Loss Forfeiture Under § 8c KStG

Loss forfeiture under § 8c KStG: the short answer

Loss forfeiture under § 8c of the Corporate Income Tax Act (KStG) is one of the most significant tax risks in German M&A. If, within five years, more than 50% of the subscribed capital, membership rights, participation rights or voting rights in a corporation are transferred, directly or indirectly, to one acquirer or persons related to the acquirer, the corporation's unused tax losses are forfeited completely (§ 8c(1) sentence 1 KStG).

The same applies to comparable situations, such as capital increases that change the shareholding ratios. Through a reference in the Trade Tax Act, the rule also applies to trade tax loss carryforwards. Losses can be preserved, however, under the group clause, the hidden reserves clause, the restructuring clause or, on application, under § 8d KStG.

For buyers of loss-making companies, start-ups and turnaround targets, the question is whether losses can be preserved and how much they are worth. For sellers and existing shareholders, the rule affects the timing of financing rounds, internal reorganisations and exits. This article explains the trigger, the exceptions and how to plan transactions.

The trigger: harmful acquisitions of more than 50%

A harmful acquisition (schädlicher Beteiligungserwerb) occurs when more than 50% of the relevant rights in a corporation are transferred within five years to one acquirer, persons related to that acquirer or a group of acquirers with aligned interests (§ 8c(1) sentences 1 and 2 KStG). Several transfers to the same acquirer within five years are added together. Both direct and indirect transfers count, so the sale of a parent company can trigger forfeiture at the level of all German subsidiaries with losses.

The five-year period starts with the first transfer to the relevant acquirer. A capital increase is treated as a transfer of subscribed capital to the extent that it changes the shareholding ratios (§ 8c(1) sentence 3 KStG). The rule refers to the sum of losses not yet offset or deducted up to the date of the harmful acquisition, including current-year losses accrued up to that date. Where the acquisition takes place during the year, the profit or loss of that year must be allocated to the periods before and after the acquisition.

Until 2015, a pro rata forfeiture also applied to transfers of more than 25% and up to 50%. The Federal Constitutional Court held that rule incompatible with the constitutional principle of equality for the period from 2008 to 2015 in its order of 29 March 2017 – 2 BvL 6/11, and the legislature subsequently abolished the pro rata forfeiture. Today, only transfers of more than 50% are harmful. The constitutionality of the full forfeiture rule has also been questioned in the courts, so taxpayers affected by significant forfeitures may consider keeping their assessments open.

The group clause

Internal reorganisations would often trigger forfeiture without an exception. The group clause in § 8c(1) sentence 4 KStG therefore provides that there is no harmful acquisition if the acquirer holds 100% of the transferring entity, if the seller holds 100% of the acquiring entity, or if the same natural or legal person or commercial partnership holds 100% of both the transferring and the acquiring entity, in each case directly or indirectly. The ultimate controlling person may itself be the top of the group, which allows restructurings below a common parent.

The group clause requires 100% shareholdings at each relevant level. Minority shareholders anywhere in the chain, including small management holdings, can prevent its application. Before any internal reorganisation involving loss-making entities, groups should check whether every intermediate holding is wholly owned and whether the parties qualify as natural or legal persons or commercial partnerships within the meaning of the rule.

The hidden reserves clause

Under § 8c(1) sentences 5 to 8 KStG, losses that would be forfeited may still be deducted to the extent that they do not exceed the corporation's total hidden reserves subject to German tax at the time of the harmful acquisition. Hidden reserves are calculated as the difference between the equity shown in the tax balance sheet and the fair market value of the shares attributable to that equity, to the extent the reserves are taxable in Germany. If equity is negative, the reference is the fair market value of the corporation's business assets.

The clause is particularly valuable for profitable companies with historic losses and for start-ups whose share price in a financing round or sale reflects significant goodwill. The purchase price in an arm's length sale of shares is usually strong evidence of fair market value. Documentation of the valuation at the time of the acquisition is essential, because the tax office will examine the calculation in the next tax audit. Hidden reserves attributable to foreign permanent establishments or to assets not taxable in Germany do not count.

