Frequently overlooked tax lock-up periods for reorganizations

published on 24 October 2024 | reading time approx. 6 minutes

The German Reorganization Tax Act (Umwandlungssteuergesetz – UmwStG) allows tax-neutral reorganizations under certain conditions. However, in order to prevent abuse, the law also provides for various lock-up periods, some of which are often overlooked. These include, on the one hand, the lock-up period of five years in connection with splits, spin-offs and other asset transfers (Sec. 15 Para. 2 UmwStG). On the other hand, with regard to trade tax, there is a lock-up period of five years in the case of a transfer of assets to a partnership and in the case of a change of legal form to a partnership (Sec. 18 Para. 3 UmwStG). Particularly if a sale is intended after a reorganization, the tax lock-up periods should be checked and adhered to in order to avoid undesirable tax consequences.

Post-spin-off lock-up period pursuant to Sec. 15 Para. 2 UmwStG

For the transfer of assets of a corporation by splitting or demerging to other corporations (Sec. 15 UmwStG) or a partnership (Sec. 16 UmwStG), it is possible under certain conditions and upon application to carry this out at book value and therefore tax-neutral. However, a five-year lock-up period must be observed. The provision was adapted and clarified as part of the Growth Opportunities Act (e.g. inclusion of "preparation of the sale" in addition to the sale with specification in Sec. 15 Para. 2 Sent. 4 UmwStG, definition of outside third par-ties). According to the current version, such a reorganization is not tax-neutral at the level of the transferring legal entity if it completes or prepares the sale to outside parties (Sec. 15 Para. 2 Sent. 2 UmwStG). Preparation for the sale is irrefutably assumed if shares in a corpo-ration (or partnership in the case of Sec. 16 UmwStG) involved in the reorganization that account for more than 20% of the shares in the corporation prior to the reorganization taking effect are sold within five years of the transfer date for tax purposes.

The background and the effects of the lock-up period of Sec. 15 Para. 2 Sent. 2 to 7 UmwStG will be illustrated using the following example:

A GmbH spins off a part of its business to the newly founded B GmbH. In return, shareholder X of A GmbH receives shares in B GmbH. After the spin-off, A GmbH retains a business unit. Three years later, X sells the shares in B GmbH to a third party.

Background of lock-up period of Sec. 15 Para. 2 UmwStG

In the event that A GmbH sells a part of the business, the profit from the sale would be subject to corporation tax plus solidarity surcharge and trade tax (tax burden approx. 30%) at the level of A GmbH. If the proceeds of the sale were distributed to X after tax, the distribution would also be subject to flat-rate withholding tax plus solidarity surcharge (tax burden approx. 26.4%). In contrast, the profit arising from the sale of the shares in B GmbH would be tax-privileged. In the case of X as shareholder, the partial income method would apply (tax burden approx. 28.5% at the top tax rate). With the lock-up period pursuant to Sec. 15 Para. 2 Sent. 2 to 7 UmwStG, the legislator thus wants to prevent the taxation of a partial sale of a business by the transferring corporation (in this case A GmbH) from being circumvented by means of a tax-neutral spin-off and subsequent sale of the shares in the acquiring corporation (in this case B GmbH).

Spin-off

The provisions on mergers (Sec. 11 et seqq. UmwStG) are applicable to the spin-off in accordance with Sec. 15 Para. 1 Sent. 1 UmwStG. However, the regulations for avoiding the realization of profits (in particular Sec. 11 Para. 2 UmwStG) are only applicable pursuant to Sec. 15 Para. 1 Sent. 2 UmwStG if a business unit is transferred to B GmbH and a business unit remains with A GmbH. This is fulfilled in the present case. Subject to the further requirements of Sec. 11 Para. 2 UmwStG, the spin-off can therefore be carried out at book value on request in a tax-neutral manner. At the same time, however, the spin-off triggers a five-year post-spin-off lock-up period.

Consequences of the sale three years later

The sale of the shares in B GmbH by X within a period of five years after the transfer date for tax purposes leads to a breach of the lock-up period (Sec. 15 Para. 2 Sent. 2 UmwStG). The breach of the lock-up results in retroactive taxation of the hidden reserves from the transfer of the business unit to B GmbH with corporation tax plus solidarity surcharge and trade tax.

The same applies if a sale to external persons is being prepared. This is the case if a sale of at least one share in a corporation involved in the spin-off takes place within five years of the spin-off (Sec. 15 Para. 2 Sent. 4 UmwStG). According to the explanatory memorandum to the law, such preparations are deemed to have been made if there are already concrete intentions to sell at the time of the spin-off or if such intentions are not merely hypothetical. The legislator irrefutably assumes that a sale has been prepared by the spin-off if shares in a corporation involved in the spin-off that account for more than 20 percent of the value of the shares in the transferring corporation on the transfer date for tax purposes are sold to external persons within the five-year period (Sec. 15 Para. 2 Sent. 5 UmwStG).

