The "bad bank" concept set out in the so-called Bad Bank Act (Gesetz zur Fortentwicklung der Finanzmarktstabilisierung) (Act) (enacted on 23 July 2009)), allows credit institutions and financial holding companies (transferring entity) to transfer specific "toxic" assets to "bad bank" special purpose vehicle (SPV) subsidiaries. In consideration for the transfer of those assets, the bad banks will issue bonds to the transferring entity which will be backed by those assets and which are eligible for guarantees from the German Financial Market Stabilization Fund (SoFFin) if certain criteria are satisfied.

The transferring entities will be obligated to make annual compensation payments to the bad bank during the term of the SoFFin guarantee. Those payments will be calculated as the difference between the transfer value of the toxic assets and the underlying value determined by SoFFin, divided by the number of years making up the term of the guarantee and may only be made from future distributable profits.

If, after complete realisation of the toxic assets, the returns exceed the sum of the annual compensation payments, that positive balance must be paid to the transferring entity for distribution to its shareholders. This procedure triggers several tax implications.

For the shareholders it is now clarified that the annual compensation payments qualify as a "negative dividend" and are not subject to taxation at the shareholder level.

Withholding tax (Kapitalertragsteuer) is only to be deducted as actual distributions are made to the shareholders. On the other hand, a positive balance paid by the SPV to the transferring entity is treated as a dividend payment to the shareholders. It is neither provided by statute nor explained in the reasoning of the law, whether the SPV or the transferring entity are obliged to deduct withholding tax. Currently the German Federal Ministry of Finance is dealing with this question, and according to initial statements in this regard it may be assumed that the transferring entity will in future be obliged to deduct withholding tax.

The annual compensation payments are tax neutral on the level of the transferring entity. Payments of a positive balance qualify as transit items on the level of the transferring entity and are tax neutral as well.

The SPV must observe that the received compensation payments, as well as the returns after complete realisation, must be shown on a separate account. Whereas the received compensation payments qualify as business income, the returns are treated as business expenses up to the amount of the received compensation payments. Exceeding returns which qualify as positive balances are prospectively subject to taxation on the level of the SPV.

Interest expenses of the SPV in relation to the issued bonds are not subject to the 25% add-back provision of the German Trade Tax Act, which is a relief in comparison to the initial legal situation. However, other tax questions are yet to be resolved. For example, the interest barrier rules may still apply to the SPVs. In addition, due to the chronological divergence between compensation payments (income) and depreciation of the fair market value of the toxic assets, tax inefficiencies may occur and have to be avoided by appropriate structuring.