The restructuring clause

§ 8c(1a) KStG disregards acquisitions made for the purpose of restructuring the corporation's business. Restructuring means a measure aimed at preventing or eliminating illiquidity or over-indebtedness while preserving the essential business structures. The law specifies how essential structures can be preserved, for example by a works agreement on job retention, by keeping the total annual wage bill over five years at no less than 400% of the initial wage sum, or by injecting new business assets of at least 25% of the gross assets within twelve months. Each route avoids loss forfeiture only if documented carefully. The clause does not apply if the business was discontinued at the time of acquisition or if a change of business sector occurs within five years.

The clause was the subject of long-running EU state aid proceedings, during which its application was suspended. Under the current application rules in § 34(6) KStG, the clause in its present version applies retroactively from the 2008 assessment period. Its requirements are narrow, and acquirers of distressed companies should document the restructuring purpose and the measures taken from the outset. Our page on distressed M&A covers related insolvency and restructuring issues.

The continuation-bound loss carryforward under § 8d KStG

Since 2016, § 8d KStG offers an additional route, designed in particular for start-ups and growth companies. On application in the tax return for the year of the harmful acquisition, § 8c does not apply if the corporation has maintained exclusively the same business since its formation, or at least since the beginning of the third assessment period before that year, and no harmful event has occurred in that period. The remaining losses become a continuation-bound loss carryforward (fortführungsgebundener Verlustvortrag).

The price is a permanent restriction. The loss carryforward is lost if the business is discontinued, put on hold, given a different purpose, extended by an additional business, if the corporation becomes a participant in a partnership or a controlling company in a fiscal unity, or if assets are transferred at below fair market value. The business is defined by qualitative features such as products and services, customers and suppliers, markets served and the qualification of employees. § 8d is not available if the corporation was a controlling company of a fiscal unity or a partner in a partnership at the beginning of the relevant period.

For start-ups financed in several rounds, § 8d can preserve losses where a new lead investor acquires more than 50%. Founders and investors must, however, weigh the restrictions on future pivots, add-on acquisitions and group structures against the value of the losses.

Avoiding loss forfeiture in transaction planning

The risk of loss forfeiture should be considered at every stage of a transaction:

1. Identify all German corporations in the target group with corporate income tax or trade tax losses, including current-year losses.
2. Assess whether the transaction, directly or indirectly, transfers more than 50% to one acquirer or a group with aligned interests within five years, taking earlier transfers into account.
3. Check the group clause for internal steps before and after the transaction.
4. Calculate hidden reserves at the date of the harmful acquisition.
5. Consider § 8d KStG and its consequences for the business plan.
6. Reflect the value of preserved losses in the purchase price, and allocate the risk of forfeiture in the SPA through warranties and indemnities.

Even preserved losses can be used only within the minimum taxation rules. Under § 10d(2) of the Income Tax Act, applied to corporations through the KStG, losses can be deducted in full up to EUR 1 million and above that only up to a percentage of the excess income, currently 70%; for trade tax, the percentage is 60% (§ 10a GewStG). With the corporate income tax rate falling to 10% by 2032, the value of loss carryforwards also decreases; see our article on the corporate tax rate cut. For broader transaction structuring, see our page on corporate and transaction tax.

Illustration: a venture-backed GmbH with EUR 20 million of tax losses raises a Series C round in which a new investor acquires 55% of the shares through a capital increase. Without an exception, all losses would be forfeited. If the post-money valuation implies hidden reserves of EUR 30 million, the losses survive in full under the hidden reserves clause. If the valuation is lower, the company can consider an application under § 8d KStG, accepting restrictions on future changes to its business.

How TRW & Co helps with loss forfeiture

We advise buyers, sellers, investors and portfolio companies on loss forfeiture under § 8c KStG: analysing harmful acquisitions in complex ownership structures, structuring transactions and internal reorganisations within the group clause, preparing hidden reserves documentation, assessing restructuring cases and § 8d applications, and drafting the related SPA provisions. We defend positions in tax audits and before the finance courts. To discuss a transaction, contact us. This article provides general information and is not tax or legal advice.