Changes to the legislation on the conversion of companies - A loan receivable as consideration is no longer possible

Practical case study on conversion via a spin-off

Up to now, sole proprietorships have frequently been converted into GmbHs by spinning off enterprises that had been run as sole proprietorships into GmbHs. Provided that these are carried out by applying the provisions under the Transformation Act (Umwandlungsgesetz, UmwG), universal succession structures are then feasible, i.e., the transfer of all the assets and contractual relationships without the consent of the other contracting parties.

Here, the sole proprietor who transfers their enterprise into a GmbH receives shares in the GmbH in return. In practice, apart from granting shares, for tax optimisation purposes it was most notably usual to agree a loan receivable against the GmbH as additional consideration. In order for it to be possible to present the conversion overall in a tax-neutral way the Transformation Act specifies many pre-requisites that have to be cumulatively satisfied.

The enterprise can be spun off either against a capital increase (for absorption) or by way of a new formation. In the following section we have assumed a new formation with share capital of €25,000. The value of the contributed business that exceeds this amount - €375,000  – can be transferred to the capital reserves. However, a tax-exempt distribution from the capital reserves is not possible on account of the statutory sequence for profit appropriation; instead, taxable distributions have to be made from net retained profits. That is why, in practice, instead of the capital reserves, the contributing shareholder would be granted a loan receivable of €375,000. A disbursement or repayment to the shareholder would be possible at any time and free of tax.

Legislative amendment and its consequences

As a result of the ‘Act Implementing the Conversion Directive and Amending Other Acts’, a reference in Section 125 UmwG to Section 54(4) UmwG has been applicable already since 1.3.2023. Under Section 54(4) UmwG, additional cash payments to be made as other consideration (including a loan receivable) may not exceed one tenth of the aggregate nominal value of the shares in the acquiring company that have been allotted. In the case of a new formation with share capital of €25,000, a loan receivable would thus be capped at €2,500. This means that the previous structure is no longer feasible if an amount of just €2,500 instead of €375,000 may be granted as a loan receivable.

The conversion has to be recorded by the Commercial Registry. When the Commercial Registry now reviews a registration and finds that a loan receivable was agreed that exceeds 10% of the value of the shares that have been allotted it would have to reject the entry. A rejection of an entry would require an amendment of the conversion agreement combined with a renewed registration that, potentially, could then take place outside of the eight month retroactive period. If the Commercial Registry were to ignore the change in the legal situation and nevertheless register the conversion, only then would the shortcomings remain unaffected and the conversion would become effective.

If, according to the new legal situation, granting a loan is effectively eliminated as an option then, in the practical case study, the amount of €375,000 would have to be transferred to the capital reserves. In principle, analogous to a loan from the capital reserves, there could be a tax-free payout made to the shareholder. Before a contribution account for tax purposes can be used to make distributions, first of all, the entire distributable profits as determined at the preceding balance sheet date would have to be distributed and thus the entire retained profits used up. Furthermore, it should be noted that, according to Section 22(1) sentence 6 no. 3 of the German Transformation Tax Act, a distribution made from the capital reserves in the first seven years following the conversion could result in, at least, a partial revocation of a requested basis rollover due to a breach of the time limit.

Structuring options 

Consequently, other structuring options should be considered:

• withdrawals during the retroactive period,
• a modified loan receivable,
• a contribution instead of a spin-off.

Withdrawals during the retroactive period
A conversion only comes into force after an entry has been made in the Commercial Register and normally takes effect retroactively from the beginning of the financial year. This time period can therefore be used to still withdraw from the proprietorship as much capital as possible that will not be needed for the business after the conversion. Despite the retroactive determination of income and assets as a GmbH - upon request - this does not apply to withdrawals during the retroactive period, which is why these should not be seen as distributions. However, as at the effective date of the transfer and taking into account these withdrawals, the equity may not be negative.

A modified loan receivable
If there is no intention to make withdrawals during the retroactive period (e.g., because the capital will be needed in the short term, or there is simply a lack of liquidity), it is nevertheless possible to grant a loan receivable indirectly. To this end, the sole proprietor could give to a spouse, for example, a sum of money from the business assets as a gift that would then immediately be made available again as a third party loan to the sole proprietor.

After the conversion has been registered, the loan entitlement can be transferred again to the current sole shareholder of the GmbH. Since the loan was not granted as part of the conversion no limitations in terms of value will generally apply. If the agreement to transfer by way of a gift includes a free right of revocation, then gift tax consequences can be avoided here. If the right of revocation is exercised unilaterally then the gift tax would expire with retroactive effect. Such a clause has been recognised by the highest courts and, in this respect, there are no objections in terms of gift tax. In view of the free right of revocation, the gifts remain not relevant for income tax purposes - while a gift is made under civil law, nevertheless, the beneficial ownership and the attribution of income remain with the original giver of the gift (the sole proprietor or shareholder). 

A contribution instead of a spin-off
The restrictions on additional cash payments under the Transformation Act do not apply to a contribution. However, in the case of a contribution, singular succession applies and the assets are transferred separately. Contractual relationships would be transferred to the GmbH solely with the consent of the other contracting parties. Consequently, if a large number of agreements have to be transferred, then the contribution could give rise to a very substantial administrative burden. For tax purposes, a contribution would otherwise be treated in the same way, which is why a contribution that involves the granting of a loan receivable for the sole proprietorship could constitute a feasible alternative.