Arsene Taxand - M&A Private Equity

A plea to render unto Caesar...

Partial contribution of assets subject to standard tax treatment: why is the loss related to non tax-deductible provisions deductible for the contributor?

In the scope of partial contributions of assets subject to standard tax treatment, i.e., not subject to the preferential tax treatment provided for under Articles 210 A and 210 B of the French Tax Code, the beneficiary may in certain cases transfer certain accounting entries carried in the contributor's books into its own accounts. In particular, it may recognize provisions for contingencies or impairment that were carried in the contributor’s balance sheet at the date of the contribution.

As the contributor receives payment in shares corresponding to the net book value of the assets contributed, these provisions do not give rise to an accounting loss when the contribution takes place, insofar as the accounting loss corresponding to the contingency covered by the provision had in fact already been recognized in the contributor’s books when these provisions were first set aside.

However, if this provision was not deducted for tax purposes because it did not meet the criteria for deductibility when it was first set aside, the contributor will not have recognized any tax loss either when it set aside the provisions (which were added back for tax purposes), or when the contribution of assets took place (in the absence of any accounting loss on contribution).

However, the beneficiary has incurred a very real loss as it has received an equivalent value in shares from the beneficiary corresponding to the book value of the assets contributed reduced by an amount equal to the provision. According to the French Tax Code, a partial contribution of assets carried out subject to standard tax treatment is treated for tax purposes as a sale or partial cessation of the enterprise and gives rise to all of the related consequences in the contributor’s books. Therefore, according to tax law, contributions not subject to preferential tax treatment are treated as a partial sale of the enterprise. Unlike a sale, the consideration for this contribution is not paid in money but in the shares of the beneficiary; however, as in the case of a sale, this contribution requires the contributor, in principle, to release all provisions it has previously set aside. If the contributor releases its provisions before the contribution takes place and writes off the loss against the assets transferred, it automatically recognizes the corresponding tax loss (I). However, if the provisions are “transferred” to the beneficiary, the contributor does not automatically benefit from this tax deduction. In our opinion, the accounting method used for the contribution should not alter the tax impact of asset contributions subject to standard tax treatment (II).

1. BENCHMARK TAX TREATMENT: RELEASE OF ACCOUNTING PROVISIONS, ALLOCATION OF LOSS AND RECOGNITION OF A LOSS ON CONTRIBUTION

1.1 Release of provision and allocation of loss to the assets transferred
According to current accounting standards, provisions that no longer serve any purpose (including both provisions for contingencies or impairment) should be released in the income statement.

In order to calculate tax income, provisions deducted for tax purposes when they were first set aside become liable for tax once they are released and, conversely, those that were added back in below the line entries (i.e., with no tax impact), are not taxed when the provision no longer serves any purpose.

As a contribution subject to standard tax treatment has the same tax consequences as the cessation of an enterprise, the provisions should be released in the contributor's books and treated symmetrically for tax purposes in terms of the treatment applied when they were originally set aside: taxable release for a tax-deduc tible provision and non-taxable release for a non-tax deductible provision.

Standard tax treatment and provisions for impairment - Provisions for impairment are released in the event of derecognition of the corresponding asset, particularly in the case of a sale or partial contribution of assets based on the book value of items recorded in the contributor’s books.

Under standard tax treatment, the assets included in the contribution must be recognized in the beneficiary’s balance sheet at their contribution value. This value must therefore be calculated, by hypothesis, based on the book value of the items contributed (i.e., net of any provisions). According to the French tax authorities’ own commentaries, under standard tax treatment it is not conceivable to transfer provisions for impairment (nor is this possible in the case of a contribution of assets at book value subject to preferential tax treatment).

Standard tax treatment and loss and contingency provisions - Loss and contingency provisions are released when the company no longer has any obligation. This situation arises in particular when the contingent risks are transferred to another company, e.g., as part of a sale or within the scope of a contribution of assets subject to standard tax treatment.

