Domination and Profit Transfer Agreements

Domination and profit transfer agreements: what they do

Domination and profit transfer agreements are the classic instruments for forming a contractual group (Vertragskonzern) under German law. In a domination agreement, a company places its management under the direction of another undertaking, which may then give binding instructions. In a profit transfer agreement, a company undertakes to transfer its entire annual profit to another undertaking. The two are usually combined in a single document (Beherrschungs- und Gewinnabführungsvertrag, often abbreviated as BGAV or DPLTA). The statutory framework is in §§ 291 ff. of the Stock Corporation Act (AktG), and the courts apply it largely by analogy to the GmbH.

In practice, the main reason for a profit transfer agreement is tax: it is a precondition of the income tax group (Organschaft) for corporate income tax and trade tax, which allows the profits and losses of group companies to be offset. The main legal consequence is that the parent must compensate any annual loss of the subsidiary.

This briefing explains how the agreements are concluded, their effects, the tax group, loss compensation and the risks on termination.

Concluding the agreement

Registration is constitutive: the agreement takes effect only when it is entered in the commercial register of the subsidiary. For tax purposes, this matters because the tax group applies for the first time for the financial year of the subsidiary in which the agreement becomes effective. Agreements intended to apply from 1 January must therefore be registered before the end of that financial year.

Legal effects: instructions, profit transfer and minority protection

Under a domination agreement, the controlling undertaking may give instructions to the management of the subsidiary, including instructions that are disadvantageous to the subsidiary if they serve the interests of the controlling undertaking or the group (§ 308(1) AktG). The management board must follow lawful instructions. Instructions may not threaten the existence of the subsidiary. In a GmbH, shareholders can instruct managing directors anyway, so a domination agreement adds less legally, but it creates legal certainty for instructions that would otherwise breach the duty of loyalty or capital maintenance rules.

Under a profit transfer agreement, the subsidiary transfers its entire annual profit, limited to the amount permitted by § 301 AktG, which excludes, for example, amounts needed to fill the statutory reserve and amounts blocked from distribution. Payments by the subsidiary to the parent under the agreement are exempt from the capital maintenance rules (§ 291(3) AktG).

Outside shareholders are protected. A profit transfer agreement must provide for an appropriate recurring compensation payment to outside shareholders (§ 304 AktG), and the controlling undertaking must offer to acquire their shares for appropriate cash compensation (§ 305 AktG). The adequacy of both is reviewed in appraisal proceedings. For listed companies, these obligations make domination and profit transfer agreements a frequent step after a takeover, as a way to integrate the target before a squeeze-out; see our briefing on squeeze-outs of minority shareholders.

The income tax group

The income tax group (ertragsteuerliche Organschaft) allows the income of a subsidiary (Organgesellschaft) to be attributed to the parent (Organträger) for corporate income tax and trade tax. The key conditions under § 14 KStG are:

• Financial integration: the parent must hold the majority of voting rights in the subsidiary without interruption from the beginning of the subsidiary's financial year.
• Profit transfer agreement: concluded for at least five years and actually performed during its entire term. Early termination is harmless only for good cause.
• Parent: a person subject to unlimited tax, or a commercially active partnership, with the shareholding attributable to a German permanent establishment.
• GmbH subsidiaries: the agreement must limit profit transfer to the amount in § 301 AktG and must agree loss compensation by a reference to § 302 AktG "as amended from time to time" (§ 17(1) KStG).

The requirement of actual performance is strictly applied. Profit must be transferred and losses compensated on the basis of correctly adopted annual accounts. Errors in the accounts can be cured under conditions set out in § 14(1) no. 3 KStG. A tax group that fails in its first five years is disregarded retroactively, which can lead to significant back taxes and the treatment of profit transfers as hidden distributions. A VAT group (umsatzsteuerliche Organschaft) follows different rules and does not require a profit transfer agreement.

