In official guidance, the Federal Ministry of Finance (BMF) addressed the application of rules regarding the tax consequences of (i) an assumption of liabilities that cannot be accrued for tax purposes (or cannot be accrued in the same amount), and (ii) an assumption of an indemnification obligation against the original debtor regarding such liabilities. The guidance will apply in the case of accruals for impending losses or liabilities (deductible for German tax purposes once they materialize), non-interest-bearing liabilities (which must be discounted for German tax purposes so that the nominal repayment amount of such debt cannot be recorded for German tax purposes before it is reflected in its net present value) and pension accruals (which must be recorded for tax purposes based on a special tax value usually below their fair market value).
Assumption of debt
In the case of an assumption of debt by a third party (“buyer of the debt”), the third party will replace the original debtor (“seller of the debt”), regardless of whether the liabilities are transferred separately (single transfer), together with a business as a whole or as part of an asset deal. According to the BMF guidance, the buyer of the debt has to reflect the debt in its tax balance sheet at its current fair market value, but only up to the amount of the costs of the acquisition. When determining the profits of the relevant fiscal year, however, the general valuation rules should apply so that a gain may be triggered to the extent these rules require the liabilities to be recorded at a lower value (e.g. pension accruals, non-interest-bearing loans) or may not (yet) be accrued at all (e.g. accruals for impending losses or liabilities which only have to be repaid out of future profits). As a result, the liability reduces the capital gain of the seller but will ultimately increase the taxable profits of the buyer in the year of the acquisition and will reverse only once the amounts become deductible for tax purposes. For example, if a purchaser acquires a business and assumes an unfavorable rental agreement for which the seller had recorded a provision for contingent losses for GAAP purposes (but not for tax purposes), the accrual would be treated as a liability in the opening (tax) balance sheet but would have to be eliminated from the tax balance sheet at the subsequent year-end leading to a profit because, under the general rules, the accrual would be deemed to be an accrual for a contingent liability which may not be recorded for tax purposes. Once the liability materializes, the purchaser can record the liability, which should lead to an expense in the tax books.
Indemnification of the seller
In the case of an indemnification of the seller, the original obligation of the seller will not be transferred to the buyer, i.e. the contractual relationship between the seller and his creditor remains intact. The buyer, however, agrees to indemnify and hold harmless the seller from his contractual liabilities under the overall purchase/transfer agreement. This agreement constitutes a new liability. In this situation, the liability resulting from the indemnification obligation must be recorded at the level of the purchaser and should increase its purchase price. It should be possible to record the liability for tax purposes at the level of the buyer (regardless of any contingent element at the level of the seller) and, therefore, should increase future depreciation and amortization. The corresponding receivable should increase the capital gain from the sale at the level of the seller. The seller will enjoy a tax deduction only when the liability materializes for German tax purposes because the rules on recognition and valuation of debt for tax purposes still apply (irrespective of how the obligations are incurred, i.e. by single asset transfer, a transfer of a business or an asset deal or in a reorganization, including a spin-off, spin-up or hive-down (see section 123 of the German Reorganization Tax Act)).
As a result, the buyer of debt should carefully monitor whether the debt can be fully accrued for German tax purposes and, if not, whether the debt is technically transferred by an assumption of the debt or by an indemnification of the seller. The seller and the purchaser may have deviating views as to how to best structure such a transaction as the tax consequences may differ.
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