Debt-to-Equity Swap: A Key Tool for Companies in Crisis

The key points in brief

• A debt-to-equity swap converts a company's debts into equity and can therefore provide a remedy where over-indebtedness (Überschuldung) is imminent.
  
• Implementation is usually effected by way of a capital increase against a contribution in kind (Kapitalerhöhung gegen Sacheinlage); the valuation of the claim, the subscription rights (Bezugsrechte) and the position of the existing shareholders (Altgesellschafter) must be structured cleanly.
  
• From a tax perspective there is a risk of restructuring gains (Sanierungsgewinne), which can be specifically exempted from tax in whole or in part under § 3a EStG where genuine restructuring measures are present – here a binding ruling (verbindliche Auskunft) or tax insurance should be examined in advance.
  

What exactly is a debt-to-equity swap?

In a debt-to-equity swap, a creditor waives its claim against the company (for example a shareholder loan) and receives shares in the company in return. Liabilities are thereby converted into equity and the balance sheet is relieved of those liabilities accordingly.

The debt-to-equity swap is particularly helpful where the debt burden is so high that banks terminate loans or the borrower's covenants are breached. The swap can then be the central measure for creating a viable restructuring concept. Typical cases of application are, for instance, heavily indebted GmbHs or AGs with negative equity, companies in restructuring or insolvency plan proceedings, and group subsidiaries whose shareholder loans are to be converted into shareholdings.

When is a debt-to-equity swap used?

A debt-to-equity swap is used where the company is significantly over-indebted or acutely in need of restructuring and other measures (interest reduction, extension of maturities) are not sufficient. The most important effect is the visible reduction of debt: liabilities disappear from the balance sheet and are replaced by equity.

This improves key ratios such as the equity ratio and the debt ratio and can result in accounting over-indebtedness ceasing to exist. Accounting over-indebtedness exists where a company's debts exceed its assets, so that equity is negative. For restructuring plans presented to banks or courts, this step is often the precondition for being able to negotiate any further at all. At the same time, the swap changes the balance of power: the creditor becomes a shareholder and acquires voting rights.

A debt-to-equity swap should therefore never be considered in isolation, but always as part of an overall concept.

How is a debt-to-equity swap implemented under company law?

Under company law, a debt-to-equity swap is generally implemented at corporations (Kapitalgesellschaften) by way of a capital increase against a contribution in kind (Kapitalerhöhung gegen Sacheinlage). The creditor contributes its claim as a contribution in kind and receives new shares in return. Several steps are necessary for this:

• Resolution: A shareholders' resolution or general meeting resolution on the capital increase is required, determining the nominal amount and the number of the new shares.
• Designation: The claim to be contributed must be described unambiguously in the resolution and in the contribution agreements (amount, creditor, legal basis).
• Valuation: The value of the claim must be determined; if it is contributed at a book value or intermediate value below its actual value, the difference increases the value of all shareholdings and can trigger tax consequences, for example gratuitous transfers between shareholders.
• Tax effects: Existing shareholders (Altgesellschafter) are in principle entitled to subscription rights (Bezugsrechte); if they waive those rights and only the creditor is admitted to subscribe for the new shares, shifts in value can arise that are relevant for gift tax or income tax purposes.

In practice this means: subscription rights, premiums (Agio), capital reserves and the position of the existing shareholders must be coordinated in legal as well as tax terms.

What tax consequences and risks arise in a debt-to-equity swap?

From a tax perspective, the critical point is the so-called restructuring gain (Sanierungsgewinn): where debts with a higher book value cease to exist or are converted into equity, income arises that would in principle be subject to income tax or corporation tax. In an already strained situation, a high tax burden can frustrate the restructuring. This is precisely where the rules on restructuring gains in § 3a EStG come in.

The example: A company with assets of 1,000 has liabilities of 1,200 – equity stands at −200 and the company is over-indebted in accounting terms. A creditor contributes a claim of 500 as a contribution in kind, debt capital falls to 700, and a restructuring gain of 500 arises.

Without § 3a EStG, this gain is charged with an assumed tax burden of 30% (corporation tax and trade tax). The tax liability of 150 reduces equity to 150. If § 3a EStG applies, the gain remains tax-exempt and equity reaches the full 300.

The difference of 150 corresponds exactly to the tax saved.

The restructuring gain can be exempted from tax subject to strict conditions. The legislature's concern is to make restructuring possible with the participation of the creditors. However, this is only possible if the company has any chance of being restructured at all and there is a convincing concept as to how this can actually be achieved.

