Issue – A purchase price with a variable component
The case in question involved the sale of a GmbH & Co. KG [German limited partnership with a limited liability company as a general partner]. Besides a fixed purchase price, the contracting parties agreed additional variable compensation based on the gross margin achieved by the company in relation to the net sales in the three subsequent financial years subsequent to the sale.
Following an external tax audit at the company of the respective years, the local tax office (Finanzamt, FA) held the view that this was a customary variable purchase price component that constituted compensation for the economic risk arising from the future development of the business that took the development of the company’s sales into consideration (i.e., in principle, a fixed purchase price less a risk premium). Consequently, the FA increased the capital gain attributable to the vendor by the earn-out amounts that had been subsequently paid. As a result, instead of the capital loss that had been claimed by the vendor, a substantial capital gain was (retroactively) allocated to him.
The vendor filed an appeal against this while making reference to the particular feature in the agreed provision on the subsequent purchase price payment that comprised solely profit and sales components. Unlike the classic earn-out provisions, where the payment of a variable component depends on achieving specific future parameters, the case in question involved a share of the company’s future profits or sales and, therefore, purchase price claims subject to a condition precedent that would only legally be ‘realised’ on materialisation of the condition precedent and, thus, would not cause a retroactive adjustment to the purchase price.
Tax court ruling on sales-related or profit-related purchase price agreements
In its ruling of 30.3.2021 (case reference: 5 K 2442/17, EFG 2021 p. 1199), the Rhineland-Palatinate tax court accepted the taxpayer’s arguments and found that, in the purchase price provision at issue, there was a profit-related or sales-related purchase price payment that, in contrast to the general principles, had to be determined not on the date of the sale (as at the closing date) but, instead, only when realised on the date of the accrual.
The tax court thus followed the previous line of the Federal Fiscal Court (Bundesfinanzhof, BFH) that – in both the area of the sale of businesses pursuant to Sections 16 and 17 of the German Income Tax Act (business disposals) as well as the sale of equity participations pursuant to Section 8b of the German Corporation Tax Act (cf. most recently BFH of 19.12.2018, case reference: I R 71/16) – held the view that sales-related or profit-related purchase price agreements, in contrast to the general principle of a closing date-based approach, are only realised on the date of the respective accrual and, moreover, may only then be subject to tax.
The tax court permitted an appeal due its fundamental importance in view of the fact that the supreme court has not yet conclusively clarified the legal position with respect to specific earn-out clauses. The appeal of the fiscal administration is currently pending before the BFH under case reference: IV R 9/16.
Putting the ruling into context
The tax court’s ruling once again shows how difficult it can be to actually achieve an economic intention and how important it is to precisely formulate the provisions in each individual case. Even if earn-out payments constitute a common pricing structure in M&A practice, nevertheless, it can be of crucial importance for the tax consequences whether these involve
- subsequent purchase price payments with a retroactive effect on the sales price or capital gain, or
- claims for payment of the purchase price subject to a condition precedent that, in each case, are only realised on the due date of an accrual.
In some cases, there can be considerable effects, for example, in the case that went before the court here – if the BFH confirms the tax court’s ruling – none of the extraordinary income that is subject to reduced taxation would have been available on the date of the sale but, instead, regular income that would have had to have been taxed at the normal rate but in the respective assessment period. As the arguments by the fiscal administration in the case in question emphatically demonstrate, by linking the payments to the future sales development or to profits for both variants it is possible to achieve the following.
- Firstly, this would be a sales transaction with a fixed price and a purchase price component where solely the amount is variable.
- Secondly, this would be a purchase price and, in addition, compensation for subsequent sales and/ or profits generated from the enterprise that has been sold.
Which of the two variants would be more favourable for the parties involved in terms of tax would, in turn, have to be determined on the basis of the specific circumstances.
Specifically formulated provisions in the compensation agreement are crucial
To assess a case in question it will be crucial to perform an appraisal of the specific wording of the agreement that relates to the variable compensation. The wording of the provision (“In addition to the purchase price...shall receive...an additional purchase price in the form of a variable compensation...’) would, first of all, support the view of the local tax office and not that of the fiscal administration. In the statement setting out its grounds for the decision on the objection, which was reproduced in the ruling, in the light of supreme court case law, the fiscal administration likewise made a distinction between
- classic earn-out provisions on the basis of specific performance indicators (preliminary purchase price with subsequent adjustments = an event with retroactive effect) and
- an agreement for variable purchase price payments in the sense of compensation from future profits and/or sales (= condition precedent).
According to this, in the case in question, it was the interpretation of individual clauses, in particular, that was disputed and less so the tax consequences.
Outlook: In this respect, in the interest of legal certainty, it would be desirable if, in its appeal decision, the BFH would express its opinion on the indicators for one or the other form of compensation provision and not merely consider the disputed clause.