In November 2022, the German Ministry of Finance (BMF) issued a letter on the income tax treatment of profit participation rights and their classification as equity or debt, which is intended to provide clarity and investment security after previous uncertainties regarding the tax treatment of profit participation rights.
The use of profit participation rights is becoming increasingly popular, especially among banks, for investments in renewable energy, and with a strong recent trend toward blockchain-based or tokenised investments.
Depending on the structure of the profit participation rights, as quasi-equity or as quasi-debt capital, the issuer may be able to deduct remuneration for profit participation rights as business expenses for tax purposes. For the holder of profit participation rights, their tax classification results in taxation are comparable to that of dividends or interest. Consequently, the tax classification and treatment of profit participation rights is of high practical relevance. In particular, how the issuer should treat profit participation rights for tax accounting purposes has so far been subject to uncertainty.
Tax accounting recognition of profit participation rights has repeatedly changed
For many years, German tax authorities accepted payments for profit participation rights as tax deductible if the requirements of section 8 (3) sentence 2 2nd alternative German Corporate Income Tax Act (KStG) did not apply, i.e. the holder of profit participation rights did not have a cumulative right to participate in the profits and liquidation proceeds of the company. This practice changed, initiated by the decree of the Higher Finance Directorate (Oberfinanzdirektion, OFD) of Rhineland of 14 December 2011 and continued by the decree of the Higher Finance Directorate of North Rhine-Westphalia dated 12 May 2016, which provided that the disclosure in the commercial balance sheet was determinative for the tax accounts, meaning that profit participation rights remuneration had to be allocated to the use of income when recognising equity. To benefit from the deduction of business expenses, the profit participation right had to be shown as debt capital in the commercial balance sheet and, in addition, the holder was not allowed to have a cumulative right to participate in the profits and liquidation proceeds of the company. In response to criticism from various quarters, a decree of the Finance Ministry of North Rhine-Westphalia of 18 July 2018 followed and the Higher Finance Directorate decree of 12 May 2016 was revoked. According to this, profit participation rights should be recognised as a liability in the tax accounts, payments thereon should be deductible as business expenses and, subject to section 8 (3) sentence 2 2nd alternative German Corporate Income Tax Act (KStG), should reduce the company's income.
The draft of the new BMF letter is intended to provide clarity and investment security after previous uncertainties regarding the tax treatment of profit participation rights. Selected key statements from the draft BMF letter are presented and assessed below.
Profit participation rights: a multi-faceted hybrid form of financing
The term profit participation rights (Genussrechte) is not legally defined. Profit participation rights are classified as mezzanine capital or hybrid forms of financing. They exist in a wide variety of forms, since profit participation right agreements can be freely structured – within certain limits, including under sections 242 and 138 German Civil Code (BGB).
Profit participation rights are contractual claims or creditor rights against the company and grant the holder only property rights and no membership or management rights under corporate law (i.e. no voting rights, no right of control and no right of attendance at shareholders' meetings). Usually, the holder of profit participation rights has a claim under the law of obligations against the issuer for repayment of the capital provided. In the case of quasi-equity profit participation rights, provision can be made for loss participation, which reduces a repayment claim in the event of a loss, and repayment can be deferred until the liquidation of the company or, in extreme cases, precluded altogether.
Distinction between silent partnership and participating loan difficult to draw
Due to the wide range of possible structuring, profit participation rights are difficult to distinguish from other financial instruments. It is of great relevance for tax practice, as income from the various instruments is taxed differently in some cases. For example, income from quasi-equity profit participation rights held by corporate investors may be privileged for tax purposes under section 8b German Corporate Income Tax Act (KStG), whereas income from similar financing instruments may be subject to full taxation. The designation of the legal relationship serves merely as an indication (substance over form doctrine). In individual cases, the presence of participatory or performance-related elements may lead to a presumption of a profit participation right in addition to a fixed remuneration, despite the designation of a capital transfer as a loan agreement. The draft BMF letter sets out general demarcation criteria for typical silent partnerships and profit-sharing loans.
- A characteristic feature of silent partnerships is the pursuit of a common purpose (i.e. the promotion of a common purpose going beyond a mere provision of capital). Thus, a right of codetermination similar to that of a member granted to the investor is deemed indicative of a common purpose.
