Liquidation proceedings in the case of a small corporation

In part one of our series, a specific case study was used to highlight how the liquidation process typically takes place in the case of a small corporation; we are now going to discuss how a liquidation is taxed. The effects that such a liquidation will entail for the shareholders will moreover also be highlighted.  

Tax treatment of the liquidation

Applicability of Section 11 of the German Corporation Tax Act  

Under Section 11 of the Corporation Tax Act (Körperschaftsteuergesetz, KStG), the preconditions for liquidation taxation are the dissolution of the company and its subsequent actual liquidation. One exception to this is the opening of insolvency proceedings because despite the failure to wind up the company Section 11 KStG will apply by analogy. 

If a corporation merely discontinues its operations and sells its assets then, according to Section 11 KStG, there is no liquidation taxation. The same applies if, despite a resolution on dissolution, the corporation continues to engage in commercial activities. 

The guidance on corporation tax similarly applies to trade tax. Likewise, the liability for trade tax does not expire as a result of the dissolution, instead it remains unaffected until the winding-up is completed.

Winding-up period 

As of the starting date of the liquidation, taxation may no longer be based on the calendar year (Section 7(3) sentence 2 KStG), but instead on the winding-up period (Section 11(1) sentence 1 KStG). The date of the dissolution under German commercial law frequently defines the starting date of the taxation period. The end of the taxation period will be either once the liquidation has been legally concluded or, at the earliest, after the blocking year has elapsed. The taxation period should not exceed three years (from the starting date). 

Winding-up profit

Basic determination  

The winding-up profit is determined by deducting total assets from the liabilities. In doing so, not only is the result of releasing hidden reserves taken into account but also the income realised during the winding up. This winding-up profit will then be subject to corporation tax. 

Option to create a short financial year. 

A special feature in terms of tax is the option to create a short financial year that stretches from the close of the preceding financial year up to the date of the resolution on dissolution and, thus, may not be included in the liquidation period. If the corporation decides not to create a short financial year, then the liquidation taxation will commence already at the close of the last normal financial year. The result that is realised until the winding up then has to be included in the calculation of the liquidation profit. Depending on how this tax option is exercised, in the case of K GmbH [German private limited company] the following options would thus be available:

a) K GmbH decides not to create a short financial year: from 1.1.2023 the special liquidation taxation would apply until the termination of the corporation on 3.5.2024. The result realised during this period will thus be declared in one single corporation tax return.

b) K GmbH follows the financial accounting treatment - which would result in a short financial year from 1.1.2023 – 27.2.2023. A ‘normal’ corporation tax return has to be submitted for this period. Consequently, the result for the period from 28.2.2023 - 3.5.2024 would be subject to the special liquidation taxation. A second corporation tax return would be needed for this.

Preparation of liquidation balance sheets

There are also specific rules that apply to the preparation of balance sheets for the liquidation of a corporation with respect to the various cut-off dates. Here, in turn, a distinction likewise has to be made depending on whether or not a short financial year was previously created. 

a) If K GmbH decides not to create a short financial year, then the opening and closing liquidation balance sheets would be prepared for the current financial year. 

b) If K GmbH makes use of its option to create a short financial year then, besides opening and closing liquidation balance sheets, an interim balance sheet would also have to be prepared in order to document the progress of the liquidation. 

The effects at the level of the shareholders

Distribution of assets

According to Section 72 sentence 1 of the Limited Liability Companies Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung, GmbHG), a company’s assets will be distributed among the shareholders in proportion to their shareholdings. Once all the liabilities have been deducted and the assets have been liquidated it would be possible to repay capital or distribute profits to the shareholders. The exact procedure will depend on the provisions in the company agreement and the individual circumstances.

In the context of a capital repayment, the company could decide to pay back a portion or all of the share capital to the shareholders. This would be effected in accordance with the requirements under the GmbhG.

As an alternative to a capital repayment the company could decide to distribute the remaining assets to the shareholders. The distribution is normally effected in proportion to the stake in the share capital. When the assets have been distributed in full to the shareholders the net wealth/worth tax liability expires. While a blocking year (Section 73 GmbHG) has to be observed for the distribution of the assets, nevertheless, advanced distributions would already serve to reduce the assets.

Determining the income 

The dissolution of the corporation will entail a reduction in nominal capital and the crediting of the contribution account for tax purposes. The extent to which the liquidation will result in income at the level of the shareholder will depend on whether the shareholding here is one within the meaning of Section 17 of the Income Tax Act (Einkommenssteuergesetz, EStG) (shareholding > 1% at some point within the period of the last 5 years), or whether the shareholder potentially even holds the shareholding in their business assets. 

If there is no such shareholding and a < 1% share is held as private assets then the only part of the liquidation proceeds that would be subject to tax would be the portion that exceeds the capital contributions. This portion would be subject to withholding tax at a rate of 25%. The repayment out of the contribution account for tax purposes constitutes a non-taxable return of capital.

In the case of a shareholding within the meaning of Section 17 EStG, the liquidation proceeds would be subject to the partial income method, whereby 40% of the income is exempted from tax. The repayment out of the contribution account for tax purposes constitutes income within the meaning of Section 17(4) EStG. In the case of K GmbH, the contribution account for tax purposes amounts to €25,000. If we assume net accumulated losses of €23,000 then the nominal capital repayment will be €2,000. Of the nominal capital repayment 40% would be exempted from tax, whereby taxable income in the amount of €1,200 would arise. Then again, of the acquisition costs for the shareholding in the amount of €25,000, S would moreover only be able to deduct 60% (15.000 €). This would give rise to a loss on disposal in the amount of €13,800 that could be offset against other income.