Getting to grips with German bonds

Author: | Published: 10 Oct 2001
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This article looks at certain key legal points that must be addressed in order to achieve a successful issue of exchangeable or convertible bonds by a German corporate issuer. Some points that arise in the German context are common to Germany and other jurisdictions. Other points, particularly in the areas of taxation and corporate authorization, are specific to Germany.

Convertible bonds are one of three types of security in Germany which confer a conversion right into new shares of the issuer. The others are bonds with warrants and naked warrants. In contrast, exchangeable bonds confer an exchange right into the shares of a third-party issuer.

One of the first points which will need to be addressed is whether the bonds should be issued by the German company ("direct issuance") or by a foreign (ie non-German) issuing vehicle (FIV), probably a wholly-owned subsidiary of the German parent company, with the structure including a guarantee (and, in the case of a convertible bond, an undertaking by the parent company to the bondholders to grant conversion rights into new but unissued shares) supporting the FIV bonds from the German parent ("indirect issuance"). The answer to this depends on the specific situation of the relevant corporate. It may be that an indirect issuance is a viable alternative to direct issuance by the German parent company because of German tax considerations.

Direct issuance

If bonds with a maturity greater than one year are directly issued, coupon payments are fully deductible for corporation tax purposes but only half deductible for trade tax purposes. The same is true: (i) if and to the extent that the amount of the coupon falls short of the market interest rate for straight bonds; and (ii) in the case of a bond with a redemption premium (ie the redemption amount exceeds the issue price).

Issuing costs are tax deductible by the German issuer, save that input VAT is not recoverable.

In the case of a convertible bond, the conversion by the investor should not be a taxable event. In the case of an exchangeable bond, the exchange will be a taxable event for investors.

Indirect issuance

There are three major German tax points to be considered when the issuer is an FIV. The first is that, if the bonds are indirectly issued and the issue proceeds are onlent by the FIV to the parent through an intercompany loan, interest payments under this loan are only half deductible for trade tax purposes. As in the case of a convertible bond, German corporate law requires that the issue proceeds are fully paid in at the level of the parent company. The German trade tax situation can only be improved by use of an FIV if the proceeds derived by the FIV from the issuance, and loaned to the parent, are in turn onlent by the parent to another foreign subsidiary (durchlaufender Kredit or channelled loan).

Second, issuing expenses incurred by an FIV are not deductible at the parent level. This can be dealt with by passing on such expenses, by fixing an appropriate interest rate for the intercompany loan.

Third, the FIV issuer will be taxed on the fee paid or deemed to be paid by the FIV for the German parent company guarantee. The German federal fiscal court recently ruled that the tax on the guarantee fee breaches EU law. However, this fiscal court decision may not in practice be applied until the European Court has ruled on the matter.

It is unclear whether an indirect issuance of a convertible bond qualifies as an exchangeable bond (with the shares of the parent company comprising the exchange property) so that the conversion (exchange) will be a taxable event for investors. Typically, however, German convertible bonds are structured in such a way that the claims of the bondholders for the delivery of the new shares upon conversion constitute direct claims against the parent guarantor, not against the FIV. Therefore, the conversion by the investor should, as in the case of a direct issuance, not constitute a taxable event. However, it cannot be entirely ruled out that the German tax authorities qualify an indirectly issued convertible bond as an exchangeable bond, arguing that the instrument is not exchanged into new shares of the issuer of the bond.

Other tax points

Convertible and exchangeable bonds are subject to different withholding tax treatment. The annual German withholding tax rate on interest payments in respect of convertible bonds is 26.375% (including the solidarity surcharge). Withholding tax will be withheld by the issuer, although no such tax is withheld if the investor sells the convertible bond prior to its maturity. The annual German withholding tax rate on interest payments in respect of exchangeable bonds held in Germany amounts to 31.65% (again, including the solidarity surcharge). It will also be levied in the case of a disposal of the exchangeable bond prior to its maturity and the withholding tax will be withheld by the German custodian, if there is one. No withholding tax will be withheld if the exchangeable is held in custody outside Germany, for instance, in Luxembourg. That might change if the EU withholding tax directive comes into effect.

