The Federal Ministry of Finance clarifies questions regarding the income tax treatment of profit-sharing capital
In a new letter from the Federal Ministry of Finance (BMF) dated April 11, 2023, the highest state tax authorities issued a statement on the income tax treatment of profit-sharing capital. The tax treatment of profit-sharing capital had not been clearly defined until now; in particular, its presentation on tax balance sheets has changed several times in recent years. At the same time, these profit participation rights—as so-called mezzanine capital or a hybrid form of financing—are enjoying increasing popularity, not only in the venture capital segment, due to the flexibility they offer.
Definition of the Term
The Federal Ministry of Finance (BMF) first provided a definition of the term, as there is no legal definition of “profit participation capital.” According to this definition, profit participation rights are purely contractual property rights of a creditor who provides funds to a corporation; in particular, the creditor has a claim to repayment of the capital provided. However, profit participation rights do not confer any rights to influence management, nor do they confer control, voting, or attendance rights at shareholders’ meetings. A characteristic feature of a profit participation right is the potential to share in losses; in addition, rights to information regarding the company are typically granted.
Naturally, the contractual flexibility in structuring profit participation rights gives rise to questions regarding their distinction from other forms of mezzanine or hybrid financing. Profit participation rights must therefore be distinguished from a silent partnership, which differs from a mere capital contribution in that the investor and the owner of the commercial enterprise pursue a common purpose, thereby establishing a joint (internal) partnership. Distinguishing profit participation rights from profit-sharing loans is more difficult and is often based on either the feature of loss participation or the participation in liquidation proceeds associated with profit participation rights; both of these features are generally absent from profit-sharing loans.
Accounting Classification: Equity or Liabilities
In principle, profit participation capital—when provided by an outside third party—must be classified as debt on the tax balance sheet, since it is not intended to be a permanent addition to the corporation’s assets and repayment is intended.
According to the auditors, profit participation capital must be reported as equity in the commercial balance sheet if all of the following criteria are met:
- Subordination of the capital contribution relative to other creditors
- Performance-Based Compensation
- Sharing in losses up to the full amount of the capital contributed
- Long-term nature of the capital provision
However, this generally does not affect its treatment as debt (liability) for tax purposes. Profit-sharing capital that is linked to conversion or option rights must be treated as debt for tax purposes until such rights are exercised.
However, a liability may be recognized for tax purposes only if an economic burden exists as of the balance sheet date. If this condition is not met, the liability must be reversed with an effect on income. This is particularly the case when the profit-sharing liability is to be settled solely from future profits or from a potential liquidation surplus (deferral of recognition pursuant to Section 5(2a) of the German Income Tax Act (EStG)). Such a situation may arise during a company’s financial crisis, particularly when subordination agreements or other contractual arrangements with better-fortune clauses are in place.
If the loan liability is reinstated at a later date, the liability is re-recorded in the tax balance sheet with an expense entry. An exception to this rule applies only if the income had to be neutralized off-balance-sheet due to circumstances arising from the corporate relationship.
Income Tax Treatment of Payments on Profit Participation Capital
Because it is classified as debt capital, any remuneration paid on the profit participation capital must be treated as a business expense of the company (interest-like expenses). In contrast, distributions related to the profit participation right—and thus profit shares (regardless of the performance-based metric used, such as EBITDA, EBIT, etc.)—may not reduce the company’s income.
Debt-Mezzanine Swap
To the extent that an existing loan is converted into a profit participation right (a so-called debt-mezzanine swap), this constitutes, for accounting purposes, an exchange of liabilities that does not affect income. This does not apply if the profit participation capital qualifies as equity due to the absence of a seriously agreed-upon repayment obligation; in this case, neither the original loan liability nor the profit participation liability may be recognized on the balance sheet—rather, the former must be written off through profit or loss. In this case as well, any motivation arising from the corporate relationship must be examined, as this could lead to a corresponding hidden contribution equal to the recoverable portion of the affected receivables.
Conclusion
Fortunately, the Federal Ministry of Finance (BMF) is shedding light on the matter, particularly with regard to accounting issues for consultants and companies. However, important questions remain unanswered:
- How should payments from profit participation rights be treated for the holder of such rights?
- How is the capital gain from the sale of a profit-sharing right taxed?
- What impact does reclassifying equity as debt—or vice versa—have on the tax contribution account?
With regard to these issues, tax advisors will continue to have to issue recommendations based on general principles. The Federal Ministry of Finance (BMF) has missed the opportunity to establish comprehensive tax legal certainty regarding the granting of profit-participation capital, even though it had the chance to clarify these issues in this letter as well.
