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.