What data is processed in a company assessment?

A frequently asked question in practice is: In which assessment processes is which data processed? At the core, the question is based on whether certain processes process past data and other processes plan data. The answer is often provided based on which the earnings values process will process the past data. Another reason to dedicate a few lines to this question.

The company assessment is future-oriented since the “salesman knows there is no profit in the past”. In other words, a company evaluation in the framework of a transaction consultation has to process plan data because only then meaningful conclusions can be made regarding the future ability to cover interest and principal payments on the investment. This statement applies not only for transaction consultations but also to all kinds of company assessments by an overall assessment system. Once again to be clear, it is irrelevant whether earnings values processes or discounted cash-flow processes are used for assessment, the processed data is always derived from a company plan. This planning data is not only required to present the documentation of the realizations derived from the past analyses, they also have to illustrate the future market development and the consequences for the company’s performance.

The reason for many misunderstandings may be the simplified earnings value process which is only regulated for tax purposes in §§ 199 et seq. of the BewG (Valuation Act). In certain ways, this process is a successor of the Stuttgart process. The simplified earnings value process is generally used with the objective of simplifying the administration and application or in conjunction with very small companies and generally processes past data. However, only assuming that this past data is representative for the future (§ 201 Para.1 of the BewG). Should this condition not be fulfilled, this process also leads to obviously inaccurate results (§ 199 Para.1 of the BewG), which cannot be used as the reason for the tax assessment.

Base interest rate, spot rates and forward rates – the secure interest rate in the company assessment

Distributions and withdrawals from companies are not secure. The calculation interest rate at which these amounts paid out to the shareholders are discounted must demonstrate the same dimension of insecurity as the company to be assessed as per the condition of risk equivalence and thus the distributions and withdrawal potentials. The starting point for modelling the calculation interest rate is a secure interest rate. The quality of the interest rate with regards to the freedom from risk ensures that risk surcharges are not recorded multiple times when developing the calculation interest rate. In addition, the secure interest rate must have the same term, i.e. the period within which the interest rate is available must be the same as the duration of the company. Since companies are generally assessed under the assumption of an infinite existence, approximate solutions must be selected for the secure interest rate due to a lack of infinite interest contracts. The expensive modelling of calculation interest rates plays a role in the framework of the assessment of companies only in the scope of statutory and social contract-related assessment reasons, i.e. when determining objective company values.

In earlier decisions regarding public law-related settlement cases, the focus of case law referred to historical lending interest rates for long-term securities. The past 15 to 30 years of empirical data are thus incorporated into the calculation. Since the interest structure curve is propagated in IDW S1, a clear change in the case law has begun so that primarily the interest structure curve is referenced when deriving the base interest rate. Interest structure curves model the future interest progression on the basis of spot rats and thus accommodate the requirements of the future relevance of the company assessment. Spot rates represent the interest rate of zero bonds or hypothetical zero bonds for maturity brackets of 1 to 30 years. This information which exists on the market regarding interest is processed into interest structure curves using the Svensson function. In cases of normal investor behaviours, higher interest rates are offered or required for longer investment maturities than for short maturities. This results in the typical interest structure progression of an increasing interest curve with a decreasing threshold growth. Interest information for maturities of up to 30 years represent good approximate solutions for the required maturity equivalence. To simplify the practical company evaluation, via the target value search function in table calculation programmes, a uniform interest rate can be determined at which the projected distributions or withdrawals can be discounted. This interest rate then represents the base interest rate for determining the calculation interest rate. There is thus no correlation between the base interest rate in the BGB (German Civil Code) and the base interest rate of the company assessment. To avoid the interest rate information from being distorted, IDW and case law recommend determining an average base interest rate which can be determined from the uniform interest rate of the last three months prior to the assessment date. The three-month period finds a correlation when determining the average stock market price as the minimum value of the corporate law-related settlement. If a uniform interest rate is not used for discounting and instead the interest rates for the exact maturity are to be used, forward rates apply. These are determined based on spot rates and describe the interest rate valid for the term steps t up to t+1. Forward rates are required for precise phase discounting since this is the only way to take the consideration of the phase-related degree of debt as per marketing values into account for the discounting. The rounding method for the base interest rate by 0.25 percent points recommended by the IDW has partially established itself. A theoretical foundation for this is lacking however. To determine the base interest rate for the purposes of the company assessment, the BaseRateGuide from WOLLNY WP is available on the homepage http://www.en.wollnywp.de/. Base interest rates for assessment dates from 8/1/1997 to the respective current date can be viewed here.