German corporate investors are subject to trade and corporation tax. Corporation tax (including the solidarity surcharge) and trade tax in Germany amount to approximately 40%, if the issuer capitalizes and depreciates an asset. The coupon, if any, will be taxable.

Corporate investors who hold convertible bonds and who are subject to unlimited German tax liability or who conduct business in Germany through a permanent establishment are entitled to a credit or refund in their tax assessment. Non-resident investors may be entitled to a partial refund of withholding tax in whole or in part under double taxation agreements. For example, there is a full refund under each of the Germany-France and Germany-UK double taxation agreements. Holders of exchangeable bonds who are subject to unlimited German tax liability or who conduct business in Germany through a permanent establishment are entitled to the same credit or refund as above. For non-resident investors, the situation is also as stated above.

No stamp or transfer taxes are in levied in Germany.

Corporate Authorization

In the case of exchangeable bonds, no specific authority is required for the management board of the issuer to issue the bonds.

In the case of convertible bonds, section 221 of the German Stock Corporation Act (AktG) states that convertible bonds may only be issued by a German company if a shareholders' resolution is passed at a shareholders' meeting of the company authorizing the company's management board to issue the bonds within five years.

Further, an issuer of convertible bonds is normally required to have sufficient of a particular form of authorized but non-issued share capital, the so-called "conditional" capital (bedingtes Kapital) to satisfy allotments of new shares pursuant to conversion (section 192 AktG). This conditional capital has to be in place at the date of issue of the convertible bonds and is normally created by a shareholders' resolution passed at the shareholders' meeting granting the section 221 AktG authorization. Three factors should be kept in mind in the context of a conditional capital increase:

  • the conditional capital increase must be tied to the section 221 AktG authorization outlined above;
  • the increase must be registered with the commercial register; and
  • the aggregate nominal amount of shares which are the subject of the increase cannot be more than half of the existing nominal share capital at the time of the shareholders' resolution on the conditional capital increase.

In principle, the issuer must make a pre-emption offer to shareholders. However, the pre-emption rights of the shareholders can be excluded by a shareholders' resolution. To avoid the need for prior shareholder approval at the time the convertible bonds are issued, the shareholders' meeting which authorizes the management board to issue the bonds may also authorize it to exclude pre-emption rights. To obtain such authorization, the management board is normally required to submit a detailed written report to the shareholders' meeting, justifying the exclusion of the pre-emption rights. Section 186 AktG requires that:

  • the exclusion serves the issuer's interest;
  • it is appropriate and necessary to achieve the proposed purpose; and
  • it is proportionate, ie the interest of the issuer can be valued higher than the interest of the shareholders in keeping their pre-emption rights.

However, pursuant to section 186(3)(4) AktG, an exclusion of pre-emption rights is deemed justified if the authorization sought is limited as follows:

  • the new shares must be issued for cash (the issue of new shares upon conversion of a convertible bond is generally considered an issue for cash);
  • the total nominal amount of the conditional capital does not exceed 10% of the existing share capital of the issuer at the time of the shareholders' resolution on the exclusion of the pre-emption rights; and
  • the issue price of the shares will be at, or not materially lower than, the present market price of the existing shares at the date of the management board resolution to issue the shares. As no market price for the convertible bonds to be issued exists, in practice an opinion of an independent expert is obtained. The expert determines the theoretical market value of the bonds at the time when the board resolution to issue the bonds is passed.

While there is some controversy in German legal literature as to whether section 186(3)(4) AktG can be applied to convertible bonds, there are German regional and appellate court rulings affirming its application. Because there is no defining German federal court ruling on this question, there is a risk that a dissenting shareholder may file an action to annul the shareholders' resolution which excludes pre-emption rights within a period of one month from the shareholders' meeting. However, if not so challenged the resolution is final, and the management board can then rely on the authority when resolving upon the issue of the convertible bonds and the exclusion of the pre-emption rights. In practice, many issuers take this route.

