Taxation of Subsequent Purchase Price Payments

The case of the ruling of the German Federal Fiscal Court dated November 9, 2023, case no. IV R 9/21, involved a German limited partnership with a limited liability company as general partner (so called GmbH & Co. KG) in which another partnership was the sole limited partner, which also held all shares in the limited liability company as general partner. The limited partner sold its shares of the partnership and all shares of the limited liability company as general partner. A fixed purchase price and an additional purchase price in the form of a profit- and turnover-related payment (earn-out payments) were agreed as the purchase price.

The basis for the variable payment was to be the gross margin achieved in the three years following the sale. Payments were only to be made if this margin exceeded a certain amount, otherwise no payments were to be made. Further purchase price payments were made in the following years. It was disputed whether these payments were taxable as subsequent operating income in the year of payment or whether they had a retroactive effect on the date of sale and led to a change in the capital gain.

In the reasons for the decision, the German Federal Fiscal Court first confirms once again the principles for determining the capital gain: the selling price is the proceeds actually realized. This includes all payments that the seller receives in direct economic connection with the sale.

In addition, the capital gain generally arises at the time of sale, i.e. with the transfer of economic ownership of the material business assets, irrespective of whether the agreed purchase price is due immediately, payable in installments or deferred over the long term and when the proceeds of the sale actually accrue to the seller.

An exception to this principle applies to variable purchase price components; they do not relate back to the date of sale. The main case of application are profit- or sales-based purchase price receivables. In these cases, the focus is on the realization of the sales consideration, as the seller only realizes the profits at the time of receipt. There is no retroactive effect to the time of sale. The German Federal Fiscal Court justifies this by pointing out that these are purchase price claims subject to conditions precedent for which it is not clear at the time of the sale whether a purchase price claim will legally arise in a subsequent year, nor how high this claim will be.

Because the earn-out payments in the case in dispute are purchase price components subject to a condition precedent, the occurrence of which is uncertain both in terms of reason and amount at the time of sale, these payments are to be excluded from the calculation of the capital gain on the reporting date in accordance with the realization principle regulated in the German Commercial Code and only taxed at the time of receipt. This is because the accrual of such purchase price components is not yet “as good as certain”.

Notices

Capital gains are taxed at a reduced rate upon application in accordance with Section 34 (3) of the German Income Tax Act (EStG). This requires, in particular, an accumulation of income. However, the German Federal Fiscal Court has left open the question of whether and, if so, how earn-out payments affect the application of Section 34 (3) EStG with regard to the sales consideration realized in a later assessment period.

A difference must be made between the payment of the fixed purchase price and the earn-out payments. According to the above-mentioned ruling, the latter are taxable as subsequent business income in the year of payment; the tax relief under Section 34 (3) EStG is not granted. For the fixed purchase price, which was paid in the year of the sale, the tax relief of Section 34 (3) EStG was granted upon application. However, as the agreed purchase price was received in different assessment periods due to the earn-out payments made in later years, there could be a lack of aggregation of income in the year of the sale, meaning that the preferential tax treatment under Section 34 (3) EStG could be excluded for the entire purchase price and denied retroactively for the fixed purchase price.

In order to avoid this, it would be conceivable, although the German Federal Fiscal Court left this open, to agree payments that are already fixed in terms of amount in the transfer agreement, but whose obligation to pay depends on the occurrence of certain conditions. The payments are therefore only uncertain in principle, but not in amount. It would also be conceivable to agree a total purchase price that is reduced by fixed amounts if profit and/or sales-dependent margins are not achieved in subsequent years. A subsequent reduction of the capital gain should not prevent the granting of the preferential tax treatment under Section 34 (3) EStG. However, the German Federal Fiscal Court has not yet commented on this either.