Termination of a profit and loss transfer agreement in context of a transaction from a legal and tax perspective

Tax groups (Organschaften) between the controlling company (Organträger) and the controlled company (Organgesellschaft) which are achieved by means of a profit and loss transfer agreement (“PLTA”) are of considerable relevance in group structures. The tax group for corporate tax (Körperschaftssteuer) and trade tax (Gewerbesteuer) purposes ensures that the income of the controlled company is attributable to the controlling company (Organträger) (S. 14 et seq. German Corporate Income Tax Act (KStG)). This particularly enables the profit and loss accounting within the tax group. If one party to this PLTA is to be sold, the tax group and thus the existing PLTA must be terminated.

The termination of a PLTA as part of a transaction is a complex process in which numerous aspects need to be considered that go beyond the correct timing of the termination. In particular, the seller and buyer should be fully aware of the risks associated with the termination and make appropriate provisions in the purchase agreement.

If provisions for an ordinary termination of the PLTA have been agreed, an ordinary termination of the PLTA is legally possible. If the PLTA provides for such a right of termination but no further details, the statutory provisions may be used. Therefore, a minimum notice period of six months to the end of the financial year applies.

From a tax perspective, a minimum term of five years must be considered. If the PLTA is terminated by ordinary notice before the end of this minimum term, the tax recognition is retroactively omitted.

The ordinary termination – as well as the extraordinary termination mentioned below – must be declared in writing. In case of termination by the controlled company having the legal form of a German limited liability company (GmbH), a notarized shareholder’s resolution is required; however, in case of termination by the controlling company having the legal form of a German limited liability company a shareholder’s resolution in writing is sufficient. If a German stock corporation gives notice of termination, regardless of whether it is a controlled company or a controlling company, no resolution of approval by the annual general meeting is required.

In view of the usually too long notice periods for an ordinary termination in context of a transaction and the minimum tax term of five years, in many cases only an extraordinary termination of the PLTA may be considered.

An extraordinary termination requires a good cause. A good cause exists if one party to the contract cannot reasonably be expected to continue the contractual relationship until the next ordinary termination date. Pursuant to S. 297 ss. 1 of the German Stock Corporation Act (AktG), such good cause is given if a contracting party is likely to be unable to fulfil its obligations under the PLTA. In case of the sale of a controlled company, good cause for the controlling company is predominantly denied, as the controlling company carries out the sale itself and thus sets the good cause. For the controlled company, the sale by its shareholder could constitute a good cause for termination. However, it is generally recognized that the right to extraordinary termination must also be agreed in the PLTA. During the establishment of the tax group, it is therefore advised to ensure that the sale by the shareholder is explicitly included in the PLTA as a good cause for extraordinary termination.

Pursuant to S. 14 ss. 1 No. 3 German Corporate Income Tax Act, good cause for the termination of the PLTA is also required for tax recognition, particularly during the minimum term of five years. The tax assessment is based on the interpretation under corporate law, but is not fully bound by it. From the perspective of the tax authorities, the decisive factor is that there are no indications of circumvention of the minimum term. This is assumed, for example, if it was already clear when the agreement was concluded that the PLTA would end before the five years had expired.

For tax purposes, the extraordinary termination of the PLTA resp. the sale of the controlled company always takes effect at the end of a financial year. If the PLTA is terminated during the financial year, the tax group ceases to exist at the end of the previous financial year, even if the minimum term is observed. However, as the PLTA does not end before the date of termination under civil law, this generally results in an obligation to transfer profits / offset losses. Under tax law, this transfer is then considered a hidden profit distribution/contribution which also entails the obligation to withhold capital gains tax. To avoid these tax implications, it is advisable to terminate the PLTA at the end of a financial year.

Instead of termination, a PLTA may also be rescinded by an agreement. The PLTA may be rescinded only as per the end of the financial year or of any accounting period otherwise contractually determined in the PLTA. Any retroactive rescission is impermissible, as it is in case of a termination. The rescission must be made in writing. In addition, a notarized shareholder’s resolution must be passed at the level of the controlled company.

For most companies, the financial year ends on 31 December of each year. If, as is usually the case, the termination of the tax group and the sale of the controlled company are to coincide in the context of a transaction without the closing date being 31 December, the financial year of the controlled company may be changed and an abbreviated financial year (Rumpfgeschäftsjahr) may be formed at the controlled company. This requires a corresponding notarized shareholder’s resolution at the level of the controlled company as it is an amendment of the articles of association. It should be noted that the amendment of the articles of association only becomes effective upon entry in the commercial register (Handelsregister). In addition, tax recognition requires the approval of the tax office which must generally be granted if the formation of the abbreviated financial year serves to terminate the tax group at the end of the financial year. 

The formation of an abbreviated financial year can also be advantageous if the buyer wishes to establish a tax group itself as the tax group is only recognized for tax purposes if the requirements are met throughout the entire financial year. An abbreviated financial year may therefore ensure a seamless transfer of the tax group. In this context, it should be noted that the rescission of the PLTA at the end of the financial year bears the risk that the closing conditions set out in the purchase agreement are not met and therefore the sale fails. In such case the tax group is still deemed terminated for tax purposes. A newly established tax group requires again a five-year minimum term.

PLTAs and their termination often play a significant role in transactions. The seller must ensure that the form chosen for the termination of the PLTA does not invalidate the tax recognition of the tax group with effect for the past. In case of a closing of the transaction during the year, the formation of an abbreviated financial year may be recommended from the perspective of the parties of the transaction. The purchase agreement should also provide for any responsibilities with regard to the PLTA and its termination from the perspective of both the seller and the buyer.