Update from Germany - January 2007
January 18, 2007
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In This Issue:
- Government Attempts to Limit Tax Exemptions for Non-German Companies
- Amendments Will Allow Cross-Border Mergers with German Companies
- Lawmakers Propose to Amend German Corporate Form—Will Investors Benefit?
- A New Era in German Labor Law
- New Federal Supreme Court Ruling on Acting in Concert
Government Attempts to Limit Tax Exemptions for Non-German Companies
By Dr. Gero Burwitz and Philip Neumann-Redlin
On November 9, 2006, the German Parliament passed the Annual Tax Bill 2007. It includes a significant tightening of the substance and activity requirements for non-German companies seeking benefits under a double taxation convention or under an EU directive (for example, the Parent-Subsidiary Directive) with regard to withholding tax exemptions or reductions. The new version of the anti-treaty/directive shopping provision went into effect on January 1, 2007.
The regulation mainly affects interposed holding entities receiving dividends, interest or royalties from German companies. For example, in private equity transactions, many groups create Luxembourg companies (LuxCo) that hold shares in a German subsidiary. According to the anti-treaty/directive shopping provision, the foreign holding company may not partake of certain benefits of the treaty or directive.
The bill is the government’s reaction to a German Federal Fiscal Court decision of 2005 stating that, according to the previous anti-treaty/directive shopping provision, treaty shopping cannot be assumed if the foreign company meets either the trade or business test or the business-purpose test.
Criteria for the Assumption of Anti-Treaty/Directive Shopping
According to the bill, authorities may assume treaty/directive shopping if the shareholder of the non-German company would not be able to claim the benefits through direct investment, e.g., because the shareholder resides in a country with less favorable treaty provisions. One of the following three criteria must also be met:
- The interposition of the foreign (non-German) company cannot be justified on grounds of an economic (business) purpose or other significant non-tax driven reasons (so-called “trade or business test”).
- The foreign company has not set up a business establishment with sufficient substance to conduct its business (business assets such as office space, personnel, etc., or the so-called “business purpose test”).
- The foreign company receives no more than 10 percent of its gross income from its own economic activities. These “active” activities are assumed to be missing as far as the interposed entity generates its gross income from the pure administration of assets.
The 10-percent-threshold criterion raises many questions and concerns and will quite likely become a hot topic with the fiscal authorities. It appears even active business outsourced to a managing company would not count toward the 10 percent threshold, and the bill does not provide a clear-cut definition of the term “gross income.” How can a German company apply the correct withholding tax rate on current payments to its foreign holding as only at the end of the business year of the holding it can be determined whether the 10 percent threshold has been met?
Moreover, according to explanatory notes, the new provision is intended to prevent passive holding companies, even those with substance and compelling business reasons, from abusing treaty and directive benefits. However, even an active holding will regularly have no substantial income other than that from its holding activities, such as dividends, interest on shareholder loans, royalties from group companies and capital gains. Therefore, these types of income may be deemed “passive income” from the administration of assets.
All of these criteria are applied solely to the interposed foreign company itself. Organizational, economic and other characteristics of related entities should not be taken into account. The anti-treaty/directive shopping provision is not applicable if the stocks of the interposed company are regularly and considerably dealt on an acknowledged stock exchange.
Once the interposed company has been qualified as passive in the sense of the new provision, it does not necessarily help if the direct shareholder of the interposed company could claim the same treaty/directive benefits on its own, e.g., the shareholder of the interposed LuxCo is another LuxCo. Supposedly, authorities will look through to all indirect shareholders. If only one of them would not be entitled to the treaty/directive benefits through direct investment, the provision might be applied.
Possible Reactions
Because the differentiation between active holding companies and passive companies administering only their own assets is vague and might be even challenged by the jurisprudence of the European Court of Justice, a proper structuring of holding entities will become much more difficult to achieve than it is today.