Loss compensation under § 302 AktG

The central liability under domination and profit transfer agreements is the duty of the controlling undertaking to compensate every annual deficit of the subsidiary that arises during the term of the agreement, unless it can be covered by withdrawing amounts from other revenue reserves that were allocated during the term (§ 302(1) AktG). The claim arises at the end of the financial year, regardless of whether the accounts have been adopted, and it is a real cash obligation. The subsidiary can waive or settle it only three years after the termination of the agreement has been published, and only with the approval of outside shareholders and unless the parent is insolvent.

For the parent, this means unlimited exposure to the subsidiary's losses. In a crisis of the subsidiary, the loss compensation claim is often its most valuable asset, and an insolvency administrator of the subsidiary will pursue it vigorously. Parent companies should therefore monitor subsidiaries under such agreements closely and consider termination before a crisis materialises. Termination does not remove the obligation to compensate the deficit of the financial year in which the agreement ends, so timing is important.

Drafting checklist

Most agreements between a German parent and a wholly owned GmbH follow a standard pattern, but small drafting errors have large tax consequences. A robust agreement typically covers:

• Parties and type: a clear designation as a domination and/or profit transfer agreement, with the correct legal names and register numbers.
• Profit transfer: the obligation to transfer the entire profit, limited to the maximum amount in § 301 AktG as amended from time to time, and rules on the formation and release of reserves.
• Loss compensation: a reference to § 302 AktG in its entirety and as amended from time to time.
• Effective date and term: commencement for the financial year in which the agreement is registered, a fixed minimum term of at least five full years, and automatic renewal thereafter.
• Termination: ordinary termination after the minimum term, termination for good cause, and a definition of good causes that is consistent with the tax authorities' practice.
• Due dates and interest: when the transfer and compensation claims fall due, and interest on late payment.
• Information rights: the parent's right to receive information and the subsidiary's obligation to provide it.

Existing agreements should be reviewed regularly, in particular when the law changes, when the parent changes (for example after an intra-group transfer of the subsidiary's shares) and before any transaction involving the subsidiary, such as a sale, merger or change of financial year.

Contractual group or de facto group?

A parent does not need a domination agreement to control a subsidiary. Without one, a de facto group (faktischer Konzern) exists. In a stock corporation, the controlling undertaking may then cause the subsidiary to take disadvantageous measures only if it compensates the disadvantage within the financial year, and the subsidiary's management board must prepare an annual dependency report (§§ 311, 312 AktG). For an AG subsidiary with outside shareholders, a domination agreement can therefore be the cleaner route to full integration, despite the compensation obligations and appraisal proceedings it triggers.

For a wholly owned GmbH, the position is different: the parent can instruct the managing directors as shareholder, and a pure profit transfer agreement is usually enough for the tax group. Many groups nevertheless combine both elements, because domination and profit transfer agreements in a single document provide legal certainty for group-wide instructions, cash pooling and transfers of resources that might otherwise raise capital maintenance questions.

Terminating domination and profit transfer agreements

Agreements can be terminated by mutual agreement, by ordinary notice where the contract allows it, or for good cause without notice (§ 297(1) AktG). A good cause exists in particular if the other party will probably be unable to meet its obligations under the agreement. Many agreements define further good causes, such as the sale of the subsidiary, a merger or a change in the financial integration. For tax purposes, termination for good cause within the five-year minimum term is harmless, but the tax authorities do not accept every contractually defined cause.

Termination has consequences. The controlling undertaking must provide security to creditors of the subsidiary whose claims arose before the termination was published, if they come forward within six months (§ 303(1) AktG). It must compensate the loss of the final, possibly short, financial year.

Termination during the financial year is often avoided by changing the subsidiary's financial year so that the agreement ends at the end of a (short) year. In M&A transactions, the termination of domination and profit transfer agreements is a standard closing step and must be coordinated with the closing date, the creation of a short financial year and the treatment of the final loss or profit in the purchase price. More detail is in our briefing on intragroup reorganisations.

How TRW & Co helps

We draft and review domination and profit transfer agreements for German groups and international parents, organise approvals and registrations, coordinate with tax advisers on the tax group, and advise on termination in reorganisations and M&A transactions. For listed companies, we advise on compensation, appraisal proceedings and the integration of acquired companies. Our corporate and tax lawyers work together on each project. Contact us to review your group agreements.