Restructuring gain (Sanierungsgewinn): tax trap or opportunity in a restructuring?

The key points in brief:

• A restructuring gain (Sanierungsgewinn) arises where creditors release a company from debts and its business assets (Betriebsvermögen) increase as a result.
• Restructuring income (Sanierungsertrag) is tax-exempt where there is a business-related restructuring with clearly demonstrable need for restructuring, capacity for restructuring, suitability for restructuring and an intention on the part of the creditors to bring about a restructuring.
• Tax-exempt restructuring income is mandatorily „set off“ against losses, negative amounts, and interest and EBITDA carryforwards; at the same time, certain business expenses (Betriebsausgaben) are permanently non-deductible.

What is a restructuring gain (Sanierungsgewinn) – and when does it arise?

A restructuring gain is the additional income for tax purposes that arises because creditors release a company in crisis from debts, so that its business assets (Betriebsvermögen) increase or additional business receipts arise.

For tax purposes, the legislation speaks of „restructuring income“ (Sanierungserträge): this covers all increases in business assets or business receipts deriving directly from such a restructuring-related release of debt. A typical example is a shareholder’s waiver of a claim (Forderungsverzicht) in respect of part of a distressed loan; the amount released increases the company’s equity and, absent special rules, would be taxable as current profit.

A restructuring gain may arise in the case of sole traders as well as in the case of partnerships (Personengesellschaften) or corporations (Kapitalgesellschaften). In the case of partnerships, whether a profit is to be recognised as a restructuring gain is decided within the separate and uniform determination procedure, because the income and its allocation among the partners are determined separately there.

Alongside the classic restructuring-related release of debt, the current rules also cover income from a discharge of residual debt in insolvency proceedings and from judicial or out-of-court debt settlement plans; these are likewise treated as tax-exempt restructuring income to the extent that they constitute increases in business assets or business receipts.

When is a restructuring gain tax-exempt?

Restructuring income is tax-exempt where all the requirements of a business-related restructuring under § 3a EStG are met. The legislation requires the taxpayer to demonstrate four points as at the time of the release of debt:

• Need for restructuring (Sanierungsbedürftigkeit): the company is in a crisis; the decisive factors are liquidity, the amount of the debts and when they fall due, the composition of the assets, the earnings position and the return on capital.
• Capacity for restructuring (Sanierungsfähigkeit): the release of debt must be a viable building block of an overall measure by which the continuation of the business appears realistically possible.
• Suitability for restructuring (Sanierungseignung): the release of debt must be objectively capable either of enabling the business to be given up without legacy burdens (restructuring related to the entrepreneur) or of preventing collapse and restoring earning capacity (restructuring related to the business).
• Creditors’ intention to restructure (Sanierungsabsicht): the creditors act with the aim of the debtor’s commercial and financial recovery; a waiver of a claim for purely company-law, private or purely consideration-related reasons is not sufficient.

Where these requirements are met, the corresponding increases in business assets or business receipts are tax-exempt. For restructuring income from a discharge of residual debt and consumer insolvency, § 3a Abs. 5 EStG provides for tax exemption even where, strictly speaking, there is no business-related restructuring satisfying all the constituent elements.

Why is the taxation of a restructuring gain a problem – and how is that problem solved?

Taxing a restructuring gain would economically frustrate the restructuring: the release of debt is intended to strengthen the equity base and create liquidity; an immediate tax payment on that gain would cut off precisely the breathing space thereby created.

The statutory solution operates on two levels:

• Tax exemption of the restructuring income: the actual gain from the release of debt is tax-exempt under § 3a EStG.
• Mandatory set-off against losses and carryforwards: at the same time, the tax-exempt restructuring income must „consume“ a long chain of losses, negative income, and interest and EBITDA carryforwards. To that end, § 3a Abs. 3 EStG prescribes a binding sequence in which, among other things, spread-forward expenses, offsettable losses under § 15a and § 15b EStG, losses under § 10d EStG and interest and EBITDA carryforwards are reduced.

