The Federal Fiscal Court (Bundesfinanzhof – BFH) on 14 April 2015 issued a decision (case no. I R 44/14, available here) that is of immense relevance for all creditors and debtors that face the need of a subordination agreement (Rangrücktrittvereinbarung) under German law.
The Federal Fiscal Court dealt with the question under which conditions a subordination agreement can be validly agreed. The backdrop of this decision is the tension between German insolvency law and German tax law. This tension is created because a subordination agreement that is concluded in order to prevent an insolvency filing may, under certain circumstances and wordings, lead to a taxable income for the debtor that will obviously cause a payment obligation vis à vis the German tax authorities. It is an internationally accepted procedure that a loan – whether granted from a shareholder or a third party – can be subordinated in order to avoid over indebtedness. In a significant number of cases this will also cover a standstill of interest to be paid. Under German tax law there is a risk that a “wrongly worded” subordination agreement might lead to a determination by the fiscal authorities that the debt that is subject to the subordination agreement is to be treated as forgiven or waived. This would lead to taxable income due to § 5a (2a) EStG (Einkommensteuergesetz – German Income Tax Code).
In the case at hand the management of a German limited liability company (GmbH) received two loans from the parent company in an amount of €7 million and USD 2,600,000. In order to avoid over-indebtedness (which would trigger a statutory obligation to file for insolvency under German law) the parties agreed in two separate agreements to a subordination of these debts. The wording of these sub ordinations agreement said that the parent company has the sole shareholder would subordinate its claim on principal and interest vis-a-vis all other creditors, including those creditors mentioned in § 39 (1) and (2) InsO (Insolvenzordnung, German Insolvency Code), that any repayment of principal or payment of interest can only be demanded from future profit or surplus in case of a liquidation. Further it was stated that in case of an insolvency the parent company would subordinate to the rank he according to § 19 sentence 2 InsO.
In the balance sheet for the year 2005 the company still accounted the full amount of the liabilities is a be the parent company.
The fiscal authorities were of the opinion that § 5a (2a) EStG would not allow the company to account the full amount of the liabilities towards the parent in the balance sheet and changed the tax assessment accordingly.
The major issue that had to be decided on in this case was, under which conditions and existing claim that is subject to a subordination agreement can still be part of the liabilities in a balance sheet produced for taxation purposes. If a liability can still be part of a balance sheet produced for taxation purposes, the subordination agreement would have no impact on the tax assessment. But if the liability cannot be part of a balance sheet produced for taxation purposes this would automatically lead to a taxable profit of the company with the corresponding negative effect on the liquidity.
Answers by the German Federal Court of Justice in summary
The Federal Fiscal Court ruled out that a liability that is only allowed to be repaid from future profits or from surplus in a liquidation event following a subordination agreement agreed-upon in an event of over-indebtedness, is a banned from the possibility of passivation according to § 5a (2a) EStG.
This ruling is based on recent statutory law which was already at that time in line with the opinion of the German fiscal authorities that any liabilities, that are only to be fulfilled in case of future income or profit can only be recognised in the balance sheet in case such future income or profit has occurred. If there is no income or profit, there is no current economic burden based on the subordinated liabilities and as a consequence there is no recognition of the liabilities in the respective balance sheet possible.
All stakeholders involved in the structuring or restructuring of a company need to be aware that the wording of a subordination agreement is critical with respect to the future cash flow. It has to be avoided in any event that the wording of a subordination agreement leads to taxable income which is a liquidity burden for the company. The wording of such subordination agreement is key and should not be dealt with half-heartedly. It might be that when structuring the future of the company this burden will not lead to an liquidity problem that could cause an insolvency filing. But certainly in restructuring cases there is a high risk that liquidity is an issue that needs to be monitored closely. We strongly recommend to review existing subordination agreements and be careful when entering into future subordination agreements in order to avoid consequences with a negative economic impact that the parties to the agreement did not want to achieve.