New (structuring) opportunities for incongruent profit distributions?

The latest announcement by the German tax authorities about incongruent profit distributions for limited liability companies (“GmbH”, Gesellschaft mit beschränkter Haftung) provides an opportunity to look at this interesting structuring tool. In this article, we will summarise the latest developments for you and provide an overview of the current tax law framework.

1. Why incongruent profit distributions? - The possible motives

Incongruent profit distributions may be of (tax) interest in Germany in the following cases:

• In the event of a reorganisation, for example, the agreement of a different advance profit in the shareholders’ agreement can make it easier for new shareholders providing money to join the company. The preferential distribution of profits can compensate for the risk associated with the investment and make entry attractive.
• In the case of family companies, underage children can participate at an early stage by utilising gift tax allowances without necessarily granting them a share in the company's success in the form of profit distributions.
• Incongruent profit distributions also offer a helpful opportunity in the start-up sector to provide financial incentives for either shareholder-managing directors or investors.

2. Previous administrative opinion: BMF letter dated 17.12.2013

In the opinion of the German tax authorities in the previously applicable letter from the Federal Ministry of Finance (“BMF”, Bundesministerium für Finanzen) dated 17 December 2013 (IV C 2 - S 2750-a/11/10001, BStBl I 2014, 63; hereinafter “BMF letter (old)”), incongruent profit distributions could only be recognised for tax purposes in relation to GmbHs if the deviating profit distribution was effective under civil law. According to the wording of the letter, the BMF only conclusively assumed this in the following two cases:

(i) A deviating profit distribution formula has been agreed in the articles of association in accordance with Sec. 29 para. 3 sent. 2 of the Act on Limited Liability Companies ("GmbH") or was subsequently included in these in accordance with Sec. 53 para. 3 GmbHG with the consent of all participating shareholders or

(ii) the shareholder agreement provide for an opening clause according to which, with the consent of the affected shareholders or unanimously, a profit distribution deviating from the ratio of shares can be resolved.

The fact that the BMF letter (old) expressly provided for the examination of an abuse of structuring within the meaning of Sec. 42 of the Fiscal Code of Germany ("AO") mean that the incongruent profit distribution was subject to general suspicion by the tax authorities in practice. This created a latent obligation for taxpayers to provide detailed evidence of non-tax reasons for a deviating profit distribution key to avoid non-recognition for tax purposes.

The German tax authorities have not yet issued any statements on the tax treatment of ineffective incongruent profit distributions. If the incongruent profit distribution is not to be recognised for tax purposes, a distribution to the shareholders in accordance with their shareholding is to be assumed, i.e. the profit allocation is based on the pro rata distribution key (for purely contractual agreements, see Berlin Tax Court, ruling dated 31.7.2000 - 8 K 8401/97). About the further consequences there is still a lack of clarity in practice.

3. Changes due to the BMF letter dated 04/09/2024

On 4 September 2024, the BMF published a new letter on the tax recognition of incongruent profit distributions (IV C 2 - S 2750-a/11/10001, BStBl. 2014 I p. 63; hereinafter “BMF letter (new)”), which replaces the BMF letter (old) and applies in all cases that are still open. It contains several reforms regarding the tax recognition of incongruent profit distributions for GmbHs.

On the one hand, some adjustments have been made to the previous explanations. The following appear to be important:

• What is new is that the groups of cases mentioned are no longer exhaustive (“in particular”), meaning that the BMF is open to recognising other cases for tax purposes. However, for reasons of legal certainty, it appears advisable to recognise an incongruent profit distribution by way of the expressly mentioned case groups that have been confirmed by the Federal Fiscal Court (“BFH”, Bundesfinanzhof).
• The German tax authorities now recognise that a subsequent change to the profit distribution key in the articles of association no longer requires the consent of all parties involved. It now follows the effectiveness under civil law. This means that a qualified majority (Sec. 53 para. 2 sent. 1 GmbHG) and the consent of all shareholders who are disadvantaged by the amendment are sufficient for the resolution to be notarised. In any case, this should make practical implementation easier in some cases.
• In the BMF letter (new), the German tax authorities also no longer explicitly mention an examination of the abuse of legal structuring. This is likely to be a consequence of case law, which is reluctant to assume an abuse of legal structuring within the meaning of Sec. 42 AO. This is consistent, as almost every hidden profit distribution is incongruent without being subject to the accusation of an abuse of legal structuring. It can therefore be assumed that, from the perspective of the German tax authorities, an abuse of legal structuring can now only be assumed in exceptional cases (“are generally to be recognised under tax law”).
  