A non-German company might pass the 10 percent threshold only if it is not restricted to typical active holding activities but runs a considerable separate business as well. However, there is a debate whether this can prevent the application of the new provision as the fiscal authorities might regard the operative business as pure alibi activities, or they might argue that holding activities must be distinguished from the operative business as they are not directly connected to them. However, it may be sufficient to render services for other group companies such as controlling, internal audit, IT, legal and tax services, etc.
Possible Violation of European Law
Considering the recent Cadbury Schweppes decision of the European Court of Justice, it is doubtful whether the new provision complies with European law. The court confirmed that a restriction on the freedom of establishment can only be justified on grounds of the prevention of abusive practices, i.e., the objective of such a restriction must be to prevent wholly artificial arrangements that do not reflect economic reality. As the interposition of a management company that has sufficient resources to conduct its business should not be regarded as an artificial arrangement, the new provision might violate European law.
Amendments Will Allow Cross-Border Mergers with German Companies
By Dr. Martin Kock
Until recently Section 1 of the law regulating the transformation of companies (Umwandlungsgesetz, Transformation Act) prevented German companies from merging with foreign companies. It expressly provided that a German company could only take part in transformations (such as mergers, splits, change of legal forms and transfers of all assets) with another German company. However, the European Directive 2005/56/EC of October 26, 2005 (Merger Directive), and the European Court of Justice’s SEVIC decision have changed the legal landscape at least with respect to mergers. On August 9, 2006, the German government resolved to implement the amendments (German Transformation Amendments), which are necessary under the European Directive, to the Transformation Act. The amendments must still be enacted by the German lawmakers, which is expected to occur in the first quarter of 2007.
Cross-Border Transformations
The Merger Directive and the German Transformation Amendments cover cross-border mergers of corporate entities (limited liability companies and corporations) that have been established under the laws of a Member State and whose headquarters are in a Member State, provided that the merging companies are subject to at least two European jurisdictions.
The German Transformation Amendments reach further than the Merger-Directive; they cover the cross-border mergers involving companies that are subject to the laws of Iceland, Liechtenstein and Norway (the members of the European Economic Area). Whether the non-German entity may take part in a cross-border merger with a German corporate entity is also a matter of the laws of the country in which the non-German entity is headquartered. In a cross-border merger, both the German and the foreign legal requirements have to be met.
However, the Merger Directive and the German Transformation Amendments do not provide for a legal framework for cross-border splits or changes of legal forms. They do not cover the merger of partnerships, and they do not regulate the tax consequences of a cross-border merger. However, it is anticipated that an older merger tax directive will also be implemented soon.
The SEVIC Decision
The guidelines of the SEVIC decision fill the gaps in the Merger Directive and the German Transformation Amendments. In the SEVIC matter, the European Court of Justice had to decide whether or not a Luxemburg company could be merged into a German company. The SEVIC court ruled that Section 1 of the Transformation Act, which allows only German mergers, was not in line with the right of European persons to freely choose their domicile (freedom of settlement). As the SEVIC court did not differentiate between corporate entities and partnerships, it is widely held that SEVIC also allows for the cross-border merger of business partnerships (provided that the applicable foreign laws do not prohibit such merger).
Civil Partnerships
German law prohibits the merger of German civil partnerships (not involving a business) as well as cross-border mergers involving foreign civil partnerships. For all partnerships German law provides a straightforward work-around: If all but one member of the partnership cease to be a partner, then all the assets and liabilities of the German partnership are automatically transferred by operation of law (Anwachsung) to the remaining partner. This concept also applies if the remaining sole “partner” is a foreign partner; thus in such cases the German partnership will have effectively “merged” with its foreign sole partner, who will then become successor to the German partnership.
Even though the SEVIC court expressly ruled only on the merger of a foreign company into a German company, it is the more current (but disputed) view that the same must apply vice versa (thus allowing the merger of a German company into a foreign company). The SEVIC court did not, however, rule on cross-border splits or changes to the legal form. Whether those transformations are now possible under German law remains unclear and under dispute.
Lawmakers Propose to Amend German Corporate Form—Will Investors Benefit?