Good times for a management buy-out (MBO)

In the coming weeks, a decision is expected from the German Federal Constitutional Court with regards to the constitutionality of the Erbschaftsteuergesetz (Inheritance Tax Act). These circumstances have shifted the focus of many companies toward the unpopular topic of “Ensuring the succession”. After this decision, it is expected that the legislators will be required to cut the tax breaks for transferring companies. Hence the hurry with regards to a succession regulation. Because whether the tax breaks for a regular exemption or optional exemption can even be utilized is determined by the so-called administrative assets test and this requires a company assessment. If there is clarity regarding this, the donation contracts and, potentially, a usufruct have to be prepared and, if necessary, prenuptial agreements, company contracts and wills have to be adapted.

However, the decision, which can no longer be postponed, to think about the successor, has also led to some sobering realizations. This may result from the self-critical admission that no suitable successor is available in the family. This is an opportunity for management employees of the company to move up to ownership positions. The current owners may have a variety of reasons for not selling to a competitor or a financial investor. The desire to transfer the company into good hands then inevitably leads to the potential option of recruiting the successor from the company’s loyal and experienced management level. On the condition, of course, that the person in question not only has the technical skills, but also the qualities of a company owner.

The purchase price is generally paid only by means of financing. In this case, the currently extremely low interest rate offers the best prerequisites to take over the company shares, if necessary, in defined stages and at defined points in time on the basis of a loan.

No prohibition on deduction for futile due diligence expenses

– BFH dated 1/9/2013 – I R 72/11, DB, 2013, p. 673, DStR, 2013, 581 –

Profits or dividends in conjunction with affiliated companies remain tax exempt in accordance with § 8b Para.1 and Para.2 of the KStG (Corporation Taxes Act). Losses in conjunction are correspondingly excluded from deduction in accordance with § 8b Para.3 of the KStG. The BFH was asked whether the expenses for a due diligence process which are to be capitalized, in principle, in the event of a successful acquisition, as supplemental acquisition costs of the participation, are excluded from deduction if the acquisition fails. Opinions for and against a prohibition on deduction were discussed in the literature.

The BFH decided in a decision dated 1/9/2013 that futile due diligence expenses are not excluded from deduction. Therefore, even if due diligence expenses have been capitalized, the derecognition resulting from the failed acquisition should be taken into consideration as reducing the profit. The opinion of the respondent tax office that there should be no prohibition of deduction as the prerequisite for the prohibition on deduction in accordance with § 8b Para.3 p.3 of the KStG is the existence of a share. Since the parties interested in purchasing could not be legally or economically ascribed shares in the target company at any time due to the failed acquisition, the prohibition on deduction as per § 8b Para.3 of the KStG is not relevant. Only this opinion, according to the BFH, correlates with the meaning and purpose of the deduction exclusion, for establishing a correspondence to the tax exemption for the sales profits for the deduction page. Since tax exemptions, with regards to the shares that were not acquired, cannot apply, there is also no room for a prohibition on deduction.

A good decision for company buyers who thus need not fear having to finance the expenses of a failed acquisition without tax effects.

How does one sell ones company – share deal or asset deal?

The terms share deal and asset have established themselves in company sales negotiations, in contract texts and in the literature on the topic of company sales. Therefore, a short clarification is appropriate. A share deal is the sale of shares, for instance a GmbH (limited liability company) share or share in a KG (limited partnership) or OHG (general partnership). The seller is the shareholder as the owner of the shares. With the sale of the shares, which constitute the legal framework of the business, the business is automatically transferred. An asset deal is nothing other than a business sale, i.e. the company’s assets or the business, i.e. machines, reserves, receivables, liabilities are transferred as required for the organization. Here, the seller is the director of the company, generally with the required approval of the shareholders. This is significant insofar as the shareholder and director are not one and the same person. Example: The family owns the company, but has the operations run by an employed, “outside” manager. So far, so easy. As expected, the differences between civil law and tax law still have a few surprises in store.

