Optimising equity rollovers in transactions from tax aspects

Especially in times of coronavirus and low interest rates, sellers and buyers have very different price expectations. In addition, private equity investors in particular often have a strong interest in retaining the seller within the company for a transitional period. Against this background, Owner Buyouts (OBOs), in which the previous shareholders roll a portion of their ownership stake over into the new equity capital structure put in place by the acquiring NewCo, are an interesting model for both seller and buyer. The seller has the option to gradually withdraw from the company. In addition, he participates proportionately in future opportunities and risks of the company and a successful resale (exit). The buyer builds confidence among employees and customers and facilitates the transfer to the new shareholders. In business practice, equity rollovers are mainly structured as minority shareholdings (usually less than 25 per cent), as the buyer wants to retain full control over structuring the business of the company and making final decisions.

This becomes particularly attractive to the seller when the model can also be optimised for tax purposes. The following base case will help illustrate the opportunities:

A medium-sized company in the legal form of a GmbH & Co. KG (limited partnership in which a limited liability company, GmbH, acts as the general partner) intends to bring an investor on board as part of an external company succession plan. The company founder wants to gradually transfer the business and therefore intends to remain at the company's disposal for a while.

Option 1: The seller sells 100 per cent of his equity interest to the external investor. This is followed by a rollover of equity so that the seller holds an equity interest in the acquiring company.

Option 2: Sale of the majority of his equity interest in KG (limited partnership); the seller himself retains 20 per cent of his equity interest.

Option 3: Sale of 80 per cent of equity interest to the external investor and contribution of the remaining 20 per cent of equity interest to the NewCo.

Modified example: Not the equity interest in the KG (limited partnership) but in the GmbH (limited liability company) is sold.

Solution for Option 1: The capital gain is taxed at 100 per cent. Assuming that the tax rate is 45 per cent, then with a sales price of 100, only 55 could be invested in the rollover of equity into the NewCo. If the reduced tax rate can be applied because the shareholder is older than 55 and has not yet claimed the tax relief, the tax burden can be reduced to approx. 22 per cent. Ultimately, however, only the net sales price can be invested in the rollover of equity, which is not an attractive option from a tax and thus financial point of view.

Solution for Option 2: In this case, the capital gain is also fully taxable; it is only a capital gain earned from 80 per cent of the equity interest in KG (limited partnership) but nevertheless tax must be paid. The reduced tax rate does not apply since not all of the equity interest is sold, but the reduced tax rate could be claimed for the later sale of the 20 per cent of the equity interest in KG (limited partnership) if the other requirements are met. All in all, however, this is not a tax-optimal outcome.

Solution for Option 3: Only in this case one could speak of a genuine equity rollover. First of all, the seller pays, again, tax on 80 per cent of the capital gain at the full tax rate. The 20 per cent, however, can be contributed to the NewCo at book value in a tax-neutral manner (Article 20 UmwStG (German Transformation Tax Act)). This first step offers a liquidity advantage, since the tax burden on the 20 per cent of the equity interest in KG (limited partnership) does not apply. Even if all requirements were met, the reduced tax rate would probably not apply either if the 20 per cent of the equity interest in KG (limited partnership) were first transferred at book value and then the remaining equity interest was sold.

In the further course, the seller can participate in the so-called leverage effect. This is due to the fact that the NewCo will usually use debt financing. Assuming that 50 per cent of financing is obtained from debt financing, the seller could acquire 40 per cent of the equity interest in the NewCo in exchange for the 20 per cent of his equity interest in KG (limited partnership), and thus have a 40 per cent share in the company's future profits. The contribution can also be further optimised as the contributing seller can receive certain consideration for his contributed equity interest. It may amount to a maximum of EUR 500,000 (absolute upper limit) or a maximum of 25 per cent of the book value, in our case of 20 per cent of the contributed equity interest. If the NewCo has the legal form of a GmbH (limited liability company), the seller could furthermore sell his shareholding after seven years in a tax-privileged manner under the partial income procedure [German: Teileinkünfteverfahren], in which only 60 per cent of the gain would be taxable. If the shares were sold before the expiry of the seven years’ period, the gain taxable at the time of making the contribution would have to be subsequently taxed on a pro rata basis at the full tax rate (decrease of 1/7 for each year that has elapsed).

In the case of a KG (limited partnership), it is apparent that the partial equity sale is particularly advantageous for younger partners (<55 years of age) who are not yet able to take advantage of the reduced tax rate.

Modified example: If the medium-sized company was a GmbH (limited liability company), the above options would be similar, the difference being that the initial sale of the shareholding in GmbH would typically be subject to the partial income procedure, i.e. 60 per cent of the capital gain would be taxable (given that the highest tax rate is 45 per cent, this would result in a tax rate of 27 per cent).

In Option 3, it would also be possible to make a tax-neutral contribution at book value to the NewCo. However, the chronological order of the steps to be taken should be observed. In the first step, the NewCo must acquire 80 per cent of the equity interest, after which the remaining 20 per cent can be contributed to the NewCo (the so-called qualified ‘share for share exchange’ according to Article 21 UmwStG). In this case, the tax neutrality of the ‘share for share exchange’ is also connected with a seven-year freeze period, if the equity interest is contributed to a corporation. If the equity interest is contributed at book value, the hidden reserves will have to be retrospectively taxed when the equity interest in the NewCo is later sold (exit). Here, too, the retroactive taxation will decrease annually by 1/7 to zero.

In order to contribute the equity interest at book value, tax pitfalls must also be avoided. If an equity interest in KG is being contributed, the functionally essential business assets (including those owned by the partners, German: Sonderbetriebsvermögen) must be contributed along. If an equity interest in GmbH is being contributed, one should look out for corporate structures involving the economic and personal integration of legally independent entities (German: Betriebsaufspaltung) as the termination of such structures can lead to compulsory withdrawals. In both cases, this could be, for example, a land plot which the shareholder has left to the company for its use.

In the end, contribution transactions must be handled professionally also post-transaction. On the one hand, the 7-year period must be observed, and, on the other hand, the obligation to provide evidence of the ownership of shares each year pursuant to Article 22 UmwStG must be met.

Conclusion

The practical case presented above shows that equity rollover models offer attractive options for both parties involved in the transaction. The seller continues to be involved with the company, has a higher share in the company's result and can pass company succession to new owners in an organised manner. The buyer acquires continuity and confidence and enjoys a liquidity advantage, as the full purchase price does not have to be paid immediately. In addition, the fact that the motivated company seller remains involved with the company increases the company value, which pays off at exit as a higher purchase price can be achieved. This is a win-win for both parties.