German VCs welcome loss carry-forward reform

A change in the law proposed by the German government would increase companies’ ability to deduct losses made in one financial year from liabilities in the following year – known as loss carry-forward. The rule change would allow for this even in instances where a new shareholder comes on board in a way that would otherwise lead to a forfeiture of the benefit, for example during a funding round.

Under current rules, if a business has a loss carried forward, it is only applicable to taxes in following years so long as the shareholder structure remains materially unchanged. If a new shareholder were to acquire more than 50% of the business, the whole tax benefit would be lost, while a pro rata reduction would take place if the new backer acquired a share of less than 50% but more than 25%.

Through this change in taxation, entrepreneurs might be more inclined to sell shares for a reasonable price, because they do not have to fear that their loss carried forward disappears" - Martin Heinsius, DLA Piper

Hubertus Leonhardt, managing partner at SHS Gesellschaft für Beteiligungs-management, which makes private equity and growth capital investments, supports the reform: “We often remain invested in startups and young companies over a longer time, and it happens regularly that they make losses on their way to bringing a profit-generating product to market. It is always unfortunate for the business and investors when the loss carried forward is lost or reduced once a new investor enters.”

Germany’s federal minister for economic affairs and energy, Sigmar Gabriel, said in a statement the government is delivering on a promise it made in its coalition agreement: “Through the new regulation, companies receive better access to investments, which they need for their growth.”

DLA Piper partner Martin Heinsius agrees this could have a positive effect for investors and companies: “Through this change in taxation, entrepreneurs might be more inclined to sell shares for a reasonable price, because they do not have to fear that their loss carried forward disappears. This could have a positive effect on pricing for VCs.”

To the letter
However, as it stands, the new law’s wording is likely to cause uncertainty among investors: “In practice the regulation will cause trouble due to indeterminate legal terms,” says Heinsius. One constraint would be that three years after acquiring shares in a company that makes losses, the operations of that company must continue unchanged. It will be complicated to prove whether this is the case. The tax advantage might expire, for instance, if a business acquires a stake in another company, creates a fiscal unity with a subsidiary, expands its product offering or moves into new business areas.

There are reasons for the restrictions. In the past, the loss carried forward was handled independently from the shareholder structure, which provided a loophole for tax avoidance. Investors acquired companies with a large loss carried forward, attached those to profitable companies and used them to diminish tax for the profitable business. The government is therefore likely to keep the requirement for continued operations in the final law.

Heinsius recommends moving away from rigid tax loss borders altogether in the future. The BVK, Germany’s private equity and venture capital association, sees the change in tax law as an important first step, but hopes it is merely a start. “Legal tax transparency and an exemption from sales tax on the administrative services provided by fund managers should be tackled as soon as possible,” its managing director Ulrike Hinrichs said in a statement.

Despite uncertainty as to whether further tax reliefs for private equity and venture capital investors are in the pipeline, the new regulatory changes send out a positive sign. This is particularly the case when compared to other draft laws proposed over the last 12 months – such as an initiative proposing the introduction of stricter merger controls in February.

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