Each of the section 221 AktG authority and the section 186 AktG authority, as well as the creation of conditional capital, require that a shareholders' resolution is passed by the holders of over 75% of the share capital present at a general meeting of the company, and by a simple majority of all voting shares in the company, unless the company's articles of association provide for a higher capital majority.

Where to list

Frankfurt and Luxembourg have been the stock exchanges of choice for previous public issues of German exchangeable bonds. German convertible bonds are normally traded with an official quotation on the Frankfurt stock exchange, and potentially on further German stock exchanges. The listing regimes for Frankfurt and Luxembourg stock exchanges are very similar, since both are subject to the EC Listing Particulars Directive 80/390/EEC. Both exchanges will require disclosure of two full years' financial statements plus published interim financial statements, of the German company or companies. In the case of a non-German issuer, for example an FIV, both exchanges will permit the offering circular/listing prospectus to be in English. In the case of direct issuance by a German company, however, a German language offering document/listing prospectus is required. In the case of convertible bonds, the offering circular will also double as the listing prospectus for the conditional capital and if a Luxembourg listing of a convertible bond is contemplated, prior clearance should be obtained from the listing department of the Frankfurt stock exchange that it does not require a German language listing prospectus. If a listing on the Frankfurt stock exchange is sought, the Frankfurt stock exchange will review and comment upon the offering circular/listing prospectus in the statutory period of 15 Frankfurt business days, pursuant to section 36 of the German Stock Exchange Act.

In practice, the crucial determinants of which stock exchange is used will also be marketing considerations, investor preference and that of the German company, which may prefer a German listing and indeed may already be listed on a German exchange.

Placement of the bonds

Any offer and sale of bonds in the Federal Republic of Germany may only be made in accordance with the provisions of the Securities Sales Prospectus Act of December 13 1990, as amended (Wertpapier-Verkaufsprospektgesetz) implementing EC Public Offers of Securities Directive 89/298/EEC. In the case of a public offer of the bonds in Germany, generally a formal securities sales prospectus is required to be prepared, filed and published in Germany prior to the commencement of the offer in accordance with applicable rules and regulations (section 1 of the German Securities Sales Prospectus Act).

Such securities sales prospectuses must generally be published in the German language, or, in the case of a foreign issue, for example an FIV, in the English language.

However, in practice a formal securities sales prospectus is in many cases not required in connection with bond issues, as such issues often benefit from one or several exemptions from the prospectus requirement, the most commonly used being the "Euro-securities exemption" and the "professionals exemption".

The Euro-securities exemption applies if the following requirements are met:

  • first, the bonds must be acquired and distributed by a bank syndicate whose members are based in different countries;
  • second, a substantial proportion of the bonds must not be offered in the country where the issuer has its seat. To satisfy the second exemption, at least 50% of the securities must be allocated and underwritten by syndicate members whose registered seat is outside the country in which the issuer has its registered seat. At least two members of the syndicate must have their registered seat in different countries from each other, each bearing its own placement risk; and
  • third, the Euro-securities exemption requires the bonds may only be subscribed or initially acquired through a credit institution or another financial institution.

The exemption for professionals means that a sales prospectus need not be published if securities are only offered to persons who purchase and sell securities as part of their profession or business, either for their own account or for the account of third persons.

No sales prospectus need be published if the bonds are in minimum denominations of at least DM 80,000 ($37,400) or minimum trading lots of at least DM 80,000 per investor.


Linklaters Oppenhoff & Rädler
Mainzer Landstrasse 16
Frankfurt-am-Main
D-60325, Germany
www.linklaters-alliance.com
Tel: +49 69 710 030
Fax: +49 69 710 03333