Any reorganization should therefore not be based solely on the time of the reorganization. Any plans or objectives of the reorganization should also be taken into account in order to be able to assess potential tax consequences.

(Trade) tax lock-up period pursuant to Sec. 18 Para. 3 UmwStG

If a corporation is merged into a partnership (Sect. 3 to 8 UmwStG), a corporation is changed into a partnership (Sec. 9 UmwStG) or assets of a corporation are transferred by splitting or spin-off (Sec. 16 UmwStG), any profit or loss from the takeover is not subject to trade tax in accordance with Sec. 18 Para. 2 UmwStG. However, if the business of the partnership is liquidated or sold within five years of the reorganization, the profit from the liquidation or sale is subject to trade tax in accordance with Sec. 18 Para. 3 Sent. 1 UmwStG. The same applies in accordance with Sec. 18 Para. 3 Sent. 2 UmwStG even if only a part of the business or a share in the partnership is liquidated or sold. Sec. 18 Para. 3 UmwStG therefore establishes a separate trade tax liability.

The background and the effects of the holding period under Sec. 18 Para. 3 UmwStG will be illustrated using the following example:

The natural person X is the sole shareholder of X GmbH. X GmbH is converted into X GmbH & Co. Sec. 3 to 8 UmwStG into X GmbH & Co. KG. Hidden reserves in the business assets are thus transferred from X GmbH to X GmbH & Co KG. Three years later, X sells the shares in X GmbH & Co. KG to third parties.

Background of lock-up period pursuant to Sec. 18 Para. 3 UmwStG

In the event that X GmbH sells its business or part of its business, the profit from the sale would be subject to trade tax (H 7.1 (4) GewStR). In contrast, the capital gain arising from the sale of the business of X GmbH & Co. KG by X would not be subject to trade tax (Sec. 7 Sent. 2 GewStG). Without a lock-up period, a (largely tax-neutral) change of legal form could therefore avoid trade tax on a profit on the disposal of a corporation. In order to avoid this, Sec. 18 Para. 3 UmwStG provides for a five-year lock-up period after the conversion.

Change of legal form

The change of legal form takes place at the level of X GmbH under the conditions of Sec. 9 UmwStG in conjunction with Sec. 3 Para. 2 UmwStG and, upon request, at book values with no tax impact. In principle, this also applies to trade tax (Sec. 18 Para. 1 Sent. 1 UmwStG). However, in future, the lock-up period of five years (time years) pursuant to Sec. 18 Para. 3 UmwStG must be taken into account in relation to trade tax.

Consequences of the sale three years later

The special provision of Sec. 18 Para. 3 Sent. 1 UmwStG means that the capital gain is subject to trade tax at the time of the sale three years after the change of legal form. There is no retroactive effect to the time of the original change of form. There is also no pro rata reduction of the amount subject to trade tax depending on the years that have elapsed (as is the case, for example, under Sec. 22 Para. 1 Sent. 3 UmwStG). Instead, the profit is fully subject to trade tax at the level of X GmbH & Co. KG at the time of the sale.

If new business assets were formed by X GmbH & Co. KG in the course of the change of legal form or after the change of legal form, the hidden reserves in these assets are not subject to taxation in accordance with the latest case law of the Federal Fiscal Court (Federal Fiscal Court ruling of 14.3.2024 - IV R 20/21, BFH/NH 2024, 863) pursuant to Sec. 18 Para. 3 UmwStG. However, this contradicts the opinion of the tax authorities, according to which these so-called newly formed business assets must also be taken into account (Federal Ministry of Finance decree dated 11.11.2011, BStBl. I 2011, 1314, para. 18.09). It remains to be seen whether the tax authorities will adapt the current draft of the UmwStE to the case law in this respect or whether they will continue to adhere to their opinion.

Any tax risks should be taken into account in the run-up to transformations that trigger a lock-up period in accordance with Sec. 18 Para. 3 UmwStG. As part of the reorganization documentation, for example, it should be checked whether tax clauses are desired that prohibit a reorganization triggering a lock-up period or - in the event of the sale of an interest in a partnership - oblige the selling partner to pay the resulting trade tax.

Conclusion

In the context of reorganizations, it is essential to keep an eye on tax lock-up periods. The purpose of certain reorganizations, such as spin-offs and demergers, is often to outsource and sell parts of the business. This can have considerable tax consequences if the post-spin-off lock-up period pursuant to Sec. 15 Para. 2 UmwStG is not taken into account. The same applies with regard to trade tax, for which the special lock-up period pursuant to Sec. 18 Para. 3 UmwStG must be taken into account and, if this is not observed, a sale that is generally not subject to trade tax becomes subject to trade tax.