A tax hurdle that often goes unrecognized when purchasing interests in partnerships is the trade tax levied on capital gains and the party liable for that tax.
When buying and selling shares in a corporation, the tax consequences with respect to capital gains are essentially limited—with a few exceptions—to the seller.
When a stake in a partnership is sold, this triggers (only) income tax or corporate income tax at the seller’s level. In contrast, pursuant to Section 7, sentence 2 of the Trade Tax Act (GewStG), capital gains are included in the target company’s business income, unless they are attributable to a natural person who is a direct partner. Consequently, capital-based buyers and investors from abroad are often surprised by the trade tax that arises upon the purchase of interests in partnerships, because the trade tax is levied at the level of the target company and must therefore be borne economically by the buyer (and, where applicable, by any remaining partners on a pro rata basis).
When drafting the contract, additional compensation mechanisms must therefore be established that provide for an economic allocation by the seller of the trade tax incurred at the target’s level. Here, too, tax pitfalls must be taken into account; in particular, care must be taken to ensure that a compensation obligation does not result in (additional) taxation of the agreed tax refund amount. This is because a trade tax refund to the target is generally considered taxable income, whereas the trade tax payable cannot effectively be recognized as a tax-deductible business expense (off-balance-sheet addition).
Taking the above into account, the following options are typically considered:
- Alternative profit-sharing agreement (based on provisions in the articles of association or a shareholders’ agreement)
- Reimbursement of business tax as a (reducing) purchase price adjustment clause (including, if applicable, an obligation to make payments into a capital account)
It should also be noted that, when calculating the capital gain subject to trade tax, results from the seller’s special and supplementary balance sheets may need to be taken into account. In this context, highly personal tax circumstances influence the calculation of the seller’s final capital gain, which can sometimes be difficult for the buyer to fully assess prior to closing.
Therefore, as part of tax due diligence conducted prior to the purchase of partnership interests, it should be routinely verified whether the sale could lead to a tax risk or even be a deal-breaker in light of any applicable trade tax holding periods resulting from prior conversions (in particular, changes in legal form), and whether such a risk is sufficiently covered by the indemnification and warranty provisions of the SPA.
Provided that the buyer and tax advisor keep an eye on the trade tax risks throughout the acquisition process—ideally by including an appropriate provision in the letter of intent, by conducting tax due diligence (which has been expanded to cover these risks), and by drafting the SPA accordingly—these risks can be comprehensively identified and minimized or eliminated through appropriate contractual arrangements.
An interesting structuring option in connection with or following the acquisition of a partnership is the so-called “accrual model,” which will be discussed in a subsequent article.