By Dr. Martin Kock
The German Federal Ministry of Justice (BMJ) published a preliminary proposal for several far-reaching amendments to the German Limited Liability Company Act (GmbHG) in May 2006. By far the most popular German corporate form, particularly for small and medium sized-businesses, an estimated one million limited liability companies (GmbH) currently exist in Germany. The proposed amendments intend to both enhance the attractiveness of the GmbH as a business vehicle in light of increasing competition with other European corporate forms and to prevent abuses of the GmbH structure.
Although the draft proposal may still be subject to further changes during the parliamentary process, the amendments propose to lighten existing financial requirements, eliminate restrictive capital share preservation rules and improve investor protections in share acquisitions.
The cost of incorporating has always been considered a significant obstacle for those intending to launch small or medium-sized businesses in Germany. German laws currently require a GmbH to have a statutory minimum capital of €25,000 (of which at least half actually has to be paid up upon incorporation). Several recent European Court of Justice rulings have stated that businesses operating solely within Germany may also be incorporated under the laws of other Member States (with less restrictive incorporation requirements), which establishes what is often referred to as a “competition” of corporate forms. Considering the significant financial burden, businesses have no incentive to incorporate in Germany if they can do so elsewhere for a lower fee and still operate within German territory. To encourage businesses to incorporate in Germany, the amendments propose a reduction of the statutory minimum capital amount from €25,000 to €10,000 (of which €5,000 must be paid up upon incorporation).
Currently every acquirer of shares in German limited liability companies faces uncertainty to some extent. Because German laws currently do not provide for a bona fide acquisition of shares
in a GmbH from someone who is not the true holder of such shares, investors cannot be sure their share acquisitions are valid. In every transaction where the intended target company is incorporated as a GmbH, the acquirer’s advisors have to try to retrace an uninterrupted chain of share transfers from the incorporation of the company until the present in order to assess whether the potential seller actually owns the shares in question. However, advisors can only examine the documents they are given, which may not include every sale and transfer of shares.
Despite not providing for the aforesaid bona fide acquisition of shares, German law nevertheless obliges the managing directors of a GmbH to submit updated shareholder lists to the commercial register, a public register maintained by the local courts (Amtsgerichte), after every change in a GmbH’s shareholder structure. If Parliament passes the amendments, however, potential acquirers of shares will be able to rely on a shareholder list that displays incorrect shareholdings, provided the respective false entry has remained unchallenged for a period of three years. While the proposed amendment does not provide for an unrestricted possibility of a bona fide acquisition of GmbH shares, it will significantly ease the process if incorporation occurred many years before the intended acquisition. Under the amended law, a potential acquirer would only have to retrace the uninterrupted chain of share transfers for a period of three years prior to the intended transaction.
It is important to note the shareholder lists do not state whether shares are pledged or otherwise encumbered. Therefore, investors should still cover their risk and secure the seller’s guarantee.
Other proposed amendments concern the deregulation of capital preservation rules. Under German law, assets required to maintain the nominal capital of a GmbH must not be repaid to the shareholders. According to the Federal Supreme Court (BGH), upstream loans (those granted by the GmbH to its shareholders) might be considered impermissible repayment. As a result, not only the shareholder who receives the funds but also the managing director of the company is liable for the repayment of the loan. The draft proposal includes an exemption to this rule and deems transactions between the GmbH and a shareholder permissible if they are in the interest of the company.
The amendments will also affect loans granted by the shareholders to the GmbH (shareholder loans)—currently, the rules are highly complicated. According to the German rules on so-called “equity replacing loans” (eigenkapitalersetzende Gesellschafterdarlehen), shareholder loans are considered equity (rather than debt) if granted or not immediately terminated when a GmbH experiences a financial crisis. In case of an insolvency, the loan is qualified as subordinated debt (nachrangige Verbindlichkeiten). These complicated laws are to a large extent founded in the sophisticated case-law of German courts. The draft proposal intends to delete the respective provisions in the GmbHG and to introduce new rules in the German Insolvency Code (InsO). Shareholder loans will then always be considered subordinated debt in case of insolvency, regardless of when they were granted.
