book value.

Retaining special business assets in the parent company’s business assets

If economic assets that are essential for operations that are held as special business assets remain in the parent company’s business assets, then these would have to continue to be carried at book value. However, according to the BMF’s draft circular, there is a risk that the entire hidden reserves of the share in the company would have to be realised.

Please note: The current situation means that keeping back a shareholder loan would indeed be harmful for a transfer at book value even though such a loan would not have any hidden reserves. 

A transfer in advance to an affiliated company

If a shareholder does not transfer economic assets that are essential for operations that are held as special business assets to the business assets of the company that has elected to exercise the option but, instead, transfers them to another set of business assets then, according to the BMF’s draft circular, margin no. 20.07 of the German Reorganisation Tax Decree would apply to the notional change of legal form under Section 1a KStG.

Therefore, to determine the applicability of Section 20(2) sentence 2 UmwStG it will be necessary to review the requirements under the ‘step transaction rules’. 

The series of steps within the meaning of the case law of the Federal Fiscal Court (Bundesfinanzhof, BFH) is a single set of commercial circumstances that because of a plan that is made in advance are ‘artificially’ dissected; here, the individual steps will be assumed to be significant only insofar as they facilitate the attainment of the final state. Normally, the artificial dissection is supposed to achieve more favourable taxation. In the case of sale transactions that are subject to tax the aim is to reduce the assessment base. If a ‘sell-off plan’ involves several steps then all of these steps have to be conceptually bracketed together and considered to be a single transaction.

Consequently, there is a risk that, e.g., an advance transfer, at book value, of the economic assets that are essential for operations but held as special business assets to an affiliated GmbH & Co. KG [German limited partnership with a limited liability company as a general partner], where the transfer is commercially related to and occurs at the same time as the exercise of the option by a company, will constitute an artificial dissection of a single set of circumstances to achieve favourable taxation. In the opinion of the fiscal administration, the above situation could preclude the transfer of the remaining company shares at book value.

Conclusion and Outlook: The BMF’s draft circular will probably mean that, for many companies, the exercise of the option will founder over the strict requirements for the transfer of economic assets that are essential for operations but are held as special business assets as well as over the ‘step transaction rules’. It remains to be seen whether the BMF will publish this draft without any amendments, particularly with respect to the treatment of special business assets, or whether it will abandon its view on the transfer of special business assets as well as the application of step transaction rules and make the path to exercising the option significantly easier and more practical.