Germany: 231. Tax Authorities Relax Reorganisation Requirements

The German Tax Reorganisation Act in force since 1995 permits three types of divisive reorganisations – split-ups, split-offs, and drop-downs – without triggering tax, provided two principal conditions are met:

• any unrealised appreciation (hidden reserves) inherent in the assets transferred must remain subject to German taxation and
• the assets transferred – and for split-offs the assets retained as well – must constitute a branch of activity, an interest in a commercial partnership, or a 100 % share in a corporation.

The latter requirement poses many issues. Until recently, the tax authorities interpreted the key term "branch of activity" in such a way as to severely restrict the options available to taxpayers when structuring divisive reorganisations.

In the voluminous tax reorganisation directive issued in March 1998, the tax authorities defined "branch of activity" with respect to the rules developed under §§ 16 and 34 of the Income Tax Law. Under these provisions, the gain realised on the disposal (sale, liquidation, or termination) by an individual of a commercial business or a discrete part thereof qualifies for certain deductions and, more importantly, taxation at a preferential income tax rate.

The case law associated with these provisions holds that a branch of activity is only disposed of when all material assets associated therewith are disposed of in a single transaction or set of related transactions. The term "material assets" is in turn interpreted to include business assets related to a branch of activity that are functionally unimportant, but contain significant unrealised appreciation (hidden reserves). A so-called "quantitative approach" is thus taken to identify the assets which have to be disposed of to qualify for the income tax preferences. In the context in which it was developed, an inclusive definition of such assets makes sense because it increases the assessment base and prevents taxpayers from holding back "choice morsels" to selectively defer taxation.

By applying the same rules to divisive reorganisations, the tax authorities prevented taxpayers from separating appreciated assets functionally irrelevant to a particular branch of activity from the branch of activity in the context of such reorganisations. Since the general policy of the tax reorganisation laws is to defer taxation on economically sound mergers, it did not make sense to condition the deferral on the continued presence of economically irrelevant assets in a branch of activity after a divisive reorganisation.

The tax authorities have now seen the wisdom of this argument and reversed themselves. A directive issued last year by the Federal Ministry of Finance abandons the "quantitative approach" to defining branches of activity for purposes of the rules governing divisive reorganisations and adopts instead a "functional approach," under which only those assets functionally important to a branch of activity need stay with it in a divisive reorganisation.

While the stance originally taken by the tax authorities was widely criticised in the literature, taxpayers nevertheless disregarded it at their peril when planning reorganisations. By changing their position, the tax authorities significantly expand the flexibility of Germany's tax reorganisation laws. The new directive applies to any cases now pending on the issue it addresses.

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