Will the amendments truly result in a boost to the popularity of the GmbH in the “competition” of corporate forms? If and when—and in what form—the proposed changes will finally be adopted remains to be seen.
A New Era in German Labor Law
By Dr. Paul Melot de Beauregard
After several years of discussions and despite numerous obstacles from all sides, the new German Equal Treatment Act (Allgemeines Gleichbehandlungsgesetz, AGG) went into effect on August 18, 2006. Through this act, Germany fulfilled its duty vis-à-vis the European Union and implemented European anti-discrimination legislation into German law. With this a new era begins in German labor law as anti-discrimination was almost an unknown topic to it in the past.
Background
A couple of years ago four EU directives, which prohibit discrimination due to race, ethnic origin, religion and ideology, disability, age, gender and sexual identity, went into effect. EU Member States were required to incorporate the directives into their national legislation, and the transition period for some of these directives has already expired. The previous German government tried to convert the requirements of the mentioned directives into German law through a measure entitled “Anti-Discrimination Act.” Due to a heavy protest—from associations, churches, etc.—the conversion was never completed. The current government made a new attempt and, in connection with the agreement concerning the federalism reform, overcame the resistance of the states. The Equal Treatment Act went into effect on August 18, 2006.
Alterations for the Employers
Section 12 of the Equal Treatment Act will be particularly significant for employers in the future. Employers are now obliged to take appropriate action to protect their employees from discrimination based on the mentioned criteria. This protection includes preventive measures.
Employers must—particularly in line with occupational and further education—point out the inadmissibility of such discriminations and undertake every action possible to avoid them. If an employer trains employees in an adequate manner to prevent discrimination, then such duties are met. In the case of future discrimination claims, employers should assume judges will ask if and to what extent they have provided anti-discrimination training.
In the event that employees violate the prohibition to discriminate employers must take appropriate, necessary and adequate measures to prevent further discrimination in each particular case (e.g., warning, transition, relocation or termination). Further, they may be obliged to compensate an employee who claims discrimination in terms of both financial and non-pecuniary damages. However, this does not apply if the neglect of duty was not caused by the employer, which will be determined by reviewing the extent to which an employer met its duty to educate employees in advance of the discriminatory act.
Consequences for Companies
Throughout the legislative process, several different parties expressed their doubts, ranging from expected burdens to companies to higher costs for more bureaucracy. It remains to be seen how the new act will actually prove in practice, but it is clear that employers now have a duty to explain the new legislation to and to train their employees.
New Federal Supreme Court Ruling on Acting in Concert
By Dr. Patrick Nordhues
“Acting in concert,” a situation in which in which investors work together to attain the same investment goal, is one of the most controversial issues in German takeover law. According to the the Securities Acquisition and Takeover Act (Wertpapiererwerbs-und Übernahmegesetz, WpÜG), the majority owner of a stock-listed company must make a mandatory tender offer to the shareholders of a stock-listed target company when gaining control of the company. In general, control is obtained as soon as an individual shareholder holds 30 percent or more of the voting rights. Section 30 paragraph 2 WpÜG, the German regulation on acting in concert, stipulates that the above rules also apply when a group of shareholders coordinate their voting conduct to gain comparable influence without any single shareholder actually holding 30 percent of the voting rights.
Section 30 Paragraph 2
The activities that constitute acting in concert are not particularly clear. Agreements on the exercise of voting rights in individual cases are exempt from the law, but explicit agreements between shareholders and any other coordination of voting conduct are not. Therefore, the question regarding the scope of Section 30 para. 2 WpÜG is of central interest.
What defines “acting in concert”?
While the stated primary aim of Section 30 para. 2 is to protect minority shareholders, recent Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) decisions suggest protection of “30 percent” group shareholders’ rights as well. “Acting in concert” has recently been discussed in connection with Deutsche Börse AG. In this case investment funds coordinated their interests to cause a personnel change in the management structure. The subsequent BaFin investigation concluded that because the evidence did not show the involved investment funds influenced the management of Deutsche Börse AG, they did not act in concert.