Example: The example assumes restructuring income of 1,000. Before that amount benefits from § 3a EStG even in part, the set-off sequence prescribed by § 3a Abs. 3 EStG must be worked through in full. First, transfers of obligations under § 4f EStG reduce the income by 50, followed by losses under § 15 Abs. 4, § 15a and § 15b EStG in the amount of 100. Next come the current loss for the restructuring year at 150 and – regularly the weightiest item – the loss carryforward (Verlustvortrag) under § 10d EStG from the previous year at 300. Thereafter, other negative income under §§ 2a, 2b and 23 EStG is set off at 50 and, finally, interest and EBITDA carryforwards under § 4h EStG at 150. In total, this cascade consumes 800 of the 1,000; only the remaining amount of 200 is definitively tax-exempt under § 3a EStG.

The figures used are freely chosen and serve solely to illustrate the mechanism; they do not permit any conclusions as to a typical distribution, since this depends in the individual case largely on the amount of the loss carryforwards actually available. The presentation also simplifies the statutory text: § 3a Abs. 3 Satz 2 EStG provides for further items and special rules, for example for co-entrepreneurships, which are not set out here in detail.

At the trade tax (Gewerbesteuer) level, § 7b Gewerbesteuergesetz (GewStG) ensures that the reduced restructuring income first reduces negative trade income and carryforward shortfalls; only the remaining balance then no longer has any profit-increasing effect. This prevents the restructuring gain from leading to an additional burden by way of trade tax, while at the same time old shortfalls are largely consumed.

Flanking this, § 3c Abs. 4 EStG makes clear that business expenses and reductions in business assets which are directly economically connected with tax-exempt restructuring income (including expenses arising from debt-recovery certificates) are not deductible; expenses already deducted are to be corrected retroactively, even in the case of tax assessment notices that have become final. This precludes the tax-exempt restructuring income from having a further tax-reducing effect by way of corresponding expenses.

What typical tax risks and structuring problems arise in connection with a restructuring gain?

Restructuring cases are highly complex for tax purposes, because several provisions interact and mistakes can lead to considerable disadvantages. The typical risks are as follows:

• Missing or inadequate evidence of the restructuring requirements: where the need for restructuring, the capacity for restructuring, the suitability for restructuring and the creditors’ intention to restructure are not properly documented (for example, no restructuring plan, no consistent creditor agreement), the tax office (Finanzamt) may refuse the tax exemption, with the result that the release of debt becomes fully taxable.
• Release of debt without a genuine intention to restructure: a waiver of a claim for company-law reasons, in the context of an exchange of performance or on purely private grounds does not qualify as a restructuring-related release of debt; the resulting gain is then taxable and subject to the general rules (including trade tax).
• Errors in the set-off of losses and carryforwards: § 3a EStG contains a detailed set-off cascade; an incorrect sequence or incomplete set-off can lead to incorrect determination notices and subsequent corrections, because even final assessment notices may be amended in favour of the tax authorities for as long as the assessment limitation period for the restructuring year is still running.
• Consequences for corporate bodies left out of account: in the case of corporations, in addition to § 3a EStG, particular regard must be had to § 8c Körperschaftsteuergesetz (KStG) on the use of losses in a group context and to § 11 KStG on liquidation; restructuring measures (including a release of liabilities) may affect the ability to use loss carryforwards or conflict with reorganisations.

Solving these problems requires coordinated restructuring planning: a viable restructuring plan with payment and earnings forecasts, structured agreements with the creditors and early coordination with the tax office create the basis for recognition of the tax-exempt restructuring income and for an error-free set-off of losses.

What was the restructuring decree (Sanierungserlass) – and what significance does it still have today?

The so-called „restructuring decree“ was an internal administrative rule of the Federal Ministry of Finance (BMF) which gave concrete form to the income tax treatment of restructuring gains and to equitable measures (deferral of payment and remission) on substantive grounds under §§ 163, 222, 227 AO.

In practice, the decree made it possible to defer and remit tax on restructuring gains where economic grounds militated against immediate or full taxation. The case law of the Federal Fiscal Court (BFH) had, however, called it into question in part; in response, the legislature introduced, by means of the Act on the Prevention of VAT Shortfalls and Other Provisions, § 3a EStG and § 7b GewStG among others, which govern the tax exemption of restructuring income on a statutory basis.

Today, the restructuring decree remains relevant only to the extent that it may continue to have effect by way of legitimate-expectation rules for legacy cases predating 8 February 2017 through the equity provisions of the AO. For new restructurings, the decisive basis is the statutory exemption of restructuring income under § 3a EStG, including the special application and transitional rules.