Caution needed when shareholders waive claims

Background

Shareholders of corporations and partnerships waiving claims is a widespread structuring tool for boosting companies in financial trouble. Shareholder waivers also have a solid place in preparing for company successions, especially in partnerships. In these cases they can reduce harmful administrative assets as part of the exemption of business assets from inheritance or gift tax. However, the income tax implications of shareholder waivers must always be examined, as a recent decision by Germany’s Federal Fiscal Court (BFH) on 16 December 2023 (case IV R 28/20) shows once again.

Income tax treatment of shareholder waivers at corporations

The income tax treatment of shareholders of a corporation waiving claims has been largely clarified by numerous BFH rulings. First of all, it must be determined whether the claims waiver is business-related or caused by the company relationship. It is generally assumed that the waiver of claims is due to the company relationship if a non-shareholder would not have declared the waiver of claims if such non-shareholder had exercised the due care of a prudent businessman (known as the arm’s length principle). If the waiver of the claim is caused by the company relationship, a hidden contribution to the corporation is to be assumed in the amount of the recoverable part of the claim and a generally taxable income of the corporation in the amount of the non-recoverable part of the claim as a result of the derecognition of the corresponding liability (the BFH calls this a discontinuation gain). In addition, the balance of the corporation’s tax contribution account is increased by the recoverable portion of the receivable. If the claims waiver is for operational reasons (e.g. because major third-party creditors also waive their claims), the corresponding liability of the corporation must be derecognised and, subject to a tax exemption for restructuring income, the full nominal amount of the liability results in a taxable discontinuation gain at the level of the corporation.

Income tax treatment of partner waivers at partnerships

Until the ruling of 16 December 2023, the tax implications of a shareholder waiver with respect to partnerships had not yet been covered by supreme court case law. The legal situation is therefore much less certain than in the case of shareholder waivers at corporations. There are various opinions on this in the legal literature, including the opinion that criteria which are relevant in the context of shareholder waivers in relation to corporations, such as the nature of the reason for the waiver (operational or through the company relationship) and the recoverability of the receivable, are far less important in the case of a partnership due to the income tax transparency of partnerships and that even if a receivable with a reduced value is waived, a taxable gain is not effectively realised at the level of the partnership at all or is only realised in the future (when the waiving partner leaves the partnership or the partnership is dissolved).

BFH ruling of 16 December 2023

In its ruling of 16 December 2023, the BFH had to rule on the tax implications of a partner waiver in partnerships for the first time. The question at issue was whether a taxable discontinuation gain arises if a partner acquires a receivable from “their” partnership for less than the nominal value and subsequently waives the (worthless) part of the claim that exceeds the purchase price. The lower court took the view that taxable income arose in the partnership, but that this income should be allocated to a tax equalisation item and only taxed when the partner leaves the partnership or when the partnership is fully terminated. In deviation from this, the BFH ruled that the resulting income could not be neutralised by creating a tax adjustment item. As a result, in the view of the BFH, the partnership realises a discontinuation gain that is immediately taxable. According to the BFH, this was not in conflict with the income tax transparency of partnerships. The fiscal authorities have decided to apply the BFH ruling on a general basis.

Analysis and practical implications

Caution is also needed when partners in a partnership waive claims. It is often said that a shareholder waiver has no income tax disadvantages, regardless of the reason for the waiver and the recoverability of the receivable, in any event due to the transparency principle, or that such tax disadvantages would only be effectively realised at a later date. As the BFH decision shows, this must be examined on a case-by-case basis and may result in an immediately taxable discontinuation gain if the valuation of the receivable in the special tax balance sheet of the partner differs for any reason from the valuation of the corresponding liability at the level of the partnership. In practice, these cases are not always immediately obvious. In addition to the commercial balance sheets, the special tax balance sheets must also be audited.

If the valuations in the special tax balance sheet of the partner and in the overall balance sheet of the partnership correspond, a waiver by the partner (even if the value of the receivable is limited or non-existent) should still not lead to a taxable discontinuation gain at the level of the partnership, because any income from the derecognition of the partnership’s liability is offset by an expense of the same value in the special tax balance sheet of the partner. While the BFH did not have to rule on this specific question in the case at hand, the strict “accounting” approach taken by the BFH supports this interpretation.

The BFH ruling is likely to have rendered obsolete the arrangement proposed in legal literature of selling the receivable in question below its nominal value to a shareholder who subsequently declares a shareholder waiver instead of a claim waiver by a non-shareholder.

In addition to the income tax implications of a claim waiver, any gift tax implications must not be neglected.