In the case of WMF Württembergische Metallwarenfabrik AG, the discussion of Section 30 para. 2 WpÜG focused on the question of when agreements concerning supervisory board elections constitutes acting in concert. The September 18, 2006, decision of the Federal Supreme Court (Bundesgerichtshof, BGH) ruled on a situation in which three investors held a total of 51 percent of the voting rights in WMF and were parties to a stand-alone agreement regarding the disposal of their shares. These shareholders coordinated their interests regarding the supervisory board’s election of its chairman. The plaintiff, also a shareholder of the target company, argued that these investors acted in concert to gain control over the company and requested the publishing of a mandatory takeover offer and interest payments on the compensation in the offer.
On April 27, 2005, the Higher Regional Court (Oberlandesgericht, OLG) in Munich had decided the coordinated voting conduct in the board election resulted in a relevant acting in concert and ruled in favor of the plaintiff. The BGH, however, repealed the OLG’s ruling and decided that the three shareholders were not obliged to launch a mandatory tender offer. It then held that acting in concert is limited to a coordination of voting rights in the shareholders’ meeting, and elections conducted in the supervisory board are not subject to Section 30 para. 2. The judges argued that supervisory board members are obliged to the serve the interests of the company and are neither “representatives” of the shareholders nor subject to any instructions by them.
In addition, the BGH argued that the shareholders only exercised their voting rights in an “individual” case, which is exempt from the provisions regarding acting in concert. A case is “individual” when—according to the BGH—the coordination of voting rights only refers to one unique case and does not include an additional agreement regarding a future business concept of the company. This “business concept” must include extensive and precisely phrased business intentions, intentions to which the relevant shareholders in this case obviously did not agree.
Definition Remains Unclear
The decision of the BGH restricts the scope of Section 30 para. 2 WpÜG in favor of legal certainty, but the decision is questionable as minority shareholder protection is supposedly the pre-eminent aim of this provision. In cases of de facto control of a company when a single shareholder or several shareholders pool their interests, the minority shareholders should be given the opportunity of opting out. However, the 30 percent shareholders (whether a single investor or a group of investors) are in a position in which they can exercise continuous control over the company. Such control cannot be established through an isolated coordination of voting rights or through proceedings in the supervisory board, a body independent of the stock corporation.
The BGH’s decisions seems to suggest the “individual” case exclusion trumps the minority shareholder opt-out. However, shareholders in German stock-listed companies should still be aware of the potential risks of coordinating voting rights with other shareholders and acting in concert.
McDermott News from Germany
McDermott proudly welcomes Dr. Stephan Rau as partner and Dr. Andrea Helfrich as associate to its Munich office.
Stephen’s practice focuses particularly on health care, in which he advises investors on company law and licensing issues. His clients also include shareholders, and in spring 2006 he handled the entry onto the German market of the largest public Canadian cheese manufacturer. In spring 2004 Stephen advised on the foundation of the first German private medical center. Since then he has represented numerous laboratories, laboratory equipment manufacturers, radiology groups, hospitals and other investors in corporate restructures and licensing matters.
Andrea focuses her practice on German and international commercial and corporate law, and cross-border transactions in the health care sector. She earned an LL.M. in French, European and international corporate law at the Paris-Assas University, and wrote her Ph.D. in Munich und Paris on a legal comparison subject as part of a European scholarship program.
Our German offices frequently host receptions, seminars and other events for clients and colleagues. On November 16, 2006, lawyers from our European corporate practice gathered in our Munich office to discuss how AIM, the junior market in London, can best serve mid-cap companies. Our team provided an overview of AIM and the initial public offering (IPO) process and detailed special considerations for German issuers. They also advised attendees on best practices for accessing U.S. investors.
Please visit www.mwe.com/info/events for a current listing of Firm events.
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