M&A Vocabulary – Experts explain: Profit and Loss Agreement

In business practice, so-called profit and loss agreements are agreed between companies due to considerable tax advantages. A profit and loss agreement is a contract between two companies under which a dependent company transfers part or all of its profits to the controlling company, which in return undertakes to offset any losses. Such kind of agreement is often concluded in the context of a fiscal unity scheme (steuerliche Organschaft). Profit and loss agreements can also be concluded in combination with a so-called controlling agreement (Beherrschungsvertrag) in order to place the dependent company under the uniform management of the controlling company and thus also be able to issue instructions to the management board of the dependent stock corporation (Aktiengesellschaft). However, such an agreement between interlocking companies (Organschaftsvertrag) is not necessary to establish a fiscal unity scheme. The conclusion of an agreement between interlocking companies is avoided in practice in order to prevent the attribution of employees employed by the dependent company at the level of the controlling company. The One-Third Participation Act (Drittelbeteiligungsgesetz) only provides for this insofar as a controlling agreement exists between the two companies, but not if a profit and loss agreement is concluded.

The dependent company can take the form of a German stock corporation, a German partnership limited by shares (Kommanditgesellschaft auf Aktien), a Societas Europaea (“SE”) and, under certain conditions, a German limited liability company (Gesellschaft mit beschränkter Haftung - GmbH). The controlling company, on the other hand, is independent of legal form.

The dependent company undertakes to transfer the entire profit to the controlling company. In return, the contractual partner undertakes to offset any net loss for the year (Jahresfehlbetrag) during the term of the agreement. The term “entire profit” refers to the net profit that would be generated if there were no profit and loss agreement. This entire profit is no longer shown as profit in the final commercial balance sheet, but as a liability, having only been recognized as profit in a preliminary balance sheet to determine the payable amount. In the profit and loss account, the payable amount is separately recognized as an expense. If there are external shareholders or partners in the dependent company, appropriate settlement (Abfindung) for the sale of the stock to the controlling company and annual compensation shall be agreed if the shareholder remains in the company. The compensation shall provide for a recurring payment based on an average profit to be determined. 

The conclusion of a profit and loss agreement requires prior approval resolutions in order to be effective. 

On the part of the dependent company (in the case of a stock corporation), the general meeting (Hauptversammlung) shall give its approval with a three-quarter majority of the share capital represented. This approval resolution shall be notarized by a notary. Whereas, if the dependent company is a German limited liability company, the resolution is passed by the shareholders' meeting. It is disputed whether the latter can only take place with the approval of all shareholders or whether a three-quarters majority is also sufficient. To avoid jeopardizing the agreement, it is advisable to pass a unanimous resolution. This shall also be notarized. 

If the controlling company is also a German stock corporation, a German partnership limited by shares or a SE, the same applies to the resolution as for the dependent company – an approval resolution is therefore required, which shall be passed by a three-quarters majority and be notarized by a notary. In the case of a GmbH, on the other hand, a three-quarters majority is sufficient for approval. Notarization is not necessary in this case.

In order for the profit and loss agreement to be effective, the dependent company shall also be entered in the commercial register. 

The tax advantages of a profit and loss agreement arise primarily from the possibility of a fiscal unity scheme, which allows the profits and losses of the dependent company to be consolidated at the controlling company.

The profits and losses of the dependent company are treated as income of the controlling company for tax purposes. This can lead to a more efficient use of tax loss carryforwards and tax allowances. The fiscal unity scheme allows the profits of the dependent company to be taken into account when calculating the corporate tax of the controlling company. This can lead to a reduction in the effective tax burden. It is advisable to stipulate a minimum contract term of five years. In a recent judgement (BFH, dated 2 November 2022 I R 29/19), the Federal Fiscal Court (“BFH”) pointed out that the profit and loss agreement shall be implemented for its entire term.

It is important to note that the tax benefits of a profit and loss agreement are not without risks. Meeting the requirements for a fiscal unity scheme is crucial and there are legal and tax aspects that need to be carefully considered. 

In the M&A context, clear regulations on the termination of profit and loss agreements play a central role, as both the seller and the purchaser have an interest in the legally secure termination of the agreement, at the latest at the time of the transfer of the shares. The purchaser has an interest in realizing future profits itself, while the seller no longer wishes to be obliged to offset losses. In particular, the following aspects shall therefore be taken into account when drafting the share purchase agreement: