Tax traps due to the violation of lock-up periods in the course of reorganizations

published on 16 August 2024 | reading time approx. 4 minutes

The German Reorganization Tax Act (Umwandlungssteuergesetz - UmwStG) contains several lock-up period regulations, the violation of which can cause serious tax consequences. They must be observed, particularly in the context of M&A transactions. On the one hand, the violation can result in unwanted tax burdens at the level of the target company. On the other hand, a contributor may be subject to retroactive taxation with regard to the earlier contribution at a later point in time without any own action and without receiving any liquidity. Potential protections should be examined and considered in the SPA negotiations.

Example 1: Lock-up period following restructurings pursuant to section 20 UmwStG

When transferring businesses, parts of businesses and shares in partnerships to a corporation, it is possible under certain conditions to transfer these at book value and therefore tax neutral. In return, the contributor receives new shares in the corporation (at least in part).

Such contributions that meet the respective requirements and take place below the fair market value generally trigger a seven-year lock-up period. The period begins on the transfer date for tax purposes. In this case, the contribution may be taxed retroactively for the contributor if the contributor sells the new shares within a period of seven years or realizes an equivalent event (section 22 para.1 UmwStG, so-called transfer gain I).

In addition to (individual/corporate) income tax, trade tax must also be taken into account for taxation purposes.

The following practical example shall illustrate this:

The contributor, GmbH & Co. KG 1, receives new shares for the tax-neutral contribution of the 100% limited partnership interest in GmbH & Co. KG 2 into the acquiring corporation. Three years later, GmbH & Co. KG 1 sells all its shares in the corporation.

Initial contribution

The contribution was made under the conditions of section 20 para. 1 in conjunction with para. 2 UmwStG at book value without any tax impact. At the same time, however, the contribution triggered a seven-year lock-up period. All applications were submitted in due form and time. In addition, the obligations to provide evidence under section 22 para. 3 UmwStG were complied with.

Tax consequences of the sale after 3 years

The sale of the new shares received in the corporation by the GmbH & Co. KG 1 within a period of seven years after the date of the contribution results in a violation of the lock-up period (section 22 para. 1 sentence 1 UmwStG). The reason for this is that the sale of the shares in the Corporation is subject to tax relief (partial income procedure for individuals or section 8b para. 2, 3 German Corporate Income Tax Act (Körperschaftsteuergesetz – KStG) for corporations as limited partners of GmbH & Co. KG 1), whereas the sale of the 100% shareholding in GmbH & Co. KG 2 would have been subject to taxation as a capital gain within the meaning of section 16 German Income Tax Act (Einkommensteuergesetz – EStG).

The violation of the lock-up period results in retroactive taxation of the hidden reserves from the contribution (so-called contribution gain I), with a deduction of 1/7 for each full year that has elapsed since the tax transfer date (here: 3/7) (section 22 para. 1 sentence 3 UmwStG). It should be noted that the (retroactive) contribution profit is determined at the level of GmbH & Co. KG 2 and is also subject to trade tax at this level, unless it is attributable to an individual as a directly participating partner (section 7 sentence 2 German Trade Tax Act (Gewerbesteuergesetz - GewStG). The economic burden may therefore not be borne by the initial contributor, but by the transferred company itself.

Any trade tax risks resulting from the violation of the lock-up periods should be protected by purchasers as part of M&A transactions, for example through tax indemnifications in the SPA.

Example 2: Lock-up period following restructurings pursuant to section 21 UmwStG

Under certain conditions, it is also possible to contribute shares in a corporation to another corporation at book value and therefore tax neutral. In return, the contributor receives (at least partially) new shares in the acquiring corporation. For the transfer to be tax neutral, that the acquiring corporation must have the majority of voting rights in the acquired company immediately after the contribution (so-called qualified share swap).

Such contributions also generally trigger a seven-year lock-up period. The period begins on the transfer date for tax purposes. The contribution may be taxed retroactively at the level of the contributor if the acquiring Corporation sells the transferred shares within a period of seven years (or realizes an equivalent event) and insofar as the contributor's profit from the sale of these shares would not have been tax-free at the time of the initial transfer in accordance with section 8b para. 2 KStG (section 22 para. 2 UmwStG, so-called transfer profit II).

The following practical example shall illustrate this:

The contributor, individual X, Reives new shares in Corporation 2 for the tax-neutral transfer of the shares in Corporation 1. Three years later, Corporation 2 sells all shares in Corporation 1.

Initial contribution

The contribution was made under the conditions of section 21 para. 1 sentence 1 in conjunction with sentence 2 UmwStG at book value without any tax impact. At the same time, however, the contribution triggered a seven-year lock-up period. All applications were submitted in due form and time. The obligations to provide evidence under section 22 para. 3 UmwStG were also complied with.

Tax consequences of the sale after 3 years

The sale of the shares in Corporation 1 by Corporation 2 within the period of seven years after the contribution date leads to a violation of the lock-up period (Section 22 para. 2 sentence 1 UmwStG). The reason for this is that the sale of the shares in Corporation 1 by Corporation 2 is taxed more favorably (application of section 8b para. 2, 3 EStG, 5% is taxable) than would have been the case if the shares in Corporation 1 had been sold by the individual X (application of section 3 no. 40 EStG, 60% is taxable).

The violation of the lock-up period results in retroactive taxation of the hidden reserves from the contribution (so-called contribution gain II), with a deduction of 1/7 for each full year that has elapsed since the date of the contribution (here: 3/7) (section 22 para. 2 sentence 3 UmwStG). However, the proceeds from the sale of Corporation 1 are received by Corporation 2. The contributor, who must pay tax on the contribution gain II, often lacks the liquidity to pay the taxes.

This case primarily affects individuals as sellers in the context of an M&A transaction who are re-invested in the acquisition vehicle or acquisition structure and thus transfer part of their share in the company to be sold to the acquisition vehicle in a tax-neutral manner in return for new shares. From their point of view, care must be taken in the purchase agreement documentation to be able to influence the avoidance of lock-up period violations or at least to ensure that they have sufficient financial resources available to repay the tax burden in the event of a lock-up period violation.

Conclusion

Potential lock-up periods should always be checked in the context of M&A transactions, as these can have a negative tax impact on the transaction. Depending on the persons affected and the extent of tax consequences, measures should be taken to protect against this.