Upon final completion of the transaction, the provisions no longer serve any purpose as they concern a business which the contributor has hived off. For both these reasons, we consider that the provisions carried on the contributor’s books should be released, not only for tax purposes, but also for accounting purposes. The situation is akin to the sale of ongoing business assets for which the consideration is paid in shares. Therefore, by definition, releasing this provision allocates the corresponding loss to the assets transferred if the assets are contributed net of this provision.

1.2 Release of a provision gives rise to a loss on contribution in the contributor’s books
Release of provisions for impairment and loss and contingency provisions generates accounting income. If the provision was not deducted for tax purposes when it was originally set aside, this accounting income is deducted in order to calculate tax income (in the case of non-tax-deductible provisions).

Moreover, the contribution of assets for an amount net of any provisions for impairment and contingencies set aside gives rise to a loss equal to the amount of the provision released (where the provisions were equal to the amount of the reduction applied to the net value of the assets transferred).

This automatically gives rise to the recognition, at the time of the contribution, of a tax loss equal to the accounting loss recognized when the provisions were set aside. This tax loss is clearly justified in view of the change in the nature of the loss from possible (provision) to definitive (release of the provision and recognition of the loss within the scope of the contribution). A subsequent sale of the shares received under the contribution agreement (which frequently occurs in the case of contributions subject to standard tax treatment) moreover attests to the irreversible nature of this loss.

2. THE ACCOUNTING TREATMENT OF A PARTIAL CONTRIBUTION OF ASSETS CANNOT LEAD TO A CHANGE IN THE APPLICABLE TAX TREATMENT
It is clear that in reality these provisions are not always released in the accounts and that the beneficiary frequently transfers both the gross value of the assets contributed and the corresponding “transferred” provisions onto its books. The entire contribution is therefore accounted for directly in the balance sheet.

In any event, in our opinion, the accounting treatment of the contribution cannot modify the tax impact of a partial contribution of assets subject to standard tax treatment. As we have already stated, the contributor incurs a real, definitive loss within the scope of the contribution. It is therefore entitled to recognize this loss from a tax standpoint. We consider this view to be grounded both in principle and in equity (2-1), and a practical solution needs to be found either in the form of a below-the-line deduction or on the basis of the theory of accounting error (2-2).

2.1 In the case of contributions subject to standard tax treatment, the contributor should be able to deduct the loss on contribution for tax purposes

We should point out that the impossibility of deducting the loss set aside in the event of transmission of the provision via a partial contribution of assets does not have any financial impact when the contribution is subject to preferential tax treatment. Although the acquisition cost theory prevents a merging or beneficiary company from deducting a charge relating to the management of the merged or contributor company which arose or was foreseeable prior to the effective date of the merger or contribution, this charge may still be deducted from the income of the beneficiary insofar as a provision of tax law prohibited its deduction in the form of a provision in the contributor’s books. The provision set aside by the contributor and taken to the beneficiary’s balance sheet within the scope of a contribution subject to the preferential tax treatment for mergers is not then taxed in the beneficiary’s books when it is released.

Therefore, by way of an exception, in the event that the beneficiary takes such provisions to its balance sheet (in principle, this would be the case for a contribution made at net book value), the preferential tax treatment allows for the deduction of a loss in the beneficiary’s books by means of “symmetrical” accounting treatment by the beneficiary of the provisions set aside by the contributor.

Standard tax treatment does not offer such flexibility as the tax authorities only allow for symmetrical tax treatment of provisions when the operation was subject to preferential tax treatment. In the case of a partial contribution of assets subject to standard tax treatment, the beneficiary may not deduct the loss set aside as a provision because this loss is offset by the taxable nature of the release of the provision. We consider this solution to be appropriate and consistent as, if the beneficiary is not allowed to deduct the loss for tax purposes, it is simply because this loss was not incurred by the beneficiary and therefore does not belong to it. When the contribution took place, the beneficiary took on the assets and liabilities at a reduced value that already reflected the amount of this loss. Moreover, if the provision not deducted in the contributor’s books and “contributed” subject to standard tax treatment no longer served any purpose, it would have been released and taxed in the beneficiary’s books. This taxable income would simply recognize the gain made by the beneficiary.