- The distinction to a profit-sharing loan is challenging. Both financial instruments are based on contractual agreements and in both cases the investor receives a profit-related remuneration. A clear distinction can be drawn where, in addition to profit sharing, a share in the liquidation proceeds is also granted, because the qualification as a quasi-equity profit participation right typically supersedes the qualification as a profit-sharing loan. In contrast to a profit-sharing loan, a profit participation right may also involve participation in losses.
Accounting principles for issuers of profit participation rights
In the draft of its new letter, the BMF sets out the following principles for the tax balance sheet distinction of equity as against debt capital for issuers of profit participation rights.
The overriding principle is a strict separation of tax accounting and income recognition. The decisive criterion is usually an existing repayment obligation. In other words, whether (i) the capital provided is to be permanently transferred to the assets of the issuer of profit participation rights with no repayment intended (equity), or whether (ii) it is presumed that capital is being provided on a temporary basis with the intention of repayment (debt). According to the new draft BMF letter, in the standard case of an agreed repayment claim and interest, the general presumption is that this is debt capital to be recognised in the tax accounts.
The BMF has therefore based the tax accounting classification on the general principles for the distinction between equity and debt capital as established by the German Federal Fiscal Court (BFH) in its established case-law (most recently, in its judgment of 27 February 2019, file no. I R 73/16). According to the draft BMF letter, it is clear that the criteria set out in section 8 (3) sentence 2 2nd alternative German Corporate Income Tax Act (KStG) (i.e. a participation in the profit and in the liquidation proceeds) are not relevant, given that this is not an accounting provision but an income determination provision.
Furthermore, it is also expressly clarified for tax accounting purposes that the criteria for the commercial balance sheet classification pursuant to the statement HFA 1/1994 of the Institute of Public Auditors in Germany (IDW) (subordination of the provided capital, performance-related remuneration, participation in losses up to the full amount of the provided capital and long-term nature of the capital provision) are not determinative for its tax accounting classification. Moreover, the granting of profit participation rights in crisis and the existence of conversion or option rights alone should not be decisive for the classification as equity or debt capital, but should be included in the overall assessment, in regard to the specific circumstances of the individual case.
However, when classifying profit participation rights as debt, they should not be recognised as liabilities in the tax accounts if either (i) there is no anticipated financial burden, which is the case in particular where, due to the specific circumstances of the individual case, it is highly unlikely that the creditor will (or will no longer) enforce the claim (compare most recently the German Federal Fiscal Court (BFH) judgment of 19 August 2020, file no. XI R 32/18; the lack of assets on the part of the issuer of profit participation rights is not the only determinative factor in this respect), or (ii) the prohibition on recognition in the tax balance sheet pursuant to section 5 (2a) German Income Tax Act (EStG) applies (i.e. if the repayment obligation has only to be made from future income or profits).
Principles of income calculation for the issuer of profit participation rights
Irrespective of tax accounting, any corporation issuing profit participation rights must classify the latter for the purpose of determining income in compliance with the standards set out in section 8 (3) sentence 2 2nd alternative German Corporate Income Tax Act (KStG). If there is no cumulative participation in profit and liquidation proceeds, remuneration on profit participation rights recognised as debt capital in the tax accounts can also be deducted as business expenses. Otherwise, the expenses must be added back for tax purposes. For the interpretation of these two criteria, the draft BMF letter, in predominant agreement with previous practice, provides further guidance:
- Participation in profits: The criterion of "participation in profits" is to be interpreted broadly. Participation in the profits of the company is understood to mean the participation of the rights holder in the financial success of the issuing company or the (tax) performance of the company as a reference figure. The annual surplus, net retained profit, EBIT and EBITDA as well as dividend distributions can, for example, serve as starting point or assessment basis for profit sharing. There is to be no participation in profits if the remuneration is dependent on the results of a specific division of the company (tracking stock), on individual assets or on other group companies. In addition to participation in profits, participation in losses is not required.