The conditions for the tax exemption in detail:

• Debt release without any cause rooted in the shareholding relationship: § 3a EStG presupposes a release from business debts (e.g. bank or supplier claims, shareholder loans) from which income arises within the business assets; this release must not be predominantly caused by the shareholding relationship, that is, it must not primarily serve the purpose of benefiting shareholders, but must be directed at the restructuring of the company.
• Need for restructuring on the part of the company: The company must be in a clear economic crisis, for instance with a high debt burden, strained liquidity, imminent insolvency or over-indebtedness; this state of distress must be demonstrated in a comprehensible manner on the basis of ratios such as the relationship between liquid funds and the debt burden, the maturity of the liabilities and the earnings position.
• Restructuring intent on the part of the creditors: The creditors must grant the debt release with the recognisable aim of preserving the company or restructuring it in an orderly manner; if this restructuring intent is absent – for instance where the release takes place within the framework of a normal exchange of services or for other motives (e.g. pure group policy without any corporate crisis) – there is no privileged restructuring income.
• Suitability of the release for restructuring purposes: The debt release must be objectively suitable for eliminating or significantly defusing the company's crisis, that is, for reducing the debt burden to such an extent that solvency and the equity base become viable again; a very small release without any appreciable relief regularly fails to satisfy this condition.
• Obligation to exercise elections in a profit-reducing manner: Where the restructuring income is tax-exempt under § 3a EStG, all tax elections within the company must be exercised in a profit-reducing manner in the year of restructuring and in the following year, in particular by recognising the lower going-concern value for assets pursuant to § 6 Abs. 1 Nr. 1 Satz 2 and Nr. 2 Satz 2 EStG. The background to this is that only the restructuring income is to remain tax-exempt – it is specifically not to be possible to realise further hidden reserves free of tax.
• Set-off against losses and carryforwards: The tax-exempt restructuring income is set off, in a sequence prescribed by law, first against current losses, existing loss carryforwards and interest and EBITDA carryforwards; only the amount remaining thereafter is definitively regarded as tax-exempt, while the loss and interest carryforwards are reduced accordingly. The background here, too, is that only the restructuring gain is to remain tax-exempt.

Important: privileged treatment of discharge of residual debt and debt settlement plans

Income from the discharge of residual debt under the Insolvency Code or from certain debt settlement plans for avoiding or carrying out consumer insolvency proceedings is likewise tax-exempt, in so far as it constitutes an increase in business assets or business receipts, even where the general criteria of a company-related restructuring in the narrower sense are not fully satisfied.

Because the application of § 3a EStG and the tax exemption of the restructuring gain depend heavily on the specific individual case and frequently concern substantial amounts, either a binding ruling (verbindliche Auskunft) should be applied for from the competent tax office (Finanzamt) or tax insurance should be taken out before a debt-to-equity swap is implemented, covering the risk of a differing tax assessment at a later date. This makes it possible to avoid a supposedly tax-exempt restructuring nevertheless leading, years later, to considerable tax claims that push the company back into crisis.

Important: In practice, the so-called restructuring opinion (Sanierungsgutachten) pursuant to IDW S 6, prepared by auditors, is of decisive importance. It makes it possible to demonstrate the need for restructuring and the suitability of the measures for restructuring purposes to the tax office or the insurer. Without such an opinion, it will as a rule be doubted that both conditions are satisfied. The restructuring opinion pursuant to IDW S 6 is also the most important basis for the discussions between creditors, shareholders and the company.

What alternatives are there to the debt-to-equity swap?

Debt-to-equity swaps are not the only means of addressing over-indebtedness or grounds for insolvency. Depending on the starting position, other instruments may be more appropriate or necessary in addition:

• Debt waiver with a recovery clause (Besserungsschein): The creditor waives its claim in whole or in part and receives an entitlement to subsequent payment if the company's situation improves at a later date. For tax purposes this can likewise trigger a restructuring gain, which may be privileged under § 3a EStG.
• Qualified subordination (qualifizierter Rangrücktritt): The claim is structured contractually such that it is serviced only out of future profits, liquidation surpluses or unencumbered assets. Grounds for insolvency can thereby be eliminated without the creditor becoming a shareholder. Depending on the structuring, the claim must continue to be recognised as a liability in the tax balance sheet or not, which has a direct effect on the equity reported.
• Pure refinancing or deferral of payment: Debts can be refinanced, for instance through more favourable loans, or a deferral of the liabilities falling due can be agreed with the creditors.

Which solution is appropriate depends on whether creditors are prepared to become shareholders, on how far the shareholder structure may be altered, and on which tax and insolvency law objectives are to the fore. A combination of several measures is frequently necessary in order to achieve a viable solution.