Individual companies can only be sold as asset deals, i.e. the salesperson sells the business assets of his or her individual company, since the individual company does not have its own legal personality. This applies in both civil and tax law. Capital companies can either be sold by transferring the shares, ergo a share deal, or by a GmbH selling its business assets, an asset deal. Here too, there is no difference between civil and tax law with regards to the allocation as a share deal or asset deal. Particularities arise when it comes to partnerships. If the shares of a KG or OHG are transferred as per civil law, i.e. sold, then this is treated as an asset deal with regards to tax law. I.e., tax law simulates the potential partial purchase of the business assets of the partnership for the purchaser of the shares. This has tax-related benefits for the company purchaser since business assets can be amortized, but the shares of a company, as non-depreciable financial goods, cannot.

For the company seller, the sale of a partnership is therefore advantageous because he or she can bring up the tax benefits for the company seller in the framework of purchase price negotiations as an argument that increases value. On the other hand, the income tax burden for company sellers over the age of 55 is slightly more than half the normal income tax rate. The conclusion that capital company sellers should therefore choose the asset deal is, however, not correct as such, since the asset deal is, in principle, disadvantageous for the seller when selling a capital company. This is because the sale of the business is not treated any differently than any other turnover. Ergo, completely normal commercial and corporate taxes are incurred on the sales profits from the sale of the business. If the seller then distributes the profits after taxes to then liquidate the empty shell of the capital company, the usual withholding tax of 25% plus solidarity surcharge has to be paid. The total tax burden is therefore significantly higher than if the seller were to sell the shares of its GmbH or AG (stock company). In this case, only the income taxes in the framework of the partial income process are incurred with a tax burden of maximum, approx. 27% plus solidarity surcharge.

No principle without exception. The asset deal can be sensible for company sellers of a GmbH or AG if

1.    there are sufficient tax losses carried over in the company that can be utilized in this manner.

2.    due to a low yield in the company, the purchase price is expected to be more or less the balance sheet equity capital.

In the first case, the profit is more or less compensated by the losses carried over. In the second case, no profit is generated because the company is ultimately sold at its booking price. This is nothing other than the sale at the value of the indicated equity capital.

The employees are transferred to the purchaser along with the company assets in a share deal. But an automatism also applies in an asset deal, which is regulated in § 613a of the BGB. Therefore, in the event of a company sale, the employment contracts are also transferred. This regulation is contractually mandatory.

With regards to sales tax, a company sale, called a business sale there, is not considered taxable revenue which means no sales tax-related consequences need to be taken into account. The sale of shares is sales tax free.

As a result, the tax advantages for the purchaser from an asset deal are the other side of the tax disadvantages for the seller. The exceptions were listed under 1. and 2. The sale of partnerships is beneficial to both parties. The seller can sell shares, will be treated courteously with regards to taxes and the purchaser is benefited by the fiction of an asset deal with which the purchaser can amortize these and thus the exchequer is involved in the financing of the purchase price. Share sales in capital companies are (still) treated mildly with regards to taxes as the income tax burden is around 27%. The company is assessed in order to determine the purchase price in accordance with the earnings value process for both share deals and asset deals. There is therefore no rule that asset deal sales have to be based on the substance value and a share deal has to be based on the earnings value. The seller must take the tax effect into account in the assessment in an asset deal.

Minimum value rule and group valuation

The deterioration of the inheritance-tax related alleviation regulations to be expected through a decision of the German Federal Constitutional Court has motivated several medium-sized companies to implement planned order of succession. In this connection, the company to be transferred must be assessed for tax purposes. In doing so, the minimum value regulation based on the net asset value introduced in 01/01/2009 by the legislator and the inheritance tax reform law must be observed. In practice, increased problems concerning the application of this minimum value regulation in accordance with Article 11 para. 2 p. 3 of the BewG [German Fiscal Law] were mainly observed in companies in group structures. The question to be answered is:

“Does the minimum value regulation in corporations have to be applied at Group company level or does the comparison take place between the capitalised value and/or discounted cash-flow value and the net asset value at group level?”

The solution presented by Wollny in DStR 42/2014 leads to a comparison at group level. The first approach that was presented refers to Article 2 BewG and deduces the Group as a subject of valuation from its scope of provisions on the economic unit. The second approach that was presented, explains the logical contradictions which resulted from an observation at Group company level and proves this by using the “sale of a business” course of action by supporting the approach of net asset values. The understanding of the minimum value regulation demonstrated by the second solution is directly applicable to evaluation processes according to civil law.