- Participation in liquidation proceeds: The term "participation in the liquidation proceeds" of the company is construed to mean the final liquidation assets within the meaning of section 11 German Corporate Income Tax Act (KStG) (i.e. a pro rata participation in the hidden reserves). There is also deemed to be a participation in the liquidation proceeds if the rights holder already participates in the hidden reserves of the company prior to its liquidation. According to the draft BMF letter, a partial participation in the hidden reserves would already be sufficient, although it is unclear whether a certain minimum threshold applies. In the case of profit participation rights with loss participation, this will already be the case if a minimum repayment of the profit participation rights at nominal value is agreed, as in this respect there will be at least a partial participation in the hidden reserves to compensate for reductions in the profit participation capital due to losses. This is surprising since this would effectively eliminate loss participation and would apply irrespective of the amount of a pro rata liquidation value or the existence of hidden reserves. In the practical structuring of accumulating profit participation rights, care must be taken to ensure that not only the accumulated remuneration is disbursed but also a share in the liquidation proceeds, or to avoid disbursement of only the liquidation proceeds without prior payment of the accumulated profit shares.
The draft BMF letter does not state whether the remuneration on a profit participation right recognized as debt constitutes an interest expense for the purposes of the interest barrier (Zinsschranke) as defined in section 4h German Income Tax Act (EStG). In the BMF letter on the interest barrier of 4 July 2008, para. 11 generally refers to debt in the tax accounts (i.e. capital that must be recognised as liability and does not form part of equity for tax purposes). According to the principles in the draft BMF letter, this is not to be determined based on section 8 (3) sentence 2 2nd alternative German Corporate Income Tax Act (KStG). However, para. 11 of the BMF letter on the interest barrier refers specifically to section 8 (3) sentence 2 2nd alternative German Corporate Income Tax Act (KStG) as a distinguishing feature regarding profit participation rights.
Income tax treatment of profit participation right remuneration for the rights holder
With reference to the German Federal Fiscal Court (BFH) ruling of 10 July 2019 (file no. XI R 53/17), the draft BMF letter clarifies that the tax accounting by the participation right issuer is independent of the legal qualification by the rights holder, absent a so-called correspondence situation. In all other respects, however, the draft BMF letter lacks further statements on the taxation of the profit participation rights holder and leaves questions unresolved.
This relates in particular to the treatment of payments from equity participation rights as defined in section 20 (1) sentence 1 no. 1 German Income Tax Act (EStG) in conjunction with section 8b (1) sentence 1 German Corporate Income Tax Act (KStG), to which the right to profits and liquidation proceeds of a corporation is attached. These are generally taxed in the same way as profit distributions on genuine business shares (e.g. dividends), unless the tax contribution account (steuerliches Einlagekonto) is deemed used (although it is not stated whether the contribution of equity participation rights qualifies as a contribution to the tax contribution account). It remains open whether and how profit participation rights are to be included for the purposes of determining the minimum threshold triggering the application of the participation privilege/exemption for corporate investors (Schachtelprivileg) (10% pursuant to section 8b (4) German Corporate Income Tax Act (KStG) or 15 % pursuant to section 9 no. 2a or 7 German Trade Tax Act (GewStG)). According to the prevailing view in the tax literature, quasi-equity profit participation rights are also to be regarded as "participations" within the meaning of the participation privilege. This is also in line with the opinion of the German Federal Fiscal Court (BFH) on section 17 German Income Tax Act (EStG) (judgment of 14 June 2005, file no. VIII R 73/03), the opinion of the Reich Fiscal Court on trade tax (judgment of 9 March 1937, file no. I A 21/37) as well as the ruling of the Higher Finance Directorate (OFD) of Frankfurt/Main of 16 October 2002 on trade tax. However, minority opinions argue against inclusion in the tax exemption under section 8b (1) sentence 1 German Corporate Income Tax Act (KStG) due to the lack of a shareholding in the capital stock or share capital, or make this dependent on a parallel existing shareholding under company law that meets the minimum holding requirements.
The taxation of the sale of equity participation rights is the same as for the sale of company shares.
Are all open questions clarified in the final letter?
Since the BMF letter on the income tax treatment of profit participation rights is still at the draft stage, it remains open whether the BMF will provide further clarifications in the final version, whether it will eliminate any doubts and, in particular, whether it will address the income tax treatment for the holder of profit participation rights in greater detail.
For more information on the BMF draft letter and how it might affect your business, contact your CMS client partner or local CMS experts: