The tax treatment of profit participation capital has been the subject of much discussion in practice in recent years, also on account of administrative rulings issued. In particular, the ruling of the North Rhine-Westphalian Office of Tax Administration (Oberfinanzdirektion (OFD) Nordrhein-Westfalen) dated May 12, 2016 (S 2742-2016/0009-St 131) caused great uncertainty among affected issuers of profit participation capital. Pursuant to this ruling, a profit participation right that qualifies as equity in the commercial balance sheet should also qualify as equity in the tax balance sheet due to the principle of materiality, with the consequence that distributions thereon should not be deductible under the general rules of § 8 (3) sentence 1 of the German Corporate Income Tax Act (Körperschaftsteuergesetz, KStG).
This revision of the tax authorities’ view has been widely criticized in practice and also in the literature. In a regulation dated July 18, 2018 (S 2133-000036-V B1), the Ministry of Finance of North Rhine-Westphalia had reacted to this and revoked the regulation.
The BMF has now published a draft circular in November 2022, in particular on the tax balance sheet allocation of profit participation capital.
Accordingly, due to the lack of a statutory definition of profit participation capital, the tax authorities initially assume that they are of a debt nature. The criteria used in practice to date, such as the absence of a termination option on the part of the profit participation certificate holder or the fact that repayment can only be demanded at the time of liquidation, are not intended to change this interpretation.
However, the BMF seeks to clarify that, for classification as equity or debt capital, it must be examined whether the participation rights are similar to equity or obligations. This must be assessed on a case-by-case basis on the grounds of various criteria, such as the existence of profit and/or loss participation, promotion of a common purpose, etc. In addition, there should be a differentiation from other financial instruments, e.g. the silent partnership and the profit participation loan, as has been the practice in the past.
In fundamental terms, the BMF draft assumes classification in the commercial balance sheet. Pursuant to German Accounting Standard IDW/HFA 1/94, profit participation capital is to be reported as equity if the following criteria are cumulatively met:
- Subordination of the capital transfer to other creditors;
- Performance-related remuneration;
- Participation in losses up to the full amount of the capital provided;
- Long-term nature of the capital transfer.
However, debt capital under tax law is not necessarily excluded even if it is classified as equity in the commercial balance sheet. When distinguishing between debt and equity for tax purposes, an existing repayment obligation is a decisive criterion for the determination of debt capital.
In the opinion of the tax authorities, even when profit participation capital is issued during a crisis, it should initially be assumed that it qualifies as debt capital. Only special cumulative indications, such as a transfer of capital in connection with the opening of insolvency proceedings, low current profits in the case of a high debt ratio, etc., should speak in favor of qualification as equity.
Where conversion and option rights are present, it should be assessed on a case-by-case basis whether the capital is provided to the company on a permanent basis. In the opinion of the BMF, debt capital should be assumed in this case as well. However, the explanations that, depending on the structure of the conversion and option rights, the capital may qualify as equity from the outset are not entirely comprehensible, e.g. if exercising the right is the only economically sensible option. This could lead to inconsistent qualifications if the right is not exercised.
In the opinion of the tax authorities, a lack of an economic burden speaks against the recognition of a liability in the tax balance sheet. When exactly this is lacking, however, is unfortunately not specified.
To the extent that there is debt capital for tax purposes, the remunerations paid should generally be treated as operating expenses for income tax purposes. However, if remuneration is paid on profit participation capital which are linked to the right to participate in profits and liquidation proceeds, these do not reduce the income of the issuer of profit participation capital. For this purpose, the tax authorities list examples of when participation in profit and when participation in loss are present.
Notice:
As a matter of principle, the draft of the BMF letter is to be appreciated, as legal uncertainties from the past are eliminated. There is certainly still a need for improvement in the area of conversion and option rights and the presentation of an economic burden. It therefore remains to be seen whether and how the BMF will make further improvements in the final version.