Germany: Parent May Write Down Subordinated Loan to a Subsidiary - Supreme Tax Court

The case before the Supreme Tax Court concerned a loan made by a parent to its subsidiary. The subsidiary suffered losses, which forced the parent to subordinate the loan and to suspend the interest charges and repayment obligations until the subsidiary had recovered financially. Had the loan not been subordinated, the subsidiary would have been insolvent and obliged to file for receivership. The parent owned the premises and other fixed assets of the subsidiary without having any other particular function, and this gave the business the status of being "divided" between two entities. This concept of German tax law means that business valuations have to take both units into account, at least to the extent of reflecting the "business importance" of the one for the other.

On subordination, the parent wrote the debt off because it saw the market value to have fallen to nil. Repayment was no longer legally or practically possible until the subsidiary had returned to permanent profitability, and, in the meantime, no interest was being earned. There was no indication as to when recovery might be expected. The tax office and lower tax court denied the deduction because the act of subordinating the loan meant that it should have been re-qualified by the parent as part of the cost of the investment in the subsidiary. The cost in investment could not, however, have been written down with tax effect in these circumstances.

The Court now held that despite the subordination, and despite the "division" of the same business between debtor and creditor, the loan had not lost its original character. It based this view on the subordination agreement itself which clearly defined the conditions for later repayment. It also took into account the lack of any conflicting evidence that might suggest the real intentions of the ultimate owners to have been something else. The fact that debtor and creditor were two parts of, effectively, the same business did not invalidate the loan write-down. Neither did the parent/subsidiary relationship and there was no requirement for each side to take an equal and opposite position in its own accounts. However the division of the business did mean that the value at which the loan could still be carried as an asset depended on the overall position of the business, i.e. on the expected maintainable future earnings of both halves taken together. Because the subordinated loan was a company law substitute for capital, its market value should be determined on principles appropriate for investments. Thus, it was up to the taxpayer to show that a willing buyer would have paid less than the owners' original cost of investment in the parent in order to acquire the complete business. If this demonstration succeeded, there would be no bar to attributing a portion of the shortfall to the loan in justification of a corresponding write-down in the parent's books.

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