In actual fact, in the absence of any below-the-line correction for tax purposes, the contribution subject to standard tax treatment of provisions not deducted when they were set aside would give rise to the impossibility of deducting a charge which is by nature tax-deductible and which the contributor has every reason to deduct. Moreover, it is the contributor that incurs the loss when the contribution takes place and not the beneficiary, which acquired the assets and liabilities at a reduced value, net of this loss.

2.2 Searching for a solution: below-the-line deduction for tax purposes or invoking an accounting error
In order to reestablish tax income for the contribution subject to standard tax treatment at an identical level to that obtained in the event of release of the provision, it would simply be necessary to book a below-the-line deduction for tax purposes for the amount of the loss on contribution. The solution is either to book this adjustment on its own or to book this entry along with another one relating to the fiscal requirement to release provisions for tax purposes as the contribution subject to standard tax treatment is deemed to be comparable to discontinuance of business activity (below-the-line release of the provision offset by non-deduction of the provisions in question when they were set aside). In the event of a challenge to these adjusting entries by the tax authorities, we think that it is necessary to return to the source of the problem, i.e., the divergence between the accounting treatment applied (balance sheet entries) and the interpretation under tax law (cessation of an enterprise): in order to reconcile these two interpretations, it would be necessary to assert that failure by the contributor to release a provision in the case of a contribution subject to standard tax treatment is the result of an accounting anomaly, insofar as the beneficiary assumes the risk to which the provision relates.


Therefore:
- If the beneficiary assumes the risk to which the provision relates, the provision set aside in the contributor’s books no longer serves any purpose and its release automatically gives rise to a loss on contribution, insofar as the contributor receives shares for an amount net of the provision.
- If however, the contributor continues to bear the risk, the valuation of the net assets contributed no longer takes account of the risk. In that case, there are two possibilities: either the contributor receives shares for an amount that corresponds to the “risk-inclusive” net book value of the assets transferred (i.e., as if the risk was to be borne by the beneficiary) and in this case it recognizes a tax loss for the corresponding amount, or it receives shares for an amount that corresponds to the net book value of the assets contributed bumped up by the amount of the provision and it recognizes neither a profit nor a loss. Thus, provisions not released in the income statements of contributors may be viewed as simplification of the accounting procedure and they may therefore be analyzed as accounting errors. The simplified accounting procedure used by the contributor was based not on a choice between several options provided for by law, but on an error (a shortcut) made when accounting for the contribution and misinterpretation of both an accounting and fiscal obligation. This analysis was clearly reflected in a decision of the Conseil d’Etat (French Supreme Administrative Court), which deemed that in the event of a company merger subject to standard tax treatment, the provisions set aside by the merged company no longer serve any purpose and must therefore be added back to the profits generated by this company in its last fiscal year. Obviously, in order for the error to be rectified, either by the tax authorities or at the initiative of the taxpayer, it must have been made in good faith. In our opinion, failure to elect for the special tax treatment available under Articles 210 A and 210 B of the French Tax Code in the contribution agreement would be sufficient proof of good faith as this means that the parties used standard tax treatment.

In conclusion, the problems encountered by certain contributors in making use of the fiscal benefits of the economic losses actually incurred when they transferred provisions that had not been deducted for tax purposes when they were originally set aside, appear to us to be contrary both to equity and to the application of tax law. The tax treatment of non-deductible provisions contributed subject to standard tax treatment needs to be clarified by the accounting authorities and the Conseil d’Etat in order to render unto Caesar what is Caesar's.

Olivier Vergniolle