Tax Aspects of Selling a Company: Mind the Indirect Partial Liquidation.
Capital gains from the sale of privately held shares are generally tax-exempt. However, if the sale is made into business assets, part of the gain may be recharacterized as taxable dividend income under certain conditions.
1. Background
The indirect partial liquidation prevents taxable dividends from being circumvented by selling a participation with non-business required assets. If such assets are distributed by the acquirer after the sale, this is, from an economic perspective, a deferred dividend. This would have been taxable prior to the sale, but is now included in the purchase price as an apparently tax-exempt capital gain. The statutory rule corrects this by recharacterizing part of the capital gain as taxable dividend income.
2. Conditions
An indirect partial liquidation is triggered if the following conditions are met cumulatively:
- Sale from the private assets of an individual
- Transfer to the business assets of an individual or corporate entity
- A qualifying participation (at least 20%) is concerned
- A distribution of substance occurs within five years of the sale
- The assets already existed at the time of the sale, were distributable under commercial law and not required for business purposes
- The seller knew or should have known about the planned distribution (cooperation; usually presumed)
3. Distribution of Substance
Harmful are not only formal dividends, but also hidden profit distributions or other benefits in favour of the acquirer or related parties. This may include:
- Dividends in kind
- Loans that are not at arm’s length and lead to a reduction in net assets
- Guarantees for third-party loans
- Reorganizations such as the absorption of the target company by the acquirer
4. Tax Consequences and Contractual Protection
If an indirect partial liquidation is triggered, part of the sale proceeds is recharacterized as dividend income (subject to partial taxation). The taxable amount is allocated to the year of the sale (realization). The relevant basis is the lowest of the following amounts:
- Purchase price
- Amount of distribution
- Distributable reserves under commercial law
- Non-business required assets
To avoid tax consequences in connection with an indirect partial liquidation, a corresponding clause is usually included in the share purchase agreement. This typically provides that the acquirer shall not make harmful distributions of substance or reorganizations during the five-year blocking period, or – in the case of a breach – indemnify the seller for any resulting tax disadvantages.
It is worth mentioning in this context that dividend distributions to the extent of ordinary net profit (in the transaction year and subsequent years) should generally not qualify as harmful distributions.
5. Tax Ruling
It is advisable to clarify in advance the requirements and potential consequences of an indirect partial liquidation by means of a tax ruling with the tax authority competent for the seller. Any planned actions by the acquirer should also be reviewed and confirmed in a ruling to ensure that they do not trigger an indirect partial liquidation.
This note provides a general overview of the indirect partial liquidation and does not constitute individual tax or legal advice. Every share deal can entail different tax implications, which is why a case-by-case assessment is essential.
If you have any questions or would like to discuss your individual situation, I would be pleased to hear from you.