  Note: Despite this positive development, it is probably advisable to continue to document existing non-tax, economic motives or any compensation for disadvantages agreed in this context to be certain in any case.

On the other hand, the BMF letter (new) takes up two judgements of the BFH that have been issued in the meantime as additional case groups. Accordingly, incongruent profit distributions that are effective under civil law are now expressly recognised:

1. A resolution that is passed unanimously for only one relevant measure and can no longer be contested by any shareholder (BFH, ruling dated 28.09.2022 - VIII R 20/20) and
2. a shareholder resolution effective under civil law to the effect that the profit share attributable to the majority shareholder is allocated to a shareholder-related revenue reserve, while the profit shares of the minority shareholders are distributed incongruently over time (BFH,ruling dated 28.09.2021 - VIII R 25/19).

The tax recognition of resolutions that break through the articles of association at certain points enables a one-off deviating profit distribution without having to meet the strict formal requirements of an amendment to the articles of association (notarisation, entry in the commercial register), which significantly reduces costs and effort. The recognition of temporally incongruent profit distributions can be used as an instrument to postpone taxation for some shareholders, as the distribution does not have to be made to all shareholders at the same time. This increases the options and flexibility for a GmbH.

4. Open questions regarding incongruent profit distributions

However, there is still a lack of statements on known problems that affect the practice, including

• Recognition of incongruent profit distribution agreements for partnerships
  
  Incongruent profit distributions are frequently utilised, particularly in the venture capital and private equity sector. These can be used to compensate for additional services or intangible contributions (expertise or networks) made by a shareholder. For example, the initiators in the form of the responsible investment manager of a fund organised as a partnership often receive a performance-related remuneration, the so-called carried interest. This remuneration is reflected in the partnership agreement via a capital-disproportionate profit distribution agreement.
  
  Despite a recent BFH ruling (ruling dated 16.04.2024 - VIII R 3/21), which confirms the tax recognition of profit distribution agreements in partnerships that are effective under civil law, there is no corresponding reference in the BMF letter (new). The inclusion of this point would have been desirable to create further legal certainty and to present the recognition of incongruent profit distributions and profit distribution agreements across all legal forms.
  
  
• German gift tax on incongruent profit distributions
  
  German gift tax implications must always be considered in the case of incongruent profit distributions. Unfortunately, the BMF letter (new) failed to take a position on this and create legal certainty. In the case of an incongruent profit distribution, a gift from the company in favour of individual shareholders is generally rejected.
  
  However, in the event of an incongruent profit distribution, a gift between the shareholders may be considered. According to the German tax authorities, a gift regularly exists in particular in cases of a non-performance-related, certain incongruent profit distribution (R E 7.5 para. 7 sent. 10 and 11 of the Inheritance Tax Guidelines). The Rhineland-Palatinate tax court also recognises that an incongruent profit distribution can lead to a double burden of income and gift tax (ruling dated 7.10.2021 - 4 K 1274/20, EFG 2022, 27, marginal no. 55). The BFH has not yet expressly commented on this. Something different should apply to a temporally incongruent profit distribution or if non-tax motives are agreed and documented. 
  
  To minimize gift tax risks and ensure recognition for German income tax purposes, it is advisable to seek expert guidance when conducting an incongruent profit distribution. This will ensure that all relevant tax issues are considered when structuring the distribution.

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The above information is for information purposes only and does not replace legal or tax advice.

Our research assistant Lara Salomon helped to write this article.