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Tax aspects of acquisitions in Germany.

Traditionally, tax planners have not viewed Germany favorably, primarily because of its high tax rates and relatively complicated administrative rules. However, companies wanting to invest in Germany may be able to use various planning techniques intended to reduce the effective tax burden following an acquisition.

A foreign investor wanting to establish itself in Germany can do so either by forming a new subsidiary or other entity or by acquiring an existing business. Acquisitions usually cost more than forming new entities, but can reduce the German operation's startup efforts and may also lead to future synergies. Further, German tax rules offer a variety of incentives (such as amortization of goodwill, tax-free step-up of asset book values to the purchase price paid and generous debt pushdown possibilities) that may result in a narrower tax base than would be available in many other countries.

Tax considerations in planning a German business acquisition concentrate mainly in three areas:

* Tax due diligence.

* Negotiation of tax clauses and indemnities.

* Transaction structuring.

The tax due diligence review should identify all tax exposures to avoid surprises in future tax audits, describe the tax history and status of the target and comment on opportunities for the future. The tax due diligence group should work closely with the financial and legal teams to present an overall analysis. The results of the due diligence review and the projections of the future tax position can help reduce the risks inherent in an investment decision, as they will be reflected in the target valuation and, therefore, form the basis for the final negotiation phase.

With the target's tax risks generally transferred to the acquirer, the purchaser needs to ensure that all critical matters are covered appropriately by guarantees or "hold harmless" clauses in the purchase agreement. While standard tax clauses exist, each transaction is unique and requires contractual provisions specific to the individual case (e.g., consequences of hidden profit distributions, warranties for the existence of loss carry-forwards or the amount of retained earnings, etc.). In any event, indemnities can only supplement, but never substitute for, a thorough tax due diligence procedure.

The final task is designing tax-efficient acquisition and disposal structures that add value to the transaction. The tax planner must address at least five objectives: (1) maximizing the loan interest deduction in Germany with respect to the acquirer's financing costs; (2) stepping up asset value to the purchase price actually paid (with a concomitant increase in depreciation for following years); (3) minimizing transaction costs (such as the 3.5% real estate transfer tax); (4) planning exit strategies in advance (to ensure that the investor retains the greatest possible amount of transaction gain); and (5) minimizing the capital gains tax the seller bears. The last point is often crucial for obtaining the best terms.

Clearly, there are no standard acquisition patterns. Rather, the strategy needs to be tailored to each specific case. Key issues are defining whether individuals or corporations are the sellers and whether a foreign or German corporation or partnership is the target.

Because Germany remains a relatively high-tax jurisdiction, purchasers generally want to inject acquisition debt (and the respective interest deductions) into Germany. The rather generous German thin capitalization rules (which allow a 9:1 debt/equity ratio for holding companies and a 3:1 debt/equity ratio for operating companies), along with an absence of limits for partnership financing, may make it possible to inject substantial acquisition debt into Germany by using a German acquisition vehicle. Using hybrid financial instruments, acquiring a German partnership or using a German partnership as an acquisition vehicle (in the case of a German corporation acquisition), may have favorable results with respect to interest deductions.

Under German tax law, both an asset acquisition and a partnership interest purchase result in a direct step-up of asset values. In the case of a partnership interest acquisition, the acquirer, through so-called supplementary tax balance sheets, may allocate the "hidden" reserves to the respective assets and claim tax depreciation on these amounts. With respect to the acquisition of a German target company, there are special reorganization provisions that also offer a possible solution for a tax-free step-up of the underlying assets' tax bases. Under these provisions, a conversion or merger of the target company into a partnership is required.

These reorganization provisions allow a company's assets to be transferred to the partnership at book values. This transfer, alone, would not produce a step-up in tax values. However, when (as is usually the case) the cost of the shares is higher than the net assets transferred by the target to the partnership, relief can be claimed for the resulting merger loss (generally, the price for the hidden reserves including goodwill). This merger loss is not immediately deductible, however; the amount must be allocated in a supplementary tax balance sheet to the assets to which it relates and amortized over the useful life of the assets involved (15 years for goodwill).

This result may be jeopardized, however, if the shares are "tainted" either because they were acquired from abroad, held by a nonresident or by the Treuhandanstalt (Reunification Privatization Agency) at any time within the last 10 years, or acquired from German resident individuals if the capital gain has not been subject to tax (because of the asymmetric tax treatment that could result from a combination of capital gains not being taxed in Germany and a tax-free step-up) . Whether the taint on the shares may be removed in more complex acquisition structures is uncertain. However, as is usual in such cases, an increase of complexity designed to avoid the problem would increase the vulnerability of the structure to additional "anti-abuse" challenges by German tax authorities.

One point often overlooked is that Germany can be an attractive location for an intermediary holding company, which can also be used for acquisitions of foreign target companies. In addition to the shareholder debt financing rules, there are favorable rules in other areas, such as those that effectively enable a significant amount of the financing costs of investment in foreign subsidiaries to be deducted against the domestic income of the German (intermediate) parent, or those exempting capital gains on the sale of foreign investments from German taxation while allowing corresponding losses as deductions.

Tax consulting in the case of an acquisition does not end with the signatures on the purchase contract. The next step is post-acquisition structuring that integrates the acquired business in the most efficient way into the existing group. The establishment of tax consolidations (e.g., an Organschaft in Germany), the transfer of shareholdings, the centralization of functions and the adjustment of finance and transfer pricing arrangements are only some of the issues to be addressed. A further step is to identify factors in effective tax rate calculations that underpin the global tax position. Acquisitions provide a real opportunity to reconsider elements of the previous tax policy and overcome existing tax-related pitfalls and, thus, achieve positive bottom-line consequences.

A thorough tax due diligence review, carefully drafted tax warranties and a tax-effective acquisition pattern (tailored to the individual needs of each specific case) are key dements in a successful acquisition. This is particularly true in cross-border acquisition cases when, as in the case of the U.S. and Germany, the consequences of two sometimes quite different tax systems have to be meshed.
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Author:Ditsch, Stefan
Publication:The Tax Adviser
Date:Jul 1, 1998
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