Germany: Conversion Of Shareholder Loans. What Companies Need To Pay Attention To In Terms Of Legal And Tax Aspects When Converting Shareholder Loans Into Equity.

Tax payments and exposure to claims in the event of insolvency are imminent.

A simple loan waiver can be declared quickly. It is also not complicated to transfer a loan receivable to the capital reserve as a voluntary contribution or to reclassify it from the loan account to the equity account of a partner in a partnership. In this way, a shareholder loan is converted into equity in no time. Even if things must be done quickly, the consequences of such a transaction should be carefully examined and optimally structured before implementation,. regardless of whether the company is a corporation or a partnership. This recommendation applies particularly if the company is already in crisis. Despite the "good purpose" of bolstering equity, significant downsides are imminent if the wrong arrangement is made.

What can happen?

• Taxable profit: In case of corporations (German limited liability companies or joint-stock companies, etc.), a loan waiver or a contribution of the loan receivable by the shareholder can result in a profit that is subject to corporate income tax and trade tax. This happens if the shareholder's receivable had previously been impaired due to the threat of payment default. This will regularly be the case for companies in crisis. Taxable profit is the difference between the market value of the receivable and the nominal value of the loan liability (German Federal Tax Court of June 9, 1997, GrS 1/94). The worst case scenario is that there is an outflow of taxes during the crisis affecting the company's liquidity. This happens if the corporation does not have sufficient loss available or the so-called minimum taxation applies.
• Gift tax: If the company has several shareholders, often not all of them have granted loans to the company. If a shareholder waives a loan receivable beyond his ownership interest or contributes a loan receivable without increasing his shareholding, this may constitute a gain for the other shareholders subject to gift tax. The German Federal Tax Court (Bundesfinanzhof, BFH) has already found this to be the case for a disproportionate contribution to a partnership (BFH dated February 5, 2020, II R 9/17). This is not only the case between family members. If the ownership structures are adjusted, gift tax can still be triggered. This is the case if the shareholders do not agree on a valuation of the company in advance and there is an over- or undercompensation. Hidden reserves or losses have often not been taken into account in such cases.
• Challenge under insolvency law: If the company later becomes insolvent despite the equity increase, the prior conversion of a shareholder loan into equity may be considered to be the repayment of the loan if it is incorrectly structured. The insolvency administrator may challenge the repayment of a loan. This is possible if it is made within a year before the company became insolvent. The consequence would be that the shareholder would have to re-advance the loan amount to the company. He can then file his claim in the insolvency table - with an uncertain repayment ratio. Since the amount of the loan has not been repaid to the shareholder in cash when it is converted into equity, re-advancing the loan can pose a fundamental threat to the shareholder's liquidity.
• If the company has not only obtained shareholder loans but also bank loans, the shareholders must often subordinate their loan. Such subordinations often restrict repayment and the right for the shareholder to transfer the loan receivable. The conversion of the shareholder's loan into equity may constitute a violation of the terms of the loan agreement and the subordination. The shareholder could then be exposed to damage claims by the banks. If necessary, the conversion of the shareholder loan must be coordinated with the banks.

When structured carefully, these risks often can be avoided without impairing the objective of the arrangement. In terms of taxation, there are even structuring opportunities, for example when it comes to optimizing the use of losses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.