Using jouissance rights for a tax-efficient financing structure

When financing the purchase price for the acquisition of a company, mezzanine capital, can be considered in addition to the “classic” financing instruments. Mezzanine capital is characterised by its subordination to senior loans and often serves to close funding gaps. The term “mezzanine capital” is not a strictly defined term. It is a hybrid form of equity and debt capital which can be structured in such a way as to lean either more towards equity or debt capital, depending on the circumstances of the individual case.

Jouissance rights are a special form of mezzanine capital. According to a judgement issued by the Federal Court of Justice (BGH), jouissance rights are claims under the law of obli-gations which can be structured in such a way that they grant the holder a legal status similar to that of a shareholder, however, without conveying voting and administrative rights under company law.

In a recent judgement, the Federal Court of Finance (BFH) specified the principles for the tax treatment of income resulting from jouissance rights and thus created legal certainty. The facts of the case as well as the legal arguments are discussed below.

Facts

A Canadian subsidiary (CanCo) had issued jouissance rights to its domestic parent company (GerCo). Payments resulting from the jouissance rights were fixed at an amount of at least 4% and at maximum 16% of CanCo´s net profit. GerCo treated the payments received as tax-free dividend income, whereas CanCo treated the cash distribution as tax-deductible interest payments.

In the course of a tax audit, the German tax authorities classified the payment distributions received by GerCo as taxable interest income instead of equity-related dividends and subsequently amended GerCo’s tax assessment notices. Subsequently, GerCo took legal action against this decision.

Judgement of the BFH

The Federal Court of Finance (BFH) confirmed the view of the tax authorities and came to the conclusion that the payments resulting from jouissance rights were to be treated as taxable interest income received by GerCo. In the judgement, the Federal Court of Finance (BFH) refered to the wording of Section 20 Para. 1 No. 1 Income Tax Act (EStG) – as well as Section 8 Para. 3 Sentence 2 Corporate Tax Act (KStG) – and considered jouissance rights as equity-related financing instruments in cases where the holder of the jouissance right participates in the profit and the liquidation proceeds of the issuing company. Only if both conditions are cumulatively met such payments resulting from jouissance rights will constitute tax-free dividend income. If one of those two conditions is not met, the Federal Court of Finance (BFH) takes the view that the jouissance rights will not be considered as equity-related jouissance rights (“beteiligungsähnliche Genuss-rechte”), but rather as debt-related jouissance rights (“obligationsähnliche Genussrechte”) from which taxable interest income is generated.

In the case at hand, the participation of GerCo in the liquidation proceeds of CanCo was not (explicitly) stipulated in the jouissance rights agreements. In the view of the Federal Court of Finance (BFH), the final assets of a corporation to be wound up must be taken into account, i.e. the participation of the holder of jouissance rights in any (additional) liquidation proceeds and the associated participation in the hidden reserves of the issuing company. In the absence of any such participation in the liquidation proceeds, other circumstances cannot substitute this indispensable requirement for assuming equity-related jouissance rights:

Both the profit-related nature of distributions resulting from jouissance rights and the subordinated repayment of jouissance capital at par value in the event of liquidation do not result in a participation in the liquidation proceeds.
The position of the holder of jouissance rights as sole shareholder itself is also insufficient. Although sole shareholders would be entitled to participate in all hidden reserves of the issuing company, this fact does not result causally from the jouissance rights agreements, but rather from the position of the shareholder.
Even a long term of jouissance rights (in the case at hand: 40 years) does not lead to an equity-related jouissance right.
Ultimately, a conversion right of the holder of jouissance rights to acquire shares in the company is also of no significance for the estimation whether the hybrid financing instrument at hand qualifies as equity-related jouissance right or debt-related jouissance right.

Comments

The above explanations demonstrate that there is considerable tax structuring potential when using jouissance rights for financing the purchase price of company acquisitions:

If the jouissance rights agreement provides for a participation in the profits and liquidation proceeds of the issuing company (= equity-related jouissance rights), the distributions resulting from such jouissance rights represent dividend income which is 75% tax-free for a recipient in the form of a corporation. However, the distributions do not reduce the tax base of the issuing company.
If the jouissance rights agreement provides for a participation in profits but not an explicit participation in the liquidation proceeds of the issuing company (= debt-related jouissance rights), the distributions resulting from such jouissance rights qualify as interest income which is either fully taxable for the jouissance right holder (in case of a corporation) or subject to a 25% withholding tax (in case of an individual). In this case, the distributions constitute deductible interest expenses for the issuing company which reduce the tax base.

Therefore, it should be assessed in each individual case whether the tax implications of using jouis-sance rights as financing instrument are in line with the economic interests of the buyer.